Monday, November 19, 2012 - Debtmageddon: the Non-Problem Problem

Debtmageddon: the Non-Problem Problem

by Sinclair Noe

DOW + 207 = 12,795
SPX + 27 = 1386
NAS + 62 = 2916
10 YR YLD +.04 = 1.61%
OIL + 1.22 = 86.67
GOLD + 18.20 = 1732.90
SILV + .80 = 33.21

Pete Domenici and Alice Rivlin are co-chairs of the Bipartisan Policy Center for Debt Reduction Task Force, offering the following recommendations in an article in the New York Times over the weekend:

Economic growth must precede full-scale debt restraint.

Congress should take action now to pass legislation phasing in tax reform that yields new revenues and restructuring entitlements to curb the continued growth of federal spending, particularly for health care.

We cannot resort to such ham-handed mechanisms as the approaching sequester cuts, large across-the-board tax increases and other elements of the “fiscal cliff.”

In late 2010, the task force recommended a holiday from the full 12.4 percent Social Security payroll tax, not the partial 2 percent cut that Congress ultimately passed. The idea is that whether it comes in the form of a payroll tax holiday, an income tax rebate or another similar mechanism, the most pressing priority is to get the economy out of “stall speed.”

The task force also suggested a possible “framework” for the lame-duck Congress to pass a modest down payment on deficit reduction in December, while pursuing a comprehensive agreement, a “grand bargain” of sorts, in 2013.

If I may break it down in a nutshell; growth before austerity.

Federal Reserve Board Chairman Ben Bernanke will travel to New York City tomorrow to deliver a speech in which he will explain that the central bank is not having any second thoughts about its ultra-easy monetary policy stance. Bernanke will likely use his speech to emphasize once again that monetary policy will remain highly accommodative and will stay that way even after the recovery strengthens. Fed watchers generally think the Fed will boost its easing power in December by converting its expiring Operation Twist program into an outright Treasury purchase plan program. At the moment, the Fed is buying $45 billion of Treasurys per month under this plan, but the purchases are offset by sales of short-term securities. Don't expect any groundbreaking news from the Fed head, but expect a tone generally supportive of further easy monetary policy. The next Fed FOMC meeting is December 12-13.

Bernanke and the FOMC will likely adopt a wait and see attitude. They will wait to see if the dysfunctional Congress will really run like lemmings over the fiscal cliff. They might, but we have to let it play out. Policymakers are faced with a new round of momentous choices – how to balance the imperative for job creation with the pressure to address budget shortfalls. There will be temptations to hold firm and there will be temptations to cut a deal. The whole framework around cutting a deal is based on the idea that we must reduce the deficit and there must be fiscal responsibility. You could replace fiscal responsibility with austerity for the purposes of discussion.

The federal budget deficit isn’t the nation’s major economic problem and deficit reduction shouldn’t be our major goal. Our problem is lack of good jobs and sufficient growth. Deficit reduction leads us in the opposite direction — away from jobs and growth. Too much deficit reduction, too quickly would suck too much demand out of the economy; however, more jobs and growth will help reduce the deficit. With more jobs and faster growth, the deficit will shrink as a proportion of the overall economy. Europe offers the same lesson in reverse: Their deficits are ballooning because their austerity policies have caused their economies to sink. Yes, they are cutting spending but their economies are shrinking faster than the spending cuts; and the debt-to-GDP ratio grows. In fact, if there was ever a time for America to borrow more in order to put our people back to work repairing our crumbling infrastructure, it’s now.

And yet, there is still a loud chorus for debt reduction, and the media has bought into the idea, or at least they've hooked onto the fear factor involved with the phrases “fiscal cliff” and “debtmageddon”. They repeat the talking points of a small cottage industry that has sprung up around debt reduction. They say that it is a given that tax rate will go up; they say it is a given that spending will be cut; it's a given that deficits are bad. There has been very little discussion and debate about the dangers of deficit reduction. And so, the closest we've come to a serious debate is to discuss the timing: It all boils down to timing and sequencing: First, get the economy back on track. Then tackle the budget deficit.

Sounds good, but why does the deficit have to be tackled? Deficit hawks routinely warn unless the deficit is trimmed we’ll fall prey to inflation and rising interest rates. But there’s no sign of inflation anywhere. The world is awash in underutilized capacity As for interest rates, the yield on the ten-year Treasury note is about 1.6%, near record lows.

We certainly don’t want to go where Europe has been going lately. They’re a great example of how NOT to manage your way out of a debt crisis. It would take superb timing to avoid the fate of the Eurozone nations by planning for deficit reduction later, or at all? The assumption here is that there must and will be a time when we can reduce the deficit without harming the economy. What if there’s no such time? What if any substantial deficit reduction to under 4% of GDP, a figure envisioned in most of the deficit reduction plans being offered, means making the private sector poorer in the aggregate? Wouldn't that get priced in?

That's not just a theoretical question. Right now, the US imports more than it exports in an amount greater than 4% of GDP. If we continue to do so, and the Government deficit is forced down to a number below 4% of GDP, then a private sector surplus in the aggregate will be literally impossible to attain, and, if we continue with such a policy, year after year, the private sector will lose more and more of its net financial assets as the Government eats the private economy in a fit of fiscal irresponsibility, that since it’s now way past 1984, the austerity advocates label fiscal responsibility.

