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April 2008 Archives

April 1, 2008

Lest We Forget, Capitalism Works

To support the new regulatory mindset is to assume that economically-free countries, as opposed to those centrally planned, are frequently burdened with sclerotic growth and commercial failure. One would also have to take a giant intellectual leap backwards in the direction suggesting that government bodies free of the discipline wrought by the marketplace are somehow better suited to solve the problems before us. In truth, it is private interests, those that operate fully accountable to consumers and investors, who regularly adapt to all manner of changes in what is a highly fluid economy.

Apparently forgotten by our Washington minders is that the U.S. and the world shifted to more of a laissez-faire style precisely because heavy regulation proved so wanting when it came to fostering a high level of economic vitality. Indeed, it was the process whereby the U.S. and other countries shed the discredited views dictating economies needed to be managed from the “Commanding Heights” that led to the economic renaissance of the ‘80s and ‘90s.

When we learn that our leaders want to backtrack from what proved so successful, we have to ask if the people to whom we’ve entrusted power are really so obtuse as to believe we were better off in the era before free markets ascended as the Rule. To the extent that our leaders are intoxicated by the “fatal conceit” suggesting the infinite decisions that are the marketplace need regulation, we should eagerly remind them of their faulty thinking.

Perhaps it’s shooting fish in a barrel, but when we consider the economic calamities of the 20th and 21st centuries, all occurred due to too much governmental involvement in the economy, as opposed to too little. The legislative error that was Smoot-Hawley triggered the 1929 stock-market crash, and in its aftermath, all manner of legislative mistakes that turned what would have been a minor downturn into the Great Depression.

The unfortunate malaise of the 1970s was once again not a function of markets not working, but instead the result of President Nixon severing the dollar’s link to gold. The inflation that ensued drove already high levels of taxation even higher, and made investment and countless forms of economic activity less profitable. When we consider the gas lines experienced during the ‘70s, rather than a signal of market failure, they were the result of pricing regulations that reduced incentives for retailers to bring petroleum to the market.

Despite the triumph of free markets in the 1980s and beyond, government still inserted itself at times, and among other things, we have the S&L disaster to show for it. Rather than something that resulted from market failure, the federal government’s efforts to prop up an S&L industry that served no market purpose led to the privatization of profits and socialization of losses that cost American taxpayers billions.

More modernly, the imposition of Sarbanes-Oxley as a reaction to the unfortunate implosions of Enron and Worldcom turned what was mostly a non-event for stocks into a market rout as CEOs were forced to become accountants rather than innovators. And if we ignore the likelihood that FEMA’s very existence is a violation of the Constitution, the former’s ineptitude in the wake of Hurricane Katrina was useful as a “teaching moment” about the effectiveness of government in contrast with the brilliant efficiency exhibited by Wal-Mart in response to the same hurricane.

During his press conference at which he announced the new regulatory structure, Paulson said, “We know that a housing correction has precipitated this turmoil, and housing remains by far the biggest downside risk to our economy.” If we ignore his questionable economic analysis about the role of housing in any economy, we can say that the federal government created the problems we’re experiencing today through the weak dollar it has issued in this decade alongside massive subsidization of the housing market; subsidization that gave Washington the power to lean on lenders in ways that lending standards were made less stringent.

And when we address what is called the “subprime debacle,” can’t we at some point ask if anyone expected anything less than what we’re now experiencing? Subprime loans are thus described precisely because they’re risky. Rather than expressing shock at the rising rate of foreclosures in the housing market, we should say that markets are working very efficiently in that subprime borrowers are to some degree expected to walk mortgages. The irony here is that absent problems in this space, mortgage lenders would likely have been brought before Congress to explain the “exploitation” of borrowers who’d proven able to make payments at usurious rates.

On the financial front, Paulson seeks to expand the turf of the Federal Reserve as “Market Stability Regulator” given its traditional “role of promoting overall economic stability.” The mind races when confronted with the absurd notion that the Fed has had much to do with “overall economic stability,” but needless to say it seems folly to assume that a body wholly incapable of issuing a stable unit of account (and seemingly not desiring to do so either) should somehow be given even more regulatory oversight.

The reality is that markets being markets, they’re supposed to be unstable at times as new industries and innovations push out the old. But if we ignore the latter, we should say that just as the Fed and the rest of federal government have traditionally been late to commercial mistakes invariably discovered by private interests, the notion that a reconfiguration of the doings of career civil servants will somehow make them more effective market watchdogs is too silly for words.

The other shame here is that we’ll never know what might have happened had the Federal Reserve ignored the problems at Bear Stearns. We’re told that the health of the world financial system made the Fed’s actions necessary, but that being the case, it seems fair to assume that absent the presence of our central bank, private interests would have worked out a solution given how much money was at stake. That the financial establishment invited the Fed to participate in the Bear Stearns debacle speaks to a Faustian bargain of impressive proportions when we contemplate the future regulations that will be demanded in return.

Despite the regulatory apparatus that he proposes, Paulson expects “that we will continue to go through periods of market stress every five to ten years,” as though good or calm times for the markets must necessarily lead to occasional meltdowns. Paulson misses the point. Stock markets buffet and economies stop growing not due to economic freedom, but due to governmental activity in the areas of money, regulation, trade, and tax that make productive effort less profitable. That Washington has regressed in this decade in three of the four areas mentioned largely explains why an investment in the S&P 500 Index nine years would presently yield no gains.

What the economy needs right now is for the government to sit back and let the problems before us slide into the proverbial ditch. Only then will the costs of unused capital of the human and technological variety reach market-clearing levels so that the economy can start growing again. Capitalism works, and it was our initial embrace of it that made the last twenty-five years so abundant. Now is not the time to abandon it.

April 3, 2008

Is the GOP Still the Party of Economic Growth?

Upon reaching the Oval Office, the new president’s first economic program meant to reverse an economic slowdown was not marginal tax rate cuts, but $80 billion in tax rebates. Though the latter merely shifted money from one set of hands to another, the president promoted the rebates in a Keynesian light meant to “put more money in peoples’ pockets.”

When it came to trade, this administration quickly slapped a 30 percent tariff on certain kinds of foreign steel, and followed up with tariffs on soft-wood lumber and shrimp. So bad was the administration’s reputation when it came to trade that Brink Lindsey of the libertarian Cato Institute felt compelled to point out that “U.S. credibility on trade, internationally, is hovering near zero.”

Not done erecting economic barriers, the administration chose to harass a country that had recently shed its statist economic policies in favor of a strong embrace of free markets. Though China sought to speed its escape from the crushing drudgery that was communism through a yuan/dollar link, one that facilitated an explosion of trade between two countries formerly at odds, the president regularly sent top Treasury officials over to Beijing in hopes of convincing China to de-link its currency from the dollar. The intent there was to make Chinese goods more expensive (meaning less competitive) in U.S. markets.

In late 2001, and in May of 2002, formerly blue-chip firms Enron and Worldcom respectively imploded before our eyes. Despite the severity of those high-profile collapses, stock markets took the failures in stride. Indeed, the Dow Jones Industrial Average fell a total of 3 percent over the period that both companies went under. Markets adjusted as they always do.

The problem going forward was that the administration felt the need to act in order to rid executive suites of alleged corporate malfeasance. The Department of Justice opened up more than 100 corporate investigations, while filing charges against over 150 people. An indictment of Arthur Anderson alone led to the loss of 80,000 jobs and untold wealth given the firm’s inability to survive the DOJ’s effective death sentence.

Not content there, the president signed Sarbanes-Oxley into law, describing it as “the toughest piece of anti-fraud legislation since FDR.” Among other things, Sarbanes-Oxley foisted strict, time-consuming accounting rules on public firms irrespective of size, and it required public-company CEOs to sign off on the veracity of accounting statements with heavy personal liability if they were later proven incorrect. Talking about the impact of the new rules, Xerox’s Anny Mulcahy noted at the time that there is a “drive for averageness” in corporate suites today. And with the markets sensing the likelihood that CEOs would be forced to act more like accountants than entrepreneurs, the S&P 500 fell 175 points in the three weeks surrounding Sarbanes-Oxley’s passage.

And when we think about Sarbanes-Oxley, we have to consider the power of entrenched political classes to pass laws mostly free of consequence at the ballot box. Canadian economist Reuven Brenner has written about how “unfettered campaign finance allows the decentralization of influence.” The latter is what is required for economies to thrive, so it’s essential that politicians don’t ever become so powerful such that they can retard economic growth with myriad rules and regulations.

This is important considering the president was sent a campaign finance bill (McCain-Feingold) authored by a Republican and Democrat; one meant to restrict the ability of individuals to contribute money in ways that would influence voting, and the making of policy more generally. Though he could have vetoed the unconstitutional restrictions on free speech littered throughout the bill, the president signed it. Thanks to McCain-Feingold, politicians now possess an even greater ability to pass economy-enervating laws without fear of facing a well-financed opponent who might shed light on how those rules impoverish us.

To classical economic thinkers government spending isn’t just unfortunate for the debts incurred on the backs of future generations, but more troublesome for capital being siphoned away from the productive sector into immediate government consumption. When it came to spending, the administration in question was highly profligate.

With the wind at his back after signing farm and prescription-drug bills, the president oversaw what Cato Institute scholar David Boaz describes as “the biggest expansion of entitlements since the LBJ years.” Though the president parroted his predecessor (Bill Clinton) in promising to “cut wasteful spending and be wise with the people’s money,” his desire to show “compassion” meant he never vetoed a spending bill of any kind during his first seven years in office.

Of course, one way for governments to reduce the level of debt wrought by spending is to debase the currency. And when it came to poor dollar management, this president and the monetary authorities he appointed were particularly effective.

Beyond the aforementioned tariffs and jawboning of China that were an implicit admission on the administration’s part that it would prefer a weaker dollar, the president appointed Treasury Secretaries who publicly mocked the value of a strong greenback. His first Treasury chief noted that a “strong dollar” meant little in policy terms. The latter’s successor asked at a G-8 meeting in France, “What’s wrong with a weak dollar?”

Talking up the qualities of his third Treasury secretary, the president said he “will insist on fair treatment for American businesses, workers and farmers,” plus he’ll seek to “maintain flexible, market-based exchange rates” for currencies of trading partners. The comment about “market-based exchange rates” was a clear signal from the president that his new appointee would utilize strong ties within the Chinese government in an effort to convince Chinese officials to end the dollar/yuan peg.

The president also got the chance to select a new chairman of the Federal Reserve, and when given the opportunity, nominated someone of ambiguous political leanings. The nominee was a self-professed expert on the causes of the Great Depression; his alleged insight the incorrect view that our being on the gold standard was the cause. And when asked what would solve Japan’s economic problems back in 2000, the nominee perhaps tipped people off to his broad economic views given his assertion that, “Perhaps it’s time for some Rooseveltian resolve in Japan.” The comment about Japan of course raised further questions about any expertise when it came to understanding our Depression in the 1930s.

When we look at the dollar, since 2001 the president’s chief monetary authorities have overseen its fall to levels previously unseen. Indeed, gold is presently at all time highs, while the dollar has reached new lows against every major currency. Despite the aforementioned signals which scream inflation, the Treasury secretary maintains a stance of “benign neglect” toward the dollar, while the Fed chair remarkably sees inflation moderating in the coming quarters given his view that slow growth is an inflation cure.

As one would expect, the falling dollar led to quite a bit of economic dislocation such that our economy is now thought by 75 percent of Americans to be in recession according to the latest polling data. Seeking to fend off any downturn in what is the president’s last year in office, rebates have once again been offered up to increase “aggregate demand.” This has occurred in concert with Treasury interventions in the mortgage market along with a recent Federal Reserve bailout of a collapsing investment bank.

The Wall Street Journal recently reported that the result of all the economic uncertainty “will be a heavier hand of government in the form of corporate bailouts, fiscal incentives and regulation.” When asked for his thoughts on the increasingly muscular actions of federal officials, the president said, “My comment is that the Treasury Department and the Fed are taking swift action.”

So who is this president? There’s no riddle here in that presumably none of us have been on an island over the last seven years. President George W. Bush, a Republican, has overseen a massive increase in the size and scope of government on his watch, and did so in conjunction with a collapsing dollar that has surely marginalized by now any of the gains enjoyed from the tax cuts he signed into law in 2003.

Still, if any of us had been secluded for the past seven years, a description of the Bush years without attribution would likely have had most any Republican assuming a Democrat had been in control. Is there an explanation for this? The first one would be that all politicians disappoint. By definition. Beyond that, given the statist direction taken by the Republican party in this decade, it’s fair to ask if it any longer represents laissez-faire growth. Many would point to the even harsher anti-growth views held by Hillary Clinton and Barack Obama, but it seems a lot of their stances at present are pure politics.

Even if they’re not, it would be hard to find an administration in modern times that has been more interventionist than the present one. That in mind, stinging losses for the GOP may be just what the doctor ordered. Indeed, maybe the pain of being out of power will force them to look inward, and in doing so, perhaps understand that when a Democrat runs against a Democrat, a Democrat always wins.

Doubling Down in Las Vegas

He is spending upward of $9 billion more to build 13 additional casino hotels in Macao, and about $4 billion on one in Singapore. Next? Perhaps India, Japan, Korea, Thailand. Certainly Bethlehem (Pennsylvania, that is -- really).

Macao's gambling revenue, which surpassed the Strip's in 2006, soared 46.6 percent last year to $10.4 billion. Macao's February revenue was up 67 percent over February 2007. Las Vegas is largely immune to U.S. economic cycles: In January, the Strip's casino gambling revenue fell only 1.3 percent, and a few "whales" could make up that margin over a weekend.

Whales, in the language of Las Vegas, are, Adelson says, those who can win or lose $3 million in one stay. There are only a few thousand whales in the world, but they are multiplying fast in China -- thank you, People's Republic. Adelson says that when 60,000 people a day are gambling at Macao's Venetian, 40 percent of the casino's revenue comes from 59,700 of them, and 60 percent from 300 others, probably including three to eight whales. In the Venetian here, 20 percent of the gamblers provide 80 percent of the revenue. Business cycles do not dent Adelson's confidence that the rich will always be with us: "The upper end is never vulnerable."

Adelson brandishes for a visitor a June 20, 1955, issue of Life magazine, the cover of which asks if Las Vegas is "overextended." The city then had fewer than 3,000 rooms. Today it has 138,000, and 45,000 more are under construction or planned. Although Adelson thinks gambling will remain this city's motor and scoffs at the notion of Las Vegas becoming primarily a "family destination," he does think it will become to Southern California what south Florida has been to the Northeast. What Northern winters did for Florida, California's government (high taxes, low performance) will do for Las Vegas.

Far from threatening Las Vegas, state governments, America's foremost promoters of gambling, have, Adelson says, "enlarged the market." State lotteries (and casinos -- 28 states have them) whet people's appetites for a trip to gambling's mecca.

A long-running show at the Hilton here is "Menopause: The Musical." While the number of Americans over 65 has increased 20 percent since 1990, in Nevada the number has increased more than 100 percent. Poet Philip Larkin once said he would like to go to China if he could be home for dinner. Adelson and other makers of modern Las Vegas have obliged people like Larkin, sort of.

The Venetian has gondolas plying indoor canals that, unlike Venice's, do not smell: "Score one for the Americans -- when they rebuild Europe," Paul Cantor of the University of Virginia writes, "they correct it, they improve it, they get it right." Las Vegas's hotel casinos also include Paris, and New York New York. Las Vegas, says Cantor, "fulfills a deep-seated American dream -- to be able to pack the whole family into the station wagon and drive to Europe."

Frommer's guidebook suggests that there should be a Hoover Dam Hotel and Casino -- why drive 30 miles when you can see a replica on the Strip? This, says Cantor, is democracy -- giving the masses access to the world, albeit radically reduced.

Thanks to Adelson, Macao has its Venetian -- a replica of a replica of a city. So China has passed into postmodernism's erasure of distinctions between high and low culture, and between originals and copies, without yet achieving modernity. Buffett and Gates may still be richer, for now, but Adelson's achievements astonish and multiply.


April 5, 2008

Thoughts on the Continuing Crisis

If the Rules are Inconvenient, Change the Rules

Several times in the past few months I have reminded readers of the problem that developed in 1980 when every major American bank was technically bankrupt. They had made massive loans all over Latin America because the loans were so profitable. And everyone knows that governments pay their loans. Where was the risk? This stuff was rated AAA. Except that the borrowers decided they could not afford to make the payments and defaulted on the loans. Argentina, Brazil and all the rest put the US banking system in jeopardy of grinding to a halt. The amount of the loans exceeded the required capitalization of the US banks.

Not all that different from today, expect the problem is defaulting US homeowners. So what did they do then? The Fed allowed the banks to carry the Latin American loans at face value rather than at market value. Over the course of the next six years, the banks increased their capital ratios by a combination of earnings and selling stock. Then when they were adequately capitalized, one by one they wrote off their Latin American loans, beginning with Citibank in 1986.

The change in the rule allowed the banks to buy time in order to avoid a crisis. It did not change the nature of the collateral. They still had to eventually take their losses, but the rule change allowed both the banks and the system to survive. I have made the point that the Fed and the regulators would do whatever it has to do to manage the crisis.

All the major new multi-hundred billion dollar auctions at the Fed where the Fed is taking asset backed paper as collateral for US government bonds does not make the collateral any better, of course. It just buys time for the institutions to raise capital and make enough profits to eventually be able to write off the losses.

Thus it should not come as a surprise to you, gentle reader, that the rules have been changed in much the same way as in 1980. In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis mine):

"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

(The full letter is at http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm.)

So, now banks can simply say that the low market prices for assets they hold on their books are actually due to a forced liquidation or distress sale and don't reflect what we believe is the true value of the asset. Therefore we are going to give it a better price based on our models, experience, judgment or whatever. In today's Continuing Crisis, nearly every type of debt and its price can be classified as a forced liquidation or distressed sale.

Does this make the asset any better? Of course not. But it buys time for the bank to raise capital or make enough profits to eventually take whatever losses they must. And who knows, maybe they will get lucky and the price actually rises?

There are two problems with this rule. First, it clearly creates a lack of transparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company.

Second, can a forced liquidation or distress sale be from a margin call? Obviousy the answer is yes. But as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors. Cue the lawyers.

Is this a bad ruling? Of course. But is it maybe necessary? It just might be. My first reaction was that this tells us things are much worse than we think. The struggle to get the mark to market ruling only to abrogate it in certain circumstances less than a year later has to gall a lot of responsible parties. It seems like it is 1980 and Latin America all over again. Let me repeat: The Fed and the Treasury (who oversees the SEC) will do what it takes to keep the game and the system going.

Let's Re-arrange the Deck Chairs

Treasury Secretary Hank Paulson put forth a number of "new" ideas for changes in the regulatory structures. Nothing I saw will help all that much in the current crisis. It's more like re-arranging the deck chairs as the ship is going down. It seems like most of it is being proposed to prevent another crisis like the one we are in from occurring in the future. That simply insures that Wall Street will have to invent whole new ways to create a crisis in the future. I am sure they will be up to the task.

Most of the proposals are basically good ideas that have been discussed for a long time, like merging the CFTC (Commodity Futures Trading Commission) and the SEC. We are the only country with such a bifurcated regulatory system. Good luck with getting that through Congress, though. The Agricultural Committees in the Senate and the House oversee the CFTC and futures trading, dating back to the 1930's when all that was traded was agricultural products. Now the CFTC oversees a vast derivatives market, which of course makes campaign donations to members of those committees. Think those Congressman want to see their major campaign donors go away? Of course, that means the Finance Committees would get new donors. It will be amusing to watch and see who "wins."

The really interesting item is the potential for the Fed to regulate investment banks, which makes some sense if they are going to loan them money at the discount window. Left unsaid and up for future negotiation is whether that would mean investment banks would have to reduce their leverage. Right now, investment banks utilize about twice the leverage as commercial banks. That leverage is what makes them so profitable. Take that away and they lose a lot of their profit potential.

A great part of the continuing crisis can be laid at the feet of too much leverage in too many places. The world is de-leveraging fairly rapidly. In some circles, it looks more like an implosion. The Fed and the SEC have made it very clear they want to have more authority to oversee all sorts of funds and investment banks so they can get a handle on the amount of leverage in the system. What you do with that information is another thing, but they want it and will use the Continuing Crisis to get that authority. My bet is that investment banks are going to be forced to reduce their overall leverage "for the good of protecting the system from itself" or some such twisted logic.

So, let's sum it up. The problem is so severe with the financial companies assets that the SEC is going to allow some of them to "cook the books" so they can survive. That means there are going to be large and continuing write-downs for many quarters to come. There is a minimum of another $3-400 billion in write-downs (and maybe a lot more) coming from mortgage related assets, not to mention credit cards and other consumer related debt. And the investment banks may be forced to reduce their leverage and thus their profitability?

Putting money in the major financial stocks is not investing. It is gambling on a very uncertain future. There is simply no way to know what the value of the franchise is. There are other places to put your money.

Regulations Coming to a Hedge Fund Near You

The SEC pushed through rules last year to regulate hedge funds. The courts ruled (properly, I think) that the SEC did not have congressional authority to do so. The hedge fund industry fought tooth and nail to avoid regulation and dodged the bullet.

I think the mood in Congress is going to be such that as the authorization for many of Paulsen's proposed changes make their way through Congress, some of them are going to allow the SEC the authorization they need to regulate hedge funds. The Continuing Crisis almost makes it a sure thing.

So, a quick note to my friends in the hedge fund industry. Forget fighting regulation and start negotiating. Recognize that regulations are coming and do what you can to make them as rational as possible. Also, make sure you (we) get the rights of other regulated funds, like the ability to advertise and not be so secretive, at a minimum. And maybe a more reasonable interpretation of the research analyst rules, which I note that many seem unaware of the implications on hedge funds and private offerings of the research analyst rules.

I am regulated by FINRA (the former NASD) which is overseen by the SEC, the NFA (the self-regulatory arm of the CFTC) and various state financial authorities. It seems like we get a regulatory audit almost every year from someone. My small firm survives, and so will hedge funds. Does it cost a lot of money and time to be regulated? Sure. But that is the price of doing business.

Will making hedge funds register make them any safer? I doubt it. Think of Enron and WorldCom. REFCO was registered and somehow hid a $500 million dollar bogus loan from regulators, their investment bankers and auditors. But it will make them more transparent. If we are going to have to pay the costs of being regulated let's make sure we get the benefits.

More Fun in the Unemployment Numbers

Payrolls tumbled by 80,000 today, more than forecast and the third monthly decline, the Labor Department said today in Washington. The unemployment rate rose to 5.1%, the highest level since September 2005, from 4.8%. The household survey shows the number of unemployed people rose by 438,000. (That is not a typo!) In March, the number of persons unemployed because they lost jobs increased by 300,000 to 4.2 million. Over the past 12 months, the number of unemployed job losers has increased by 914,000.And of course, when you look into the numbers it is worse than the headlines implies.

Prediction: we will see 6% unemployment before the end of the year.

There were negative revisions totaling 67,000 job losses for the last two months, making those months even worse. This means that the Bureau of Labor Statistics (BLS) is clearly over-estimating the number of jobs in the first announcement. That is because they have to extrapolate based on recent past data. And as I continually point out, as the economy softens, they are going to continue to overestimate the number of jobs. It's one of the problems of using past performance to predict future results.

Job losses since December are now at 286,000 in the private sector and 232,000 overall, counting for growth in government. What was up? Health care (23,000) and bars and restaurants (23,000 also). Initial unemployment claims are up by almost 25% for the last four weeks over last year, and this week were over 400,000. Given the job losses, this is not surprising.

This month the BLS hypothecates 142,000 jobs being created in their birth/death model. You can guarantee this will be revised down. For instance, they assume the creation of 28,000 new construction jobs as the construction industry is imploding. Total construction spending has fallen for the last four months in a row. Somehow they estimate 6,000 new jobs in the finance industries. Does anyone really think we saw a rise in employment in mortgage and investment banks?

Buried in the data is a picture of a squeezed consumer. Inflation is now running ahead of the growth in wages. As the chart below shows, average hourly earnings were up just 3.6%, but inflation was 4.5%. That means consumers must struggle to maintain their standard of living. No wonder retail stores shed 12,000 jobs last month. Light vehicle retail sales are down by 20% form last year. This all paints a picture of a very challenged consumer.

A Muddle Through Recession

The business sector is clearly in recession. The ISM manufacturing index came in at 48.6. Anything below 50 means manufacturing is in decline. There was a sharp drop in new orders. New orders have been below 50 for four months. Employment has been below 50 for four months. Backlog of orders has been well below 50 for six months. Yesterday the ISM service index was again below 50 for the month of March.

Given all the data, why then do I still think we will not see a deep recession? Because corporate America is in much better shape than in the beginning of past recessions. Lower inventories, better cash to debt ratios, not as much as excess capacity, and so on. As Peter Bernstein notes in his latest letter, nonfinancial corporate debt is at its lowest level in 50 years, and four standard deviations below the average from 1960 to 2000.

