Reason Foundation

The Time-Bomb Keeps Ticking

Posted on July 25, 2012, 5:31pm | Tom Clougherty

The Wall Street Journal recently carried an essay by David Wessel, author of the forthcoming book, "Red Ink: Inside the High-Stakes Politics of the Federal Budget". It provides an excellent breakdown of the budget crisis looming over the federal government.

Perhaps the most striking fact contained in the essay is that 63 percent of the budget is on auto-pilot: "Social Security benefits get deposited. Health-care bills for Medicare for the elderly and Medicaid for the poor are paid. Food stamps are issued. Farm-subsidy checks are written. Interest payments are dutifully made to holders of Treasury bonds." In technical jargon, this is non-discretionary spending - unless Congress actively stops it, such spending continues every year without the need for any further authorization. Throw in an ageing population and inexorably rising healthcare costs, and it becomes clear that such spending is only heading in one direction - skywards.

What is most worrying is that the federal government currently only funds 66 percent of its spending through taxes. For the rest, it has to borrow. And while that may be bearable in the short-term, as nervous investors around the world pile into US Treasuries and push bond yields to record lows, it spells big trouble in the medium- to long-term. Every cent the government borrows now means more debt interest payments - and even more non-discretionary spending - in the future.

For an idea of just how bad it could get, take a look at this 2010 working paper from the Bank of International Settlements. Its projections indicate that without a policy shift, US public debt would rise to more than 400 percent of GDP by 2040. That would translate into annual debt interest payments equaling 23 percent of GDP - well in excess of total federal tax revenues, which have averaged a little over 18 percent of GDP since the Second World War. Such a scenario is plainly impossible: the US would be forced to default on its obligations long before things reached that point.

The policy implication here is straightforward enough: non-discretionary spending programs like Social Security, Medicare and Medicaid need urgent, drastic reform to put them on a more sustainable footing. The problem is politics: neither party is really serious about dealing with this fiscal time-bomb. Politicians' electorally-driven time horizons are just too short to permit the sort of significant, structural changes that are required.  Perhaps a rise in Treasury yields will force the issue. Maybe another showdown over the debt ceiling will do the trick. But I won't be holding my breath. As the Austrian economist Detlev Schlichter puts it, when it comes to debt, governments around the world are determined to "extend and pretend".  Sadly, it is only a matter of time before reality catches up with them.

Stockton Begins Legal Battle in U.S. Bankruptcy Court Today

Posted on July 6, 2012, 12:53pm | Harris Kenny

Updated on Friday July 6, 2012 at 1:28 PM Eastern.

Last week Stockton, California became the largest city (by population) to file for bankruptcy in U.S. history. The initial hearing is today in U.S. bankruptcy court in Sacramento. The trial is especially significant because the city’s lawyers are attempting to use bankruptcy to impose losses on its bondholders, which include private financial institutions and the state of California. Steven Church of Bloomberg reports:

No U.S. municipality has used bankruptcy to force bondholders to take less than the full principal due since at least 1981, and possibly as far back as the 1930s, according to lawyers and court records.

Church reports the city’s three largest creditors include:

1. California Public Employee Retirement System (CalPERS), $147.5 million;
2. Wells Fargo Bank NA as trustee for $124.3 million in pension obligation bonds; and
3. Wells Fargo Bank NA as trustee for three other sets of bondholders owed $107 million.

One of the most interesting subplots will be the legal battle between CalPERS, and Wells Fargo Bank North America and Assured Guaranty Ltd. Cate Long, a guest contributor to Reuters’ MuniLand blog, speculated on Twitter today whether or these calculations are accurate though. Assured Guaranty Ltd. insured $161 million of Stockton’s bonds. Meanwhile, National Public Finance Guarantee, which has insured about $224 million of Stockton's debt, is owned by MBIA Inc. Combined, MBIA Inc. and Assured Guaranty Ltd. hold approximately $385 million in Stockton's debt, and at this point they are allowed to argue together in court. In the case of principal reduction, these parties arguably have the most to lose.

This morning, Church wrote:

Bondholders will be limited to two main options if they are to block Stockton in court, said Lee Bogdanoff, a bankruptcy attorney: get the case thrown out or defeat the city’s reorganization proposal.

“The most important power they have is a seat at the negotiating table,” Bogdanoff, a founding partner of Klee, Tuchin, Bogdanoff & Stern LLP in Los Angeles, said in a telephone interview. “They can try to influence the decision makers.”

Today’s hearing will differ from a typical corporate case, Bogdanoff said. Unlike a company, the city doesn’t need to ask U.S. Bankruptcy Judge Christopher Klein for permission to pay any bills it ran up before filing for court protection, such as wages, utility bills or rents. As a result, creditors won’t be able to use the hearing to pressure the city on its spending habits, Bogdanoff said.

The first legal question today is about the city's mediation process. California Assembly Bill (AB) 506 passed earlier this year requiring distressed municipalities to enter mediation before declaring bankruptcy. While Wells Fargo Bank NA was awarded three city parking garages and city hall, the parties failed to resolve their differences. The intention behind AB 506 was for future cities filing for bankruptcy to avoid the flurry of lawsuits that ensued after Vallejo, California’s filed for bankruptcy several years ago.

Scott Smith of The Stockton Record reports:

Marc Levinson, the lead attorney hired to represent Stockton, will ask U.S. District Judge Christopher Klein to unseal a 790-page document at the heart of a three-month-long, closed-door mediation process that attempted, yet failed, to avert bankruptcy.

Levinson argues in court papers that this massive document, which resembles a bankruptcy plan, lays out in detail what the city in mediation asked its major creditors to give up...

Proving in court that a municipality first tried to avoid bankruptcy and that it is, in fact, broke are basic facts that must be established before moving ahead with a bankruptcy case...

(U.S. District Judge Christopher Klein) is expected to rule from the bench today on two other motions that Stockton filed:

• First, the city wishes to set an Aug. 9 deadline for any challenges to the legitimacy to Stockton's bankruptcy.
• Second, the city has asked to maintain a website designed to tell each of the 6,000 stakeholders of upcoming hearings and filings, rather than having to send each a notice by overnight mail, which would be costly and labor intensive."

For more on California municipal finance issues, see my previous posts on Stockton and Mammoth Lakes. For the latest on Detroit, Michigan, see Detroit and Michigan: A Fragile Bargain and Detroit and Its Unions Fight Over Work Rules from Melissa Maynard of Stateline.

Mammoth Lakes, California Files for Bankruptcy

Posted on July 5, 2012, 2:56pm | Harris Kenny

Earlier this week Mammoth Lakes, California filed for bankruptcy, news largely missed in the run up to the Fourth of July holiday. The Mammoth Lakes Town Council voted unanimously on Monday July 2 to authorizing the filing of a petition for relief under Chapter 9 of the Bankruptcy Code in U.S. federal court. Mammoth Lakes has 7,700 permanent residents and is located about 300 miles north of Los Angeles. Mammoth Lakes is Mono County’s only incorporated community and it is best known for its proximity to Mammoth Mountain Ski Resort.

On June 27 the town issued the results of its AB 506-mandated mediation, which included 16 total parties but did not include its largest creditor, Mammoth Lakes Land Acquisition (MLLA). The mediation lasted 60 days and a full list of agreements reached is available on the town’s website here. Parties include groups like CalPERS (California Public Employee Retirement System), public employee unions, non-profit organizations, contractors, bodies of government, for-profit developers and financial institutions. MLLA was one of several parties that did not participate in mediation.

According to a statement issued by the town:

Bankruptcy, unfortunately, is the only option that the Town is left with, after its largest creditor, Mammoth Lakes Land Acquisition (MLLA) repeatedly refused to mediate its $43 million judgment against the Town, and obtained a State court order requiring payment of the full judgment by June 30, 2012.

City officials distill their fiscal woes down to two problems:

1. "A lack of sufficient revenue to pay its current and anticipated obligations, as evidenced by a $2.7 million initial shortfall in its 2011-2012 fiscal year budget, balanced through painful measures in June 2011, an additional unanticipated shortfall of $0.9 million in the same 2011-2012 fiscal year that forced the Town to reduce its already low available cash, and a projected $2.8 million budget shortfall in its 2012-2013 fiscal year.
2. A Writ of Mandate issued by a State Court ordering the Town pay a $43 million judgment owed to MLLA by June 30, 2012.”

The $43 million judgment owed to MLLA appears to be what pushed Mammoth Lakes over the edge. The Los Angeles Times reports:

A state appellate court decision in December 2010 upheld the judgment and chastised the town for trying to back out of the agreement it signed in 1997 with Mammoth Lakes Land Acquisition.

The agreement required the developer to make improvements to nearby Mammoth Yosemite Airport’s fixed-based operations. In return, it would receive rights to develop a $400-million Hot Creek hotel project on 25 acres at the airport and an option to buy the land.

The court found that Mammoth Lakes changed its priorities in 2007 after it determined the project would interfere with Federal Aviation Administration policy governing the use of the airport property for aeronautical purposes and, as a result, derail the town’s plans to extend the runway to accommodate Boeing 757 passenger jets.

The developer, which had invested in some improvements at the airport, filed a breach of contract lawsuit against the town after it refused to move forward with the hotel project until the FAA policy issues were resolved.