Public investments that spur future job-growth and productivity shouldn’t even be included in measures of government spending to begin with. They’re justifiable as long as the return on those investments – a more educated and productive workforce, and a more efficient infrastructure, both generating more and better goods and services with fewer scarce resources – is higher than the cost of those investments.

In fact, we’d be nuts not to make these investments under these circumstances. No sane family equates spending on vacations with investing in their kids’ education. Individuals can differentiate between spending and investing. Yet the politicians can't seem to do that with our federal budget.

I suspect the real concern over a “deficit problem” is due to fear of the markets and,maybe, just maybe there is no problem with running continuous deficits provided the Fed, along with the Treasury, control interest rate targets, and that the bond markets are powerless to impose their will on Mr. Bernanke and the Treasury Secretary if they want to keep rates near zero, or at any other level of interest they would like the US to pay. Well, guess what, the bond markets and the ratings agencies are basically powerless to drive up interest rates against the combined determination of the Fed and the Treasury to keep them low.

Of course, too much deficit spending can cause inflation, but the remedy for that is to raise specific taxes and lower specific spending in such a way that price stability and full employment result from fiscal policy. The best fiscal policy is one that spends what the US needs to spend to solve its serious problems.

Gross domestic product probably increased at about a 2.9 percent annual rate in July-September, according to economists from Goldman Sachs and Barclays. That would be the fastest quarterly growth this year, beating the Commerce Department’s initial estimate of 2 percent. Help is coming from a housing recovery, strengthening job market and healthier household finances that are driving gains in consumer confidence and spending. While the damage from Sandy and an anticipated tightening of fiscal policy mean growth will decelerate this quarter and next, the economy may emerge on stronger footing in the second half of 2013.

Sales of previously owned homes climbed in October. Purchases increased 2.1 percent to a 4.79 million annual rate. According to the report from the National Association of Realtors property values rose over the past 12 months by the most in seven years as inventories dropped to the lowest level in almost a decade.

Thirteen cents of every retail dollar is spent at gas stations, but that level has stagnated in recent years amid weaker demand. Americans spent some $47.85 billion at gas stations in October; that represents 13% of the $367.56 billion spent at all retail locations in the month. That share has increased a bit in recent months, but overall it’s little changed over the past two years. In the third quarter it was 12.5%, the same level as the first quarter of 2011.

The American Petroleum Institute reports US oil demand fell 2.3% in October from a year earlier, to 18.4 million barrels a day. Demand in the first 10 months of the year was 2.1% below the same period in 2011. A modest economic recovery and continued high unemployment, as well as higher fuel-economy standards, have reduced demand.

Another factor in reduced demand for gasoline, in relation to retail sales, is that e-commerce continues to grow. More than five cents of every dollar spent at retailers in the July-to-September period was spent online. That share has basically quintupled in the past decade, and while growth slowed slightly during the recession, it has continued to steadily march upward. The more goods people can get online, the less time they need to spend in the car traveling to brick-and-mortar retailers.

The shadow banking industry has grown to about $67 trillion, $6 trillion bigger than previously thought. The Financial Stability Board, or FSB says the size of the shadow banking system, which includes the activities of money market funds, monoline insurers and off- balance sheet investment vehicles, “can create systemic risks” and “amplify market reactions when market liquidity is scarce.”

The FSB, a global financial policy group comprised of regulators and central bankers, found that shadow banking grew by $41 trillion between 2002 and 2011. The share of activity based in the US has declined from 44 percent in 2005 to 35 percent in 2011, moving to the UK and the rest of Europe.

While regulatory watchdogs believe they have reined in excessive risk-taking by banks in the wake of the collapse of Lehman Brothers in 2008, they are concerned that lenders might use shadow banking to evade the clampdown. Already, the European Union is planning to target money market funds in a first wave of rules for shadow banks next year.

The FSB also targeted repurchase agreements and securities lending for tougher rules, recommending that regulators implement minimum standards for calculating losses on the different types of collateral used in the transactions.

Repurchase agreements are contracts where one investor agrees to sell a security and then buy it back at a future date and a fixed price. Securities lending agreements involve institutional investors such as pension funds lending financial instruments against cash collateral. The group is also concerned that regulators are unable to monitor the scale of the trades. 

The FSB says large firms should disclose more information about the deals to investors and may be required to publish regular statements detailing how much collateral they have and what it is used for. The need here is simple: a lack of transparency and disclosure results in counterparty risk, which in turn can lead to credit freeze, runs, and a general repeat of 2008. In other words, the FSB report tells us that the problems of 2008 haven;t been fixed, they've only grown in size.

New research from the Federal Reserve Bank of New York finds cheaper monthly mortgage payments significantly reduce mortgage default risk even when the principal value of the home stays the same. The report was based in part on findings on the performance of Alt A adjustable-rate mortgages, between 2008 and 2011.

The report says: “Interest rate changes dramatically affect repayment behavior. Our estimates imply that cutting a borrower’s payment in half reduces his hazard of becoming delinquent by about two-thirds. Government or lender programs that allow underwater borrowers to refinance at a lower rate, or loan modifications that lower the interest rate, have the potential to significantly reduce delinquencies, and the view that principal reduction is the only way to meaningfully reduce defaults is incorrect.”

Here's the scary part; they're just figuring this out.  Years ago, most people learned that when the loan sharks put the rates too high, it resulted in default; when rates were lower and closer to reasonable, people tended to pay their debts.