The recession we are now in is a consumer spending led recession driven by a falling housing market which is infecting the entire country. Can anyone still claim that the subprime problems would be contained as many did just last summer? Consumer spending is going to fall even more as credit becomes harder to get.

The situation is neatly summer up by Bernstein:

"The debate over whether we are or are not in a recession continues. There is, however, no debate about resumption of rapid economic growth in the near future. That's without question the most unlikely outcome. Yes, there are some bright spots, such as exports in the governmental largess that lies just ahead - and the likelihood of additional government assistance in some form. The Federal Reserve is also doing its part to lubricate the snarls in the financial markets.

"But the household sector is in deep trouble and will remain in trouble for an extended period of time. The combination of falling home prices, the complex problems in the mortgage area, limited financial resources and high debt levels, new constraints and higher costs on consumer installment credit, and probably rising unemployment already sluggish growth and jobs tend to restrain spending by the largest and most important sector of the economy.

"Imagine what would happen if all of these adverse forces struck a business sector stuffed with inventories, busy installing a massive amount of new productive capacity, with labor costs rising and productivity falling, and an overload of new debt to service. A difficult situation in the rest of the economy could be rapidly converted into a deep recession. But the business sector has kept inventory accumulation to a moderate pace, has limited in capacity growth, and has been conservative in adding to debts outstanding. How lucky can you get?

"Some observers are convinced that we are heading toward a deep depression in any case. We are not so sure. We believe the likely duration of these troubles is a greater concern than the depths the system might reach. The condition of the business sector as pictured above is the primary reason for this more hopeful outlook."

But a recession for at least two quarters and a Muddle Through Economy for at least another 18 months is not going to be good for consumer spending, job creation and most especially corporate profits. I continue to predict more disappointment for corporations that are tied to consumer spending and industries that are associated with housing.

S&P analysts continue to project earnings to be up by 15% in the third quarter of this year and by almost 100% for the fourth quarter this year over last year. Yes, I know there are a lot of one time charges and write-offs in the last two quarters of last year which make comparisons difficult. But in a recession and a slow recovery, how likely is it that we will not see even more "one-time" write-offs. And as noted above, there are more than twice as much subprime losses in our future as we have written off as of yet.

As I have written about at length in past issues, bear markets are made by continued earnings disappointments. It typically takes at least three difficult quarters to truly disappoint investors. We are just in the early stages. The recent drop in the stock market has been primarily caused by the Continuing Crisis in the credit markets, and only modestly by disappointing earnings. We need a few more quarters of disappointment to really get to a bottom in the stock market. It could be a long summer.

How Much do we Borrow for a $1 growth in GDP?

Finally, I want to give you a chart from my old friend Ian McAvity from his latest newsletter Deliberations, which he has been writing for 36 years! Basically, it makes the point that the amount of new debt in relationship to GDP is rising. We borrowed in one form or another $5.70 for each $1 rise in GDP last year.

Debt in all forms rose $7.86 trillion for the previous 8 quarters to $48.8 trillion dollars. Nominal GDP was only $14.1 trillion. This is of course unsustainable. At some point, debt growth must slow dramatically. As the world deleverages, decreasing debt and the resultant slowing of consumer spending will become a head wind for GDP growth.

London, Switzerland and South Africa

Next Wednesday I head out to California for my 5th annual Strategic Investment Conference in La Jolla. It is completely sold out for the first time. My partners in the conference, Altegris Investments have been doing yeoman work to make it come off in high fashion, and I thank them. I return and immediately head over to London and then Switzerland. I will be speaking for Bank Sarasin at a resort in Switzerland in the Interlaken area, and will stay on for a few days to be tourist and take some needed R&R and fly back on Monday evening.

I will be in South Africa in Johannesburg from May 5 - 8 and in Cape Town from May 12 - 14. If you are interested in attending my presentations you should contact Prieur du Plessis. You can use the contact button on his excellent blog: www.investmentpostcards.com.

I am going to try and play golf for the first time in at least a year. I will be terrible, but I will be playing with good friend and savvy commodity trader Greg Weldon and I look forward to it. Then in the afternoon two of the best Science Fiction writers and futurists in the world, Vernor Vinge and David Brin are going to join me, serious technology maven Dr. Bart Stuck and financial guru and brilliant thinker Rob Arnott for two hours of rambling conversations about the future. My daughter Tiffani wants to record it, and if we do (and with everyone's permission) we will post it on the net. Then 240 new and old friends gather Friday and Saturday to hear some really interesting speakers and enjoy each other's company. It looks to be a great week.

I hope you can enjoy your week as much as I will. And make it a good one. Now if the Rangers can just win their home opener on Tuesday, it will get even better.

Your amazed at how lucky I am analyst,

John Mauldin

Copyright 2008 John Mauldin. All Rights Reserved

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April 8, 2008

Falling Prices Offer Big Opportunity

Undrafted out of high school and cut from the 1988 U.S. Olympic baseball team, future Hall of Fame baseball player Frank Thomas ultimately got called up by the Chicago White Sox for the 1990 season. From 1991 to 1997 Thomas finished in the top 10 of MVP voting every season; winning the award twice in ’93 and ’94. By the time Thomas left the world champion White Sox in 2005 he was the team’s all-time leader in home runs, walks and slugging percentage.

Still, Thomas left Chicago under a controversial cloud with team executives of the belief that his skills had diminished. With his value as a player in freefall in the eyes of baseball GMs, Thomas was reduced to signing a $500,000 contract with the notoriously cheap Oakland A’s. Happily his story didn’t end there. Thanks to his willingness to accept his new market value, Thomas went out and hit 38 home runs in 2006; success that led to a 4th-place finish when the media voted on the AL’s Most Valuable Player. After his season with the A’s, Thomas proceeded to sign a 2-year, $18 million dollar contract with the Toronto Blue Jays.

Shunned as a football recruit by the University of Southern California during high school, Tom Brady signed with the University of Michigan and was relegated to seventh on its deep depth chart of quarterbacks. Brady played behind Brian Griese for two years, then battled with “can’t-miss” recruit Drew Henson for the starting job during his final two seasons as a Wolverine. Though he ultimately won the starting job and secured All-Big Ten honorable mention honors both seasons, Brady slid all the way to the 199th pick of the 2000 NFL Draft; drafted behind NFL also-rans including Giovanni Carmazi, Chris Redman and Spergon Wynn.

Importantly, his low cost relative to other draft-eligible players made him more appealing to the New England Patriots and coach Bill Bellichick. Although he started out 4th on the Pats’ depth chart, Brady bided his time under Drew Bledsoe, and when the latter went down with a serious injury on September 23, 2001, Brady stepped in and led his team to victory in 11 out of 14 regular season games before quarterbacking them to Super Bowl XXXVI. Three Super Bowl victories later, and one league MVP on his resume, Brady will surely be a first ballot Hall of Famer when he eventually retires.

Famous today for its revitalized Art Deco buildings, as recently as the 1980s Miami’s South Beach section was considered very poor and run down, and had a high rate of crime. Glamour when it came to the southernmost section of Miami Beach was a distant memory.

But where the average individual sees failure, the entrepreneur sees opportunity. Agent Irene Marie opened Irene Marie Models (Miami’s first full service modeling agency) in 1989 in the former Sun Ray apartment building, and hotelier Ian Schrager soon followed with the opening of the Delano Hotel. Schrager is famous for finding areas down on their luck, and opening hotels that attract the glamorous and even more development. What was formerly a run-down area of faded beauty now attracts the world’s beautiful thanks to previously collapsing values that made new investment possible.

During the first third of the 20th century, Pasadena, California was a resort town for well-to-do Midwesterners eager to escape the winter chill of the Midwest. Prominent industrial families including the Wrigley’s, the Gambles and Huntingtons constructed remarkable winter homes that still stand today. Colorado Boulevard stood as the equivalent of Beverly Hills’ Rodeo Drive, and it was where the rich went for shopping, food and entertainment.

Sadly, the Great Depression hit Pasadena hard, and by the 1970s formerly alluring Colorado Boulevard had been reduced to a combination of seedy bars, pawn shops and adult bookstores. Rather than a place to stroll, it became a street to avoid. But with property values at their nadir, entrepreneurs did what they always do in sensing value where others don’t, and soon enough restaurants, movie theaters and clothing stores revitalized a street that once served as a symbol of urban decay.

And when we look to New York City, formerly abandoned and inexpensive areas such as Tribeca, the Meat Packing District and the East Village now compete with midtown and uptown Manhattan for residents and top chefs. So great has Manhattan’s revitalization been that previously down-market areas outside the borough such as Brooklyn’s Williamsburg are now considered very fashionable.

The stories found in the sports and property sectors take on new relevance amid attempts by our political class to shield us from the difficulties that arise when an economy slows. Much is being made by politicians of reduced demand for workers and property, and to fix this seeming shortfall, a bipartisan effort is afoot to aid both. Low-income workers will receive checks from the federal government, while Illinois Senator Dick Durbin (D) is seeking an extension of unemployment benefits. On the property front, Congress is set to pass a $15 billion “housing stimulus package” meant to drive more home purchases through various tax breaks which would make a heavily subsidized sector even more reliant on state handouts.

The Washington consensus is a mistaken one; one rooted in the misbegotten belief that employment and housing slowdowns result from collapsing demand. That’s incorrect. Instead, our leaders should recognize that buyers of housing and labor disappear when both are supplied at rates above the market-clearing level. It’s only when prices are allowed to fall that intrepid buyers step in given their unending search for value.

So if we ignore for now the enervating quality of subsidies and handouts, we must say that they’re most problematic for pricing workers and housing at levels that make them unattractive to employer and investor alike. Indeed, as the examples from the sports and property world indicate, a great deal of success is conceived when markets are left alone to sort out all manner of prices. And if Washington simply steps aside, today’s property and employment showdowns will surely father more success stories.

Misunderstanding Japan, Misdiagnosing America

It may sound contradictory, but there is a common thread: the policy programs once proposed to resemble Japan and now proposed to avoid her fate are virtually identical – as well as unworkable, and counter-productive.

In the days of “stagflation,” John Kenneth Galbraith and others pointed across the Pacific to the tightly regulated Japanese economy and lauded the close relationship between big government and big business. Therein lay America’s salvation, we were told.

Except the United States found salvation elsewhere, within ourselves, in our own uniquely American entrepreneurial spirit. And – unhappily for those always pining for central planning – to the extent that our economy was saved by direct action, it wasn’t more interference that did the trick, but a conscious choice to have less. And other factors that made a difference were largely unplanned, unforeseen, and bottom-up.

Deregulation stimulated entrepreneurial activity across the economy, in virtually every sector, from the biggest corporations to the smallest start-ups. It had a particularly revolutionary impact on the financial markets. Michael Milken's innovative way of breaking apart huge underperforming conglomerate companies – much derided at the time – gave the entire capital market a jolt of energy that continues to this day. It also pushed issues of corporate governance and performing for shareholders front and center.

As to the happy accidents, a case in point is the Employee Retirement Income Security Act (ERISA), passed by Congress in 1974. This law, among other things, established individual pension vesting. Later amendments effectively created the venture capital industry. As the economy worsened, engineers and other creative workers found that they could leverage their pensions to take risks on new ventures. Needing partners, they found them in the form of a new kind of co-risk taker: the venture capitalist.

Another happy accident arose from the Bayh-Dole Act. This legislation – not intended to encourage economic recovery – ended up doing exactly that. By clarifying that the results of federally supported research would be the intellectual property of the inventor (or his employer) and not the government, it provided a huge boost to human capital innovation. The incentives for discovery this law created continue to pay off every day.

America did not emerge from stagflation by becoming more like Japan, but by returning to its entrepreneurial roots. Yet now, our politicians tell us, America must avoid becoming more like Japan by turning our backs on those roots.

The list of prescriptions is wearying: more government regulation of the credit markets, new oversight for investment banking, consolidate government control of the public equities markets, develop housing scores, force consumers to listen to lectures before they buy a house, create mortgage guaranty funds, and on and on.

It’s not exactly a solution in search of a problem – no one can doubt that America’s economy in general, and the financial markets especially, are in a rough patch. But it is the wrong solution, for a problem that is not nearly so dire as the central planners suppose.

Focus on the credit crunch alone and things look dire indeed. But consider some of the other fundamentals. Over the last 25 years, America has enjoyed a period of enormous growth in productivity. Employment has been stable and close to full – a far cry from the 10 percent unemployment at the low point of the stagflation era. Nor do we suffer anything like the annualized CPI inflation rate of 13 percent.

In addition, the U.S. today can boast something that it didn't have in 1980. Since then America has rediscovered entrepreneurial capitalism. Entrepreneurs are the bedrock of our growth. They are responsible for most innovations, and thereby for the creation of most new jobs and new wealth. In fact, since the early 1980s, during which time America weathered three recessions, nearly all net new jobs created came from firms less than five years old.

So, to bring a quick end to this recession, the best thing the United States can do is get out of the way of the entrepreneur. If government must act, it should make entrepreneurship more attractive and more viable for more Americans. It could relieve new start-up businesses of some of the tax burdens they face at the state and local level. It might relax labor rules for new firms for the first few years. It could create an expanded program of wage insurance for displaced workers. (Such a system would create a stronger incentive for finding work than the current system of unemployment benefits and, from the entrepreneur’s perspective, might boost the velocity of workers eager to augment their skills or learn new ones on the job.)

Finally, government could lower immigration barriers for highly skilled workers so that some of the brightest engineers and innovators in Japan and elsewhere could come to the U.S. and help us show the world that entrepreneurial capitalism – American style – is worth a second look.

April 9, 2008

Predatory Lending, or Mortgage Fraud?

Sen. Clinton’s speech and the mortgage industry report, coming within days of each other, illustrate the two separate and often mutually exclusive tracks that the discussion of the subprime crisis is taking these days. On the one hand, remedies proposed separately by Senators Clinton and Obama, as well as the bailout package agreed to by both Republicans and Democrats in Congress last week, essentially treat many subprime borrowers as victims of seedy mortgage brokers, opportunistic lenders and aggressive Wall Street houses. Under this narrative many borrowers were ‘lured” (in a term used by both Sen. Obama and the New York Times) into mortgages they couldn’t afford, and the Bush administration’s rescue plan--which involves urging borrowers and lenders to work out new loan terms individually--amounts to too little help at too laborious a pace to make a difference.

And yet the more time that passes the clearer we begin to see the extent to which many borrowers themselves may have participated in creating the mess from which we are preparing to rescue them. As more mortgages go bad and enter foreclosure, their details are coming under scrutiny, and the facts are not always pretty. They suggest that while lenders became too careless and some brokers were clearly swindlers, many borrowers were more than simply naïve or overly optimistic; a good many were probably cheating. Any federal legislation package that provides the financing to rework millions of thousands of subprime mortgages quickly is likely to reward quite a few of these chiselers.

One place to look for the cheating is in the speculation which helped drive the market, and which has played so large a role in today’s rising default volume. Everyone, of course, decries speculators, and it’s de rigueur in any speech or editorial endorsing giant bailout packages to denounce these gamblers and exclude them from any help. But as more mortgages unwind, we’re discovering that not only was speculation more rampant than we thought, but that many of these gamblers were deceiving lenders and builders by hiding their intentions.

So-called ‘occupancy fraud’—in which a speculator claims he will live in a house he is buying when it is actually a property he is purchasing for investment purposes-- accounted for about 20 percent of all mortgage swindles during the go-go years of subprime lending, according to a study by BasePoint Analytics, which specializes in detecting mortgage fraud. Buyers hid their intentions because lenders generally require bigger down payments on purchases of investment properties, and some builders will limit the number of investors they allow into a new development, because these buyers are more likely to walk away from a property when the market tanks. Home builders in hot markets were especially susceptible to this fraud because investors would purchase houses in new developments with the intent of flipping them as soon as they were ready to be occupied. Several builders told the Wall Street Journal earlier this year that while they thought that only 10 percent of their sales were to investors in recent years, in fact, it now appears that as many as a quarter of their homes were being snapped up by speculators, who often lied about their intent even when builders required them to sign documents affirming they would reside in their homes.

The level of occupancy fraud is significant because it suggests that speculation accounts for a larger part of the troubled mortgage market than most people realize. For one thing, some of the country’s highest foreclosure rates are in states which until recently had a hot, investor-driven housing market, notably California, Nevada and Florida. In fact, among the five states with the highest rates of foreclosures, defaults by known speculators (that is, those who admitted they were buying investment properties) account for more than one-fifth of all mortgages going bad. We don’t know exactly how many additional defaults can be attributed to occupancy fraud, but some studies have suggested the misrepresentations were widespread. Fitch Ratings, for instance, looked at a portfolio of 45 subprime loans that defaulted within their first year and found that in two-thirds of the cases borrowers never occupied the property, though they said they intended to.

Mortgage fraud, however, doesn’t stop at cheating by investors. There’s evidence that a wide range of borrowers, many probably aided by unsavory brokers, were using inaccurate data and phony documents to purchase homes they otherwise couldn’t afford, and hoping that a rising housing market would keep the deception from coming back to hurt them. One measure of the possible extent of the fraud: BasePoint Analytics took a look at millions of subprime loans and found that in 70 percent of cases where mortgages go bad quickly (exactly the kinds of mortgages that account for a chunk of today’s rising default rates), there was some misrepresentation by the borrower, broker or appraiser, or some combination of the three. Those loans were five times more likely to default quickly than mortgages without falsifications.

One area of particular abuse was so-called ‘stated income’ loans which require little or no documentation of a borrower’s earnings. Originally designed to help self-employed borrowers who don’t have ready access to documents like W-2 forms, no-doc loans became widespread during the height of the real estate boom because lenders naively believed that borrowers wouldn’t lie about income to qualify for loans that they couldn’t afford to pay back. But as soaring housing values made it possible for homeowners to refinance out of unaffordable mortgages using their new homes’ rising equity, lying on no-doc loans became common. One lender which compared 100 stated income loans with IRS data found that in 60 percent of cases, the income that borrowers claimed exceeded their actual earnings by 50 percent or more. BasePoint found in its study that some applications exaggerated income by as much as 500 percent.

Housing advocates, some politicians and journalists have tried to portray borrowers with misrepresentations on their loans as victims rather than cheaters, people put into mortgages they couldn’t afford by dishonest mortgage brokers. But many of these borrowers were irresponsible at best, and complicit at worse. Many apparently sought ‘guidance’ from brokers in to how to tailor their personal details to qualify for mortgages they were seeking, and some merely turned over their applications to brokers and allowed them to fill in the details. In one illustrative case described by an Associated Press story, for instance, a woman who understood that she couldn’t afford a loan for a house was told by a broker that she could rent the property to make ends meet. She went ahead on that basis but couldn’t find a renter and defaulted because her income wasn’t sufficient to pay off the loan. She now claims she was victimized by the broker’s bad advice and by inaccuracies on her application that someone, not her, filled out. How did the inaccuracies get there? She merely signed a blank application and gave it to her broker to fill out, she says, with little concern for the accuracy of the data to be added to the documents she signed.

Untangling the true blame in such cases is going to be nearly impossible, but including such borrowers in government bailouts—as advocates and some politicians have urged--will make it hard to exclude just about anyone whose mortgage applications included misrepresentations.

One thing which suggests that many borrowers were in on the scam is the proliferation of services and websites designed to help people cheat on their applications. During the height of the frenzy borrowers could purchase a higher credit score by paying to attach their names to the accounts of people with better credit. Some services would, for a fee, issue check stubs to provide phony employment verification, and for an extra $25, even give over-the-phone employment verification to any lender checking on an applicant. Some websites even offered to set up phony bank accounts in an applicant’s name and fill them temporarily with real assets to provide phony proof to lenders that the applicant had cash on hand for a down payment.

Many borrowers who used such techniques could be bailed out by some of the large government aid packages currently being discussed, such as the proposal to allow subprime borrowers to refinance into government backed loans, which would essentially bury any misrepresentations in new, more affordable, “cleaner’’ loans. That prospect has prompted the Bush administration, as well as likely GOP presidential nominee John McCain, to temper their enthusiasm for some of the larger bailout plans being discussed.

But many of those advocating a massive government bailout of subprime borrowers now argue that such a move is necessary, even if it rewards some of the ‘undeserving.’ The threat to our economy is so deep and broad that the housing market must be saved, they argue, even if the unworthy are rewarded. Yet geographically the foreclosure crisis remains concentrated in a few places where speculation was rampant, like California and Florida, and is hardly a threat in many other places. Those two states alone accounted for 36 percent of all subprime adjustable rate mortgages that went into foreclosure in the fourth quarter of 2007, because that’s where much of the risky lending was taking place.

It’s common now when discussing the subprime mortgage crisis to talk about the frenzy that drove the market at its height. The question is to what extent ‘frenzy’ is now becoming an acceptable synonym for ‘fraud’.

April 10, 2008

Who Has McCain's Economic Ear?

Commenting on executive compensation to Reuter’s on Monday, Holtz-Eakin declaimed that, "Job No. 1 of the president is to use the bully pulpit to shine a light on behavior that is less-than-exemplary," and when asked about executive pay, he said, “That’s certainly the case here.”

According to Reuters, Holtz-Eakin said McCain would like to see shareholders and company boards take action to make sure “that pay packages for CEOs are reasonable and in line with performance.” And in a speech on Sunday, McCain joined the executive-bashing echo chamber when he blasted the “outrageous” and “unconscionable” compensation of Bear Stearns and Countrywide executives, along with their “co-conspirators” on corporate boards. Holtz-Eakin and McCain miss the point on numerous levels.

For one, companies serve at the pleasure of shareholders, not the president. As such, companies should be allowed to make decisions when it comes to pay in either transparent or opaque fashion; the decision ultimately an economic one relating to what attracts investors. Importantly, investors are free to sell shares in companies that tend toward opacity or that compensate in ways they don’t approve.

Secondly, as investors have found over the years, top management is priceless. While Michael Eisner, Jack Welch and the late Roberto Gouizueta respectively left Disney, GE and Coca-Cola as billionaires, one would be hard pressed to find a shareholder who objected given how the shares of each company strongly outperformed the S&P 500 during their tenures. More modern evidence supporting the idea of the importance of CEOs comes from the rally in Starbucks’ shares after Howard Schultz resumed there as CEO, not to mention the 5.3 percent jump in the market cap of Merrill Lynch on the day that John Thain’s arrival as CEO was announced. It is because top executives can have such a positive impact on companies that their pay is so high, but the process is not foolproof. If it were easy, investing would be easy.

Thirdly, for Holtz-Eakin and McCain to assume that shareholders and company boards can know in advance whether pay packages might be “reasonable” defies common sense. The world of sports offers up myriad examples here in that ahead of the 1998 NFL Draft, many GMs had future bust Ryan Leaf rated ahead of future Hall of Famer Peyton Manning. Back in 1984, Sam Bowie was drafted before Michael Jordan. Former Home Depot CEO Bob Nardelli’s pay package would likely fall into the category of what Holtz-Eakin and McCain would deem “less-than-exemplary” corporate activity, but he was able to command it because he was heavily in demand by numerous corporate boards hopeful that some of his GE magic would rub off on the companies they served.

If we’re willing to ignore the views on executive pay, it would be very difficult to brush off Holtz-Eakin’s comments to U.S. News’ James Pethokoukis last week. It’s what he did not say, and what he did not seem to understand that should have those who think McCain will be good on tax policy a little bit worried.

To be fair, when asked by Pethokoukis about the economic boom under Bill Clinton, Holtz-Eakin said, “The economy survived higher taxes—that doesn't mean the higher taxes caused it. I am sure it was not true, and it doesn't mean the higher taxes were a good idea.” He also noted the positive impact of lower taxes and deregulation in the ‘80s.

But in discussing U.S. productivity over the last few decades, he observed that it disappeared in the ‘70s, and “no one knew why.” There lies the concern. It seems pretty obvious what caused productivity to fall in the ‘70s, and it had to do with a top tax rate of 70 percent that was made even more confiscatory by a falling dollar; the latter a productivity killer for driving a great deal of capital away from the innovative economy into real assets such as gold, housing and art. Shades of today?

Holtz-Eakin also failed to mention that until 1969, the top rate on capital gains taxes was 25 percent. In '69 Congress raised the minimum rate on investment success to 50 percent, and as Bruce Bartlett pointed out in his 1981 book Reaganomics, the “effect of this tax change was immediate and dramatic.” Indeed, with productivity-enhancing companies heavily reliant on capital, the new capital gains rate caused the annual number of IPOs to fall from a high of 1,298 in 1969 all the way to a low of eighteen in 1978. New companies raised $3.5 billion in 1969, but with capital taking safe haven from inflation and a 50 percent investment-success penalty, by 1978 a measly $54 million was raised.

When we consider Holtz-Eakin’s positive comments about the ‘80s tax cuts, to some degree we can say this is a basic and shrewd political calculation to talk up the Reagan era. In short, Republicans traditionally run on tax-cutting platforms, while Democrats campaign for tax increases.