The court found the city had not lived up to its end of the bargain.

This filing is reminiscent of Stockton, California’s recent filing, in that the city was ill equipped to handle the economic downturn and aggressive economic development projects initiated during the boom years went sour. It's important to note that every city is unique and this reinforces that we are not seeing contagion at the local level. Mammoth Lakes is hoping that through bankruptcy they can solve fiscal woes and either free up revenue, or issue additional bonds, to pay its creditors over the next ten years.

The following public services will remain open and/or available:

• The Police and Fire Departments, along with other safety partners such as paramedics and Sheriff's office, will provide high levels of response and care;
• Road, parks, and airport maintenance services will continue as scheduled;
• Town Office business hours and service deliver will continue as usual without interruption of services;
• Community services and providers such as Mammoth Hospital, Mammoth Community Water District, and Mono County are separate from the Town and are not impacted.

For more on municipal finance issues, see my previous posts on Stockton, California and Jefferson County, Alabama. For an update on Harrisburg, Pennsylvania, see this post by Maggie Clark of Stateline (in short, the state barred the city from declaring bankrupcty until November 30.) For an update on Detroit, Michigan, see this post from Melissa Maynard of Stateline (in short, officials continue to hammer out the details of the consent agreement signed in April by Michigan Governor Rick Snyder and Detroit Mayor Dave Bing.)

What Happened in Stockton?

Posted on June 27, 2012, 3:41pm | Harris Kenny

Last night the Stockton, California City Council voted 6-1 to adopt a spending plan for operating under bankruptcy protection, and to file a motion with the courts to share information from the confidential mediation. With almost 300,000 residents, Stockton is the largest city to file for bankruptcy in U.S. history.

In February 2012 Stockton voted to enter bankrupcty mediation. Policymakers negotiated with the city's creditors for months starting in late March 2012 and ultimately failed to prevent the filing. Negotiations were in compliance with AB 506, a new California law requiring municipalities file for reorganization of debt, and Stockton was the first city to file for use the law since its passage. Negotiations may not have been a waste of time though because they may help the city avoid a string of lawsuits, according to the Los Angeles Times, which is what happened after Vallejo, California’s filing in 2008.

While high profile stories like this signal blood in the water for narrative-hungry national media outlets, think tanks and pundits, there are often layers of complexity. So, what happened in Stockton? And is it happening anywhere else?

The most important takeaway right now is that no, Stockton’s decision to file bankruptcy is not necessarily a harbinger of things to come. The city’s financial situation is unique and does not reflect the financial standing of a significant number of municipalities in the U.S. That being said, there are relevant themes that policymakers and investors should recognize.

California Common Sense issued the definitive report on Stockton's financial situation entitled, "How Stockton Went Bust: A California City's Decade of Policies and the Financial Crisis that Followed." The report details the three most significant factors, which are distinct but interrelated, contributing to Stockton’s bankruptcy.

1. The housing and financial collapses.

The housing bust decimated Stockton’s housing prices, and so went the city’s property tax (and related) revenues. Housing prices plunged from nearly $400,000 in median home prices in 2006, down to $110,000 in 2009 (where median prices were in 2000 before the bubble.) Meanwhile the city has the second highest rate of foreclosures in the country. Revenues from related areas, such as: sales taxes, utility user’s taxes and housing permit fees also plunged.

The city burned through emergency cash funds and took efforts to rein in spending that weren’t enough. For example, they issued a hiring freeze for open positions in May 2008 and cut the general fund by $90 million in the last three years. Despite those efforts they continued to run budget deficits.

2. Excessive optimism and unsustainable compensation promises.

City policymakers appear to have mistaken the real estate bubble for real growth. (The Los Angeles Times reports that state mediation law requires assigning blame in cases of bankruptcy, which will determine whether this was an honest mistake or if there was corruption at play.) This reported optimism led to breakneck pace spending on various redevelopment initiatives. The city sold $129 million in bonds to fund rehabilitating the Philmathean building’s rehabilitation, the downtown marina and waterfront’s development and the Hotel Stockton’s renovation.

California Common Sense found that the city also renegotiated generous compensation for city employees, when employee services compose approximately three fourths of the city’s almost $200 million budget. For example, city employees receive a guaranteed salary increase from 2.5-7%, depending on General Fund revenue growth—even if the General Fund shrinks from the previous year. Meanwhile employee healthcare costs are also rising, growing at a rate of almost 10 percent over the past decade. Other post-employment benefits (OPEB), including pensions, are also rising steadily. The city now faces more than $800 million in unfunded liabilities for pensions and OPEB.

3. An ill-timed bond offering.

In 2007 the city sought to lower it’s pension costs, so policymakers undertook a bond offering to lower interest payments on roughly $125 million of its pension obligation. The proceeds of these pension obligation bonds were given to the California Public Employees’ Retirement System (CalPERS) to manage. California Common Sense found that CalPERS was overexposed to the real estate and stock markets, so it was unable to meet the expected returns. The original pension obligation bond money is now worth under $100 million while the city owes $248 million.

Increased debt payments, combined with multiple years of negative net annual activity, ultimately pushed Stockton over the edge. While bankruptcy will sort out the details of the city’s restructuring, it’s safe to say that employee services (namely police and fire) will be at-risk throughout the process. Public safety represents 80%, or almost $160 million, of the city’s nearly $200 million annual budget. Stay tuned to Reason Foundation’s Out of Control Policy Blog for more on Stockton in the days and weeks ahead.

Durbin Swipe Fee Watch V: Gas Retailers

Posted on April 23, 2012, 12:20pm | Victor Nava and Anthony Randazzo

It is time for another edition of the Durbin Swipe Fee Watch. 

Recall that the Durbin Amendment was a last minute measure added to the Dodd-Frank Act. The provision, which directed regulators to cap bank interchange fees-the fees banks charge retailers in order for the retailers to use the banks debit card-was naturally lobbied for hard by retailers. Regulators later set the limit at 21 cents per transaction, less than half of the average 44 cents per transaction prior to the rule.

At the time, Senator Durbin hoped that the lowered fees would reduce prices and amount to savings for consumers. That hasn't been how the movie has played out though. 

The most recent evidence comes from new research showing that while the automobile gas retail industry has achieved $1 billion in annual savings from the lowered swipe fees, these are not savings being passed on to consumers. Of the 134 billion gallons of gasoline sold in 2011 approximately 48 billion gallons were purchased using debit cards, and with the average savings for gas retailers of about 3 cents/gallon on debit card purchases courtesy of the Durbin Amendment, you get the $1 billion figure. The reduced swipe fees mean less cost for the retailers, but what about the consumers?

With debit as the overwhelmingly most popular payment choice at the pump (comprising of 36 percent of all transactions), the reduced swipe fees have essentially given the gas retailers a subsidy windfall rather than any savings for consumers. 

It is well documented that gas price averages were 26 percent higher in 2011 compared to 2010. Much of this could be blamed on the Arab Spring or Federal Reserve's QE programs driving up commodities prices. The data shows that consumers should be seeing a 4-5 cent discount for an average 16 gallon pump when they pay with debit. But with prices ever climbing the ill conceived Durbin Amendment has just put that money into the pockets of the gas stations.

While it is not necessarily a bad thing that small businesses (gas retailers) have reduced costs, it is a problem that this has come at the expense of other businesses (banks), all because Washington decided to pick favorites. Disguising their rule as somehow for the betterment of consumers has simply become a joke.

We predicted this back in 2010. Since Durbin Amendment's directed regulation has started its film reel many banks have ended debit card reward programs and flirted with monthly debit card fees. Retailers such as Redbox have even had to increase prices as a direct result of the Durbin Amendment. All of this has caused measurable harm to consumers, with little evidence of an aggregate benefit for them, and all this while big box retailers stand to make millions and more. The notion that businesses would voluntarily pass along these savings to consumers and that the banks would not find other ways to make up for lost revenues is baffling, and very short-sighted by the U.S. Congress.

Now in its fifth edition, the Durbin Amendment Swipe Fee Watch has reached the level of both the Rocky and Planet of the Apes movie franchises in that, like both Rocky V and Battle for the Planet of the Apes, you are now wishing the Durbin Amendment never happened. We all fear the release of the next edition.

Japan Reports Huge Current Account Deficit. Should the U.S. be Worried?

Posted on March 9, 2012, 3:46am | James Groth

Last January we highlighted that Japan was stepping up their foreign exchange borrowings through the Federal Reserve. They currently stand at $18.1 billion and have remained about that size since their initial borrowing in December. Though this amount is hardly alarming, it may possibly be an indicator of events to come.

Japan is in a precarious situation given the size of their debt, the demographics of their population, the history of their international finances, and the current trend towards current account deficits that could upset a very fine balance.

We detailed all of these elements about Japan last January in a blogpost and warned that if sustained current account deficits were to persist in Japan, the United States could find itself in a precarious situation of its own.

Sure enough, yesterday, Japan reported the largest current account deficit since comparable records began in 1985. It’s one of only five monthly current account deficits ever recorded, and by far the largest.