More crucial is a core understanding of why economies soften, particularly in the present environment when so many assume we’re either in or headed for a recession. For Holtz-Eakin to pass off the 1970s economic failures as mysterious along the lines of sunspots or draughts speaks volumes. He should know exactly why the economy underperformed in the ‘70s, because in understanding that failure, he would be able to help McCain articulate the need for the marginal tax cuts and improved dollar policy that will help us emerge from today’s “1970’s-lite.”

So when we contemplate a John McCain presidency, we have to ask whether his beliefs match the kind of rhetoric we’d expect from any successful GOP candidate. The commentary coming from his top economic advisor suggests the more optimistic among us might be disappointed. Just like the man he serves, Holtz-Eakin doesn’t seem quite on board with why tax cuts are so effective. That being the case, McCain partisans should hope for a lot more Steve Forbes on the campaign trail, and a lot less Douglas Holtz-Eakin.

April 11, 2008

America's War-Torn Economy

It used to be thought that wars were good for the economy. After all, World War II is widely thought to have helped lift the global economy out of the Great Depression. But, at least since Keynes, we know how to stimulate the economy more effectively, and in ways that increase long-term productivity and enhance living standards.

This war, in particular, has not been good for the economy, for three reasons. First, it has contributed to rising oil prices. When the United States went to war, oil cost less than $25 a barrel, and futures markets expected it to remain there for a decade. Futures traders knew about the growth of China and other emerging markets; but they expected supply – mainly from low-cost Middle East providers – to increase in tandem with demand.

The war changed that equation. Higher oil prices mean that Americans (and Europeans and Japanese) are paying hundreds of millions of dollars to Middle East oil dictators and oil exporters elsewhere in the world rather than spending it at home.

Moreover, money spent on the Iraq war does not stimulate the economy today as much as money spent at home on roads, hospitals, or schools, and it doesn’t contribute as much to long-term growth. Economists talk about “bang for the buck” – how much economic stimulus is provided by each dollar of spending. It’s hard to imagine less bang than from bucks spent on a Nepalese contractor working in Iraq.

With so many dollars going abroad, the American economy should have been in a much weaker shape than it appeared. But, much as the Bush administration tried to hide the true costs of the war by incomplete and misleading accounting, the economy’s flaws were covered up by a flood of liquidity from the Federal Reserve and by lax financial regulation.

So much money was pumped into the economy and so lax were regulators that one leading American bank advertised its loans with the slogan “qualified at birth” – a clear indication that there were, in effect, no credit standards. In a sense, the strategy worked: a housing bubble fed a consumption boom, as savings rates plummeted to zero. The economic weaknesses were simply being postponed to some future date; the Bush administration hoped that the day of reckoning would come after November 2008. Instead, things began to unravel in August 2007.

Now it has responded, with a stimulus package that is too little, too late, and badly designed. To see the inadequacy of that package, compare it with the more than $1.5 trillion that was borrowed in home equity loans in recent years, most of it spent on consumption. That game – based on a belief in ever-spiraling home prices – is over.

With home prices falling (and set to continue to fall), and with banks uncertain of their financial position, lenders will not lend and households will not borrow. So, while the additional liquidity injected into the financial system by the Fed may have prevented a meltdown, it won’t stimulate much consumption or investment. Instead, much of it will find its way abroad. China, for example, is worried that the Fed’s stimulus will increase its domestic inflation.

There is a third reason that this war is economically bad for America. Not only has America already spent a great deal on this war – $12 billion a month, and counting – but much of the bill remains to be paid, such as compensation and health care for the 40% of veterans who are returning with disabilities, many of which are very serious.

Moreover, this war has been funded differently from any other war in America’s history –perhaps in any country’s recent history. Normally, countries ask for shared sacrifice, as they ask their young men and women to risk their lives. Taxes are raised. There is a discussion of how much of the burden to pass on to future generations. In this war, there was no such discussion. When America went to war, there was a deficit. Yet remarkably, Bush asked for, and got, a reckless tax cut for the rich. That means that every dollar of war spending has in effect been borrowed.

For the first time since the Revolutionary War, two centuries ago, America has had to turn to foreigners for financing, because US households have been saving nothing . The numbers are hard to believe. The national debt has increased by 50% in eight years, with almost $1 trillion of this increase due to the war – an amount likely to more than double within ten years.

Who would have believed that one administration could do so much damage so quickly? America, and the world, will be paying to repair it for decades to come.

Joseph E. Stiglitz, Professor of Economics at Columbia University, received the Nobel Prize in economics in 2001. His most recent book, co-authored with Linda Bilmes, is The Three Trillion Dollar War: The True Costs of the Iraq Conflict. Copyright: Project Syndicate, 2008.

Political Institutions' Impact on Trade Flows

What factors determine the size of trade flows between countries? Trade theory suggests that comparative advantage and resource endowments explain why countries trade and what they trade, but these models have less to say about how other factors influence the total volume of trade between countries. To measure bilateral trade flows, policy analysts often employ “gravity models,” which suggest that “mass” (usually proxied by GDP) ought to increase trade flows while distance ought to decrease them. Additional economic and geographic variables are usually included to account for specific characteristics of countries that also may influence trade flows. More recently, researchers have augmented the basic gravity model with political and institutional variables in order to better understand how factors such as currency unions, tariffs, wars, and exchange-rate regimes affect trade flows between countries.

Studies examining the effects of currency unions on trade, and more specifically the effects of the Eurozone on trade among its members, are leading examples of the new emphasis on understanding how institutions affect trade. Advocates of the euro suggest that a single currency boosts trade among members of the Eurozone by reducing uncertainty over exchange-rate movements, by lowering transactions costs, and by spurring competition. While noting that there are costs to adopting the euro (such as the freedom to deviate from the ECB’s interest-rate path), policymakers who favour the new monetary arrangement point to the growth in trade among constituent members as one reason why it ought to be maintained. To date, there is little agreement on the precise impact of the Euro on trade, but recent estimates suggest that it may have boosted average trade by roughly 5 to 10 percent within the Eurozone (Baldwin, 2006).

Other types of political relationships also have the potential to influence trade flows. For example, many of the studies that report on the salutary effects of currency unions also provide evidence that a country’s prior colonial status exerts a large and statistically significant positive effect on current bilateral trade. This finding raises several interesting questions, including whether extant empires boost contemporaneous trade, and if so, how they operate to influence trade. Although formal empires declined during the twentieth century, the changing geopolitics of the 21st century and the continued underperformance of sub-Saharan African countries have reignited interest in understanding how earlier empires and colonial relationships affect economic outcomes (Ferguson 2004; Lal 2001, 2004; Acemoglu, Johnson, and Robinson, 2001).

The Age of High Imperialism

Examining the Age of High Imperialism (1870-1913) helps to shed light on how political relationships can come to dominate trade flows. The late nineteenth and early twentieth centuries are often referred to as the first era of globalization, and provide a nice benchmark for comparison with the modern period since the earlier period was also characterized by durable monetary arrangements (the gold standard) and currency unions (the Latin and Scandinavian Monetary Unions). But the dominant political feature that dictated both trade and financial flows during the earlier period of globalization was empire.

Even though the British Empire, which spanned five continents, was still unrivalled during the 19th century, continental European countries began to more actively challenge Britain’s role on the world stage in the latter half of the century. New imperial powers sought overseas territories to complement their growing economies, which had been stimulated by the industrial revolution. Colonial acquisitions during this phase of expansion included Britain extending its holdings in Burma, Malaysia, and Africa, France consolidating its Indo-Chinese Empire and its foothold in Madagascar, and Germany carving out an empire in Africa. The Age of High Imperialism also included the United States, which had acquired the Philippines and Hawaii after its war with Spain.

The notion that trade and empire are linked is certainly not new. Scholarly debate reaches back over a century, but few studies have attempted to measure the effects. Recent research based on a large, new database of over 21,000 bilateral trade pairs from the Age of High Imperialism finds that, on average, being in an empire more than doubled trade, even after controlling for a variety of standard economic and geographic influences (Mitchener and Weidenmier, 2007). The study also suggests that the contemporaneous effects of empire on trade were larger than the effects of either non-empire currency unions or the gold standard – the largest currency arrangement in history – and significant enough in size to overcome the tyranny of distance.

Although there are many possible ways in which a particular colony’s trade was affected by being in a nineteenth or early-twentieth century empire, trade policies and lower transactions costs appear to be important in explaining why being in an empire boosted trade. Like tariffs and regional free trade agreements today, imperial trade policies of a century ago strongly influenced trade flows. In particular, preferential trade agreements (which were designed by colonies and metropoles to set higher rates on non-empire goods and were used by the Portuguese, American, Spanish Empires and British Dominions), as well as customs unions within empires (employed by France and many of its colonies) significantly boosted the flow of trade within empires.

Empires also lowered transactions costs and payments frictions by promoting a common language among merchants (a lingua franca), creating familiarity with local customs and culture, and encouraging the development of distribution and marketing channels and the formation of social networks. As with the euro today, the role of “vehicle currencies” and currency unions was central to lowering the transaction costs associated with trade. In the empires of last century, transactions costs declined significantly due to the widespread propagation and use of colonial currencies. The United States introduced the dollar in its dependencies after acquiring many of its colonies in the Spanish-American War of 1898. British and German colonies joined the sterling and mark blocks or formed currency unions with other colonies in the region. British colonies in East Africa, for example, formed a silver rupee union with India that also included some areas in East Africa that were members of the German Empire. The large increase in trade flows due to empire-based currency unions may have been especially pronounced during the first era of globalization since many colonies, especially in Africa, had largely conducted trade through barter. When the economies became monetized as a result of colonization and the introduction of colonial currencies, trade rose in response to the benefits that accrued from having a standard unit of account and medium of exchange.

Tariffs, currency unions, free trade areas, and empires hinge on the commitments of rulers and policymakers to maintain their existence. Even after these commitments are abandoned, such institutions can continue to exert influence over economic outcomes. The research on trade points to the complexities in understanding the legacies of institutions. Research suggests that prior colonial status still boosts bilateral trade today. In the classical economics tradition, some researchers view these larger trade flows as welfare enhancing, while others point to the potential pitfalls of “locking” ex-colonies into long-run trade patterns that are sub-optimal and potentially counterproductive for economic development. Other researchers focus on the relationship between institutions, trade, and economic development. Some suggest that settler colonies, in particular, may have benefitted from the trade and openness that the British Empire promoted; trade may have left institutions that fostered greater economic development and growth as a result. On the other hand, European empires may have undermined long-run productivity and growth in other colonies by leaving extractive institutions that did not introduce protections for private property or restrain governments from expropriation (Acemoglu, Johnson, and Robinson, 2001). While empires appear to have increased trade flows then and now, in creating the machinery for trade, empires also imparted institutions that had ambiguous effects on economic growth and development.

Kris James Mitchener is an Assistant Professor of Economics at Santa Clara University.


Acemoglu, Daron, Simon Johnson, and James Robinson. (2001). “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review 91(5):1369-1401.

Baldwin, Richard. (2006). “The Euro’s Trade Effects” European Central Bank Working Paper 594 (March).

Ferguson, Niall. (2004). Colossus: The Price of American Empire. New York: Penguin Press.

Lal, Deepak. (2004). In Praise of Empires: Globalization and Order. New York: Palgrave Macmillan.

Mitchener, Kris James and Marc Weidenmier. “Trade and Empire.” Economic Journal (Forthcoming) and NBER Working Paper 13765.

Political Institutions' Impact on Trade Flows

What factors determine the size of trade flows between countries? Trade theory suggests that comparative advantage and resource endowments explain why countries trade and what they trade, but these models have less to say about how other factors influence the total volume of trade between countries. To measure bilateral trade flows, policy analysts often employ “gravity models,” which suggest that “mass” (usually proxied by GDP) ought to increase trade flows while distance ought to decrease them. Additional economic and geographic variables are usually included to account for specific characteristics of countries that also may influence trade flows. More recently, researchers have augmented the basic gravity model with political and institutional variables in order to better understand how factors such as currency unions, tariffs, wars, and exchange-rate regimes affect trade flows between countries.

Studies examining the effects of currency unions on trade, and more specifically the effects of the Eurozone on trade among its members, are leading examples of the new emphasis on understanding how institutions affect trade. Advocates of the euro suggest that a single currency boosts trade among members of the Eurozone by reducing uncertainty over exchange-rate movements, by lowering transactions costs, and by spurring competition. While noting that there are costs to adopting the euro (such as the freedom to deviate from the ECB’s interest-rate path), policymakers who favour the new monetary arrangement point to the growth in trade among constituent members as one reason why it ought to be maintained. To date, there is little agreement on the precise impact of the Euro on trade, but recent estimates suggest that it may have boosted average trade by roughly 5 to 10 percent within the Eurozone (Baldwin, 2006).

Other types of political relationships also have the potential to influence trade flows. For example, many of the studies that report on the salutary effects of currency unions also provide evidence that a country’s prior colonial status exerts a large and statistically significant positive effect on current bilateral trade. This finding raises several interesting questions, including whether extant empires boost contemporaneous trade, and if so, how they operate to influence trade. Although formal empires declined during the twentieth century, the changing geopolitics of the 21st century and the continued underperformance of sub-Saharan African countries have reignited interest in understanding how earlier empires and colonial relationships affect economic outcomes (Ferguson 2004; Lal 2001, 2004; Acemoglu, Johnson, and Robinson, 2001).

The Age of High Imperialism

Examining the Age of High Imperialism (1870-1913) helps to shed light on how political relationships can come to dominate trade flows. The late nineteenth and early twentieth centuries are often referred to as the first era of globalization, and provide a nice benchmark for comparison with the modern period since the earlier period was also characterized by durable monetary arrangements (the gold standard) and currency unions (the Latin and Scandinavian Monetary Unions). But the dominant political feature that dictated both trade and financial flows during the earlier period of globalization was empire.

Even though the British Empire, which spanned five continents, was still unrivalled during the 19th century, continental European countries began to more actively challenge Britain’s role on the world stage in the latter half of the century. New imperial powers sought overseas territories to complement their growing economies, which had been stimulated by the industrial revolution. Colonial acquisitions during this phase of expansion included Britain extending its holdings in Burma, Malaysia, and Africa, France consolidating its Indo-Chinese Empire and its foothold in Madagascar, and Germany carving out an empire in Africa. The Age of High Imperialism also included the United States, which had acquired the Philippines and Hawaii after its war with Spain.

The notion that trade and empire are linked is certainly not new. Scholarly debate reaches back over a century, but few studies have attempted to measure the effects. Recent research based on a large, new database of over 21,000 bilateral trade pairs from the Age of High Imperialism finds that, on average, being in an empire more than doubled trade, even after controlling for a variety of standard economic and geographic influences (Mitchener and Weidenmier, 2007). The study also suggests that the contemporaneous effects of empire on trade were larger than the effects of either non-empire currency unions or the gold standard – the largest currency arrangement in history – and significant enough in size to overcome the tyranny of distance.

Although there are many possible ways in which a particular colony’s trade was affected by being in a nineteenth or early-twentieth century empire, trade policies and lower transactions costs appear to be important in explaining why being in an empire boosted trade. Like tariffs and regional free trade agreements today, imperial trade policies of a century ago strongly influenced trade flows. In particular, preferential trade agreements (which were designed by colonies and metropoles to set higher rates on non-empire goods and were used by the Portuguese, American, Spanish Empires and British Dominions), as well as customs unions within empires (employed by France and many of its colonies) significantly boosted the flow of trade within empires.

Empires also lowered transactions costs and payments frictions by promoting a common language among merchants (a lingua franca), creating familiarity with local customs and culture, and encouraging the development of distribution and marketing channels and the formation of social networks. As with the euro today, the role of “vehicle currencies” and currency unions was central to lowering the transaction costs associated with trade. In the empires of last century, transactions costs declined significantly due to the widespread propagation and use of colonial currencies. The United States introduced the dollar in its dependencies after acquiring many of its colonies in the Spanish-American War of 1898. British and German colonies joined the sterling and mark blocks or formed currency unions with other colonies in the region. British colonies in East Africa, for example, formed a silver rupee union with India that also included some areas in East Africa that were members of the German Empire. The large increase in trade flows due to empire-based currency unions may have been especially pronounced during the first era of globalization since many colonies, especially in Africa, had largely conducted trade through barter. When the economies became monetized as a result of colonization and the introduction of colonial currencies, trade rose in response to the benefits that accrued from having a standard unit of account and medium of exchange.

Tariffs, currency unions, free trade areas, and empires hinge on the commitments of rulers and policymakers to maintain their existence. Even after these commitments are abandoned, such institutions can continue to exert influence over economic outcomes. The research on trade points to the complexities in understanding the legacies of institutions. Research suggests that prior colonial status still boosts bilateral trade today. In the classical economics tradition, some researchers view these larger trade flows as welfare enhancing, while others point to the potential pitfalls of “locking” ex-colonies into long-run trade patterns that are sub-optimal and potentially counterproductive for economic development. Other researchers focus on the relationship between institutions, trade, and economic development. Some suggest that settler colonies, in particular, may have benefitted from the trade and openness that the British Empire promoted; trade may have left institutions that fostered greater economic development and growth as a result. On the other hand, European empires may have undermined long-run productivity and growth in other colonies by leaving extractive institutions that did not introduce protections for private property or restrain governments from expropriation (Acemoglu, Johnson, and Robinson, 2001). While empires appear to have increased trade flows then and now, in creating the machinery for trade, empires also imparted institutions that had ambiguous effects on economic growth and development.

Kris James Mitchener is an Assistant Professor of Economics at Santa Clara University.


Acemoglu, Daron, Simon Johnson, and James Robinson. (2001). “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review 91(5):1369-1401.

Baldwin, Richard. (2006). “The Euro’s Trade Effects” European Central Bank Working Paper 594 (March).

Ferguson, Niall. (2004). Colossus: The Price of American Empire. New York: Penguin Press.

Lal, Deepak. (2004). In Praise of Empires: Globalization and Order. New York: Palgrave Macmillan.

Mitchener, Kris James and Marc Weidenmier. “Trade and Empire.” Economic Journal (Forthcoming) and NBER Working Paper 13765.

Is it a Bull, Bear or Cowardly Lion Market?

For the next dozen years or so the US broad stock markets will be a wild roller-coaster ride. The Dow Jones Industrial Average and the S&P 500 index will go up and down (and in the process will set all-time highs and multiyear lows), stagnate, and trade in a tight range. At some point during the ride, index investors and buy and hold stock collectors will realize that their portfolios aren't showing much of a return.

I know this prediction has a mild sci-fi feel to it. After all, how could I possibly know what the market will do, especially that far into the future? Though I'll explain in more detail in just a second why I have the audacity to make this prediction, let me offer you a little factoid: over the last 200 years, every full-blown, long-lasting (secular) bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years. Yes, this happened every time, with the exception of the Great Depression, over the last two centuries.

Though we tend to think about market cycles in binary terms - bull (rising) or bear (declining) - in the long run markets spend a lot more time in bull or range-bound (sideways) states, roughly half in each, and visit a bear cage a lot less often then we think. This distinction between bear and range-bound markets is extremely important, as you'd invest very differently in one versus the other.

Are bull markets driven by superfast economic growth? Are range-bound markets caused by subpar economic growth? Could the subpar market performance be related to high or low inflation?

The answer to all these questions is undoubtedly - "no." Though it is hard to observe in the everyday noise of the stock market, in the long run stock prices are driven by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or contraction).

As is apparent from Exhibits 1 & 2, either by a decade at a time or a market cycle at a time, it is difficult to find a link between stock performance and the economy (e.g., GDP, corporate earnings growth, or inflation). The connection does exist, but periods of disconnect appear to last for decades at a time.

Exhibit 1

Exhibit 2

What about interest rates? Exhibit 3 shows P/Es for the S&P 500 (based on one-year trailing earnings) and inverse long-term bond yields - the implied P/E - the famous Fed Model. This model, despite its name, is NOT endorsed by the Fed; it indicates the existence of a tight relationship between (inverse of) long-term Treasury bonds and P/Es of the S&P 500.

Exhibit 3

By taking a look at the last full 1966-2000 range-bound/bull market cycle (see Exhibit 3), we can see that the Fed Model perfectly predicted the direction of equities in relation to interest rates (okay, assuming you could predict interest rates). Long-term interest rates were rising from 1966 to 1982, while implied and actual P/Es were falling. Whereas from 1982 to 2000 interest rates were dropping, and implied and actual P/Es were rising. Intellectually that makes sense, because stocks and bonds compete for investors' capital, and thus higher interest rates make equities less attractive and vice versa.

However, it is hard to find ANY relationship between interest rates and the animal with its name on the secular market if you look at the first 66 years of the 20th century. None!

It is difficult to dismiss the role interest rates play in stock valuations, but they seem to be a second fiddle in the orchestra conducted by economic growth and valuation. If the Fed Model worked flawlessly, how could we explain declining P/Es of Japanese stocks in the last decade of the 20th century, when interest rates declined and were scratching zero levels?

It is valuation! If earnings growth in the long run remains consistent with the past, P/E is the wild card that is responsible for future returns. Though continued economic growth appears to be a wildly optimistic assumption given the meltdown of the housing industry in particular, and job layoffs, it is not particularly unrealistic to predict that we will see economic growth overall. With the exception of the Great Depression (see Exhibits 1 & 2), though it had its ups and downs, economic growth was fairly stable throughout the 20th century. Earnings, though more volatile than real GDP, grew consistently decade after decade, paying no attention to the animal (bull, bear ... or cowardly lion - my pet name for range-bound markets, whose bursts of occasional bravery lead to stock appreciation, but which are ultimately overrun by fear that leads to a subsequent descent) lending its name to the stock market.

Though economic fluctuations were responsible for short-term (cyclical) market volatility, as long as economic performance was not far from the average, long-term market cycles were either bull or range-bound. Valuation - the change in price to earnings, its expansion or contraction - was the wild card that was mainly responsible for markets being in a bull or range-bound state.

Market Cycle Math

So let's examine the stock market math for secular bull, range-bound, and bear markets. The following Exhibit 4 shows sources of price appreciation in past bull, range-bound, and bear markets.

Exhibit 4

During bull markets, a vibrant, peaceful combination of P/E expansion (a staple of bull markets, a great source of return) and earnings growth brings outsize returns to jubilant investors. Prolonged bull markets start with below- and end with above-average P/Es.

P/Es are some of the most mean-reverting creatures, and range-bound markets act as clean-up guys: they rid us of the mess (i.e., deflate high P/Es) caused by bull markets, taking them down towards and actually below the mean. P/E compression wipes out most if not all earnings growth, resulting in zero (or nearly) price appreciation plus dividends.

Bear markets are range-bound markets' cousins; they share half of their DNA: high starting valuations. However, where in cowardly lion markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not there to help. Economic blues (runaway inflation, severe deflation, subpar or negative economic or earnings growth) add oil to the fire (started by high valuations) and bring devastating returns to investors.

A true secular bear market has not really taken place in the US, but one has occurred across the pond in Japan. The market decline caused by the Great Depression, though referred to as the greatest decline in US stocks in the 20th century, only lasted three years and thus doesn't really fit the traditional "secular" requirement of lasting more than five years. Japan's Nikkei 225 suffered (see Exhibit 5) through a true secular bear market: stock prices declined over 80 percent from their 1989-1991 highs until they bottomed in 2003 (the market seems to be coming back now). For more than a decade the country struggled with deflation caused by its banking system coming to a near halt on the heels of a collapsing real estate market and the bad loans that came with it. Of course, all this took place on the heels of a huge bull market, and thus very high valuations.

Exhibit 5

A unique aspect that contributed to the severity and longevity of the Japanese deflation was a cultural issue: the Japanese government intervened and did not allow structurally defunct companies to go bankrupt, thus tampering with the nucleus of capitalism (and Darwinism as well), creative destruction. I must admit, it seems that lately we've been importing a lot more from Japan than their cars and flat-screen TVs, as the US government steps in to "fix" our troubled financial firms. (In the following articles I argue against government bailing out homeowners and against the Fed bailing out the economy).

Where Are We Today?

Today stocks may appear cheap at first glance, at least if you look at valuations of the late 1990s. They are not! To minimize the impact of cyclical profit volatility, let's first take a look at stock market historical and current valuations, based on 10-year trailing earnings, as shown in Exhibit 6. This way we capture a full economic cycle.

Exhibit 6

The conclusions we can draw are:

  • Secular bull markets end at P/Es much above average. The 1982-2000 bull market ended at the highest valuations ever!
  • Secular range-bound markets ended when P/Es were below average.
  • Markets spent very little time at what is known to be a "fairly valued" state of 15 times 12-month trailing earnings. Historically, stocks only saw average valuations on the way from one extreme to the other. From 1900 to 2006 the S&P 500 spent less than 27% of the time between P/Es of 13 and 17.
  • Today, after eight years of plentiful volatility and no returns, what the WSJ called a "lost decade," stocks are not cheap. If you look at ten-year trailing earnings, they are still at levels where previous range-bound markets started. In other words, based on 10-year trailing earnings, stocks are still at 64% above their average stated valuations.

Now, if you look at historical valuations where P/Es are computed based on one-year trailing earnings (see Exhibit 7), the picture is not that exciting but less grim. At about 18 times trailing earnings, US stocks don't appear that expensive.

Exhibit 7

Unfortunately, the cheapness argument falls on its face once you realize that (pretax) profit margins are hovering at an all-time high of 11.5%, about 35% above their historical (since 1980) average of 8.5%. Similarly to P/Es, profit margins are extremely mean-reverting. As companies start to earn above-average economic profits, new competition waltzes in and competes these excess profits away - arrivederci fat profit margins. Once this happens, the "E" in the "P/E" equation will decline as well, and P/Es will rise from 18 to 22. An additional point: as you see in Exhibit 8, margins don't have to revert and stop at the mean; historically they've gone below the mean - that is how the mean is created. (In the February 4th, 2008 issue of Barron's I rebuffed common
arguments against profit-margin mean reversion.)

Exhibit 8

As a side note: The bulk of excesses in overall profit margins, 54.5% to be exact (see Exhibit 9), were in "stuff" stocks (i.e., energy, materials, and industrials). Profit margins will deflate when the global economy slows down. This goes far beyond oil and commodities. Companies that make "stuff," which historically have been very cyclical (today is no different) have benefitted from tremendous operational leverage that contributed to considerable improvement in margins. However, leverage works both ways: lower sales and high fixed costs will push margins to the other extreme.

Exhibit 9

Financials were responsible for 22% of the excess in margins, as they benefitted from tremendous liquidity hosed down by the Fed over recent years; now they are drowning in it. Their margins are compressing at a faster rate than you can read this.

Finally, the "new" economy stocks are responsible for 17% of the excess. However, I'd argue that these industries have transformed substantially since 1988, so that higher-margin software and services now account for a much larger portion of technology and telecom sales. It is kind of like Microsoft (ironically the "new" economy) vs. IBM in 1988: the hardware company (the old economy) vs. the new. Of course IBM of today is lot more of a software and service company than the hardware company it was in the 1980s. Thus the "new" economy stocks should have higher margins than they did in 1988, but by how much? I don't know, but they likely will face a lower margin compression than "stuff" and financials.

The bottom line: Remember those long-term double-digit returns you were promised by stock market gurus during the last bull market? Well, an average passive buy-and-hold investor will be lucky to have very low single-digit returns for the long term. In fact, during the last 1966-1982 range-bound market, investors received almost zero real total returns.

Analyze and Strategize

Fairly depressing stuff, and it sounds like the investor is going to have to eat lower returns. However, there are strategies to improve portfolio performance so that one can do well, even in a trading range. Whether you are a buy-and-hold or stalwart value investor, there are opportunities that don't require you to day trade stocks. You don't have to change your investment philosophy, but you have to tweak your stock analysis and strategy a little to adapt it to range-bound markets.

Modify your analysis: To clarify, I created an analytical framework where stock analysis is broken down into three dimensions: Quality, Valuation, and Growth.

Quality. Though often it is in the eye of the beholder, in my book I clarify what constitutes a quality company (i.e., sustainable competitive advantage, strong balance sheet, great management, high return on capital, and a lot more). But the lesson here is, you want to compromise as little as possible on this dimension, because it is very difficult to recover from significant losses in the range-bound market. Stick to quality.

Growth. This dimension consists of earnings (cash flows), growth, and dividends. When you own companies that grow earnings, time is on your side. Dividends are extremely important in range-bound markets, in fact 90% of the returns in past range-bound markets came from dividends, vs. less than 20% in past bull markets. Also, today an average stock (i.e., S&P 500 index) yields only 1.7%. Do you really want 1.7% to be 90% of your total return?

Valuation. This dimension requires the most modification: the valuations that we saw in the 1982-2000 bull market are not coming back anytime soon, but don't step into what I call the relative valuation trap. Don't buy stocks based solely on their relative cheapness to their prices in the past, but rather based on what their future cash flows will bring. To combat a constant P/E compression, in the range-bound market increase your required margin of safety.

That value (i.e., low P/E stocks) beats growth (high-valuation stocks that have high expectations built in) has been historically documented by numerous studies. After doing extensive study of the 1966-1982 range-bound market, I found that value kills growth. Cheaper stocks had a lower P/E compression and generated bull-market-like returns, plus they had a natural advantage: their lower P/Es led to higher dividend yields. Stock selection matters in the range-bound market. Blindly throwing money at market indices - a strategy that did wonders in the past bull market - will bring market-like returns, which likely will not pay for your dream house or fund your retirement.

Strategize: Once you have determined, based on the Quality, Valuation, and Growth framework, what stocks are to be bought and at what prices, you can start applying a range-bound market strategy.

A long-lasting secular range-bound market consists of many mini (months to several years long) cycles. For instance, the last 1966-1982 range-bound market consisted of five mini bull, five bear, and one range-bound market (See Exhibit 10).

Exhibit 10

Successful investing is a lonely place, as it requires an independent thought process that often goes contrary to the herd mentality. In the range-bound market, a contrarian mindset comes in especially handy, as you'll be selling when everyone else is buying. Your stocks will be hitting their fair value, and you'll be buying when everyone else is selling - during the mini bear markets.

This is not to suggest that you need to be a market timer, not at all. Market timing only looks easy with the benefit of hindsight, and it is very difficult to do on a consistent basis. Instead, time (price) individual stocks, one at a time. Buy when they are undervalued and sell when they are fairly valued, and repeat the process over and over again. In other words, instead of focusing on the bowling alley (the market) focus on the ball (individual stocks).

Selling is looked upon as a four-letter word, and therefore a sin, in a bull market. A buy-and-hold strategy (which is often just buy and forget to sell) is rewarded richly in secular bull markets - every time you made a "don't sell" decision, stocks go higher. And though buy and hold is not dead but in a coma (waiting for the next bull market), it takes investors to a place of no returns. Forgive yourself the "sin" of selling and become a buy-and-sell investor.

The almighty US constitutes 4% of the world population, but its stock market capitalization represents more than a third of the world's wealth. It has been comfortable for us to buy US stocks; it felt safe. However, by solely focusing on US stocks we are insulating ourselves from a greater pool of stocks to choose from. You don't need to become an Indiana Jones of international investing by venturing into fourth-world countries like South Paragama or Liberania (ok, I made those up, didn't want to offend folks in Turkmenistan or some other places heading towards the stone age), but there are plenty of countries that have a stable political regime and the rule of law.

I could be wrong but I doubt it

What if I am wrong and the range-bound market I describe is not in the cards? After all, history is prolific about the past but mute about the future. What if they find life on Venus and our economy starts growing at double digits and the secular bull market thunders upon us? Or the current credit market problems spill into a Japanese-like prolonged recession, causing a bear market? Every strategy should be evaluated not just on a "benefit of being right" basis, but at least as importantly on a "cost of being wrong" basis. An active value-investing strategy has the lowest cost of being wrong in comparison to other investment strategies, as you'll see in Exhibit 11.

Exhibit 11

April 15, 2008

The Rich and Their Taxes

Reading all of this after having filed your taxes, you probably imagine that the rich are doing a nifty job of avoiding theirs, and that it’s an overburdened middle class that is mostly supporting America’s government—from the war in Iraq to our many domestic programs. And you’d be wrong. As Internal Revenue Service data demonstrate, the rich are getting wealthier, but they are also paying a steadily increasing share of the federal tax burden. Over 25 years, in fact, the percentage of the federal income tax bill paid by the wealthiest Americans has doubled, even as it has shrunk for all others. We are rapidly becoming a society in which a very few pay the greatest part of the cost of government, and everyone else enjoys the benefits. And many people, from our Democratic presidential candidates to members of Congress, want to make it even more so.

To consider how the landscape has changed, it’s worth looking at taxes paid by various income groups over time, via data crunched by the IRS. In 1980, with Jimmy Carter still as president, the top 1 percent of filers, those who reported an adjusted growth income of $80,580 or more, paid 19 percent of all federal income taxes. That was actually less than the total tax share of people collectively in the 11th to 25th percentiles, that is, middle income taxpayers making roughly between $24,000 and $35,000 (in 1980 dollars), and also less than the total share of those earning between $13,000 and $24,000, who represented the 26th to 50th percentiles.

A decade later, despite tax cuts in the 1980s that many critics claimed benefited the rich, our top 1 percent of filers were paying more of the total--25 percent of the country’s tax bill—than anyone else. The portion of taxes paid by the top filers continue to grow throughout the 1990s and into the new century, pausing only for recessions, which are generally periods in which the share of taxes paid by the rich falls because their incomes tend to decline the most. By 2005, the most recent year data are available, our top 1 percent of filers were paying nearly 40 percent of the federal income tax bill, while those in the 2nd to 5th percentile paid another 20 percent. Every other group saw its share of the tax bill decline, sometimes substantially. Those taxpayers in the 26th to 50th percentile (that is, with an adjusted gross income roughly between $31,000 and $62,000) paid 11 percent of all federal income taxes, down from 20 percent back in 1980, while those in the 11th to 25th percentiles (earning between $62,000 and $104,000 today), paid 16 percent of the federal tax bill, down from 24 percent in 1980.

How can all of this be true if, to hear Warren Buffett tell his story, it’s so easy for the rich to minimize their taxes? Buffett’s claim, based on comparing his tax rate to those of people who worked for him, got plenty of publicity, and probably invoked in many people the memory of Leona Helmsley’s infamous line, “only the little people pay taxes.” Buffett’s low tax rate, some people conjectured, was a result of the fact that he earned mostly dividend and capital gains income, and those are now taxed largely at a 15 percent rate.

But Buffett is an exception—one of the super rich. By contrast, most of the wealthy in America today garner their income principally from wages, and thus not only pay more in taxes, but pay taxes at a higher real rate than everyone else—Warren Buffett aside. While taxpayers in every bracket do what they can to minimize their taxes, in 2005, the top 1 percent of filers paid 23 percent of their adjusted gross income in income taxes. Those earning between $62,000 and $104,000--certainly part of the middle class that Hillary Clinton says is bearing a bigger burden because of tax cuts for the wealthy--paid an average tax rate of 9 percent. The tax rate of those with incomes between $31,000 and $62,000 was under 7 percent, or less than one third of the tax rate of the rich.

Of course, this is only the federal income tax. We have other taxes in America, including payroll taxes and even corporate taxes—which individuals pay indirectly through taxes on businesses in which we own shares. The Congressional Budget Office, a nonpartisan entity like the IRS, figures all of those into its calculations of tax rates that Americans pay and concludes that the richest 1 percent pay an even higher real tax rate than the IRS figures—31 percent of income.

Yes, these stats do tell us that some people are doing very well in America, including presumably many people who were middle or low-income workers sometime during the past 25 years and have now vaulted into the top 1 percent of earners. But the data also tell us that much of the hyperventilating in our public discussions about the rich not paying a fair share of taxes is disconnected from reality.

Still, given how skewed the discussion has become, it seems almost certain that with a Democratic victory in the presidential race come November, we will see taxes—and the overall share of taxes paid--rise for the wealthy. Are there any dangers in a society where a fleetingly few earners pay such a big share of taxes, and where some folks’ notion of fairness means taxing these few ever more? We might consider that question by looking at states with their own progressive state income taxes.

Last week, for instance, a labor union-supported policy group released a study noting that Connecticut now has the largest gap between the rich and the poor in the nation. The local pages of the New York Times dutifully reported on this study and asked, what could be done as a remedy? Raise taxes, the advocates urged, heedless of the fact that in Connecticut the top 5 percent of the state’s taxpayers already bear the bulk of the state’s income tax burden. The situation is much the same in neighboring New Jersey and in New York where, for instance, the top income bracket represents just 0.4 percent of taxpayers, but they pay one-third of the state’s income tax.

Is there a consequence to this? Well, for one thing, it’s practically compulsory when talking about the state government in each of these three places to use the adjective “dysfunctional.” All three states have seen governors resign in disgrace within the past several years. All three states are rife with corruption, pork barrel spending and government inefficiencies. Hardly a day goes by that the newspapers don’t reveal yet another outrage of waste, or mismanagement or thievery.

Yet little changes in the government of these states, much to the amazement of outsiders, who often wonder why voters continue to stand for it. The answer, I tell them, is that a very small percentage of voters are paying for this waste, mismanagement and bloat. The rest pay so little that they don’t really care, or they benefit from bloated government, either through jobs in the oversized public sectors, or as users of services.

This is what you get when the few support the many--the direction the federal government is now heading. You get Connecticut, New York or (God help us) New Jersey.

April 16, 2008

GOP, Dems Out of Ideas

In 2008, net petroleum imports will likely cost $400 billion, up nearly ten fold since Bill Clinton took office. Many oil dollars sent to Arabia, Russia and other friendly places are not spent on American goods and do not create jobs here.

Coupled with booming prices for food prices, rising gasoline, electricity and heating bills give Americans less and less to spend on nonessentials, and retail sales sink, layoffs mount, and wages falter.

U.S. exports have not kept pace to pay for oil and the other goods we buy abroad. Since Bill Clinton took office exports have increased about $1.1 trillion, while imports have jumped $1.7 trillion.

The overall result is a whopping $700 billion dollar trade gap that reduces GDP by $250 billion and longer-term economic growth by even more.

Americans use too much gasoline, and the ethanol program dents the problem much less than it pushes up prices for butter, baked goods and beef, and instigates food shortages in poor countries.

Ethanol is the sophistry begotten by pandering for farm votes. The real answer lies in more fuel efficient vehicles manufactured with readily available and reasonably obtainable technologies, within our reach.

Sadly, hardly anyone in Washington—including the trio of Senators running for President—seems willing to embrace truly rapid deployment of hybrids, lighter vehicles, fuels cells, and more efficient diesel and gasoline engines.

Our free trade policies would raise productivity and living standards if we paid for what we buy abroad with exports, because exporting industries use labor more productively and spend more R&D. However, governments in China, Japan, and much of Asia intervene in foreign exchange markets to keep their currencies artificially cheap and U.S. exports too expensive in rich markets with the greatest untapped opportunities.

McCain, Clinton and Obama all refuse to back bills pending in Congress that would get tough with Asian currency manipulation, and establish conditions for more balanced trade with those protectionist regimes.

Since the 1980s, banks have moved from making loans funded by deposits to jobbing out lending to mortgage brokers and private equity funds, and wrapping mortgage, credit card and business loan payments into complex bonds for sale to insurance companies, pension funds and other fixed income investors.

Mortgage brokers made liars loans, built on questionable assessments of home values and borrowers ability to pay. The banks understated default risks to fixed income investors, and skimmed off excessive profits and bonuses, and left too little to cover defaults.

The Bush Administration is seeking tougher standards for mortgage brokers and real estate appraisers but its financial regulation reform proposals go light on the questionable business practices of the Wall Street banks.

Predictably, fixed income investors will no longer buy bonds created by the banks, and the banks have much less money to lend homeowners, consumers and honest businesses.

The presidential contenders, all busy harvesting contributions in New York’s financial district, have not explained what they plan that would fix that mess.

On important energy, trade and banking issues, McCain offers Bush redux.

Clinton’s platform is a throwback to 1970s French statism, something President Sarkozy is trying to escape.

Obama is offering what he does best. An Elmer Gantry campaign, full of expressions of hope but thin on policy and anything truly new.

It seems elephants have long memories but few new ideas. Donkeys are endearing but even less adaptive.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

April 18, 2008

Repeal Housing's Mortgage-Interest Deduction

The mortgage-interest deduction harms our economy in many ways. For one, it constitutes relief for one segment of society at the expense of those who choose not to own a home. Those who don’t are forced to subsidize homeowners through theoretically higher rates of taxation on income. Considering the static approach those in Washington take to tax cuts and tax increases, the revenues “lost” due to the mortgage deduction make it more difficult for Congress to reduce marginal tax rates. So in a sense the tax relief brought about by the deduction reduces the economy’s overall vitality through greater penalties levied on actual work.

And since deductions on interest payments help to reduce the effective tax rate of many Americans, there exists less of a push to bring all manner of tax rates down altogether. Indeed, if certain segments of our society don’t feel the sting of taxation, how can we expect them to take up the cause of reducing taxes?

When the present housing moderation is considered, the mortgage deduction made buying a home more attractive such that owners themselves have become a powerful voting block. With politicians ever eager to solve problems with the money of others, fear of the special-interest group that is homeowners has engendered a variety of bailout proposals that will be funded on the backs of taxpayers whether they own or not.

Perhaps worst of all for our economic health, the mortgage-interest deduction drives capital away from the productive sector of the economy, and into the ground. 19th century economist John Stuart Mill called the latter “unproductive investment,” whereby capital is consumed rather than offered up as investment. This should concern all Americans, because to the extent that tax incentives create individual preference for consumption over savings, investment lags, and with lower investment comes lower wages.

Assuming a repeal of the mortgage-interest deduction without tax simplification, would this be so bad? Many might assume it would be in the sense that effective tax rates would rise. It’s a fair point, but that’s merely the “seen” in the concept being discussed.

Unseen once again is that with housing no longer receiving preferential treatment, individuals would be far more likely to save and invest in ways that would accrue to personal earnings. And while the direction of the dollar is the biggest driver of nominal home prices, the theoretical fall-off in demand for housing would lead to lower prices that would enable what is an unproductive asset to be purchased with a smaller percentage of total individual wealth.

Unseen also is that any presumed drop in home values would not only be made up through increased pay, but through increased wealth brought about by greater overall demand for traditional investments such as stocks and bonds. This of course flies in the face of conventional economic wisdom incorrectly suggesting that our economy is reliant on exorbitant home prices.

In answer to those who’ve bought into the charitably absurd notion that rising real-estate values are stimulative, think back to the ‘80s and ‘90s when housing greatly lagged the equity markets, and voters were much happier. It can’t be stressed enough that housing does best when the dollar is weak. In short, it’s an asset class that thrives in times of inflationary pressure; inflation correlating very well with recession. If that's not enough, consider that housing boomed under Presidents Nixon, Carter and George W. Bush. All three were or are unpopular. Think about it...

Returning to the tax implications of repeal, forgotten in the mortgage-interest discussion is the basic truth that stationary assets such as houses are easy to tax. Put simply, humans are mobile and can easily flee tax tyranny, houses aren’t and generally can’t.

Indeed, the “seen” when mortgage-interest deductions are considered is the tax advantage gained by those who’ve taken out mortgages. The “unseen,” however, is the ease with which local governments are able to capture gains achieved federally with confiscatory rates of taxation on property. Sure enough, according to a story in USA Today, property-tax collections rose 7 percent in 2006 to a record $377 billion. When local taxes are brought into the equation, effective rates of taxation rise substantially thanks to the greedy hand of local government.

The mortgage-interest deduction and all manner of housing subsidies distort investment in ways that reduce our pay, keep our rates of taxation higher than they might be, and make housing marginally less affordable for those who don’t yet own, but would like to. So while any attempt at repeal would generate all sorts of sky-is-falling protest, an end to the subsidy would pay great economic dividends that would accrue to everyone, not just the special interest that is today’s homeowner.

April 19, 2008

The Muddle Through Question

The second group asks the obverse of the coin: "John, how can you see a long, slow recovery? Look at all the good things like [insert your favorite bullish statistic: low interest rates, a rising stock market, the worst of the credit crisis behind us, the stimulus checks just now getting to consumers, etc.]. Don't you think that means we will get back to a full growth economy by the end of the year?"

I have given both questions some thought as to which I should answer first. I think it makes more sense to start with the bullish question first and then go into why things are not as bad as many analysts suggest.

Clowns to the Left of Me, Jokers to the Right of Me,
Here I am Stuck in the Muddle Through Middle With You!

I take some comfort in being in the middle. It is when you get on the edge that you are most often wrong, but that also means you have the most people who disagree with your position. And there are a lot of people who disagree with me. But then, a lot of people disagreed when I said the subprime crisis would be serious enough to cause a recession. As to whether I am right about Muddle Through this time, we will see. But it is where my thinking comes out.

So, let's make the case for a recession which will last at least for two if not three quarters and then a slow recovery of at least a year and half where GDP is in the range of 2% on average.

First, this recession is fundamentally a consumer recession, brought on by a bursting of the housing bubble and a credit crisis. Consumer spending is under pressure from several main areas.

First, as the housing market stalled and then began to drop, we saw a fall in housing related spending, in construction, furniture, mortgages, etc. Remember when most economists and analysts wrote last summer that there would not be a recession from the housing crisis because housing was only 5% of the economy? The rest of the economy was doing just fine, they opined. Don't worry. Be happy.

The problem is that the resulting fall in housing prices produces a negative wealth effect. I have used the following chart many times, but it is good to review it again quickly.

Notice that without mortgage equity withdrawals the US economy would have been in outright recession for two full years in 2001-2, and would have been quite sluggish for the next two years. That is what you should expect from the bursting of a major equity market bubble and 9/11. But because the value of the US housing stock was rising and doing so rapidly, people felt comfortable borrowing against the ever-rising value of their homes. We borrowed and spent our way out of that recession. Coupled with the Bush tax cuts (a very important element!) and low Fed rates, we bounced backed rather handily.

But now, home values are falling and will likely do so for another year at the least. As Woody Brock pointed out in this week's Outside the Box, we are at the beginning of a reversion to the mean on national wealth. We are getting a reverse wealth effect. People either can't or won't borrow as much and thus we get negative stimulus from housing prices. It is likely that people are going to start saving more, which while a good thing from an individual stand point, it is a drag on overall consumer spending.

Second, even though core inflation is tame, real inflation that includes the things you and I actually buy is high and rising. I drove past a gas station in La Jolla where the price of gas was over $4 a gallon. Money that is spent on gas and rising energy bills is money that cannot be spent on discretionary items. Rising food bills means that there is less money left over to buy entertainment and other modest luxury items.

Third, rising unemployment clearly means that a small but growing segment of the population has less money to spend. Unemployment is at 5.1% and is likely to rise to over 6%. That is clearly bearish of consumer spending.

All of these factors suggest a recession of at least two quarters if not three. While lower Fed funds rates and the efforts by Congress to stimulate lower mortgage rates will eventually help, it will not be an immediate panacea.

As to a slow and prolonged recovery, the "Muddle Through Recovery," the reasons to me are clear. The cause for the current recession is the bursting of the twin bubbles of the housing markets and the credit crisis. These are problems that are going to take several years to solve, not matter that the Fed does to interest rates and opening the discount window to investment banks for all sorts of mortgage and other asset backed paper. While doing so is a good thing, we still have to work our way through 3.5 million excess homes, 2 million of which are vacant. That will take a few years.

Further, we have to develop new sources for the buying of debt. We vaporized 60% of the market for debt in the implosion of CDOs, SIVs, CLOs, etc. These buyers are never going to come back. It took 15 years to create that market. It will take a few years to create its replacement. (More thoughts on how we do that in a later letter.)

Let me offer one caveat. If the Bush tax cuts are not kept largely intact you will see the recovery that I think will be coming in late 2009 and 2010 evaporate quickly. If an Obama (probably) or a Clinton (small chance) get their way, we will see the largest tax increase in history. That is not the medicine that the economy needs when it is weak already. It could easily push the economy back into recession as it will make the consumer even weaker.

A Soft Depression? Not.

So, if things are all that bad, why won't we roll into the soft Depression that Bill Bonner and others predict? It is quite easy to make a very bearish case with a falling dollar, rising inflation, a seemingly never-ending rise in oil and commodity prices, a nasty housing market crash, a frozen credit market and more.

To establish a basis for my relative optimism, I have to re-visit what is for me a painful moment in my forecasting life. This is just between you and me, gentle reader, and I would appreciate you keeping this just between us.

Back in 1998, I thought the US and the world would drift into a recession caused by the failure of some large computer programs not being fixed on time for the Y2K rollover. I did not think it would be the disaster some thought, but I did see the potential for problems.

Why? Because of one statistic that was very clear. 50% of all major software projects for 40 years did not finish on time, and a large percentage of those missed their targets by years. That number had not changed for decades.

The Y2K software problem was very real. There were thousands of huge software projects under way by late 1998 to fix the problem. I went to many software conferences and talked with the software developers and management who were quite distressed. Their concern was real.

How, I asked them (and myself), could we expect all the projects to be done on time when the clear record said that software was difficult and managers very poor at getting things done on time. While I expected most things to be fixed, it seemed reasonable to think that there would be some problem areas. And I generally got agreement from very serious managers and consultants.

I remember talking about this with the late Harry Browne, a true friend and a very wise investment writer (and the nominee of the Libertarian Party for President for two elections). Harry was generally bearish on many things. But he told me there would be no Y2K problem. I confronted him with my evidence and research.

"John, you are missing the main point. A free market figures out how to solve problems. This is a problem that we know about well in advance. It is not slipping up on us. If it must get solved in order for a company to survive, it will get solved. End of story."