Below is an updated chart from our previous post:

The Financial Times wrote the following about the alarming shortfall:

“Following a full-year trade deficit in 2011, a first for Japan for more than two decades, fears are intensifying that the country is rapidly moving towards a lasting current-account deficit, which could lead to a reliance on foreigners buying government bonds. That, in turn, could drive up interest rates, threatening a fiscal crisis.”

Japan’s current account deficit is likely to reverse to a surplus next month, and many economists are not expecting full-year current account deficits for years to come. Given the size of Japan’s exports, one can hardly argue. Continued current account surpluses in the near-term are about as much of a sure thing as the Greek debt swap agreement that occurred just three hours ago.

But the writing is on the wall for it to happen sooner rather than later, and who knows, 2012 may very well see a full-year deficit. After all, no one expected Japan to turn in a trade deficit for 2011, and they did just that.

Point is, the future is unpredictable, and the US is not at all in a position to deal with the effects of Japan running deficits. Japan’s immediate solution would be to start dumping treasuries.

Politicians can banter all they want about the right time to begin reducing America’s debt and to curb spending. If, however, some exogenous shock occurs like say one of our largest creditors selling a trillion dollars in treasury securities, talk is cheap. The market, that we’ve all seemed to have forgotten, will make our decisions for us.

Our previous post can be found here.

Why is Europe So Delusional on Greece?

Posted on February 24, 2012, 2:32pm | Anthony Randazzo

Earlier this week I noted that Europe was trying to buy time with this bailout package offer. Here are a couple of more clarifying explanations for why the EU’s economic ministers are lying to us about this bailout of Greece having the possibility of success what Europe is trying to buy. Hans-Werner Sinn being interviewed by Spiegel Online:

SPIEGEL ONLINE: Why are the euro-zone countries so adamant that Greece must remain in the currency?

Sinn: This isn't really about the country. The Greeks are being held hostage by the banks and financial institutions on Wall Street, in London and Paris who want to make sure that money keeps on flowing from government bailout packages -- not to Greece, but into their coffers.

SPIEGEL ONLINE: What about the contagion that a bankruptcy or a Greek exit would involve? Financial markets may speculate that other countries will suffer a similar fate as Greece.

Sinn: There may be contagion effects. But I think this argument is being instrumentalized by people who are worried about losing money. People keep on saying "the world will end if you Germans stop paying." In truth only the asset portfolios of some investors will suffer.

And then there is Bill Frezza writing for Forbes about the endless attempts to avoid a “credit event”:

Now those same idiotic bankers, along with the French and German politicians they control, are conspiring with the Greek government to pretend they can fix the problem by forcing private bondholders to “voluntarily” swap one set of worthless bonds for another set of worthless bonds, without acknowledging a default that in a sane world would be all but inevitable.

The reason for this urgency? Private holders of these worthless bonds also hold hundreds of billions in insurance that would have to be paid to them should those bonds fail. And who are the sellers of these insurance policies? Why, the same idiotic bankers who control the French and German politicians!

European politicians don’t want their banks going down, and banks figure this bailout is the cheaper option. Sounds like incentives to lie.

The Concise Case for a Consumption Tax

Posted on February 24, 2012, 10:43am | Anthony Randazzo

John Tamny’s RealClearMarkets column yesterday looked at questions regarding the American tax code, the reasons for our high deficit, and the nature of the income tax. He concludes:

But as history has revealed in ugly fashion, politicians have very little discipline when it comes to spending, and the extra revenues have largely been used to expand existing government programs, or fund new ones. As for the deficits themselves, they've arguably been the result of investor belief that politicians are at the very least good at raising revenues from the productive class, thus making our deficits a good bet if markets are to be believed.

In that case it's time to look for modes of taxation most stimulative to economic effort, but that don't stimulate government growth through heavy revenue collection. A consumption tax would remove the existing penalty on work, would encourage savings and investment, but at the same time would make taxation a voluntary event, thus limiting not just government revenues, but also the government's ability to deficit spend given the limits imposed.

What would this shift provide as benefit? Earlier in the piece Tamny lays out a concise case for a consumption tax:

One form of taxation that has not been tried in modern times is a national consumption tax. The first glance advantages are of course positive.

For one, an income tax is a price placed on productive work effort. Worse, considering what monumental wealth generators Americans tend to be, such a tax is a grand source of revenue that allows our government to harshly expand its footprint on our economy.

And then not discussed enough is how successful it is at securing revenues from the "vital few", or the greatest wealth producers with the most productivity to tax. Supply-siders often brag about how much our tax code at present takes from the top 1 percent (at present the number is around 40 percent of total federal income tax revenues), but this isn't something we should be proud of.

Not asked enough is why the rich owe so much more than everyone else. Instead, it should be said that by virtue of growing wealthy the rich have conferred myriad benefits on society through lifestyle enhancing innovations and jobs, so to then hit them with a major portion of the tax bill seems backwards.

Better it would be to let taxation on the national level be voluntary. The more one consumes, the more one pays.

Such a tax would firstly support the most economically beneficial act of all which is to encourage saving. It is through savings that we expand the capital base necessary so that good ideas can be matched with investment, and a consumption tax would aid just that.

Second, a consumption tax would be the one way that the citizenry could limit the ability of the federal government to collect revenues. If in place, it's not unfair to assume that Treasury's ability to sell bonds necessary to fund a government that always seems to grow would be reduced. If so, as in if Treasury debt is made less attractive to investors, credit would migrate elsewhere; logically toward economic concepts that tend toward wealth creation rather than capital destruction.

Third, assuming an economic downturn, downturns regularly coinciding with reduced consumption, the federal government would be forced to get by on a smaller budget alongside Americans similarly making do with less. This alone speaks to recessions shorter in duration.

Indeed, as past columns have revealed about the 1920-21 US recession, it was then that government spending was cut in half in response to the economy's recessed condition. Of course with funds left in the private sector as a result, the subsequent rebound was rather powerful, and with a consumption tax we could perhaps count on something similar.

Read the whole piece here.

The Coming Greek Default

Posted on February 22, 2012, 5:00pm | Anthony Randazzo

Over at Reason.com this afternoon, I have a new column on the Greek debt crisis. Last year we looked at the numbers on the blog and came to the conclusion that no matter what happens, Greece is going to default. With a new Greek bailout on the table, we update the numbers but come to the same conclusion:

The target is to get Greek debt down to just 120.5 percent of GDP by 2020. But a confidential 10-page report prepared for European finance ministers that was leaked on Monday suggests that the best-case scenario is closer to 130 percent of GDP by the end of the decade. Furthermore, the report suggested that if the bailout deal is not upheld on the Greek side, debt could rise to the 180 percent of debt-to-GDP range.  To put this in perspective, Greece should be at something more like 60 or 70 percent of debt to GDP to be a stable European nation. [...]

The second bailout is also based on overly rosy estimates of economic growth for Greece. Where the Greek economy has seen negative GDP growth of 7 percent recently and is projected to have no growth in 2012 or 2013, the target goal of 120.5 percent of GDP by 2020 assumes economic growth of 2.3 percent in 2014 and 2.0 percent in 2015. But growth from where?

Read the whole commentary here.

If you want to start making a list of reasons why Greece will default here is a starter:

• It took over a year for Greece to start mandatory public sector layoffs because of constant protests and demands from the Greek citizenry that they retain their paychecks with salaries three times the private sector and no requirement to actually show up for the job. 
• Greece consumes more than it produces—partly because its people are busy consuming and not working, and partly because it doesn't produce that much period. It is a tourist based economy that can't generate rapid growth needed to eventually draw in the revenues needed to pay their debts after this second bailout goes through (if it goes through).
• The Greek penchant for tax evasion isn't just going to disappear overnight.
• For Greece to really have a future the nation needs to take a collective pay cut (probably somewhere between 25% and 50%), but a Trojan horse is more likely to appear on their shores than this happening willingly. It would be much simplier to make this happen by getting Greece out of the Euro and going back to the drachma—but it'll take a default for the Euro to let Greece go. One way or the other, this is all inevitable.

For even more see these two interviews from earlier this week on the Greek debt crisis.

Monday on GBTV's Real News: 

Tuesday on RT's The Aloyna Show:

Which is the "Do Nothing" Party?

Posted on February 17, 2012, 10:43am | Adrian Moore

Recently before Congress Treasury Secretary Geithner responded to a question from Rep. Paul Ryan saying, "You are right to say we're not coming before you today to say 'we have a definitive solution to that long term problem.'  What we do know is, we don't like yours."

As Guy Benson at Townhall put it:

Those two sentences speak to a mentality so bereft of intellectual vigor, so stunningly and candidly shallow, so thoroughly irresponsible, so politically myopic, selfish, and cowardly, that it should disqualify this crew from a second term in office.  What a disgrace.  Remember this moment the next time Democrats accuse the GOP of being the "do nothing," intransigent, "party of no."

House Passes Legislation Putting the GSEs on Budget

Posted on February 8, 2012, 3:41pm | Anthony Randazzo

The House of Representatives voted yesterday to put Fannie Mae and Freddie Mac on budget. This should be bigger news than anyone is getting it. As the bill (H.R. 3581) would profoundly change the way the government counts its debt, it should at minimum be a topic in the presidential debate.