I just shook my head and took comfort in my research. And I was wrong, of course. Interestingly, all the investment advice in that book ended up being right as the stock market did drop, long term interest rates fell, and the economy did go into a recession and so on. I ended up being right for the wrong reason. And some of my very first and now long term readers met me through that book, so all was not lost.

But in looking back on it, I realize what I had missed. Whenever I talked to managers at these conferences (and I talked to a lot of them), they all told me privately that they were going to meet their deadlines, but the real concern was other companies or projects. I missed the forest for the trees. Everyone was busy making sure they were going to be fine. I look back now and wonder how did I miss it?

As it turned out, Harry was absolutely right. Because there was a literal drop dead date on each of the projects, management became very focused. It seems now that we know software projects can be finished on time if the motivation is survival of your company.

It is a lesson that has been burned into me.

Now, let me throw out a very important and interesting point. Today I am in Switzerland speaking on behalf of Bank Sarasin to their mainly institutional clients. (I should note my hosts at Sarasin were most thoughtful. It is a very impressive bank with very good people.) The conference was in German except for my speech and one by a Swedish Economics professor named Dr. Kjell Nordstrom. I attended that session and am glad I did. It was a fascinating presentation.

When I travel around the world, I am used to a certain amount of America and/or Bush bashing. It is just part of the background noise.

So, I was somewhat surprised to see the professor, in the middle of a talk on why some businesses succeed and others fail, put up a rather large flag of the United States and went on to say that the US would be the dominant developed country for his life, the life of his children and the life of their children's children. You could feel the surprise in the room. It is not what they were expecting to hear. I certainly did not.

He started out saying that someone could come to the US and within 3-5 years you could become a citizen. Making a long story short, in his native Finland it took 3-4 generations before you would be considered Finnish. He went on around the world. There are very few cultures where an immigrant can become a naturalized citizen and be accepted into the culture. China? No. Japan? No.

In Germany, the professor recently talked to the top 100 managers of Siemens. This is a company that employs 462,000 people doing business in 192 countries. In that room of the top management there were 99 Germans and one Austrian. Think of similar multi-national companies in the US. Such a room would be full of diversity.

A young lady Ph.D in physics in Lajore, Pakistan does not dream at night of immigrating to China or Germany, where opportunities would be very limited. No, she and millions more like her dream of coming to the US. He said that 85% of the people living in Silicon Valley were immigrants. The best and brightest in the world choose to go there.

Because for him, America is not a country, but an idea. It is the idea that any person can come and make a life for themselves as an equal. And it is that freedom to rise or fall that makes the US what it is.

So, what does this have to do with Muddle Through? Let's return to the original question.

First, things are not as bad as they seem. Most of the US economy is doing just fine. Businesses have not overbuilt capacity, have large cash positions and lower debt than is normal at the end of a business cycle. In the 70's and 80's, we were much more dependent upon manufacturing for employment, and thus were subject to large increases in unemployment when too much capacity met slack demand and businesses cut back as quickly as they could. Even if we rise to 6 or 7 percent unemployment, that does not rise to the level of a major recession. (And yes, I know if you lose your job it seems like a depression.)

Second, the Fed has responded, if a little late, to the credit crisis, buying time for banks to find capital. While there will be many more write-offs from bad debts and mortgage paper in the future, most banks will survive in some form. The key is that the Fed did buy us time. The banks and pension funds are still going to have to write off about twice what they already have, but not all at once. It will be several years before we are through this mess, but that is why we Muddle Through and not crash. I still contend that if the Fed had allowed Bear Stearns to crash that we would experience a soft depression. It would have been ugly. But they didn't and we won't.

And while the housing crisis is really bad if you are trying to sell a home, it is also an opportunity if you are a buyer. We will work through the excess homes that are in the market, as US population is growing and the natural demand that stems from that growth will help pick up the slack.

And the credit crisis? It will get solved, because like the Y2K problem, it must be solved if we are to survive. (I am working on a paper in which I will outline how I think this will work itself out.) And the creativity that infuses this country will rise to the occasion. Yes, I know that it was that creativity coupled with greed which caused the problem in the first place. But hopefully we will get it right this time. Again, for reasons I will outline in later letters, I have reason to believe we will.

So, I think my position in the middle is the right one. We do have very real problems and will suffer a recession. The problems will not be solved quickly. But they are not fatal problems. Time is required for the markets to heal themselves. And during that time, things will be slower than has been the case in recoveries from "normal" recessions.

And let's close with a quick commercial. Investing in this environment is tricky. The speakers at my recent Strategic Investment Conference in La Jolla gave us some very good insights, and I intend to post their speeches over time. If you are an accredited investor (net worth over $1.5 million), and would like to see some of the specific recommendations and presentations of the hedge and commodity funds that presented, you can go to www.accreditedinvestor.ws, and my partners at Altegris Investments will be glad to show you the world of commodity and hedge funds. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC. Member FINRA.)

I spent part of this week in London with my partners there, Absolute Return Partners, and am quite excited about what we are doing in the area of alternative investments for those of you that are in Europe. You can also sign up at the same site mentioned above.

And now, for those who have a net worth of less than $1.5 million, as we announced a few weeks ago, I am now working with my friend Steve Blumenthal and his team at CMG to offer a variety of investment managers who can work directly with you. I am proud of the managers we have on the platform. To see the managers and their returns, and how they are doing lately in this turmoil, just click on the following link and fill out the simple form. The minimum account size is $100,000. http://cmgfunds.net/public/mauldin_questionnaire.asp

South Africa and Swiss Mountains

I am seriously struck by the beauty of Interlaken. The mountains are simply magnificent. The Eiger and the Jungfrau are awesome on their beauty. Tomorrow we will tour the area courtesy of a local guide who is a reader and return next Monday. And the Victoria Jungfrau Hotel deserves is reputation as one of the finest in the world. I highly recommend it if you are in the area.

I will leave in two weeks for South Africa. If you would like to come to the presentations I will be making there, you can go to www.investmentpostcards.com and click on the link to write Prieur du Plessis a note.

The mountains and local attractions are waiting, and I think I am going to hit the send button a little early and go be tourist for the weekend. They have had bad weather up until I arrived, and I hope that luck holds for a few more days. Have a great week.

You're glad to be stuck in the middle with you analyst.

April 21, 2008

Time To Reduce Trade and Migration Barriers

In June 1930 the Smoot-Hawley tariff act in the US turned a stock market collapse into a crippling, decade-long Great Depression. Now, with a financial meltdown going on, is therefore NOT the time for politicians to be more protectionist. Yet last year the European Union dropped the principle of "free and undistorted competition" from its Lisbon treaty, and this year US presidential hopefuls Barack Obama and Hillary Clinton are muttering negatively about liberal trade and migration. Meanwhile, massive agricultural subsidies look likely to continue under the new US farm bill despite record high prices in international food markets – prices that are partly due to US and EU mandates and subsidies for biofuels.

The benefits of High Food Prices

According to international food agencies, today’s high agricultural prices, to which income growth in China also is a contributor, look set to continue for some years rather than being just a short-term blip. That is just the god-send that the WTO’s Doha round of multilateral trade negotiations needs to bring member governments back to the negotiating table. The agricultural talks have been the stumbling block, yet agricultural policies contribute about one-third of the global cost of subsidies and barriers to merchandise trade and so need to be an integral part of any Doha agreement.

How do today’s high international food prices help? Because they allow WTO-bound food import tariffs and other forms of farm price support to be lowered without it requiring actual prices received by farmers in the EU, US and Japan to fall much below the levels they would otherwise receive in the next few years. That may not help agricultural-exporting countries immediately, but it will in years to come when international food prices return to more-normal levels.

The Gains from Liberalization

The costs of merchandise trade barriers and farm subsidies are very conservatively estimated to be of the order of $300 billion a year. It assumes competition is perfect, which it is not, and that nothing happens to services policies under Doha, which again is too pessimistic. We suggest that if more realistic assumptions are used, estimates of the global cost of protection actually rise from anywhere between $460 billion a year to over $2.5 trillion.1

But more trade in goods is only part of economic liberalisation. Another is trade in "factors of production", including labour. Several recent studies have suggested huge gains even from modest liberalisations in the mobility of labour. For example, an increase in migrants from developing to high-income countries that accumulates to a 3 percent boost in the latter’s labour force (both skilled and unskilled) by 2025 might increase global income by nearly $700 billion a year by 2025. This flow represents a total of 14 million workers and their families coming at the rate of a little over 500,000 extra migrant workers per year. It entails a loss of merely 0.4 percent of the developing countries’ workforce, and even in the developing countries’ skilled category it represents only a 1.7 percent loss of workers. Even if you subtract the cost of moving to the host country for immigrants and the social-welfare benefits they may get when they arrive, the net benefits are sizeable compared with those from freeing up trade in goods.

Estimates of the net benefits from a permanent partial reform of goods trade barriers and farm subsidies following the Doha round, and those from expanded migration over the period to 2025, have been generated using the same economy wide global economic model that is used by the World Bank for projecting world economic growth. The figures vary with assumptions and the discount rate used, but projections through to 2100 show that developing countries would enjoy an increasing share of the benefits of free trade as their economies expand. Under an optimistic trade reform scenario, the present (2008) value of net benefits of trade liberalisation (if we ignore the impact reform could have on economic growth rates) is almost the same as that from 25 years of expanded migration from a global perspective.

Specifically, the net gains from Doha partial trade reform through to 2100 – even if no growth dividend is included – are as much as $11 trillion using a 6% discount rate, or $36 trillion if 3% is used, while those from greater migration to 2025 are $12 trillion or $38 trillion at 6% and 3% discount rates, respectively. Importantly, it is citizens of today’s developing countries who overwhelmingly would reap the lion’s share (around three-quarters in aggregate) of those benefits. If one adds in the potentially large, but less well estimated, effects of liberalisation on economic growth in the decade and a half following the reforms, the benefits are very much larger.


In sum, this evidence strongly supports the view that gradual reductions in wasteful subsidies and trade barriers, including barriers to migration, would yield huge benefits for little economic cost. At the same time, global inequality and poverty would be reduced. Although there might be some local social and environmental problems, these are usually tackled better and more cheaply by instruments other than trade barriers or subsidies. The most obvious way to achieve the benefits of liberalisation is via a successful conclusion to the Doha round of trade negotiations. If this does not happen soon, pressure for increased migration is to be expected, and a positive response to it could be hugely beneficial for the world’s poor. Such a response by rich countries to increase their intakes of migrant workers is not something that requires multilateral agreement, and so should be easier. Yet politicians are trying to keep migrants out, not let them in.

Kym Anderson is the George Gollin Professor of Economics and Foundation Executive Director of the Centre for International Economic Studies (CIES) at the University of Adelaide and CEPR Research Fellow.

L. Alan Winters is a Professor of Economics at the University of Sussex and CEPR Research Fellow.


Anderson, K. and L.A. Winters (2008), “The Challenge of Reducing International Trade and Migration Barriers”, published by the Copenhagen Consensus 2008 project and also as CEPR Discussion Paper 6760, March.

World Bank (2006), Global Economic Prospects 2006: Economic Implications of Remittances and Migration, Washington DC: The World Bank.


1 This column draws from the authors’ paper for the Copenhagen Consensus 2008 (CC08) Project. The views expressed are the authors’ alone.

Financial Innovation: Aspirin or Amphetamines?

That stability reflected a simple quid pro quo: regulation in exchange for freedom to operate. Governments brought commercial banks under prudential regulation in exchange for public provision of deposit insurance and lender-of-last-resort functions. Equity markets were subjected to disclosure and transparency requirements.

But financial deregulation in the 1980s ushered us into uncharted territory. Deregulation promised to spawn financial innovations that would enhance access to credit, enable greater portfolio diversification, and allocate risk to those most able to bear it. Supervision and regulation would stand in the way, liberalizers argued, and governments could not possibly keep up with the changes.

What a difference today's crisis has made. We now realize even the most sophisticated market players were clueless about the new financial instruments that emerged, and no one now doubts that the financial industry needs an overhaul.

But what, exactly, needs to be done? Economists who focus on such issues tend to fall into three groups.

First are the libertarians, for whom anything that comes between two consenting adults is akin to a crime. If you are selling a piece of paper that I want to buy, it is my responsibility to know what I am buying and be aware of any possible adverse consequences. If my purchase harms me, I have nobody to blame but myself. I cannot plead for a government bailout.

Non-libertarians recognize the fatal flaw in this argument: Financial blow-ups entail what economists call a "systemic risk" - everyone pays a price. As the rescue of Bear Stearns shows, the government may need to bail out private institutions to prevent a panic that would lead to worse consequences elsewhere. Thus, many financial institutions, especially the largest, operate with an implicit government guarantee. This justifies government regulation of lending and investment practices.

For this reason, economists in both the second and third groups - call them finance enthusiasts and finance skeptics - are more interventionist. But the extent of intervention they condone differs, reflecting their different views concerning how dysfunctional the prevailing approach to supervision and prudential regulation is.

Finance enthusiasts tend to view every crisis as a learning opportunity. While prudential regulation and supervision can never be perfect, extending such oversight to hedge funds and other unregulated institutions can still moderate the downsides. If things get too complicated for regulators, the job can always be turned over to the private sector, by relying on rating agencies and financial firms' own risk models. The gains from financial innovation are too large for more heavy-handed intervention.

Finance skeptics disagree. They are less convinced that recent financial innovation has created large gains (except for the finance industry itself), and they doubt that prudential regulation can ever be sufficiently effective. True prudence requires that regulators avail themselves of a broader set of policy instruments, including quantitative ceilings, transaction taxes, restrictions on securitization, prohibitions, or other direct inhibitions on financial transactions - all of which are anathema to most financial market participants.

To grasp the rationale for a more broad-based approach to financial regulation, consider three other regulated industries: drugs, tobacco, and firearms. In each, we attempt to balance personal benefits and individuals' freedom to do as they please against the risks generated for society and themselves.

One strategy is to target the behavior that causes the problems and to rely on self-policing. In essence, this is the approach advocated by finance enthusiasts: Set the behavioral parameters and let financial intermediaries operate freely otherwise.

But our regulations go considerably further in all three areas. We restrict access to most drugs, impose heavy taxes and marketing constraints on tobacco, and control gun circulation and ownership. There is a simple prudential principle at work here: Because our ability to monitor and regulate behavior is necessarily imperfect, we need to rely on a broader set of interventions.

In effect, finance enthusiasts are like America's gun advocates who argue that "guns don't kill people; people kill people." The implication is clear: Punish only people who use guns to commit crimes, but do not penalize others by restricting their access to guns. But, because we cannot be certain that the threat of punishment deters all crime, or that all criminals are caught, our ability to induce gun owners to behave responsibly is limited.

As a result, most advanced societies impose direct controls on gun ownership. Likewise, finance skeptics believe that our ability to prevent excessive risk-taking in financial markets is equally limited.

Whether one agrees with the enthusiasts or the skeptics depends on one's views about the net benefits of financial innovation. Returning to the example of drugs, the question is whether one believes that financial innovation is like aspirin, which generates huge benefits at low risk, or methamphetamine, which stimulates euphoria, followed by a dangerous crash.

Dani Rodrik, a professor of political economy at Harvard University's John F. Kennedy School of Government, is the first recipient of the Social Science Research Council's Albert O. Hirschman Prize. His latest book is "One Economics, Many Recipes: Globalization, Institutions, and Economic Growth."

April 22, 2008

Sound Money & Free Markets Will Spur Recovery

Casting aside where blame presently lies, the U.S. financial system certainly is challenged. Annualized foreclosure filings increased 75% last year to 1.3 million, while Economy.com estimates that 9 million homes are now negative in equity. Two million home-owners face mortgage re-sets this year, after an aggregate loss in U.S. home values approaching $3 trillion.

The above will impact the value of mortgage-backed debt, with losses and write-downs already totaling over $200 billion, and some estimates double that in 2008. Too many banks and brokerages are over-leveraged, and the ratio of risky assets to capital exceeds prudent levels at many firms (i.e., at year-end, Bear Stearns’ ratio of Level III [riskiest] assets to capital was 157%, and this was not the highest on Wall Street).

Does all this justify the unprecedented actions the Federal Reserve has taken, which have paved the path for new levels of government intervention? According to the most recent Flow of Funds Report of the Federal Reserve, U.S. household net worth was over $57 trillion at year-end 2007, and the total value of all real and financial assets in the U.S. stood at $185 trillion. Global equity market capitalization now stands at $60 trillion, while U.S. GDP is over $14 trillion. Given the dot-com collapse burst which cost U.S. equity-holders $7 trillion, sub-prime losses totaling 3-4% of GDP thus seem absorbable in this larger context. The underlying health and asset base of the U.S. economy also calls into question the “meltdown” scenario which, like Continental Illinois in 1984 and Long Term Capital Management in 1998, featured Fed and Treasury intervention as justified by an alleged “meltdown” possibility.

Additionally and importantly, credit market borrowing to all businesses is up, and bank lending of all types has increased by 8% since last August, when this sub-prime “crisis” fully emerged. The MZM money supply measure grew by $111 billion in March alone, and is now annualized at over 15% per year growth, so liquidity “seize-up” is not a problem, at least with respect to available funds. And while unemployment has increased to 5.1%, job losses are less prevalent than at the start of previous recessions, assuming we're in one now.

Regardless, panic has gripped Washington in three policy areas. First, beyond the $400 billion in new lending already committed by the Fed, the clamor for ever-easier money and lower interest rates, even to the point of monetization of commercial debt via the direct printing of banknotes, has reached consideration in respectable quarters. Second, given the rescue of “rich” Bear Stearns creditors, a comprehensive bail-out of mortgagors and various unemployment relief and assistance measures seems all but certain in concert with February’s $168 billion in “stimulus” spending. And finally, the whole sub-prime debacle has elicited calls for a new level of regulatory oversight across the financial services sector, because again, as “everybody knows” there was “not enough” oversight in the first place. The hapless U.S. tax-payer, already facing $270 billion in higher annual taxes scheduled for 2011, is now to be sacked as well with bills to pay for the mistakes of others, with higher inflation thrown in for good measure.

The moment has arrived for a return to clear thinking, which would evince the need for reversal of the current trajectory of policy response in these three areas:

(i). Monetary policy -- To generate economic recovery as rapidly as possible, the most important single policy requirement is the return of a strong dollar. Record lows for the dollar against the euro, along with $117 oil and $1000 gold confirm the Fed’s recent easy money policies begun back in 2001. Fed policy-makers, still ensnared by the framework of the Phillips curve trade-off between inflation or recession – a paradigm which has empirically been shown to be invalid for any but the shortest of timeframes – have pushed real short-term interest rates back into negative territory, and committed half the Fed’s balance sheet to new lending. Additionally the Fed is now prepared to “prop up” failing financial institutions, effectively monetizing bad debt, in the hope that liquidity will buy time for underwater firms to return to solvency.

This is an error which will have unfortunate consequences, perhaps as bad as the alleged “meltdown” which Fed experts seek to avoid. Sound money is indispensable to economic growth and sustainable prosperity – indeed, to civilization itself. The primary reason for this is straightforward: in a capital-using economy based on an extended division of labor, a medium of exchange is needed which minimizes instability in value due to the currency (“cash-induced” changes in value). In other words, shifts in value between traded goods will ideally be manifested in relative price changes which reflect only supply-and-demand (“goods-induced”) shifts, and not changes in the value of money (viz., due to inflation). Thus, in addition to maximizing the volume of trade and exchange, sound money permits investment and resources to flow to their “highest-valued uses”, according to the wishes of consumers, and avoids what Nobel economist Robert Lucas has called a “signal extraction problem” of price changes due not to supply-and-demand, but rather to false signals sent by increasing the quantity of money.

Inflation is pernicious precisely because it distorts these relative prices, causing resources to flow into investments which are not based on real demand, and thus leads to a job-destroying correction to clear inventories and re-allocate capital which was previously invested in error. Inflationary booms, in other words, carry the seed of their own busts, spreading misery and hardship in the ensuing correction. Additionally, inflation is of course an attack on real property: it hurts creditors at the expense of debtors who repay obligations in dollars with less purchasing power; impoverishes pensioners living on fixed income; and, transfers wealth from private sector taxpayers to government via what is a de facto hidden tax.

All of this leads to one final harmful effect: capital decumulation. Over time, inflation both reorients investor and consumer horizons toward the short term, and impedes entrepreneurial calculation of current and prospective profits and losses, thus inhibiting long-horizon capital investment. This of course has been manifestly demonstrated in the great hyperinflations of the past (e.g., Germany in 1923), which destroyed not only capital, but ultimately civil society.

Thus, the Fed’s argument that current inflationary policies are needed to promote employment, increase exports, and provide cheap credit now to shore up weak balance sheets is, while well-intentioned, devoid of a view to the long term. The choice is not between recession or inflation, with the intent to raise rates later, but rather between a short (and perhaps sharp) correction now, in which assets would be re-priced and balance sheets recapitalized to prudent levels of equity, and a 1970’s style era of malaise later, which may ultimately last for years.

(ii). Fiscal policy -- Senator Christopher Dodd (D-Connecticut) and Congressman Barney Frank (D-Massachusetts) are pushing legislation to provide up to $300 billion in assistance to mortgagors and housing investors, along with assorted relief for unemployed workers caught in the downturn. Again, while perhaps well-intentioned, these measures do little good. Up to one-third of underwater mortgages are presently held by speculators who do not even occupy the properties; rewarding them makes little sense. Many other home-buyers made poor decisions and will never be able to afford mortgages given their income, so payment assistance now merely delays the ultimate sale and re-pricing which needs to occur. To say this directly, many current home-owners should be renters. Ultimately, beyond the obvious moral hazard problem, such a housing bail-out will only add to federal deficits; the latter pulling capital from the private sector in favor of immediate government consumption.

Additionally, the U.S. economy is facing a massive tax increase in 2011 due to prior legislation, and now has the second highest corporate tax structure in the developed world. Democrats running for President are also uniform in their intent to raise capital gains and payroll taxes. Markets have surely factored in this portentous fiscal policy mix at the present time – none of this is helpful to economic prosperity.

(iii). Regulatory and trade policy -- Both Congress and the Administration are now deep into analysis of new regulations for U.S. financial markets and institutions, the implication being that lack of regulation has caused the present mess. This is an obfuscatory absurdity. Economist James Buchanan won a Nobel Prize by outlining the myriad examples and harmful effects of government failure, including errant regulation or bureaucratic ineptitude due to either lack of information or proper incentives. Recent events have only confirmed his insight.

The Federal Reserve’s stop-go monetary policy moves have fathered numerous boom-and-bust cycles, and induced severe recessions, from 1929 to the present. The Office of Federal Housing Enterprise Oversight (OFHEO), which is mandated to govern Fannie Mae and Freddie Mac, had 250 regulators who collectively missed Enron-era irregularities and accounting malfeasance, and up to the present moment has erred in allowing $200 billion in additional leverage on the balance sheets of the housing giants, when equitization of their capital structures is urgently needed. Many other examples could be cited from, say, the Federal Home Loan Bank Board (of S&L crisis fame), SEC, OCC, or the moral hazard-challenged FDIC, but the point is that heavier regulation of finance is hardly a panacea, and more than likely counterproductive. Regulatory burdens also send jobs and capital to other shores, ceteris paribus.

Finally, international free trade promotion may well slow, as again, political interests dominate sound economics, imperiling free trade agreements with countries such as Colombia and South Korea. The economic effects of stultifying the intensification of the international division of labor and specialization are well-known, and usually render both parties poorer than otherwise. For example, Caterpillar Inc. sells more heavy bull-dozers to Colombian coal mines than any other country in the world, but without the trade agreement, will continue to face a price disadvantage against the Japanese maker Komatsu. Colombians pay for equipment not to their maximal satisfaction, and union jobs are lost in Illinois, thanks to Congress. All of this is unhelpful in a period of looming recession.

In sum, U.S. monetary, fiscal, trade, and regulatory policies are all headed in the wrong direction given the current situation, and together may create the very economic disaster the political class in Washington says it seeks to avoid. The Fed has unleashed the twin furies of moral hazard and inflation, both of which will deliver blows in the period ahead. Congress and the Administration, meanwhile, have shown ineptitude, or at least tone-deafness, by advancing policies inimical to economic growth in the long run. In a time of significant challenge for U.S. firms and taxpayers – challenge which, by the way, the Fed and the political class themselves foisted upon the American people – a new direction is sorely needed on all policy fronts. Alas, the last member of the political class who fully understood the interconnection between these policy areas, and why they were, collectively, conditions both necessary and sufficient for economic growth, is long gone. He left Washington more than 19 years ago, flying home to California.

John L. Chapman is an NRI Fellow in Economics at the American Enterprise Institute.

Analysis of John McCain's Economic Plan

In McCain’s defense, it’s certainly true that heavy spending is an economic retardant. This is so for government taking earned income that could be saved and consuming it, not to mention that when governments compete with the private sector for funds to spend, they reduce the amount of capital that would otherwise be made available to job-creating businesses and entrepreneurs. Still, the fact that McCain led with spending cuts as the answer to a flagging economy speaks to his discomfort when it comes to talking up tax cuts.

McCain’s vision for spending cuts is mostly good, however. He’s proposed a one-year spending freeze on non-defense discretionary spending, and as a military man himself, it can be safely assumed that he’ll credibly seek to reduce a lot of military waste too.

What’s unfortunate is his desire to make wealthier seniors pay more for prescription drugs under Medicare Part D. While this writer would desire near abolishment of Medicare altogether, penalizing the very people (the rich) who have and continue to fund the federal government speaks to a creeping version of socialism that has infected both parties. Indeed, how can politicians credibly ask the top 1 percent of earners to fund the unfortunate behemoth that is the federal government while regularly seeking to reduce the alleged benefits they receive? Politics are doubtless at work here, but it would be nice if rather than these implicit slights imposed on the wealthier among us, politicians would begin to acknowledge how much worse off we’d all be absent the economic blessings that reach us thanks to the vital few.

On the tax front, McCain’s plan is a mixed bag of good and bad. The positives include his stated desire to make the 2003 tax reductions on income and capital gains permanent, a cut in the corporate tax from 35 to 25 percent, and somewhat good, abolition of the alternative minimum tax (AMT). What’s presently unknown, however, is how much his seemingly newfound support of marginal rate cuts is rooted in real belief, as opposed to being pure politics.

Sometimes forgotten is that McCain voted against the aforementioned 2003 tax cuts given his fears of deficits and wealth gaps. Many commentators, including Cato Institute senior fellow Alan Reynolds, worry his present tax stance is somewhat political in nature and that he’ll surely revert to deficit-oriented austerity once in office. McCain’s appointment of noted deficit hawk Douglas Holtz-Eakin as his chief economic advisor is another negative signal that if elected, tax cuts will be pushed aside. In the aforementioned Kudlow & Co. interview, McCain did make the important point that, “It is not taxes that are insufficient, it’s spending that’s out of control,” but it would be nice if he defined his terms on taxes far more to show that he’s truly on board with the essential good that results when work and investment are penalized less.

Regarding corporate taxes, it should be said that so long as trade is free (McCain is very much in the free-trade camp), it really doesn’t matter where corporations are formed. Indeed, New York and New Delhi are no worse off for Microsoft having incorporated in Seattle. What makes corporate tax cuts truly necessary is the basic truth that entrepreneurs enjoy the greatest success in the United States.

When we consider this reality, a cut in corporate rates is arguably one of McCain’s best policy positions for making it easier for corporations to form stateside. What’s a near certainty is that Bill Gates could not have created what became Microsoft in Paris or Bombay, so anything that makes incorporations easier here will accrue to both ours and the world’s economy. Notably, McCain gets immigration right too, so the ideal scenario for him over the long-term would be to push liberalized immigration rules that make efforts to work in the U.S. legal. A combination of corporate tax cuts and legalized work would in time lead to a revitalized entrepreneurial sector that would once again make the U.S. economy the envy of the world.

Looking at the bad in McCain’s tax plan, U.S. News & World Report’s James Pethokoukis wrote last week that the problem with tax “relief,” as opposed marginal cuts that increase the desire to work and save is that “it would mean even fewer people paying any income taxes at all.” Unfortunately, McCain seeks to double from $3,500 to $7,000 the personal exemption for dependents. This act alone would enable many more Americans to avoid paying income taxes, thus making broader reform of the tax code an even more distant object.

The above is why abolishment of the AMT is presently questionable policy. Indeed, with more and more Americans not paying much in the way of income taxes at all, abolishment of the AMT would make taxes on the federal level even less onerous such that major reform would be more difficult politically. A better strategy from the GOP considering the AMT hits blue-state voters the most would be to tie AMT abolishment to broad reform, or at the very least, tie it to making the 2003 cuts permanent.

As for McCain’s desire to allow immediate expensing of business-equipment purchases, this is faulty industrial policy run amok made even worse considering McCain's stated aversion to aiding special interests. Put simply, we shouldn’t be complicating the tax code even more with rules that favor one business-constituent group over others. Secondly, it’s bad policy. The reality is that American business success stories from Google to FedEx to Goldman Sachs are successes of the mind, as opposed to equipment. Rather than pushing a Keynesian plan meant to stimulate equipment purchases, politicians should be closing special-interest loopholes in favor of reform that reduces the success penalty without regard to the kind of commerce engaged in.

Asked by CNBC’s Larry Kudlow about executive pay, McCain opined that “there are bad corporate executives and corporate greed that has to be checked.” While it says here that free markets constitute the ultimate check on alleged corporate greed, that quality executives are priceless, and that CEO pay when it comes to company successes and failures reflects their potential value, even those who agree with McCain should be concerned with his stance.

Indeed, even if it were true that markets are wanting when it comes to punishing business failures, if the executive branch can somehow have a controlling stake in CEO pay, it will surely aggregate to itself powers those concerned about executive pay won’t like. One area to look is anti-trust given McCain’s idolization of Teddy Roosevelt. Despite the fact that anti-trust rules arguably weigh on our economy more than the most governmental policies, if as president McCain were to nose his way into pay, he logically wouldn’t stop there. The desire of some to let the executive branch rein in occasional mistakes on the pay front will reveal itself in ways many won’t like.

Lastly, when asked by Kudlow about the falling dollar, McCain’s response was concerning for his mention of the trade “deficit” somehow factoring into the weak greenback. That there’s no causal relation between the two was a red light, plus McCain’s desire to give drivers a “summer holiday” from federal gas taxes speaks to a fundamental misunderstanding about why gasoline is presently expensive. McCain, like seemingly every candidate in this cycle, has not picked up on the basic truth that oil and gas are expensive precisely because the dollar is weak.

That no one with a shot at the White House has addressed this basic issue speaks to how uninspiring this election will be. With no candidate aware of the strong correlation between inflation and recession, we on one hand have a candidate like McCain who presently embraces certain market-friendly ideas that he’s historically been uncomfortable with. On the other, we have two candidates from the Democratic side of the aisle who frequently seek to outdo each other in terms of showing they’re good on tax “fairness;” meaning they’ll reduce the wages of those not yet rich by taxing the rich.

So in assessing our future economic prospects under all three candidates, whatever their true policy instincts, we thankfully have the existence of the stock markets to make sure none cause too much damage. Indeed, while it’s presently fashionable to question the markets and the signals they provide, as a nation of investors we can rest assured that no matter who’s elected, the often harsh message of the markets will presumably restrain any of our choices from causing too much harm. Other than that, buyer beware.

The Effect of Mergers on Consumer Prices

More than a thousand merger requests are filed with U.S. antitrust authorities each year, but only a small number of these transactions are blocked or modified because of concerns that they might result in higher, anticompetitive consumer prices. Recent examples of highly debated proposed mergers include the combination of Delta and Northwest airlines and Microsoft’s bid for Yahoo!. Although very significant public and private resources are devoted to the administrative review of the potential anticompetitive effects of mergers before they are approved, there has been surprisingly little evaluation of whether the mergers that have been permitted are actually anticompetitive. Absent this information, it is impossible to determine whether government policies are either too stringent or too restrained or to make rational adjustments to these policies.

More generally, the value and effectiveness of antitrust policy itself is the subject of intense debate that must rely on very little factual information. Crandall and Winston (2003), for example, argue that antitrust policy has not been beneficial for consumers, while Baker (2003) argues to the contrary.

Which mergers would be anticompetitive?

In the late 1990s, the U.S. economy experienced the largest merger wave in its history with the number of merger filings more than doubling between 1994 and 1999. In recent research, we selected the consummated mergers to study from those that, based on the public record, appeared to be the most problematic from the antitrust agencies’ point of view: those most likely to result in anticompetitive price increases (Ashenfelter and Hosken 2008). The price increases from these mergers provide an upper bound on the price increases that other permitted mergers may have produced and a lower bound on the price increases that might otherwise have occurred in mergers that were blocked. We thus provide an indication of whether government merger policy may have been too hostile or too acquiescent. To identify potential mergers we searched the Merger Yearbook and identified five consummated mergers where the merging parties produced products that were substitutes in markets that appeared from press accounts to be somewhat concentrated. The five cases are Proctor and Gamble’s purchase of Tambrands (feminine hygiene products), Aurora Food’s purchase of Kraft’s Log Cabin breakfast syrup business, Pennzoil’s purchase of Quaker State motor oil, General Mills’ purchase of the branded cereal business of Ralcorp, and the merger of the distilled spirits businesses of Guinness and Grand Metropolitan.

Difference in differences

To control for other confounding factors that may also have changed at the time of the event such as the effect of possible changes in demand or costs on prices, we use a “difference-in-differences” estimation to measure the consumer price effect of mergers. We consider multiple control groups and windows of data surrounding the events we study. Our preferred control group consists of the private label products sold in each industry. The advantage of private label products as a control group is that they are likely to be distant substitutes to consumers for the higher quality branded products affected by the merger. Yet private label products should share many of the same inputs (with the exception of advertising) that are used to manufacture branded products. Assuming that these private label products are supplied perfectly elastically, the prices of these products should serve as good controls for costs, while at the same time they should be relatively unaffected by any anticompetitive price increase by the merging parties. Our preferred merger window contains a symmetric amount of data pre- and post-merger. By dropping the data within three months of the merger date, we avoid the issue of exactly when the firms start coordinating their pricing behaviour, leaving us with uncontaminated measures of the firms’ pre- and post-merger pricing.


Our empirical results indicate that four of the five mergers we study resulted in some increases in some consumer prices. The estimated price increases might be considered relatively modest, as they are typically between 3% and 7%. However, given the large amount of commerce in these industries, the implied transfer from consumers to manufacturers is substantial. While the magnitude of some price effects varies with our empirical specification, the conclusion that consumer prices did not decrease, and most likely increased, was not altered when we changed the way we measured consumer prices or the control group, or when we changed the choice of the window of time surrounding the merger during which price changes might be implemented.

Too acquiescent regulators

Some advocates of less intervention may be surprised to learn that our best estimate of the price effects of the marginal merger are positive, not negative as would be the case if the marginal merger were producing large benefits to consumers through the efficiency of the enlarged firm.

Our results have several limitations, and thus it would be premature to conclude either that the mergers we studied were, on net, harmful to consumers or that our evaluation is comprehensive. First, we are not able to analyze either the possible longer-term effects of mergers on prices that may result from the increased economic efficiency of merged firms, nor are we able to study the role of mergers in the development of new products. Second, we have restricted our analysis to consumer products mergers, which, although they attract much attention, constituted a small fraction of mergers in the period we study. Finally, our study has only examined the implications of Type II errors, the failure to block a merger when it might be useful to do so. Our study does not analyze Type I errors, rejecting mergers that would not have resulted in higher prices. It is possible that by allowing some anticompetitive mergers to take place, the government may also allow many efficient mergers to take place that would have been challenged by a stricter antitrust policy. A complete evaluation of optimal enforcement behaviour must be based on a consideration of all these issues.

Orley Ashenfelter is the Joseph Douglas Green 1895 Professor of Economics at Princeton University.

Daniel Hosken is Deputy Assistant Director for the Office of Applied Research and Outreach in the Federal Trade Commission's Bureau of Economics.


Ashenfelter, Orley and Daniel Hosken (2008). “The Effect of Mergers on Consumers Prices: Evidence from Five Selected Case Studies,” NBER Working Paper 13859, February.

Baker, Jonathan. “The Case for Antitrust Enforcement.” Journal of Economic Perspectives Vol. 17 (2003) pp. 27-50.

Crandall, Robert W. and Clifford Winston. “Does Antitrust Policy Improve Consumer Welfare? Assessing the Evidence.” Journal of Economic Perspectives Vol. 17 (2003) pp. 3-26.

April 23, 2008

Economic Freedom Advances Human Rights

To promote justice and peace, both the UN and the church would do well to put economic rights at or near the top of the human rights agenda. Human right number one: No government or government-sponsored central bank may issue currency which loses value after being exchanged for labor or produce. Manipulated currency harms poor workers worst of all. Inflationary currency robs workers of purchasing power commensurate with the value of their labor, while also depriving them of free choice to save for working capital or improved standard of living. If they save, their savings lose purchasing power. Deflationary currency deprives poor workers of jobs, since they are always the marginally employed.

Human right number two: No person shall be taxed more than one-quarter of gains from labor or enterprise by all governments asserting authority over the individual. Twenty-five percent of earnings and all net income of every kind ought to be the limit of government’s power to take from an individual. Government can always assert that the “common good” requires the individual to give up the fruits of productivity, all the way to one hundred percent. The fact remains, however, that every increase in marginal tax rate drains capital from private endeavors and thereby costs jobs. A person ought to have unfettered right to three-quarters of his produce. With this human right observed by governments, individuals and societies prosper.

If the United Nations and the Catholic Church promote these human rights, they will be opposed by global mercantilist interests. Mercantilists are those with pools of “organized money” who influence government power for their financial gain. From the Middle Ages through the Eighteenth Century, mercantilism reigned in most nations. Influential courtiers of monarchies (and their counterparts in other forms of government) acquired market monopoly licenses protected by trade embargoes and tariffs. Impoverished populations were told the high prices they paid for necessities protected their jobs from cheap foreign competition.

Twenty-first Century mercantilists have learned to rake greater profits from financial markets without participating in the dirty work of producing goods and services. Managed currency value is better disguised than tariffs and more useful to mercantilists as a weapon of trade war. Manipulating interest rates can drive asset prices up and down. Mercantilists will not easily relinquish advantages as central banking insiders who know before the rest of us how particular currencies will be “managed” by interest rates and the injection or draining of liquidity.

Sad to say, global mercantilism lives in the United States. Its dominant influence at the Federal Reserve and at the U. S. Treasury should be obvious, but is not well reported or understood. The hallmark of Federal Reserve monetary policy since 1971 has been its manipulation of domestic interest rates. Concurrently, the Fed has devalued the dollar by ninety-six percent during the same period, mixed with bouts of severe deflation that serve as wrecking balls of economic growth. During the past twelve months alone, the dollar has been devalued 50 percent relative to gold (the only yardstick that works or matters), while economies of Europe and Asia are battered by U. S. “competition” made possible only by the weak dollar. Other central banks struggle under pressures to devalue along with the dollar, though doing so will not enable their people to avoid the ravages of inflation that will follow.

Human rights to stable currency and low taxes would advance global peace, justice and prosperity like nothing else on the international agenda. The federal government of the United States can advance these human rights more readily than can the United Nations or the Catholic Church. Reform of monetary policy at the U. S. Treasury and the Federal Reserve can produce stable currency for global commerce, permitting all other central banks to conform their own practices. Lower marginal tax rates in the U. S. drive tax rates lower around the world, as occurred in the Eighties. Right now, though, the U. S. is lagging other nations in cutting tax rates and threatens to allow the 2003 tax rates to jump immensely when they expire in 2010. Congress ought not to do that.

The Federal Reserve must stop manipulating interest rates and allow markets to set them. The Fed should be ordered by Treasury or the President to manage liquidity to stabilize the dollar’s value at a specified target price between $450 and $500 per ounce of gold. Current policy will continue to reward billionaire currency speculators and doom the world to recurring boom, bust and stagflation. Better to do our part to advance human rights. The UN and the Catholic Church are welcome to help.

The Shape of America’s Recession

The answer depends on the shape of the US recession: if it is short and shallow, sufficient growth elsewhere will ensure only a slight global slowdown. But if the US recession is long and severe, the result could be outright recession in some countries (the United Kingdom, Spain, Ireland, Italy, and Japan), and even financial crises in vulnerable emerging-market economies.

In principle, the US recession could end up being shaped like a V, U, W, or L. Which of these four scenarios is most likely?

The current consensus is that the recession will be V-shaped – short and shallow – and thus similar to the US recessions in 1990-91 and 2001, which lasted eight months each. Most analysts forecast that GDP will contract in the first half of 2008 and recover in the second half of the year.

I expect a longer and deeper U-shaped recession, lasting at least 12 months and possibly as long as 18 months – one of the most severe US recessions in decades – because today’s macroeconomic and financial conditions are far worse.

First, the US is experiencing its worst housing recession since the Great Depression, and the slump is not over. Construction of new homes has fallen about 50%, while new home sales are down more than 60%, creating a supply glut that is driving prices down sharply – 10% so far and probably another 10% this year and in 2009.

Already, $2.2 trillion of wealth has been wiped out, and about eight million households have negative equity: their homes’ are worth less than their mortgages. By 2010, the fall in home prices will be close to 30% with $6.6 trillion of home equity destroyed and 21 million households – 40% of the 51 million with a mortgage – facing negative equity. If owners walk away from their homes, credit losses could be $1 trillion or more, wiping out most of the US financial system’s capital and leading to a systemic banking crisis.

Second, in 2001, weak capital spending in the corporate sector (accounting for 10% of GDP) underpinned the contraction. Today, it is private consumption in the household sector (70% of GDP) that is in trouble. American consumers are shopped-out, saving-less, debt-burdened (136% of income, on average), and buffeted by many negative shocks.

Third, the US is experiencing its most severe financial crisis since the Great Depression. Losses are spreading from sub-prime to near-prime and prime mortgages, commercial mortgages, and unsecured consumer credit (credit cards, auto loans, student loans). Total financial losses – including possibly $1 trillion in mortgages and related securitized products – could be as high as $1.7 trillion.

Given these staggering sums, the US could face a double-dip, W-shaped recession. The main question is whether the tax rebate that US households will receive in mid-2008 will be consumed – thus leading to positive third-quarter growth – or saved. Given how financially stretched US households are, a good part of this tax rebate may be used to pay down high credit card balances (or other unsecured consumer credit) or to postpone mortgage delinquency.

Fortunately, an L-shaped period of protracted economic stagnation – Japan’s experience in the 1990’s – is unlikely. Japan waited almost two years after its asset bubble collapsed to ease monetary policy and provide a fiscal stimulus, whereas in the US both steps came early. Moreover, whereas Japan postponed corporate and bank restructuring for years, in the US private and especially public efforts to restructure assets and firms will start faster and be more aggressive.

Still, given a severe financial crisis, declining home prices, and a credit crunch, the US is facing its longest and deepest recession in decades, dashing any hope of a soft landing for the rest of the world. While a global recession will be averted, a severe growth slowdown will not. Many European economies are already slowing, with some entering recession. China and Asia are particularly vulnerable, given their trade links to the US. And emerging markets will suffer once the US contraction and global slowdown undermines commodity prices.

Nouriel Roubini is Professor of Economics at New York University and Chairman of RGE Monitor (www.rgemonitor.com).

Copyright: Project Syndicate, 2008. Visit Project Syndicate at http://www.project-syndicate.org

The Paradox of Falling European Unemployment

An old European dream has come true, but it looks more and more like a nightmare.

The dream was written on the stone of the Treaty, signed in Rome on March 25, 1957: “The Community shall have as its task (…) to promote throughout the Community (…) a high degree of convergence of economic performance, a high level of employment and of social protection, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among Member States.”

A European dream came true…

In the last ten years European unemployment has fallen to a level not seen for over twenty-five years. There are currently almost 4 million fewer people unemployed in the EU15 than in 1996. Long-term unemployment almost halved: Europe is no longer a place where half of all job seekers have been on the dole for more than twelve months, as was the case in the mid-1990s.

The disappearance of mass unemployment in Europe is not the by-product of falling participation to the labour market; it is the average employment rate in the EU15 that has increased by more than six percent over the last ten years. This is the only area in which Europe is getting closer to the ambitious Lisbon targets. Nor there are more discouraged workers crossing the pourous borders between participation and non-participation to the labour market: there was no increase in the number of non-employed persons who decided to stop searching for another job as they realized that there were no vacancies for them.

It was mainly the countries with initially the largest unemployment rates that succeeded in reducing unemployment the most. The cross-sectional dispersion in unemployment rates across regions of the EU15 (Nuts II) also declined considerably as a result of both less cross country and less within country variation in unemployment rates. This looks like a major step towards achieving the social cohesion pursued by European Governments at least since the 1957 Rome Treaty. European regions are less and less different in terms of labour market conditions.

...But it is turning into a nightmare

European Governments, however, are not capitalizing on these labour market success stories. Governments and coalitions ruling while millions of jobs were created have not been reconfirmed in office. Berlusconi’s 2001-6 Government succeeded in creating 1.3 million jobs in five years, far more than promised in the 2001 electoral campaign. This did not prevent the collapse of his popularity and the defeat at the next elections. Prodi’s 2006-8 Government had a very short life, in spite of creating more than 400,000 jobs in less than 2 years. Aznar lost in 2004 after halving Spanish unemployment and creating almost 5 million jobs during his mandate.

Public opinion polls also find rising dissatisfaction with working conditions, notably in those countries having experienced the strongest unemployment declines.


Why is a European dream turning into a European nightmare? The simplest explanation one could possibly offer is that the decline in unemployment was a demographic phenomenon, independent of changes in the incidence of unemployment among specific socio-economic groups. Europe is experiencing the ageing of its population and young people typically display higher unemployment rates than older workers. Thus, an ageing Europe is bound to have lower unemployment simply as a result of a changing age distribution of its workforce. However, this simple explanation does not work. It could at most explain one-tenth of the decline in unemployment. The remaining success is due to a fall of unemployment among all age groups. Nor does large-scale immigration, the second most important demographic phenomenon in Europe in the last decade, explain the disappearance of European mass unemployment. If anything, more migration should have involved increasing unemployment rates: the incidence of unemployment is typically higher among migrants than natives in the EU15.

In order to understand what has been going on in Europe and the paradoxical dissatisfaction of its citizens with the disappearance of unemployment, one has to go beyond labour market stocks and look at flows across labour market states. The first thing to notice is that unemployment has been declining in spite of an increase of unemployment inflows rates (inflows over the population at risk, that is working age population minus the unemployed). Put it another way, it was mainly an increase in outflows from unemployment that drove the fall in European unemployment. Secondly, one discovers that there has been an increase in mobility across labour market states, evident from computing mobility indexes over transition matrices mapping flows across the main labour market states. Significantly, the increase in mobility was stronger in the countries experiencing the largest falls in unemployment.

It was reforms!

The European labour market landscape looks much different from the sclerotic conditions of the early 1990s. Let us remind what a very influential report commissioned by the G7, the 1994 OECD Jobs Study stated at that time: “In inflexible Europe … the high incidence of long-term unemployment is associated with low inflow rates into unemployment.”

Why did this sea change from sclerotic to a more mobile Europe occur? The driving factor of the increase in labour market flows would seem to have been reforms of employment protection legislation. During the 1990s, major reforms reduced costs of dismissals: there were only four such reforms over the entire EU15 in the 1986-90 period and 16 in the 1996-2000 period. Most of these reforms were marginal in that they were confined to reducing employment protection for new hires, expanding the scope of fixed-term contracts and introducing new and more flexible contractual types (from temporary work agency to job-on-call). This dramatically changed the conditions at entry. In the countries with the strictest provisions concerning the dismissals of permanent workers, the majority of new hires are currently in these new and highly flexible contracts. For example, in Spain nine out of ten transitions from unemployment to employment occur in fixed-term contracts. The increase in unemployment outflows in Europe was largely associated with this new entry channel.
The trouble is that, rather than being just a port of entry, these contracts often become a dead-end: the probability of moving from a fixed-term to permanent contract within a year is indeed very low, of the order of one out of 20 or one out of 10. In other words, dual track reforms created long-lasting asymmetries in career paths, concentrating risk on the workers with flexible contracts. On the basis of transition matrices, it is predicted that, in the long-run, up to one third of employment will be in such flexible contracts.

Can Europeans be happier about their new labour market?

The dissatisfaction of Europeans with respect to their labour market is ultimately related to a new and apparently less favourable risk-return combination. Labour markets are becoming more risky and this entails a welfare loss for risk-averse workers unless this greater risk is compensated by higher returns. Pressures are mounting everywhere in Europe for greater state involvement in wage setting. These pressures can also be interpreted as a request of compensation for greater labour market risk. Nobody can be fully insulated from it. Even the insiders are somewhat exposed as they form expectations about job loss.

The pressures to go back are strong. But after having reduced state involvement in employment adjustment, it would be a mistake to have governments more involved in wage setting. Setting statutory and industry-specific wage minima, as recently done in Germany, exposes governments to even stronger pressures from national lobbies and leapfrogging games across industries. And there is no reason to reintroduce even the mild forms of income policy that were adopted in several EU countries in preparation for EMU membership. The problem is that centralised wage setting is not an appropriate instrument under the EMU, as macroeconomic shocks are more regional or industry-specific in nature. Thus, national-union-based systems of industrial relations are ill-suited to address new demands for microeconomic adaptability.

The best response that can be offered to the paradoxical concerns of Europeans with respect to lower unemployment is to decentralise even more wage setting and make it more responsive to productivity. Risk is magnified by the fact that any labour market transition involves a large wage loss. Centralized wage agreements tend to reward automatic adjustments of wages to tenure. Moving across jobs or experiencing even a short unemployment spell prevents moving up the wage ladder. A better risk-return combination can be offered by linking wages more closely to idiosyncratic productivity. Insofar as changing jobs involves pairing better matches, wages would increase after changing jobs rather than the other way round.