In the words of one of the legislation's backers, Rep. Scott Garret, the bill "recognizes the budgetary impact of government-sponsored enterprises Fannie Mae and Freddie Mac by bringing these black holes of debt out from the shadows and on-budget, and requires that the federal government apply the same credit accounting standards as the private sector when making or guaranteeing loans."

We have written at length about the need for the GSEs to be on budget. In a July 2010 letter to Secretary Geithner responding to requests for comment on the future of housing finance, we wrote:

The GSEs should also be formally put on the federal budget. They are in effect run by the federal government and meet the Congressional Budget Office standard for being included on the budget. Currently, the White House Office of Management and Budget does not include them. Adding them to the budget would not only be more honest, but it would add more transparency to the true drain the GSEs are on the fiscal stability of the federal government. If the GSEs were put on budget, then all cash flows from maturing mortgages or servicing fees on pools of loans would go into the Treasury to mitigate losses the taxpayers have taken on the GSEs. 

The CBO projects the budgetary impact of the two entities’ operations as if they were being conducted by a federal agency, because of the degree of management and financial control that the government exercises over them. Specifically, CBO determined that after the GSEs were placed into conservatorship, they were close enough to government agencies that they should be counted towards the budget. Using principles outlined by the 1976 budget concepts commission CBO includes estimates of losses from the GSEs to is budget baseline.

So fare the OMB, White House budget accountant, still considers the GSEs as off-budget organizations since their conservatorship maintains their technical status as federally chartered enterprises. No budget by the Bush or Obama administration has considered GSE expenses in their budget outlooks. It is possible that the Obama budget to be released next week will include the GSEs—though since the White House has no intention of pushing Congress to pass it, the move would be a token nod.

It is helpful, therefore, that some in Congress have recognized the value of putting the GSEs on budget to reflect their true impact on the country and to better measure our national liabilities. 

Not to be lost in this issue is new accounting standards directed by the legislation that would have a profound impact our debt measurement. This is unlikely to be considered in the Senate, but it is a start towards more fiscal responsibility in future legislative cycles. We can hope that it will be discussed during a presidential debate or three come the general election.

Greek Debt Talks Stall, Again. What About Portugal?

Posted on January 30, 2012, 5:47pm | James Groth

After another attempt failed to get commitment from private investors on forgiving a portion of their Greek debt, the Institute of International Finance (IIF) maintains that a deal will be finalized shortly. Considering that the IMF, ECB, and a host of other European leaders have been claiming that a deal is “imminent” for the past three months now, this once again is as believable as MF Global assuring investors one week before collapse that it “is in its strongest position ever.” What’s worse is that while this circus of negotiations continues, Portuguese bonds and spreads are blowing-up.

Below is a chart of Portuguese 10-year bond yields over the past two years. Just today, yields rose 14.3 percent to an all-time high 17.4 percent yield.

Portugal is now in the same predicament as Greece and will have to go through the same bailout and debt reduction procedures as is currently occurring in the Hellenic Republic.

Greece is trying to lock down a $170 billion bailout from the IMF which will allow it to hobble along for the remainder of the decade. Reports surfacing last week say the figure needs to be at least $190 billion. Either way, in order to receive the funding, Greece must get a voluntary agreement from the private holders of its debt to commit to taking at least a 70 percent haircut (loss) on their holdings and take as the 30 percent remainder new 30-year Greek bonds with a coupon of somewhere between three and four percent. 10-year Greek bonds currently yield 34 percent.

Why anyone would choose to accept such a deal is beyond comprehension and may be why the talks have stalled for so long. It’s a terrible deal. Remember, the commitment from private investors is voluntary.

Private bondholders know exactly how much they stand to gain and lose by choosing to accept or decline a deal. Many of the bondholders are holding derivative contracts on their bonds and may actually benefit from a Greek default. Certainly none of them will cave to the scare tactics that holding out for a default would cause a financial meltdown, and regardless, even if they suspected a meltdown would ensue, I can imagine some of the hedge fund managers drawing pride from being responsible.

None of this would even be happening if markets were simply allowed to function. Greece would default, bond holders would line up for their share of the claims, derivatives would pay out, banks would take losses, Greece would design a budget sufficient to gain new funding at a market rate albeit with significant cuts, and voila, problem solved. Instead there is this political maneuvering from the IMF, ECB, and heads of State claiming where rates need to be set, who’s entitled to a bailout, and why a ten-year-old monetary union needs to be upheld because of regional peace for all reasons. As if free trade and free movement of labor had nothing to do with the last 60 years of peace in Western Europe.

So the unending political pandering and breakdown of securities market law continues and will double once the situation in Portugal hits the fan. Portugal is issuing debt this week, and when their government realizes where their financing costs have risen to, they’ll be whining for the same treatment their Mediterranean neighbor received.

They may want to be careful what they wish for. Over the weekend, Germany asked that Greece relinquish control over its budget to a central European authority and hinted that others in distress who would be receiving bailouts do likewise. That’s the last thing any nation would want, ceding decision making authority to an institution with limited knowledge beyond a ledger, and to boot it would come at the price of nearly a decade of painful austerity.

Japan Steps Up Fed Borrowing: A Good Indicator of a Slow Motion Train Wreck

Posted on January 23, 2012, 4:05pm | James Groth

Last week the Bank of Japan (BOJ) more than doubled their Swap borrowings from the Fed to a total of $20.4 billion. Though this is a quarter of the $82.3 billion the European Central Bank (ECB) has taken out since the Fed lowered its swap rates back in December, it may be more alarming.

With all the turmoil in Europe, few have paid attention to the situation in Japan. Japan currently has a 230% debt to GDP ratio and is borrowing close to 55 percent of every dollar (yen) it spends. Consistent current account surpluses have allowed them to stay solvent by funding their debt through domestic banks and insurance companies, government pensions, and Japanese savers. Just 5 percent of its debt is owned by foreigners. It’s largely a Ponzi scheme, but because of their huge exports and saving, it has perpetuated.

But this is beginning to change.

Since the start of the financial crisis in the summer of 2007, the Yen has appreciated nearly 40 percent against the dollar, and slightly more against the Euro, a result of the massive easing by the Fed and the ECB. As a result, Japan’s exports have become more expensive, declining over the entire period. Then the Fukushima Daiichi nuclear earthquake disaster last March crippled export volumes further. 

Japan’s current account has fluctuated violently since the beginning of the Yen appreciation over the past five years, but all the while has been in decline. 2012 may very well mark the first year of current account deficits in Japan following decades of annual surpluses.

If that should prove to be true, the last place Americans want their dollars to be going is the BOJ. Without current account surpluses, domestic buyers of Japanese debt will have no source of money with which to fund the Japanese government. Foreigners surely won’t pick up the slack with Japanese 10-year yields at 1 percent when they can get Treasuries and Bunds at 2 percent.

The only possible outcome would be for Japan’s borrowing costs to at least double or massive inflation by BOJ printing. Debt service is currently half of government tax revenue, so if borrowing costs double, and all else equal, debt service will be 100 percent of revenue. Of course that cannot happen, so something catastrophic would occur prior, namely the latter option of BOJ printing and hyperinflation.

 That’s not a situation we should be throwing dollars at in blind hope. However, the one thing the current Fed loves to do is throw money at any situation regardless of the cause and potential downside outcomes. So the questions are, what factors will lead Japan to current account deficits, and as a follow-up, what happens when BOJ swap operations with the Fed soar as a result?

Demand for Japan’s exports will be at the heart of determining a deficit or surplus for Japan’s current account. A weakening Europe, and stagnating U.S. will drag on demand, and the subsequent easing by the ECB and Fed will drive the Yen higher crushing exports and continuing the slide to current account deficits.

Another factor will be growth in Japan’s imports, namely that of commodities. A stronger Yen will contribute to this, but a fundamental shift is also on the rise. There now is a greater demand for energy generation from fossil fuels like coal and liquefied natural gas (LNG) because of the earthquake. Japan generates nearly a third of its electricity from nuclear, and in an island nation of limited natural resources, commodities imports are likely to boom.

Transfer payments too are beginning to exert pressure. Japan has a top-heavy aging population and the younger generations are not saving like the generations that preceded them. Social welfare will drastically increase net transfers. This is an inevitable drag on the current account even if the former scenarios do not play out.

Thus the situation looks grim. But it should not come as a surprise because the writing has been on the walls for decades and the recent trend towards current account deficits has been in place for nearly five years. Nevertheless, the Fed is addressing the issue with its usual band-aid of free money.

I suppose one can’t blame the Fed, however, because the solution for Japan in this situation would be to sell their nearly $1 trillion in U.S. treasuries held in reserves. At a time when the Fed has just binged on U.S. debt and the future of the dollar and the U.S. economy now hinge on the ability of our government to borrow cheaply, our debt-laden controllers can ill afford any foreigner dumping our paper, let alone the second largest creditor.

So, as our Fed works to bailout Japan, we must address the follow-up question of what happens when BOJ swap operations with the Fed soar as a result. The answer unfortunately is uncertain.

The Fed enters the swaps via a fixed exchange rate with the counterparty central bank, so arguably the Fed is insulated from any risk because any central bank can simply print money if the banks that are ultimately lent to collapse and cannot repay. But if the swaps soar to something like $500 billion or more, and banks do collapse, what central banker is really going to print the money necessary to make good on their end of the swaps? All holders of Yen (in this case) would get crushed. Likewise, the Fed would tell U.S. citizens that it’s in their best interest not to demand repayment and share the pain so as not to initiate a global slowdown, world financial crisis, or whatever the scare tactic phrase du jour may be.

Again, the problem is that nothing is being done to address the fundamental issues laid out here. Rather it’s more of the same printing money, providing liquidity, and dealing with “surprise” crises as they occur.

The Fed’s swap operations can be found here. They’re currently above $100 billion and climbing. We’ll write again on these swaps when that figure becomes a pittance. 

Why the Fed Missed the Housing Bust

Posted on January 13, 2012, 11:42am | Samuel Staley

The LA Times (Jan 12, 2012) recently highlighted the cavalier attitude of Federal Reserve officials in 2006 just before the housing bubble burst.

While it's unclear what purpose the article serves other than to suggest through 20/20 hindsight that key Fed policymakers (including Bernanke and Geithner) were clueless about the state of the economy and implicitly asleep at the wheel (Paulistas take note!), the article fails to recognize that every mainstream macroeconomic forecaster missed the call. Some were warning of the bubble and its unsustainability, but the professional forecasters failed to predict the timing or depth of the bust, and none of the models (that I"m aware of) predicted the turning point. It's really a warning about putting faith in experts rather than markets. I discuss this is a bit more detail over a National Review's blog "The Corner," (see also my NR post here) and readers might be interested in also taking a look at an earlier blog post here.

The Coburn Report and Fraud

Posted on January 10, 2012, 8:21am | Anthony Randazzo

Last month Sen. Tom Coburn (R-OK) released a report detailing 100 "unnecessary, duplicative, or just plain stupid projects spread throughout the federal government and paid for with your tax dollars this year." The list included a program to boost the mango business in Pakistan ($30 million), a duplicative housing development program ($168 million), and a National Science Foundation grant for a Stanford researcher to observe how voters view political stances on climate change ($200,000). All total, the study notes $6.9 billion that could be wiped away by cleaning up some parts of the government.

The report is great in the sense that it points out number ways we can fix fraud and waste. But it is also a drop in the bucket considering what we're dealing with regarding the budget. As was noted on our blog yesterday, there are hundreds of billions in waste that can be identified and shut down. 

What should be the most clear whenever talking about cutting spending though is not so much that the nature of the deficit today is the most inherent problem, but the size and scope of government spending itself. The more projects the government spends money on, the greater these fraud opportunities become-there just aren't enough citizens to watch all of this mess. Moreover, if all of these programs are not just wasting government money but often times are crowding out the private sector. I would prefer a federal budget that spends $5 billion a year with a $500 million deficit as opposed to a government that spends $10 billion a year with zero deficits. 

Rounding Errors in the White House

Posted on January 9, 2012, 7:00pm | Paul Revere

Throughout 2011, the Obama Administration claimed a number of successes at cutting the ubiquitous "fraud, waste and abuse" in the federal budget. According to the White House's website, nearly $8.5 billion was saved in 2011, including ending the production of commemorative coins ($50 million annually) and recovery of defrauded funds in health care. Other measures will save an expected $3 billion-plus by 2015, and a separate $4 billion over the next five years.

Unfortunately for Americans, the grand total of these "successes" is equivalent to less than .0028 percent of spending in Fiscal Year 2011. It is approximately .0077 percent of last year's deficit. Most importantly, it is not nearly enough to even make a dent in our massive deficits, and these puny efforts ignore the plethora of "low-hanging fruit" that could be cut out of $300 billion-plus that make up fraud, waste and abuse in the federal government. While cutting these monies would not balance the budget, nor prevent the oncoming fiscal cliff from arriving in spectacular fashion, eliminating them is a good step in the right direction.

In 2009, then-Chairman of the Recovery and Transparency Board Earl Devaney testied that as much as 7 percent of federal spending (which is equal to $252 billion in FY2011) is lost to fraud and waste. Related, a 2009 CBS report showed $60 billion in dollars lost to fraud came from Medicare. An internal Department of Defense report in January 2011 showed-according to Sen. Bernie Sanders (I-VT)-that $285 billion in payments were given to contractors who were committing fraud while receiving the payments, from 2007 through 2009. 

Over in the White House, CNN reports that incoming chief of staff and outgoing OMB director Jack Lew stated the federal government made improper payments worth $116 billion in FY2011. While this is down from $125 billion in FY2010 (which was itself up from 2009), it means 3.22 percent of federal spending was simply irresponsibly, if presumably well-intended...and this is before the caveats from the OMB are considered. $48 billion of the 2010 improper payments were estimated to come from Medicare, and over $70 billion from Medicare and Medicaid combined.

Beyond the traditional "fraud, waste, abuse" mantra, duplication of programs is all too common. The Government Accountability Office published a report in 2011 on the duplication of federal programs (see the report here) that could equal "tens of billions" in annual savings if the duplication ended. 

Again, cutting fraud, waste and abuse won't balance the budget. It won't stop a fiscal collapse of our nation. However, was it not for the hundreds of billions of dollars in annual fraud and waste, our national debt would likely be closer to $13 trillion instead of $15 trillion and interest payments could have been around $60 billion less in FY2011. Suffice to say that in claiming a few billion in easy savings is a success is to entirely mislead the American people, and especially the young Americans (AKA the Debt-Paying Generation) who helped bring President Obama into office. 

The writer is the pseudonym of a congressional staffer who has contributed to a number of publications with ideas regarding public policy. His work reflects his own views and not necessarily those of his employer. Contact: Anthony Randazzo, director of economic research, at anthony.randazzo@reason.org

Bernie Madoff for President

Posted on December 29, 2011, 3:58pm | James Groth

The close of 2011 has brought so much liquidity and free money into the system that one has to question whether our central monetary authorities are running one big Ponzi scheme. In the last six months alone, the ECB has grown their balance sheet by €789 billion from €1.94 trillion on July 1, 2011 to €2.73 trillion today. The Fed too has been busy printing money bringing their balance sheet up more than $500 billion this year to $2.92 trillion.

The two central banks have recently begun collaborating together through existing currency swap facilities now discounted at a highly favorable rate relative to the market. The total amount drawn from the Federal Reserve is now $95 billion, up from $2 billion before the rates were reduced. We’ve written about the effects of these borrowings here.

While $95 billion is a significant amount of money, and has gone a long way to propping-up the Euro zone, it pales in comparison to the $640 billion lent to over 500 European banks through their Long-Term Refinancing Operation (LTRO). Many banks had already been borrowing from the ECB through similar facilities like the Main Refinancing Operation (MRO) and a shorter-term LTRO, but borrowing skyrocketed when the ECB allowed borrowing at 1 percent for up to three years in unlimited quantities which are the terms of the new LTRO.

These terms allow borrowers to make ungodly amounts of money never before possible in a market absent a central bank. Banks are now able to conduct carry trades by buying the debt of their country’s government risk-free with borrowed money from the ECB netting “profits” of upwards to $50 billion. It’s free money. Banks are also using the money to issue more of their own debt. The result is simply more debt hitting the market both from sovereign governments and from banks. Due to the seemingly infinite amount of free cash now available, interest on the debt is significantly lower than it otherwise would be allowing both banks and nations to continue operating in an unsustainable manner.

Banks can continue to pay their employees big bonuses and salaries while adding no value to the economy (which would otherwise be done through business loans, project loans, corporate loans, etc.) simply by taking advantage of the free money from central banks. Similarly nations like Italy, Spain, Portugal, and others can continue to offer social welfare, bloated pensions, and 25-hour workweeks without committing to austerity measures that would wean their citizens off of hand-outs and encourage their efforts into more productive means, benefitting the economy as a whole.

The Fed and especially the ECB believe that the current crisis in Europe and the financial crisis, which is still rearing its ugly head, is a liquidity problem. As such they are both throwing unlimited quantities of money at banks and governments to allow them to continue operating. They both also acknowledge that banks and governments are suffering from a crisis of confidence and that by backstopping their every failure, participants in the market (that’s you, me, institutions, sovereign wealth funds, and everyone) will be inclined to invest in and lend money to banks and governments.

The goal through all this money printing is that at some point bank assets will be able to generate enough cash flow to satisfy cash outflows from bank liabilities and similarly for governments, tax revenues will be able to satisfy all government commitments. The problem is that bank balance sheets are growing, and similarly so are government commitments. And they are both doing so from the free money furnished by central banks. Without it, banks would be forced to slim down and governments would be forced to streamline and cut commitments. So long as central banks can prop-up the massive size of banks and governments, both will continue to operate inefficiently and run-up larger and larger debts.

It has become clear that the ECB and the Fed, either unilaterally or jointly, will do whatever is necessary to continue funding the debts of banks and governments no matter what the prospects are for their future. Greece is in fact insolvent. So are a host of European and American financial institutions that would otherwise fail if not for the free money provided by central banks. Portugal is also insolvent but not to the extent of Greece, and Italy is not far behind them both. Yet, all remain funded, perpetuated by a free flow of money that circulates from banks to governments and back again providing unsustainable social services and banker compensation.