At the same time, something must be done to tackle the increasing dualism between temporary and permanent jobs in most European labour markets. This dualism is costly for the society at large as it reduces incentives to accumulate human capital: workers with fixed-term contracts are less subject to on-the-job training than the other workers. A sensible policy would be to offer a clear “tenure track” prospect to young workers by completing reforms of employment protection. Currently, there is no long-term prospect after the expiration of a temporary contract. Governments could promote permanent entrance in the permanent labour market in stages, introducing employment protection with gradualism and avoiding the formation of a long-term dual market. Job security provisions, in the form of mandated severance payments, should increase smoothly as workers acquire tenure without large discontinuities.

Waking up from the nightmare

There is ultimately a trade-off between employment and productivity growth behind the dissatisfaction of Europeans with low unemployment. Employment growth is occurring at the cost of negative or low growth of labour productivity. This prevents workers from being compensated for their higher risk exposure. The fact of the matter is that Europe is still in the middle of the river of labour market reforms. Pressures to go back are strong. Governments should resist these pressures, as they would have huge employment costs. Increasing both employment and productivity in Europe requires doing just the opposite. Governments should take us on the other side of the river: a tenure track to more stable jobs should be introduced and wage setting should be decentralized to link it more closely to productivity gains.

Tito Boeri is Professor of Economics at Bocconi University, Milan, Scientific Director of the Fondazione Rodolfo Debenedetti, Founder of LaVoce and CEPR Research Fellow.

April 24, 2008

Free Markets Are Rare in Starving Nations

Haitians are tragically starving, in other words, not because of the West’s misguided bio-fuels policies.

To read media coverage and commentary of the world’s growing hunger crisis, one would assume that the problem is largely the doing of Western democracies. We’ve been reminded any number of times, by commentators on the left and the right, that misguided efforts to convert grains into fuel have robbed the world market of precious foods. Meanwhile, that noted climatologist, Paul Krugman, has blamed the crisis in part on the West’s failure to address global warming, which he assures us has caused the drought that has curtailed food production in Australia. Even worse, the meat-eating proclivities of Westerners, critics tell us, have robbed others of food because it takes 700 calories of animal feed to produce 100 calories of beef.

It’s startling, however, the degree to which this kind of thinking is at odds with the geography of hunger around the world. If there is one thing which the countries where--according to the United Nation’s World Food Programme--hunger is rampant share in common it is that they resemble Haiti. They are places where people are often enslaved, where free markets don’t operate, where property rights are not respected and corruption is widespread, where foreign investment dares not tread, where thugs and revolutionaries often appropriate for themselves aid that is meant for others. But these are problems which the Western media can hardly speak of when addressing hunger, as if it’s unseemly to say that people are hungry because their own leaders are failing them—often despite our efforts, not because of them.

Political turmoil and the retreat of freedom have managed to make people hungry even in places where many previously were not. Heading the U.N.’s list of countries where people are most undernourished, for instance, is Zimbabwe. When the country became independent in 1980 it had, according to the Index of Economic Freedom, “extensive natural resources, a diversified economy, a well developed infrastructure, and an advanced financial sector,” as well as networks of productive farms. But the increasingly repressive regime of strongman Robert Mugabe has destroyed property rights, allowed favored government officials to seize control of farm lands, and been hostile to Western investment, in the process transforming the country “from the breadbasket of Africa into a starving, destitute tyranny,” according to the Index of Economic Freedom.

In many places, hunger is prevalent even though natural resources are plentiful. In the Democratic Republic of the Congo, where two-thirds of the country’s 62 million people are undernourished, citizens lived amid constant chaos after war broke out in the mid-1990s and the country became a battle ground for troops from eight nations in the so-called African World War, in which more than 5 million people died mostly from starvation and disease. Tragically but perhaps not surprisingly, despite abundant resources including copper, cobalt and diamonds, as well as “enormous agricultural potential” according to the United Nations, the DRC is one of the world’s poorest countries, where production of food has declined some 40 percent since war broke out.

Conflict is at the heart of the struggles and starvation of many of the world’s poorest people, especially those whom Oxford University economist Paul Collier calls “the bottom billion.” Collier argues in his book of the same name that while much of the developing world marches toward a better future, about one-sixth of the Earth’s population is being left behind in large part because of political turmoil and bad government. In all, Collier estimates, more than seven in 10 people in the bottom billion have lived through civil war, while border conflicts are common among countries where this group lives. Many of the nations that engaged in the widespread conflict that devastated the Democratic Republic of the Congo are themselves places where the population is suffering from extreme hunger, including Angola, Zimbabwe and Rwanda. Elsewhere in Africa Ethiopia, where nearly half the population of 69 million are starving, has warred with its neighbor to the north, Eretria, where starvation is also widespread, and invaded Somalia, a country which has no had a national government for some 17 years and where hunger is assumed to be extensive, although data are hard to come by because of the country’s instability.

Faced with such massive governmental breakdowns, Western aid agencies have focused much of their energies on places like China, Brazil and India--where economic progress is already lifting hundreds of millions out of poverty--while truly destitute places languish and their standards of living decline. “The World Bank has large offices in every major middle-income country, but not a single person resident in the Central African Republic,” writes Collier, who once headed development research for the World Bank. “Every development agency has trouble getting its staff to serve in Chad or Laos.”

Collier has several recommendations for the West, including tying aid to political and economic reforms, giving the poorest countries preferential treatment to Western markets until their products can compete on a level playing field with those from other developing countries like China, and finally, when all else fails, military intervention to reestablish order and save lives. Needless to say, that is his most controversial solution, though one that is finding increasing support even from unlikely sources, like New York Times columnist Nicholas Kristof, who has traveled extensively in Africa and sees little else that may make a difference to people in the direst circumstances. He argues that had the West intervened in Rwanda in 1994 and averted massacres there, the number of lives saved would have far surpassed anything accomplished by more traditional forms of aid.

Perhaps it’s because military intervention seems so unlikely—after all, the U.S. is preoccupied in Iraq and most European armies today resemble glorified police forces incapable of operations around the world—that the media prefer to focus on how Western policies have contributed to the growing hunger problem. But the West’s shortcomings have had a marginal impact, at best, and as free markets engage around the world, they are likely quickly to offset those failings. Even now in the United States farmers who have been paid by the government for years not to farm their land are ratcheting up production to meet growing demand.

What won’t change, even as the business cycle turns and markets respond, is the plight of the most destitute, who are also almost universally the world’s most enslaved people. They need democracy and free markets of their own, and until they get those, the world’s hunger crisis won’t disappear.

The Food-Shortage Myth

Though the oil “shocks” that followed are to this day described in establishment economic quarters as a function of OPEC’s largely symbolic "embargo," the real answer lay in a currency that was quickly losing value. This materialized first in the form of a rising gold price, and it soon led to broad increases in the prices of all manner of commodities.

OPEC, previously toothless due to the stability of the oil price under a world-currency regime centered around a stable dollar, had its heyday amidst a period of rising petroleum prices that shifted enormous amounts of increasingly worthless paper currency to the Middle East. In concert with inflation’s rise, so did OPEC’s stature grow; its power every bit as inflated as the cheap dollars sent over in exchange for oil.

Had OPEC’s newfound heft been merely coincidental, this would have been made quickly apparent by non-oil commodities that would have remained inexpensive alongside oil’s rise. In fact, the exact opposite situation materialized.

While the dollar price of oil rose 300% during the dollar’s first major devaluation, other commodities not impacted by OPEC machinations similarly became dear. In 1973, meat prices were rising at a 75 percent annual rate. From 1972 to 1973 the cost of a bushel of wheat rose 240 percent. Soybeans rose from $3.50 a bushel in 1972 to $12.00 in 1973.

With commodities priced in dollars, a change in the dollar’s value has a near instantaneous impact on the spot price of those same commodities. The greenback’s fall post-Bretton Woods in a sense made a broad commodity rally inevitable.

And perhaps foreshadowing the bipartisan hysteria concerning food prices today, the doomsayers of thirty years ago had their day in the sun. In 1972, the Club of Rome released The Limits to Growth, which said if economic growth were allowed to continue, the world would run out of food and commodities; oil disappearing from the earth by 1992.

Ever eager to latch on to any crackpot notion embraced by the intelligentsia, President Jimmy Carter commissioned a study from Gerald Barney at the Rockefeller Foundation titled Global 2000. The report predicted rising commodity prices thanks to declining food and oil production wrought by falling supplies of both. It is said that the report greatly impacted our 39th president, and partially explained his dour countenance throughout the 1980 election.

Moving to the present, a number of commentators from both sides of the political spectrum have called attention to rising food and commodity prices. Parroting the “visionaries” from the Club of Rome, New York Times columnist Paul Krugman recently asked whether, “limited supplies of natural resources pose an obstacle to future world economic growth?”

Kevin Hassett of the American Enterprise Institute has bemoaned a World Bank study showing global food prices have risen 83 percent over the last three years; a period in which “almost all of the increase in global maize production from 2004 to 2007 went for biofuels production in the U.S.'' Hassett’s stance becomes more interesting when we consider the long-held view of many right-of-center think tanks that U.S. farmers produce too much food.

The often insightful Ambrose Evans-Pritchard of London’s Daily Telegraph recently wrote of a “Malthusian crunch [that] has been building for a long time,” thanks to the world’s addition of 73 million mouths per year. Evans-Pritchard channels Hassett in his proclamation that the “mass diversion of the North American grain harvest into ethanol plants for fuel is reaching its political and moral limits.”

Not defending the hoax that is ethanol for one second, the fears expressed by Hassett and Evans-Pritchard are somewhat overdone. No doubt the dollar price of wheat, corn and soybeans has increased respectively 136, 203 and 205 percent since 2001. It seems like a lot, and in isolation would make their worries (along with those of Krugman) understandable.

But what all three left out of their analysis is the dollar’s near singular role in the above. Indeed, over the same timeframe the objective benchmark that is gold is up 244 percent in dollar terms. Rather than expensive, food in real terms hasn’t kept pace with a severe dollar devaluation that has spread to currencies around the world.

When inflation outside the U.S. is considered, it’s seemingly hidden owing to the desire of currency experts to compare the interplay of paper currencies lacking any market definition. But in truth, dollar devaluations going back to 1971 have historically occurred in concert with inflationary outbreaks worldwide. And that’s what’s happened over the last several years.

Since the summer of 2001 when the dollar started to fall, we’ve heard persistent chatter about the strength of foreign currencies relative to the greenback. The strength, however, has been highly illusory in that it’s merely shown that currencies not our own have been stronger than the even weaker U.S. dollar. Measured in gold, it would be hard to find any currency that hasn’t lost value in this decade; hence the worldwide inflationary outbreak that has spread to food prices, and that’s shown up in government measures of inflation that have reached multi-year highs.

So rather than a tragedy of too much growth, too much ethanol production or too little moral fiber, the food “shortage” story is as it’s always been: a dollar story. Going back to 1971 and our mistaken decision to float the dollar, periods of weakness since then have regularly led to commodity shortages of all kinds, including corn.

A simple solution to the present food problem would involve the Bush Treasury making plain that it would not just prefer a stronger dollar, but a stable one defined in terms of something real like gold. Food shortages and the alleged power of OPEC would quickly become historical relics if Treasury made such a move, but in considering our present monetary authorities, it seems that they, much like their predecessors in the Nixon Administration, do not know what they’re doing.

Reinventing Our Energy Policy

Without plentiful and low-cost energy, every aspect of the global economy is threatened. For example, food prices are increasing alongside soaring oil prices, partly because of increased production costs, but also because farmland in the United States and elsewhere is being converted from food production to bio-fuel production.

No quick fix exists for oil prices. Higher prices reflect basic conditions of supply and demand. The world economy – especially China, India and elsewhere in Asia – has been growing rapidly, leading to a steep increase in global demand for energy, notably for electricity and transport. Yet global supplies of oil, natural gas and coal can’t keep up easily, even with new discoveries. And, in many places, oil supplies are declining as old oil fields are depleted.

Coal is in somewhat larger supply and can be turned into liquid fuels for transport. Yet coal is an inadequate substitute, partly because of limited supplies and partly because coal emits large amounts of carbon dioxide per unit of energy, making it a dangerous source of man-made climate change.

In order for developing countries to continue enjoying rapid economic growth and for rich nations to avoid a slump, it is necessary to develop new energy technologies. Three objectives should be targeted: low-cost alternatives to fossil fuels, greater energy efficiency and reducing carbon dioxide emissions.

The most promising technology in the long term is solar power. Total solar radiation hitting the Earth is about 1,000 times the world’s commercial energy use. This means that even a small part of the earth’s land surface, notably in desert regions, which receive massive solar radiation, can supply large amounts of electricity for much of the rest of the world.

For example, solar power plants in America’s Mohave Desert could supply more than half of that nation’s electricity needs. Solar power plants in Northern Africa could supply power to Western Europe, while solar power plants in the Sahel of Africa, just south of the vast Sahara, could power much of West, East and Central Africa.

Perhaps the single most promising development in terms of energy efficiency is plug-in hybrid technology for automobiles, which may be able to triple the fuel efficiency of new automobiles within the next decade.

The idea is that vehicles would run mainly on batteries recharged nightly on the electricity grid, with a gasoline-hybrid engine as a backup to the battery. General Motors may have an early version of this by 2010.

The most important technology for the safe environmental use of coal is the capture and geological storage of carbon dioxide from coal-fired power plants. Such carbon capture and sequestration, or CCS, is needed urgently in major coal-consuming nations, especially China, India, Australia and the U.S. As key CCS technologies already have been developed, it’s time to move from engineering blueprints to actual demonstration power plants.

For all of these promising technologies, governments should be investing in the science and high costs of early-stage testing. Without at least partial public financing, the uptake for these new technologies will be slow and uneven. Indeed, most major technologies that we now take for granted – airplanes, computers, the internet and new medicines, to name just a few – received crucial public financing in their early stages of development and deployment.

It’s shocking and worrisome that public financing remains slight because these technologies’ success could translate into literally trillions of dollars of economic output.

For example, according to the most recent data in 2006 from the International Energy Agency, the U.S. government annually invested a meager $3 billion in energy research and development. In inflation-adjusted dollars, this represents a decline of roughly 40 percent since the early 1980s and now equals what the U.S. spends on its military in just a day and a half. The situation is even more discouraging when we look at the particulars. U.S. government funding for renewable energy technologies (solar, wind, geothermal, ocean and bio-energy) was a meager $239 million – or just three hours of defense spending. Likewise, spending on carbon capture and sequestration was just $67 million, while spending for energy efficiency of all types (buildings, transport and industry) was $352 million.

Of course, developing new energy technologies isn’t America’s responsibility alone. Global cooperation on energy technologies is needed to increase supplies and ensure that energy use is environmentally safe, especially to head off man-made climate change from using fossil fuels.

This not only is good economics, but also good politics, as it can unite the world in our common interests, rather than dividing it in a bitter struggle over diminishing oil, gas and coal reserves.

Jeffrey Sachs is an Economics Professor and Director of the Earth Institute at Columbia University.

Copyright: Project Syndicate, 2008. More at Project Syndicate.

April 26, 2008

Could IMF Have Prevented This Crisis?

As a result, the fund must change, reinforcing its supervisory role and its capacity to oversee members' compliance with their obligation to contribute to financial stability. So its failure to press the United States to redress the mortgage-market vulnerabilities that precipitated the current financial crisis indicates that much remains to be done.

Indeed, in its 2006 annual review of the U.S. economy, the IMF was extraordinarily benign in its assessment of the risks posed by the relaxation of lending standards in the U.S. mortgage market. It noted that "borrowers at risk of significant mortgage payment increases remained a small minority, concentrated mostly among higher-income households that were aware of the attendant risks," and concluded that "indications are that credit and risk allocation mechanisms in the U.S. housing market have remained relatively efficient." This, it added, "should provide comfort."

Likewise, the problem was not mentioned in one of the IMF's flagship publications, the Global Financial Stability Report (GFSR), in September 2006, just 10 months before the subprime mortgage crisis became apparent to all. In the IMF's view, "Major financial institutions in mature ... markets [were] ... healthy, having remained profitable and well capitalized," and "the financial sectors in many countries are in a strong position to cope with any cyclical challenges and further market corrections to come."

The IMF began to take notice only in April 2007, when the problem was already erupting, but there was still no sense of urgency. On the contrary, according to the IMF, "Weakness has been contained to certain portions of the subprime market (and, to a lesser extent, the Alt-A market), and is not likely to pose a serious systemic threat."

Moreover, "The U.S. housing market appears to be stabilizing ... Overall, the U.S. mortgage market has remained resilient, although the subprime segment has deteriorated a bit more rapidly than had been expected."

The GFSR confidently noted that ``stress tests conducted by investment banks show that, even under scenarios of nationwide house price declines that are historically unprecedented, most investors with exposure to subprime mortgages through securitized structures will not face losses."

Why has the fund's surveillance of the U.S. economy been so ineffective?

Suppose that the vulnerabilities piling up in the U.S. mortgage market ― right under the IMF's Washington-headquartered nose ― had taken place in a developing country. It is, frankly, inconceivable that the fund would have failed so miserably in detecting them. The IMF has been criticized for burdening borrowers with unnecessary and sometimes perverse lending conditions, but its highly qualified staff has not been shy in blowing the whistle when it perceived domestic vulnerabilities in other countries. So why didn't they scrutinize the U.S. economy with equal zeal?

The answer may be found in the IMF's governance structure. Currently, the distribution of power within the IMF follows the logic of its lending role. The more money a country puts in, the more influence it has. This may be prompting the fund to turn a blind eye to the economic vulnerabilities of its most influential members ― precisely those whose domestic policies have large, systemic implications.

This ``money-for-influence" model of governance indirectly impairs the IMF's capacity to criticize the economies of its most important members (let alone police compliance with their obligations). In any event, if its staff's criticism ever becomes too candid, these countries can always use their leverage to water down the public communiques issued by the IMF's board.

The fund can help to prevent future crisis of this kind, but only if it first prevents undue influence on its capacity to scrutinize, and if necessary, criticizes influential countries' policies and regulations. This requires a different governance structure in which power is more evenly distributed, so that the IMF can effectively exercise surveillance where it should, not just where it can.

Hector R. Torres is alternate executive director at the IMF and former chair of the G-24 Bureau in Washington, D.C. For more stories visit Project Syndicate (www.project-syndicate.org).

The Velocity Of Money

Is the Money Supply Growing or Not?

But we are not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money and how it affects the growth of the economy. But let's start with a few charts showing the recent and high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast or just about right, depending upon which monetary measure you use.

First, let's look at the adjusted monetary base, or plain old cash plus bank reserves held at the Federal Reserve. That is the only part of the money supply the Fed has any real direct control of. And it is not growing that much (less than 2%!), and a lot of the cash goes overseas, never to come back to the US. Also note that the growth in the monetary base has been trending down until recently.

Next, let's look at MZM, or Money of Zero Maturity. Stated another way, you can think of it as cash, whether in a bank, a money market fund or in your hands.

Now, remember, Friedman taught us that inflation is a monetary phenomenon. If you increase the money supply too fast, you risk an unwanted rise in inflation. If the money supply shrinks or grows too slowly, you could see deflation develop.

Note that MZM is growing at close to an 18% rate year over year. Also note that less than three years ago MZM was growing close to zero. Since that time inflation has increased. Therefore, one could make the case that the Fed is causing inflation by allowing the money supply to increase too rapidly. Case closed.

Or maybe not. More cash sometimes means that people and businesses are taking less risk. The Fed cannot control what we do with our money, only how much bank reserves it allows and how much cash it puts into the system.

Forecasting inflation from a money supply graph is very difficult. It used to be a lot simpler, but in recent decades has been very unreliable, for reasons we will look at in a moment. But it is much too simplistic to draw a direct comparison to inflation and an arbitrary money supply measure.

If we look at a graph of M2, which includes time deposits, small certificates of deposit, etc. we again see a rise in recent growth. M2 is the measure of money supply that most economists use when they are thinking about inflation. And we see that M2 is growing at a sprightly 7% year over year. This is not all that high historically, but again it is up significantly over the past few years. See the graph below. Note there have been several times (as recently as 2000) when annual M2 growth was over 10%.

I should note that M2 has been growing at 12% since the first of the year, so there is an acceleration in growth, which some find a major concern. If that pace were to continue, maybe we should worry, but M2 growth is quite erratic from quarter to quarter. In any event, there is another factor we need to consider besides the money supply.

The Velocity of Money

Now, let's introduce the concept of velocity of money. Basically, this is speaking of the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, we would have $2400 of "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function of not just the money supply but how fast the money supply moves through the economy. Stated as an equation, it is P=MV, where P is the Nominal Gross Domestic Product (not inflation adjusted here), M is the money supply and V is the velocity of money. You can solve for V by dividing P by M.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few pages, please. Let's assume an island economy with ten businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the Gross Domestic Product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc., and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. In order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does not increase, that means that (in our simple island world) on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase, GDP will stay the same. The average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production is the same, but divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars so they buy less and prices fall. So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down as will the price.

If the central bank increases the money supply too much, you would have too much money chasing too few goods and inflation would manifest its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it?

No, because we only produce 20% more goods from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services which only grew by 20%. They would start to bid up the price of the goods they want and inflation sets in. Think of the 1970's.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon down to the local dry cleaners and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month and another hundred thousand fail. Productivity over time increases, so that we are producing more "stuff" with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, new population and productivity or deflation will appear. But if money supply grows too much then you would have inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant. And it was from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts sent to me by Dr. Lacy Hunt of Hoisington Investment Management in Austin, and one of my favorite economists. First, let's look at the velocity of money for the last 108 years.

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average for the last 100 years. Also, Lacy pointed out in a conversation which helped me immensely in writing this letter, that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War 2, but even then, mean reversion would mean a slowing of the velocity of money (V) and mean reversion implies that V would go below (over-correct) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let's look at the first chart.

Now, let's look at the same chart since 1959 but with shaded gray areas which show us the times the economy is in recession. Note that (with one exception in the 1970s) velocity drops during a recession. What is the Fed response? An offsetting increase in the money supply to try and overcome the effects of the business cycle and the recession. P=MV. If velocity falls then money supply must rise for nominal GDP to grow. The Fed attempts to jump start the economy back into growth by increasing the money supply.

In this chart, Lacy assumes we are already in recession (gray bar at far right). The black line is his projection of velocity in the near future. If you can't read the print at the bottom of the chart, he assumes that GDP is $14.17 trillion, M2 is $7.6 trillion and therefore Velocity is 1.85, down from almost 1.95 just a few years ago. If velocity reverts to or below the mean, it could easily drop 10% from here. We will explore why this could happen in a minute.


But let's go back to our equation, P=MV. If velocity slows by 10% (which it well should) then money supply (M) would have to rise by 10% just to maintain a static economy. But that assumes you do not have 1% population growth, 2% (or thereabouts) productivity growth, a target inflation of 2%, which means M (money supply) needs to grow about 5% a year even if V was constant. And that is not particularly stimulative, given that we are in recession.

Bottom line? Expect money supply growth well north of 7% annually for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow arm chair economists (and that is most of us) to sit back and Monday morning quarterback for many years.

A Slowdown in Velocity

Now, why is the velocity of money slowing down? Notice the real rise in V from 1990 through about 1997. Growth in M2 (see the above chart) was falling during most of that period, yet the economy was growing. That means that velocity had to rise faster than normal. Why? Primarily because of the financial innovations introduced in the early 90's like securitizations, CDOs, etc. It is financial innovation that spurs above trend growth in velocity.

And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. Its absence is slowing things down. If the money supply did not rise significantly to offset that slowdown in velocity the economy would already be in a much deeper recession.

While the Fed does not have control over M2, when they lower interest rates, it is supposed to make us want to take on more risk, borrow money and boost the economy. So, they have an indirect influence.

I expect the Fed to cut another 25 basis points next week, and to give us a statement that will look neutral, with a nod toward difficult economic conditions. The latest Beige Book from the Fed was simply dreadful, so you can bet the governors will have a deteriorating economy in mind. Given the 25 plus year low in consumer confidence, they have little choice.

But the difference another 50 basis point cut (over the next few meetings) would make is not all that much. A 2% rate is already low. That would make the real rate (after inflation) negative. In one sense, 2% today is lower in real (inflation adjusted) terms than the 1% that Greenspan took it to. Back then inflation was just above 1%. We will have a negative real interest rate after this next cut. Depending upon which inflation measure you use (and there are a few with some wide differences), it could be as much as 2% negative. Now that is REAL stimulus.

And since we are on asides, let me predict that the official GDP for the first quarter will not be negative. You watch and see if the PCE deflator is below 3%. Call me cynical, but it would not surprise me, even as CPI is over 4%. Also, watch GDP get revised to negative next year.