Bernie Madoff promised to his clients’ unsustainable returns, much like our government and governments of the European periphery have promised unsustainable benefits and programs. At some point Bernie could not produce his promised returns from the market alone and had to take money from new clients and the portfolios of others to continue producing his stated returns. In his mind, Bernie thought this borrowing would be temporary and that once he could make up for the losses in the market, he could return the borrowed money and continue producing his stated returns. But it wasn’t to be. His promised returns proved to be unsustainable and rather than quit early and return client money at a small loss, he chose to continue borrowing more and more money from new and existing clients to fund not only his lavish lifestyle, but also the lavish lifestyles of clients he had successfully fooled into thinking they had vast wealth accruing vast gains.

We all know how it ended. Confidence broke, clients demanded more than $50 billion that had already been spent, and everyone lost. A few individuals involved even took their own life.

The situation we’re facing now is not all that different. Banks promised unsustainable returns, and governments promised unsustainable programs and benefits. Rather than taking the pain of reducing these returns and taking losses on some of the commitments, our central banks instead are choosing to borrow unlimited amounts of money to continue down an unsustainable path thinking foolishly that at some point we’ll be able to produce gains and grow so extraordinarily quickly to the point we can all return the money in good faith. Like Bernie’s Ponzi scheme, it too will fail.

We will soon see further borrowings from the ECB and most likely QE3 from the Federal Reserve to the tune of $600 to $800 billion as early as February, 2012. The Fed’s swap facility has already reached nearly $100 billion in less than a month with purchases going straight to Europe and some are projecting it to reach $1 trillion or more. Rather than bring government and bank debt to a manageable and sustainable level now through write-downs and spending cuts, we’re betting our futures on a Ponzi scheme.

Because that is the clear path we have all chosen, coupled with the fact that Obama’s approval rating is the lowest of any standing president and the GOP has been selecting their chosen one based on either good hair or a numbered tagline, it very well may be prudent to have Bernie Madoff as commander-in-chief. We could certainly use someone with his experience.

He’s slated to be in jail for the next 150 years, but maybe our government could make an exception just this once because his skills and talents as a con artist are so desperately needed to protect the security of the world’s economies.

Our country’s future, our collective ability to live the lives we deserve, and the security for both depend upon growth, innovation, and prosperity. All of which is threatened by maintaining the status quo through historically unmatched monetary control. Yes, short-term pain will be felt by spending cuts and a reduction in monetary backstopping, but it will be short-lived, and it will not be felt by all. Money should be allocated to its most productive means, not towards the discretionary wishes of a central authority. This is terribly lacking under the current regime.

Trillions and trillions have been printed and pumped into the system since the financial crisis, and all we’ve been told when inquiring about accountability is that it would have been much worse had anything short of the trillions spent not been allowed. Well, it’s been more than three years and still there is no plan for when the money printing will stop or what entity and individuals are accountable for the inevitable mistakes. Central banks are completely reactionary. Every call for capital is met with more borrowing, more printing. It is a Ponzi scheme, and it is completely out of control.

Bernie Madoff for President.

Finally, the Federal Reserve’s Bailout of Europe Hits Mainsteam

Posted on December 28, 2011, 1:25pm | James Groth

Two weeks ago, we reported here about the Federal Reserve bailing out Euro land via its recently announced discounted currency swaps. Apparently not too many people seemed to care because little was reported on the subject, and the few who did note that it constituted a Euro bailout, did not fully grasp what it would entail. Most wrote it off as a non-event. But after nearly $100 billion has been drawn from the newly discounted Fed facility in the first two-weeks of operation going straight to European banks and Euro debt purchases, the mainstream is now taking notice.

Reported today from the Wall Street Journal (a bit late, but at least they’ve come around):

“America's central bank, the Federal Reserve, is engaged in a bailout of European banks. Surprisingly, its operation is largely unnoticed here.

The Fed is using what is termed a "temporary U.S. dollar liquidity swap arrangement" with the European Central Bank (ECB). There are similar arrangements with the central banks of Canada, England, Switzerland and Japan. Simply put, the Fed trades or "swaps" dollars for euros. The Fed is compensated by payment of an interest rate (currently 50 basis points, or one-half of 1%) above the overnight index swap rate. The ECB, which guarantees to return the dollars at an exchange rate fixed at the time the original swap is made, then lends the dollars to European banks of its choosing.

Why are the Fed and the ECB doing this? The Fed could, after all, lend directly to U.S. branches of foreign banks. It did a great deal of lending to foreign banks under various special credit facilities in the aftermath of Lehman's collapse in the fall of 2008. Or, the ECB could lend euros to banks and they could purchase dollars in foreign-exchange markets. The world is, after all, awash in dollars.

The two central banks are engaging in this roundabout procedure because each needs a fig leaf. The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books.”

The full WSJ article can be found here. The article itself merely scratches the surface, but the point being that it is now reaching a mainstream audience. To those still doubting whether this Fed action amounts to anything, I encourage you to read the testimony of George Mason University Finance Professor, Anthony Sanders given to the House Committee on Oversight and Government Reform in which he warns of Fed bailout lending through these discounted swaps could reach $1 trillion or higher. A good summary and the full testimony can be found here.

The Fallacy of Demand-Side Solutions to US Economic Stagnation

Posted on December 25, 2011, 3:07pm | Samuel Staley

Innovation economist Bret Swanson dissects a recent speach by Obama Administration chief economist Alan B. Krueger in his most recent column at Forbes.com (24 December 2011). In "The 12 Keynes of Christmas," Bret notes the contradiction between the widespread recognition that supply-side entrepreneurship and innovation is critical to sustained economic growth and a policy based on increasing demand. Bret writes, in part:

"But at no time in memory has the basic idea of American free enterprise – “entrepreneurship,” “education,” “reinvent” – been more in question. In recent months, the government blocked the Keystone XL pipeline, AT&T’s next generation wireless expansion, and educational innovations by for-profit colleges. It wants to shut down almost 10% of the nation’s coal-based electricity supply.

"If you think recent policy choices, on balance, mean the U.S. might grow just 2% per year for the next few decades instead of 3%, then you intuitively know that U.S. GDP in 2020 could be $2 trillion less, in 2030 almost $5 trillion less, and in 2040 almost $10 trillion less. Maybe you are even underestimating America’s potential and the severity of wrongheaded policy."

And noting:

"The crude Keynesians think shoveling money into the economy will encourage people to buy stuff, thus encouraging businesses to increase capacity and hire, thus expanding the number of people with jobs, who might consume more goods and services. Virtuous circle in theory, but it doesn’t work."

Swanson also notes that a group of economists has emerged advocated a monetary policy that focuses on increasing nominal (non-inflation adjusted) gross domestic product (NGDP), regardless of the inflation rate. So, in principle, even if real GDP growth was zero, inflation of 5 percent could keep nominal growth at 5 percent:

"The NGDP advocates have a slightly more sophisticated expectations-based theory. Make sure people and companies know the economy will expand at least 5% per year, even if it’s all inflation, so no one will stop spending. Trouble is, for how long will consumers and firms buy stuff based purely on a government guideline that they will still be buying stuff in the future – without regard for the productive capacity or performance of the real economy? And if they don’t believe in this demand-now-because-there-will-be-demand-later dictate, will it work for any amount of time at all?"

But this is only the tip of the iceberg in terms of the damaging effects of inflation. Missing in this discussion is the perverse effects inflation plays in skewing consumption decisions. The housing bubble wasn't driven just by the increase in sub-prime and near-prime mortgages. Rather, these financial instruments enabled consumer decisions based on incorrect information about the relative value of homes and their ability to pay for them. In short, housing price inflation led to over consumption of housing. Not only was the absolute level of housing consumption higher than could be sustained by household income, the higher prices led households to buy the wrong kind of housing in the wrong place. The bursting of the housing bubble is part financial market readjustment and part property market readjustment. Inflaton makes these problems worse, not better.

Kruger's speech, delivered in Charlotte, North Carolina on December 20th, can be found here.

The Federal Reserve is Buying Euro Debt and We are All Going to Pay

Posted on December 16, 2011, 11:13am | James Groth

Two-weeks ago the Federal Reserve announced a coordinated effort by six central banks to make it cheaper to borrow dollars in emergency situations. The premium to borrow dollars overnight via foreign exchange swaps was reduced by 50 bps, and the timeframe to access this emergency cash was extended out to February, 2013.

This is old news of course, but the results of the decision are not.

The lowered rate opens up an arbitrage situation whereby a spread can be collected risk-free (barring a few low-probability outcomes). Banks and institutions in Europe as well as America and elsewhere are taking advantage of this free cash and are also exploiting it to buy en masse the debt of Spain and Italy. Essentially, the Fed, via swap lines is lending through foreign central banks to institutions and banks to immediately purchase debt, primarily that of Spain and Italy.

In essence, the Federal Reserve is buying Spanish and Italian Debt.

Not only is the manager of our sole medium of exchange risking our purchasing power to bail out the lifestyles and frivolousness of the European periphery, but they’re also bank rolling hedge funds in the process.

The announcement from the Fed came on November 30^th, but the swap lines were not accessible at the discounted rate until December 5^th, leaving two trading days for hedge funds and other large institutions with heavy cash positions to front-run sovereign debt buyers that would be making huge purchases on December 5^th. If you factor in insider trading, which for an operation like this is an absolute certainty, traders had even more opportunity to front-run. Front-running means buyers with no interest to own something, buy in front of those who are actually interested in owning, and sell to them for a profit and to the ultimate owner’s loss. For instance, I buy at $90 knowing full well that natural buyers will be coming to market in two days.  My buying drives the price up to $93 where I then sell to the natural buyers. I profit $3 from front-running, and the natural buyers lose that same $3 that they otherwise would not have had to pay had I not driven up the price. Now, magnify that $3 to a couple billion, and you can understand why hedge funds, institutions, and banks love it when the Fed gets into markets.

But there is something more inherently wrong with this situation, namely that our central bank is buying Italian and Spanish debt. The Fed will tell you of course that they are only lending to central banks, and that central banks, like the ECB, are the only counterparty. While this is true, that money is winding-up in banks all over the world, primarily in Europe, and they’re then turning around and buying dodgy debt. So should that debt plummet, like in the case of Greece over the past year, the central banks that the Fed has lent to, namely the ECB, will have to print their sovereign currency ad nauseam to come up with the dollars with which to pay us back. That would be disastrous. But it was a situation that we weren’t party to until last week.

Pundits downplayed this new Fed action on the day of its announcement, but the results of the subsequent borrowings have had significant market effects. Banks demanding dollars from the ECB through this facility came in over five times expectations at $52.3 billion. Purchases from this added liquidity brought yields on Spanish 10-year bonds down to 5.09 percent from 5.68 percent on the day of the borrowings. They had been as high as 6.7 percent when the initial front-running began.

Yields on Italy’s debt reacted the same. Italian 10-year yields fell from 6.68 percent to 5.93 percent on the day of the borrowings and had been as high as 7.3 percent. These are huge swings and they are all central bank orchestrated.

The same sovereign bond market reaction occurred this past August when the ECB stepped in through their Securities Market Program (SMP) and bought €130 billion in periphery debt. I wrote about the ridiculousness of those purchases here and here. Following the ECB action, yields plummeted much the same as they did last week, but then traded back up as the purchases leveled off. Below is a chart that shows the yields of Spanish and Italian 10-year bonds overlaid with the purchases of the SMP program and the Fed’s latest swap operations.

It is clear to see the effect these central bank actions have on bond prices and their corresponding yields, albeit artificial.

You may be thinking that this is a good thing that the yields have fallen. After all, it is rising borrowing costs (bond yields) that are causing all the pain in Europe and anything the ECB or the Fed can do to bring these costs down is good. While that may be true in the short-term, if the long-term issues of insolvency aren’t addressed, a currency crisis could ensue, and it will be much more severe and many more years longer if it is postponed through short-term liquidity injections. Ultimately, the liquidity injections may not produce any positive results save for a few months of delusion from those thinking that the problem has been solved.

Consider Greece, which back in May, 2010 had the same episode of rising bond yields. The ECB stepped in through their newly created SMP providing €70 billion to purchase the sovereign debt acting to avert what they deemed, a liquidity crisis. The below chart displays Greece’s 10-year bond yield overlaid with the SMP purchases.

It looks eerily similar to the first chart: yields are steady, yields rise, the ECB intervenes and yields plummet, yields trickle back up as the purchases level off. It is the exact same situation, at nearly the exact same yield levels, only a year earlier and a different country.  Greek yields have since skyrocketed. The country is now bankrupt.

The following chart displays the Greek 10-year yield over the past two-years, the highlighted section being the time period of the chart above.

Remember that back in May, 2010 the ECB claimed that the situation facing Greece was nothing more than a liquidity crisis and that through purchasing its bonds, the crisis could be averted. This justified their intervention. It is now clear that Greece is in fact insolvent, and its bonds reflected a solvency crisis. Under such a scenario, no matter how much money is thrown at the situation, default is inevitable. Any money invested will be lost.

Looking at the first two charts it is easy to draw parallels, and the third chart may indeed be the future facing Spain and Italy. If that should prove to be true, and the situation in Spain and Italy is a solvency crisis misdiagnosed as a liquidity crisis, the ECB and especially the Fed has no business buying their debt. It is just wasting money on an inevitable default and compounding the problems of bankruptcy, spreading the pain to millions more people than is necessary.

Americans' future now depends on the gambling of America's central bank placing bets on the probability that the lifestyles of Spaniards and Italians are conducive to paying bills and balancing a check book.

Is that a wager you would make? Doesn't matter, you already did.

Corzine Understands the Need for Congressional Oversight?

Posted on December 8, 2011, 4:06pm | Samuel Staley

Jon Corzine, the former governor of New Jersey and Goldman Sachs executive, told a Congressional committee that he didn't know where the money that investors had trusted to MF Global Holdings went. What I thought was more interesting was he reasoning for testifying before Congress unprepared and without access to critical information and documents that would allow him to answer key questions forthrightly. In written testimony delivered on December 8, 2011 to the House Agriculatural Committee, he says:

"Considering the circumstances, many people in my situation would almost certainly invoke their constitutional right to remain silent – a fundamental [Fifth Amendment] right that exists for the purpose of protecting the innocent. Nonetheless, as a former United States Senator who recognizes the importance of congressional oversight, and recognizing my position as former chief executive officer in these terrible circumstances, I believe it is appropriate that I attempt to respond to your inquiries."

This begs the following question: Congressional oversight of what? The economy?

Perhaps this is a core part of the problem. Congress isn't responsible for whether businesses make good decisions, bad decisions, are profitable or lose money. To the extent Congress has oversight, it oversees the actions regulatory agencies, not private businesses. And the courts adjudicate criminal activity such as fraud and civil disputes such as negligence.

Corzine's appearance before the House Agricultural Committee seems more like political gamesmanship and posturing than anything else.

CBO: Stimulus Will Reduce Long Run Economic Performance

Posted on November 18, 2011, 9:14pm | Samuel Staley

Peter Suderman, our colleague over at Reason.com, points out recent testimony by Congressional Budget Office (CBO) director Douglas Elmendorf that the $800 billion stimulus package passed in February 2009 will have a "net negative effect on the growth of GDP over 10 years." This is quite notable (and Suderman links to the video testimony; listen for Elmendorf's comments around 1:20 mark.) It's also worth expanding on a little.

The effects of the Stimulus program are being debated (see my extensive critique here from 2010), but the fact that the CBO recognizes the potential for all that money dumped into the economy becoming a drag in the long run implies at least their forecasting models recognize spending has to be productive in order for it to really lift the economy. Much of the support for the Stimulus package was based on a very crude Keynesian economic model that presumed that the problem with the economy was almost exclusively an artifact of depressed consumer spending. In this naive model, all you need to do is pump money into the economy so that people spend it. And, most forecasting models, don't differentiate between productive and unproductive spending. So, literally digging ditches and filling them back in again generates "positive" economic impact. (See also my comments on economic multipliers at Planetizen.com for more on this.) Of course, as national unemployment continues to hover around 9 percent, we can pretty much recognize the crude model didn't work.

In the real world growth occurs when productivity is enhanced and investment is directed by entrepreneurs into the production of goods and services that people want. Whether the product or service has been determined by a bureaucrat to be "shovel ready" is irrelevant. It's not the spending per se that drives the economy, it's the succesful investment of resources in goods and services that improve our standard of living and quality of life in meaningful and tangible ways on a broad level that boosts economic growth. That's why Apple's investment in iPads and iPods is productive investment and boosts growth while unnecessarly replacing curbs and sidewalks because they are shovel ready does not.

The hard-core truth is that the economy is in fact going through a major realignment. The housing market is in shambles, and, as my colleague Anthony Randazzo points out, we probably have a way to go before it really bottoms out. Developers, builders and buyers were responding to the wrong price signals for over a decade, creating a massive housing bubble. But the housing market is only part of the problem. Mixed into the housing market debacle is a financial system seriously out of whack. Until the financial market sorts itself out, capital won't be available for consumers or businesses to spend at the levels before the housing bust. And, it's going to take a while before businesses have a good read on what consumers really want.

The good news is that if the government can keep from jumping back into the market too soon and further distort prices, the economy should be on a firmer foundation for sustained long-term growth. That's another way of saying the short-term spending focus of the Stimulus Package set us back more than it pushed us forward. It may have solved a political problem at the time, but it probably did more to delay the necessary re-adjustments than speed them up.

That conclusion, I believe, is the takeaway from the CBO testimony.

Confidence in a Lender of Last Resort Leads to Systemic Risk

Posted on November 18, 2011, 5:15pm | James Groth

The heads of the world’s largest banks are calling on the ECB to restore confidence to European debt markets and many are advocating “unlimited” purchases of Eurozone debt. The consequences of failing to do so, they say, will lead to a debt crisis spiraling out of control. But are ECB interventions into European debt markets and its implicit status as lender of last resort actually to blame for what may become a debt crisis contagion?

In an article published this past August, I wrote about how the renewed ECB intervention in Italian and Spanish debt markets that occurred in early August 2011 was artificially pushing up prices and creating unrealistic low yields on the two countries’ debt. I ended the article warning of the unintended consequences that would be borne on investors acting on the false prices.