If You Are in a Hole, Stop Digging

I often listen to CNBC when I am driving to work (if I am not on the phone). I am amazed how often I hear (or read) about the bottom of the housing market. Often we hear that the stock market is predicting the bottom. I wonder if any of these cheerleaders actually looks at the relevant statistics. Again, let's do some basic arithmetic so that even an analyst can understand.

Yesterday we found out that new home sales are running at an annual rate of 526,000, the lowest number in almost two decades. The supply of new homes, in terms of the amount of time it would take to work through the inventory available for sale was 8.4 months last October. It is now an even 11 months. (source for data: www.weldononline.com)

How many homes did the home building industry start building last month? Housing starts were running at an annual rate of 947,000. Permits for new homes was 927,000. That means the industry is building over 400,000 more homes than they are selling. Add in a million or so foreclosures. Kill the subprime market. Really make it hard to get a loan securitized for anything but government backed mortgages.

Home construction is going to drop precipitously before the inventory of new homes is worked through. Those who are predicting a rebound this quarter are simply not paying attention to the basic math. New home prices are down 13.3% year over year. They are going much lower. Margins are going to get squeezed. Now maybe the market is pricing all this in. But I think there are better places to gamble than the home builders.

And More Write-offs to Come

And speaking of gambling, a few quick thoughts on the write-offs that we areseeing in the banking industry. We have just seen the beginning of woes. We are nowhere near close to the end, for three reasons. First, the estimated amount of write-offs from the subprime crisis is now approaching $1 trillion (courtesy of the IMF). We have seen (maybe) write-offs of about $250 billion. Where is the other $750 billion?

Now, some of it - maybe even most of it - is in insurance companies, pension funds and sovereign wealth funds. It will be years before we can even estimate how much. There will be no press releases from the Central Bank of China saying they are writing off $15 billion. Which pension fund investment committee will announce their losses? We will only "see" it in lower performance numbers.

But a lot is still in the banking system, having yet to be downgraded by the rating agencies.

Secondly, the problems are spreading from subprime. Bill King called my attention to this note from Housingwire.com. Quote (emphasis mine):

"Moody's Investors Service issued more Alt-A downgrades on Thursday morning, this time taking a heavy hand to 32 different Aaa-rated tranches from 10 different Alt-A deals. Many of the downgrades even pushed former Aaa's into non-investment grade categories - a stunning descent for top-rated Alt-A mortgage bonds that underscores two key points.

"First, defaults are obviously accelerating. Second, many Alt-A deals were issued with less in the way of overcollateralization - which, in plain English, means that these deals will start to see downgrades sooner, compared to the relative stress that a typical subprime RMBS deal can withstand before the hits start coming at the Aaa level.

"The rating agency placed an additional 254 Aaa-rated Alt-A classes on negative ratings watch Wednesday."

Clearly the default disease is moving up into Alt-A loans. Do you think any bank has written these loans off yet? There are more write-offs coming from the mortgage space. It is not unrealistic that we could see as much (in total) as we have already seen.

Third, we are in a recession. That means all sorts of business loans, commercial real estate, credit cards, student loans, car loans and so on are yet to default. Defaults on such loans are a lagging indicator. Those write-offs occur closer to the end of the recession than the beginning and we have not seen much of them yet. We will. Expect banks to continue to post ever larger reserves for losses.

All in all, we are nowhere close to the bottom of the credit crisis. The cycle of large write-downs and then going to the market for more capital is going to continue for some time, perhaps longer than a year. Anyone who is putting money in the financial stocks is gambling, not investing.

April 28, 2008

Market Power and Trade Policy

The main premise of antitrust (or competition) laws is to proscribe practices that allow firms to limit competition in the marketplace. As is well known, limiting competition allows firms to raise prices above their marginal costs (something we call market power). Market power creates profits for firms, but the profits are more than offset by losses in consumer surplus. This translates into net (or deadweight) losses for society, and such losses are, obviously, something to be avoided.

The problems associated with market power are generally well recognised by the public when the topic of discussion is domestic competition and anti-trust policies. However, when the topic is trade policy, public discussion of how it might affect market power is often confused or nonexistent. For example, one virtually never hears any worry about the potential anti-competitive effects from applying traditional forms of trade policies, such as import tariffs and quotas.

The only place that one finds competition policies mentioned with trade policies is with respect to antidumping laws. And here the application of these principles is one-sided. It is recognised (and likely overemphasised) that there can be anti-competitive effects when a foreign firm uses low prices to eliminate competitors; i.e., predatory pricing practices. However, it is clear that the actual implementation of antidumping laws applies remedies for a whole range of pricing behaviours that any competition agency would find perfectly consistent with a competitive marketplace (for example, see “Why we need antidumping reforms”).1 Indeed, the danger of antidumping remedies is that they could actually promote anti-competitive effects by helping firms collude (actively or tacitly) to achieve joint monopoly/cartel prices and profits. Most directly, this can be seen in the case of “undertakings,” whereby government agencies coordinate arrangements with foreign firms (and in consultation with domestic firms) to keep the foreign firms’ prices at predictably high levels in lieu of antidumping duties! Even a quick scan of an introductory industrial organisation text would suggest to you that this could be quite an effective mechanism for firms to coordinate tacit collusion.

Trade policy and market power in theory…

Though largely ignored in public discussions of trade policy, economists have been reasonably good at showing theoretically how various trade policies may affect market power. In general, the theoretical literature finds large market power effects from quantitative restrictions and none with tariff-based import protection.2 There is also a literature indicating that antidumping measures can raise firms’ market power for similar reasons as quantitative restrictions; namely, that such policies can allow firms to tacitly coordinate higher prices to their benefit, but to the detriment of consumers and overall welfare (for example, see Prusa 1992).

Why does the issue of market power rarely enter public discussion of trade policies? There are a number of possible explanations, but let’s discuss two where at least some of the responsibility can be placed on the economics profession. First, economists have simply not laid out these arguments very often. For example, the standard models used to illustrate trade policies in today’s typical undergraduate textbook assume perfect competition. In such a setting, import protection increases employment in the protected sector, as well as infra-marginal rents of producers, but does not lead to market power for firms by assumption. Economists need to do a better job in presenting the conceptual reasons for why trade protection programs can raise market power and lead to the same sort of welfare losses that arise in more familiar cases where monopoly power leads to undesirable outcomes.

The second explanation is that the economics profession has not provided any empirical evidence for these market power effects. These effects may exist in theory under the right sets of assumptions, but do these effects really occur?

… and in practice

Empirical evidence on this issue is beginning to emerge, and the results of a couple of recent studies suggest that we ignore the potential anti-competitive effects of trade policies at our peril. In a recent paper I co-authored with Benjamin Liebman and Wesley Wilson, we undertake a systematic investigation of the market power effects of the wide variety of trade protection programs afforded to the U.S. steel industry over the last three decades (Blonigen, Liebman, and Wilson, 2007). The U.S. steel industry has been the main industrial sector receiving trade protection during this time period, accounting for more than a third of all antidumping and countervailing duty cases, as well as enjoying periods with quantitative restrictions and safeguard remedies on imports. Our statistical results are strongly consistent with the theoretical literature described in footnote 1 in that we find large market power effects from quantitative restrictions and none with tariff-based import protection. In fact, our estimates cannot reject the hypothesis that the U.S. steel industry was able to perfectly collude during the main quota period in the late 1980s.

Surprisingly, our estimates find no market power effects from antidumping protection in the US steel industry, which the theoretical literature suggests could be significant. These results contrast with recent evidence from Jozef Konings and Hylke Vandenbussche (2005) that antidumping duties in the European Union did raise market power significantly for many domestic firms that received antidumping duties against their import rivals. However, Konings and Vandenbussche note that market power effects are much lower or even nonexistent for products where antidumping protection leads to significant import diversion – market share gets diverted to import sources not targeted by the antidumping protection, rather than the domestic firms. The is a likely explanation for our finding of little market power effects for U.S. steel antidumping cases, as Prusa (1997) found significant trade diversion in U.S. antidumping cases.


What does this all mean in light of trade policy developments over the past decade? There is both good news and bad news. The good news is that the Uruguay Round made substantial progress in eliminating quantitative restrictions, which theory and empirics suggest are by far the most harmful trade policies in terms of raising market power. The bad news is that antidumping measures are acceptable under WTO agreements and have proliferated across member countries substantially in the past decade. While the initial evidence on market power effects of antidumping measures is mixed, the theory is clear in suggesting many ways in which such protection can raise market power.

While there may be political reasons to keep trade measures such as antidumping in place, as a profession, economics needs to continue to bring more evidence to bear about the market power effects of these programs. At the same time, we need to also continue to press policymakers more about the need for competition laws to apply equally to domestic and foreign firms. If policymakers can see the logic of having national treatment laws with respect to things such as tax policies towards firms in a market, then perhaps they can also be engaged to think about national treatment with respect to application of competition laws. As it stands, antidumping policies are a completely different (and wrongheaded) set of competition laws applied only to foreign firms exporting to a market.

Bruce Blonigen is the Knight Professor of Social Science, Department of Economics, University of Oregon.


Bhagwati, Jagdish N. (1965). “On the Equivalence of Tariffs and Quotas,” in R.E. Baldwin et al., eds., Trade, Growth and the Balance of Payments: Essays in Honor of Gottfried Haberler, Amsterdam: North-Holland.

Blonigen, Bruce A., Benjamin H. Liebman, and Wesley W. Wilson (2007). “Trade Policy and Market Power: The Case of the US Steel Industry,” NBER Working Paper No. 13671.

Konings, Jozef, Hylke Vandenbussche, and Linda Springael (2001). “Import Diversion Under European Antidumping Policy,” Journal of Industry, Competition and Trade, Vol. 1(3): 283-299.

Konings, Jozef, and Hylke Vandenbussche (2005). “Antidumping Protection and Markups of Domestic Firms,” Journal of International Economics, Vol. 65(1): 151-65.

Krishna, Kala. (1989). “Trade Restrictions as Facilitating Practices,” Journal of International Economics. Vol. 26: 251-270.

Prusa, Thomas J. (1992). “Why Are So Many Antidumping Petitions Withdrawn?” Journal of International Economics. Vol. 33: 1-20.

Prusa, Thomas J. (1997). “The Trade Effects of US Antidumping Actions," in Robert C. Feenstra, ed., Effects of US Trade Protection and Promotion Policies, NBER Project Report Series. Chicago,IL: University of Chicago Press.


1 Hylke Vandenbussche and Maurizio Zanardi, “Antidumping in the EU: the time of missed opportunities,” VoxEU, 8 February 2008.

2 Perhaps the first formal treatment dates back to Bhagwati (1965), who showed that a binding quota would allow a domestic monopolist to continue to wield market power in the face of lower international prices, whereas a standard import tariff would drive the domestic monopolist price to the competitive international price (plus tariff). Game theoretic analysis of oligopoly games also indicate that quantitative restrictions on imports allowed firms to increase market power, while import tariffs do not change existing market power (for example, see Krishna 1989).

April 29, 2008

Cut, Cut, Float the Funds Rate

Major financial media continue to mis-state the problem, with Scott Patterson reporting in the Wall Street Journal that: “Low interest rates undermine a currency because they give investors an incentive to park their money in securities denominated in other currencies that earn higher yields." The Journal’s editorial board rightly agonizes about the damaging effects of weak currency, but totally misapprehends the solution.

Managing Stable Currency

The strength of the dollar may be affected on the margin by currency speculators who choose to “park” in one place or another. But the dollar’s fundamental strength is determined by demand for it as a unit of account and store of value in commercial transactions. Trust and confidence in any currency requires that its value remain stable at all times and over the long term. Stability of currency value requires a mechanism that adjusts liquidity according to changing conditions affecting demand; i.e., market willingness to invest in production.

Supply and demand for currency determines its value. This truism combined with the fact that gold has essentially unchanging intrinsic value enables a central bank (if it chooses) to manage liquidity (supply) according to changes in demand so as to keep the currency value stable. Stated simply, the central bank can keep supply in balance with demand by watching its currency’s price of gold and keeping that price stable.

Rate Manipulation Reality

Manipulating interest rates cannot stabilize currency value. Whether interest rates are high or low, the currency may strengthen or weaken depending upon the balance of supply and demand for liquidity. Interest rates should be left to markets to set. Markets best determine who deserves credit and at what rate. Central planning manipulation of interest rates as it is presently practiced by the Federal Reserve through FOMC sets the cost of bank credit in the U. S.

The FOMC's actions since 2004 deprived small businesses (who normally must borrow from banks or other lenders rather than through the financial markets) of credit. At the same time, essentially all of the abundant liquidity furnished by FOMC through 2006 flowed to large borrowers such as hedge funds, investment banks and LBO firms. This has resulted in poor credit judgments and the resulting crisis of confidence in credit quality.

Intentional Inflation

The FOMC may or may not understand this already. Yet its members choose to weaken the dollar on the intellectual pretext that weak currency expands exports, reduces imports and shrinks the current account deficit. This use of the dollar as a weapon of trade war is spurring nationalism around the world, and understandably so, as food prices soar and hungry people riot. The FOMC even theorizes that the weak dollar profits U. S. exporters but does not hurt Americans, who continue to be paid wages and buy with an unchanged “domestic” dollar. That is unadulterated sophistry.

Assume a single universal currency is devalued by fifty percent by doubling liquidity. Surely no one will deny that prices of goods and services will double during a period of adjustment. Even in this simple scenario, wages will not adjust at the same rate as prices, so standard of living will likely suffer periodically. Now assume other currencies are added to the universe. Will their presence change the fundamental effects if the original currency is devalued by fifty percent? Surely they will not. They merely add complexity and confusion, which mirror the existing international monetary non-system.
* * *

The FOMC creates the weak dollar purposely, though not with low interest rates. Even now, the funds rate at 2.25% remains at least 1.25% higher than where the markets would set it if it were floated. The inverted yield curve attests to this, with three-month bills at 1.37% and six-month bills at 1.71%. This means small business may borrow, if at all, at a rate 1.25% higher than markets deem reasonable. That environment keeps small business from expanding, creating jobs and demand for dollars.

TheFOMC should cut the funds rate to 1% or, much better, float the rate and allow the markets to set the cost of credit. Economic growth and the dollar would be far better off for having markets rather than central planners making such decisions. At the same time, the FOMC should keep liquidity in check as the economy expands, moving to a dollar price of gold at a much lower level.

April 30, 2008

Self-Inflicted Pain Hobbles States

Reading this story you would think that government budgets are simply made up of revenues that rise or fall as the economy changes. The story makes only a passing mention of the other half of the budgetary equation, which is spending. That’s a pretty big omission, considering the way our states have been splurging. Judging by figures compiled by the National Association of State Budget Officers, our state governments went on a spending spree for the last several years, as collections poured in from a variety of taxes, including some volatile sources like realty and mortgage recording taxes that were bound to turn down. From 2004 through 2007, states collectively increased their spending by almost 25 percent, a far larger gain than inflation plus population growth. The gains included a whopping 9.3 percent increase in 2007 alone, even as warning signs of a possible economic slowdown were emerging. These spending increases quickly soaked up any extra revenues produced by the super-heated economy of those years, which is one reason why so many states are facing shortfalls so soon after recording big surpluses. In the coming weeks you are sure to read about all of the programs that states are being forced to cut back as tax revenues decline, with little reference to all of the spending that they added when revenues were surging.

In some states, in fact, there has been only a slim relationship between spending and external economic conditions. New York State, for instance, can boast of only a mediocre economic performance even during the flush years. From 2005 to 2007, the state ranked 45th in job growth, and even in the midst of the boom years, Moody’s Economy.com predicted the state would lag national economic growth. Yet the state’s combined budget increase for the last three years equaled about 21 percent, far above inflation and population growth (of which New York State has virtually none). New York built this spending on a slim, volatile tax base--high-earning Wall Streeters whose big bonuses sharply boosted personal income tax collections—with little sense of how the state would pay its ever increasing bills when finance’s go-go years ended. That’s characteristic of many states which often seem to add new programs without a plan for how to pay for them over time.

What often happens, instead, is that as soon as times get tough the states begin haranguing the federal government to bail them out. This brand of tin-cup federalism was on display last week in an opinion piece published in the Wall Street Journal by Arizona Governor Janet Napolitano, and we’re sure to see more of this too. In the piece the governor blamed the feds for a host of the states’ fiscal problems, including the growing cost of subsidized health care, which states have been expanding rapidly and which now consumes a hefty 22 percent of state budgets. Among other things, Napolitano scored the Bush administration for not expanding the State Child Health Insurance Program to pay for coverage in families earning up to 250 percent of the federal poverty level. Some readers must have wondered how a failure to expand a program would cost the states money. What Napolitano didn’t say is that many states—in fact 40 of them-- went ahead and extended their Schip programs on their own, and now many can’t afford them. One of the states with the worst budget crises, New Jersey, has extended its Schip program to families earning 350 percent of the federal poverty level, or about $72,000 in annual household income for a family of four. Since 2001 New Jersey has faced persistent budget problems and has raised taxes some 35 times, totaling about $5 billion, and it still can’t pay its bills. But some lawmakers in Jersey are talking about going further even than Schip and enacting universal health care legislation in the state. This is what passes for long-term budget planning among the states.

Napolitano’s WSJ piece is a good example of the kind of budgetary passing-the-buck one hears from state officials as their deficits grow. Beyond failure to expand Schip, she blames state fiscal woes on, among other things, temporary business tax cuts in the 2008 federal stimulus package, because many states tie their own taxes to federal rates and therefore will collect less as businesses pay less to the federal government. In other words, under Napolitano’s formulation, federal tax policy’s intent should be to protect state taxes or, failing that, to provide billions of dollars in aid to the states for their revenue declines, which is what her piece was really angling for.

But perhaps before she complains further about federal corporate tax cuts (even temporary ones), Napolitano should take a look at a Tax Foundation study showing the burden that businesses bear in Arizona, and how that compares with corporate tax rates around the world. According to that study, the combined federal and state corporate tax burden on businesses in Arizona is a whopping 39.5 percent. That’s higher than the federal and state (or equivalent provincial) tax rate paid by businesses in any of the other 29 countries of the Organisation for Economic Co-operation and Development except one, Japan. In fact, in 22 of 29 countries in the OECD including Ireland, New Zealand and Spain, there are no state (or provincial) corporate income taxes on top of the federal tax rate. As the Tax Foundation notes, perhaps somewhat naively, “state officials should be champions of substantial cuts in the federal tax corporate tax rate” to improve America’s competitiveness.

Apparently the worthy folks at the Tax Foundation never met a real-life governor.

Myths About Fed Funds & Liquidity

It is important to note that many tend to look to the money supply measures as liquidity indicators of an inflationary or deflationary monetary policy. This is misleading. Money supply measures are all derivatives of the same starting point - base reserves. The Fed can’t control how reserves are utilized, nor can it directly control what proportion of reserves goes to loans, investments, or cash.

The fed funds rate, on the other hand, is the overnight rate that is charged by banks for lending their excess reserves held at the Fed to each other. The common perception is that the Fed utilizes open market operations to influence the amount of reserves in the system and therefore drive the Fed Funds rate to its target rate, set by the FOMC.

Upon closer inspection of the Board of Governor’s own data, however, this theory is indeterminate at best. In fact, the fed funds rate is not strongly correlated with reserves at all. From the late 50s through the early 80s, the fed funds rate went through several cyclical patterns, generally peaking at the top end during the early days of Volcker’s term as Federal Reserve Chairmen. During this time, base money reserves grew at a steady 3.1% annual rate regardless of the Fed funds rate (remember Milton Friedman’s 3% rule?). During this same period, the fed funds rate see-sawed from as low as 1% to as high as 19%. Subsequently, through a few start-and-stop cycles under Alan Greenspan and Ben Bernanke, the fed funds rate has generally trended downward, while net reserves are essentially where they were in 1991 with a single deflationary period and a single inflationary period in the interim.


Furthermore, two very specific temporary injections of reserves, once after 9-11 and once last August, had a de minimus effect on the effective fed funds rates. After 9-11, a 45% increase in reserves amounted to a 16% decrease in the fed funds rate in the month of September. This is not a significant amount considering the fed funds rate continued to decline while reserves quickly recovered to previous levels. Similarly, in August 2007, in response to the freezing of credit markets, the Fed added $39 billion with zero effect on the Fed Funds rate.

Because every now and then the Fed tries to engineer economic growth through liquidity expansion regardless of fiscal and regulatory policy, it is illuminating to observe in hindsight that the Fed has actually enabled three inflationary periods (1970s, 1990 – 1991, and 2002 +) and two deflationary periods (1980 – 1982 and 1997 – 2001). Each of these periods has had markedly different levels of fed funds rates. One can also infer from the data that fed funds rate varies widely between different periods of monetary instability, the prevention of which is presumably one of the primary objectives of the Fed’s manipulation of the fed funds rate. If one is still certain that the fed funds rate is the Fed’s liquidity tool, then perhaps a review of the St. Louis Fed’s November 2007 study is required, in which the Fed acknowledges statistically what can be understood by simply looking at the raw data.

A closer look at the relationship between the Fed Funds rate and base reserves would be helpful to the ongoing discussion about the Fed’s current policy actions. If we could get past the debate about the use of the Fed Fund’s rate as a policy tool, we could begin discussing the more important issue of the Fed’s failure to adhere to its real purpose: the maintenance of a stable dollar regardless of the level of liquidity as measured by reserves.

John McCain and the Decline of the U.S.

Irving Kristol, sometime editor of the magazine The Public Interest and one of the intellectual midwives of this idea, later wrote that he was interested not in whether it was true, but in whether it was useful.
Years later, he spoke of his “own rather cavalier attitude toward the budget deficit and other monetary or fiscal problems. The task...was to create a new...conservative... Republican majority – so political effectiveness was the priority, not the accounting deficiencies of government...”
Now it has become clear that John McCain – who once criticised George W Bush’s tax cuts as imprudent and refused to vote for them – has succumbed to this potion. He appears to be proposing further tax cuts that promise to cost the US Treasury some $300bn a year, to “offset” them with cuts in earmarked spending accounted for at $3bn a year, and somehow to balance the budget.
We know the consequences: McCain’s fiscal policy is likely to be standard Republican fiscal policy – and since 1981, standard Republican fiscal policy has increased the ratio of gross federal debt to GDP by nearly 2% per year.
By contrast, a typical post-WWII Democratic administration has reduced the debt-to-GDP ratio by more than 1% per year. This is one of the issues at stake in this year’s presidential election.
Policies that ignore the level of government debt lead to the currency’s collapse, depression (due to the resulting disruption of the sectoral division of labour), and high inflation – perhaps hyperinflation.
Often, the guilty blame the economic catastrophe on the sinister manipulations of foreigners like the “gnomes of Zurich” or the IMF. The US is far from that point. But even in the shorter run – over the next two presidential terms, say – the costs of a high deficit and rapid debt growth would be substantial.
A growing debt-to-GDP ratio would, in the first instance, crowd out investment, as resources that would otherwise go to fund productive investment instead support private or public consumption.
Since 1981, the US has been lucky in that inflows of capital from abroad financed the growth of government debt. At some point, this will stop, and increases in deficits will trigger capital flight from the US.
Suppose that over the next eight years larger deficits trigger neither extra capital inflows nor capital outflows, and suppose that a lower-investment America is a poorer America, with a gross social return on investment of 15% per year.
By 2016, America’s productive potential would be smaller by an amount that would reduce real GDP by 3.6% – $500bn real dollars, or roughly $3,000 per worker. In a poorer America, fewer businesses would find it worthwhile to entice secondary workers from families into the labor force, and perhaps 500,000 net jobs would disappear.
In getting from here to there over the next eight years, a higher-debt America would see productivity growth slow by perhaps a third of a percentage point per year. Average unemployment would then have to rise in order to keep workers’ demands for real wage increases at a level warranted by productivity growth.
The gross correlations between productivity growth and average unemployment found in the 1970’s, 1980’s, 1990’s, and 2000’s would increase the economy’s natural rate of unemployment by about one-fifth of a percentage point, costing an additional 500,000 jobs.
And a higher-debt America is one in which savers and lenders would have a justified greater fear that the government would resort to inflation in order to repudiate part of its outstanding debt.
The Federal Reserve would then have to fight inflation – putting upward pressure on unemployment – in order to reassure savers and lenders of its willingness to guard price stability. There are not even crude gross correlation-based estimates of the size of this effect, but economists believe that it is very real. Would it cost a negligible number of jobs? A quarter-million? A million?
Add it all up, and you can reckon on an America that in 2016 that will be much poorer if McCain rather than Barack Obama or Hillary Rodham Clinton is elected president.
Other countries that are counting on exporting to America would be affected by slower growth and lower employment in the US.
However, under McCain, the wedge between public spending and taxes would be larger, Americans would feel richer, and they would spend more at the expense of “posterity” eight years down the road. Ronald Reagan might have approved. After all, as he put it: “Why should I do anything for posterity? What has posterity ever done for me?” Or was that Groucho Marx? –

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a former assistant US Treasury Secretary.

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