From the article:

“The yield on the 10-year Italian and Spanish bonds fell from 6.2% and 6.4% respectively to 4.9% in the month of August alone…These are huge swings. But how much of those declines were as a result of ECB intervention as opposed to a market driven reduction in the fear of sovereign defaults? It is unlikely they would have dropped at all without the presence of the ECB…Those that choose to base decisions off of today’s manipulated prices will be proven fools, unless of course their mistakes once again are bailed-out.”

Many banks and institutions bought into sovereign debt markets following the August ECB intervention including the world’s largest money manager, Blackrock, which bought heavily into Italian bonds in early October when yields were trading around 5.5 percent. Banks bought in not because they read the rising bond prices as a signal of fiscal health in Spain and Italy, but rather because it was a very strong indication that the ECB would step in and purchase bonds whenever they reached a dangerous threshold in yield. The action institutionalizes risk. The caveat I provided at the end of the article: “unless of course their mistakes once again are bailed-out” is proving to be an investment strategy.

The yield on the 10-year Italian bond is now 6.65 percent and was as high as 7.48 percent on November 9. The yield on the 10-year Spanish bond is now 6.8 percent and still rising. Yields have surged. Buyers of the debt over the past two months, as I warned, have been proven fools. This is, however, unless their investment strategy works and they get the unlimited bond purchases from the ECB.

Those clamoring for massive ECB intervention, namely Blackrock, Societe Generale, Morgan Stanley and others have significant and potentially crippling exposure to European debt, much of it amassed recently as yields rose. The decision to invest in European debt wasn’t based on undervalued bonds providing a pretty picture of risk/return, but rather an opportunity to purchase excess yield with a guarantee against default and the ability to capture principal gains when the central bank pays premium prices for their junk.

Banks would not have bought European debt and exposed themselves to massive write-downs had the ECB not extended “confidence” to them as an implicit lender of last resort when it pushed down yields in August. But they did, and now there are enough systemically important financial institutions committed to the eurozone to warrant yet another bailout from a central bank. Contagion could have been stopped by letting the smallest of the problems, Greece, default and restructure. Of course they didn’t and the rising yields of Italy and other peripheral countries were bought up, committing more banks and institutions collecting mispriced yield.

Systemic risk isn’t created because of a breakdown in confidence. Rather, it exists because of a build-up in false confidence. Every instance of failing to address the root of the problem commits more and more money, resources, and people to the inevitable, but otherwise avoidable, contagion.

Nominal GDP Targeting: Inflation and Misdirection

Posted on November 16, 2011, 6:17pm | James Groth

Goldman Sachs wants it, and now Obama’s ex-economic advisor, Christina Romer wants it: more “aggressive” easing and “beautiful” policy. In a previous post we pointed to the realization that nominal GDP targeting as called for by Goldman Sachs and now Christina Romer would cost upwards of $10 trillion over the next decade and balloon our nation’s debt. What is possibly more alarming is that the adoption of such a strategy not only has no exit plan for “when (and how) to apply the monetary brakes” (despite what Goldman claims), but it also commits the Fed to keeping nominal GDP on a projected growth path regardless of cost.

In a New York Times op-ed and again in an interview yesterday, Romer calls on the Fed to “try to do something bolder and more dramatic.” She advises that the Fed should “pledge to do whatever it takes to return nominal GDP to its pre-crisis trajectory.” (emphasis mine)

Romer says that the Fed communicating the adoption of nominal GDP targeting will alone improve confidence in consumers and raise expectations of future growth and inflation thus encouraging spending on things like cars, homes and business equipment. Of course, when that isn’t enough to juice the economy, the Fed should undertake further quantitative easing, promise and lengthen the period of zero-percent interest rates, and lower the exchange rate. (emphasis mine)

Now, let’s reiterate without the sugarcoating:

We [the Fed] should instill a fear into the American consumer that his/her dollar will be debased. Thus, he/she should immediately buy stuff before his/her purchasing power is inflated to zero. When the American consumer calls our bluff and refuses to purchase that which he/she does not need, we then print as much money as is necessary and buy whatever debt we can get our hands on, loan out money for free guaranteed ‘til eternity, and then manipulate our currency so the world over can afford all the things Americans are presently not producing.

In the interview, Romer states that the Fed should encourage inflation and commit to whatever is necessary to achieve rapid growth in the short-term, and then once the economy gets back on trend, “return to normal inflation and get back to the very steady, responsible policy as before.”

Two things:

1.)    How can the Fed responsibly contain inflation after trillions of dollars have been pumped into the money supply without affecting the artificial growth they’ve just created, if it’s created?

2.)    What is stopping banks and institutions receiving all that liquidity, from simply placing arbitrage bets (which have just been guaranteed) instead of creating loans and making investments like banks and institutions otherwise would be forced to do without Fed action?

Further, how can you possibly advocate pumping trillions of dollars into an economy when everyone knows that at some point that money will need to be either removed or monetized, and how can you possibly believe that this time around banks and institutions will act differently by lending and investing for a change instead of continuing to make money risk-free?

America needs to restructure away from a bloated banking and housing driven economy and into the next great engine for growth. Adopting the ludicrous ideas of Goldman Sachs and Christina Romer will do nothing but encourage money back into these same two sectors and produce inflationary pressures that will harm whatever growth occurs in others. It’s obvious why Goldman wants such a policy to be adopted: they’ll make a killing. But Romer, not being a bank, wants to do it because as an academic she wants to test her hypothesis on the only petri dish available to vain economists: the American economy.

From the interview:

“[The policy’s] real beauty is in the short and medium-run.  It would be a policy for the fed to say, boy, because of the recession… we’re going to commit to taking some very aggressive actions to get back to the path we were on before the crisis and to go through a period of very rapid growth.  Because, that’s what we need to put people back to work. But once you’re back on that path, now we’re back to a very reasonable, responsible, low-inflation, steady-growth kind of a framework.”

Again, there is no mention of what the transition from hyperinflationary policy, to steady and stable growth will entail. She merely states that it will occur. There’s no mention of the trillions of dollars it will require, no mention of the misdirection of resources, no mention of the damaging effects of rising prices, and certainly no mention of how much money banks stand to gain as a result. It also assumes that consumers and the market respond to the new policy without skepticism, having full faith in the credibility of the Fed, which at this point is lost.

Policy cannot be decided as the labor market, stock market, bond market, or any market dictates. The “real beauty” of monetary policy is one that doesn’t require experimentation subject to human fallibility.

Is Solyndra the Tip of the Green Energy Iceberg?

Posted on November 13, 2011, 1:58pm | Samuel Staley

The New York Times (Nov 11, 2011) has a revealing article on the massive amounts of subsidies that have been dumped into green energy ventures since Obama's election. Using the Stimulus Package as a cover, the Obama Administration has funneled billions of dollars into speculative energy projects. Noting the subsidies to NRG Energy, which is building a solar eletricity project capable of powering a small city of 100,000 homes, the Times reporters write,

"The [NRG Energy] project is also a marvel in another, less obvious way: Taxpayers and ratepayers are providing subsidies worth almost as much as the entire $1.6 billion cost of the project. Similar subsidy packages have been given to 15 other solar- and wind-power electric plants since 2009.

"The government support — which includes loan guarantees, cash grants and contracts that require electric customers to pay higher rates — largely eliminated the risk to the private investors and almost guaranteed them large profits for years to come. The beneficiaries include financial firms like Goldman Sachs and Morgan Stanley, conglomerates like General Electric, utilities like Exelon and NRG — even Google."

Many of the more viable projects would have happened anyway; it's just the Stimulus money jump started them by providing easy money now. And in some cases, state and federal governments are imposing significant increases in rates to subsidize these investments. With government subsidies and guarantees covering almost the entire investment, massive failures like Solyndra are almost inevitable. Since much of the money was spent during a politically charged environment to "get the money out the door" for "shovel ready projects," we can't expect the same level of risk scrutiny for these projects that would have occurred normally. Soyndra is likely just the tip of the iceberg.

Although not intended as foreshadowing, perhaps we should take the following quote from NRG's CEO as a warning of what is to come:

"As NRG’s chief executive, David W. Crane, put it to Wall Street analysts early this year, the government’s largess was a once-in-a-generation opportunity, and “we intend to do as much of this business as we can get our hands on.” NRG, along with partners, ultimately secured $5.2 billion in federal loan guarantees plus hundreds of millions in other subsidies for four large solar projects.

“I have never seen anything that I have had to do in my 20 years in the power industry that involved less risk than these projects,” he said in a recent interview. “It is just filling the desert with panels.”

"From 2007 to 2010, federal subsidies jumped to $14.7 billion from $5.1 billion, according to a recent study.

"Most of the surge came from the economic stimulus bill, which was passed in 2009 and financed an Energy Department loan guarantee program and a separate Treasury Department grant program that were promoted as important in creating green jobs."

Can you say Moral Hazard? We saw this play run out with the financial crisis, and the Stimulus Program is creating the same problems in the energy field.  At some point, as the case of Solyndra shows, the chickens have to come home to roost on the solar panels.