Wednesday, August 29, 2012 - Today's Debt and GDP

Today's Debt and GDP 

By Sinclair Noe

DOW + 4 = 13, 107
SPX + 1 = 1410
NAS + 4 = 3081
10 Yr Yld +.02 = 1.65%

OIL – 1.02 = 96.80
GOLD – 10.50 = 1657.10
SILV - .17 = 30.83
PLAT – 3.00 = 1521.00

The month of August has been basically flat, looking at the major market indices, just a couple of points movement. You may recall that last March I was warning you about the worst six months in the market, the old idea of “sell in May and stay away”. On May 1^st, the S&P 500 closed at 1405. So, if you did get out in May, you’re doing O.K. Of course, the theory looks at the worst and best six months of the market, and based upon that you would avoid the market volatility in September and October. September is historically the worst month for stocks. The Dow Industrial Average has declined 1.4 percent on average in September since 1929. Taking a broader look at the market, September is by far the worst month for the S&P 500. It has posted an average decline of 1.3 percent since 1929. Over that period, it's the only month to drop more than 50 percent of the time. Of course, there are no guarantees in the stock market; might go up, might go down; but I think it’s a safe bet that the lazy, hazy days of summer will give way to more volume and more volatility and it could start with Fed Chairman Bernanke’s address from Jackson Hole Wyoming this Friday.

Household debt and delinquency dropped in the second quarter.

Aggregate consumer debt fell by $53 billion, or 0.5%, to $11.38 trillion, the New York Fed said in its quarterly look at household debt. From the peak in the third quarter of 2008, household debt has tumbled by $1.3 trillion.

Most of that was driven by a decline in real estate loans, which also fell 0.5%, to $8.15 trillion. The delinquency rate also fell, slipping to 9% from 9.3%.Approximately 256,000 consumers had a foreclosure notation added to their credit reports in the quarter, the lowest since mid-2007.

The one area of growing debt and delinquency came in student loans. Student loan debt climbed $10 billion to $914 billion, a surge of $303 billion since the third quarter of 2008.  Student loan delinquency rates increased for the second consecutive quarter, with the percent of student loan balances 90 or more days delinquent up to 8.9% from 8.7%.

The economy expanded somewhat faster in the second quarter than originally reported because of higher consumer spending and slower growth in imports.  The revised gross domestic product increased at a 1.7% rate in the April-to-June period, up from a first read of 1.5%. GDP, the value of all goods and services produced in the country, is considered the broadest measure of an economy’s health.

The economy’s current level of growth, however, still falls well short of what’s needed to dramatically lower the nation’s high unemployment rate and eliminate the lingering threat of another recession.

GDP is projected to grow 2.0% in the third quarter and 1.9% in the final three months of the year.

I’m not sure what GDP truly tells us. It might not be the best way to gauge progress and prosperity. As an example, consider that GDP gives approximately the same weighting to any economic activity. So, in the health care sector, if you break your leg the ambulance ride, the costs of doctors, nurses, hospitals, medicines and such are all added to the GDP. Although you wouldn’t consider it to be an economic benefit to break your leg, that is how it is counted. Marriages and divorces are both counted toward GDP without distinction. In short, GDP is a measure of quantity without regard to quality.

Some people have tried to come up with new gauges which include measurements of health, life expectancy, education, public infrastructure, fuel efficiency, community, leisure, pollution, and income equity. One appeal of GDP is that it presents a simple message; up is good; down is bad. To a certain extent we are what we concentrate on; you tend to get what you measure, so we’d better measure what we want.

Another possible explanation for slower growth is that education in the US is in decline. There are certainly other reasons that we might explore some other day, but according to some calculations we hit a plateau in educational attainment more than 20 years ago. The US is steadily slipping down the international rankings in the percentage of its population of a given age which has completed higher education.  Of course one big problem is the cost of higher education and the debt required to finance the cost. Once upon a time, California had a Plan for higher education which established a three-tier system of free public higher education; that’s right, free, as in no tuition, even for the high achievers who gained admission into the prestigious state universities. There was a pledge that the state would pay instructional costs for all residents. The Arizona constitution says that university instruction shall be furnished “as nearly free as possible” to Arizona residents.  Stupid is as stupid does.

And that brings us round to another topic that will be getting attention this week – entitlement reform.

"Rightly understood, health-care entitlement reform is not, as conservatives suggest, a matter of lessening the dependency of big chunks of the population on government largesse. It’s about weaning the members of our medical-industrial complex from their entitlement to far higher payments, despite shabby results, than their counterparts abroad get. This license for inefficiency, issued by both parties to doctors, hospitals, health plans, drugmakers and device firms, is diverting precious resources in an aging America from urgent non-health care, non-elderly needs." - Matt Miller, WaPo

So, how do we improve efficiency and lower costs? Let’s go back to the basic idea of supply and demand. More doctors, nurses, researchers, scientists, lab techs, and such – in other words if we increased the supply of trained workers and the demand stayed fairly constant, we should see a decline in prices. Of course, to increase the supply of skilled workers, you have to educate them and if you chain them down with debt for that education, you won’t lower costs.

It gets back to the idea of quality versus quantity in the GDP. A cigarette adds more to GDP than a crown of broccoli. . Higher health care costs add to GDP, whether it is the cost to treat diabetes or the cost of preventive care.  Student loans and debt adds to the GDP but ultimately student debt does not improve quality of life, or at least it improves it far less than a society that is willing to make the investment in free education or nearly free education for those willing to study. The money goes somewhere, and right now it goes to servicing debt rather than going to education and ultimately an educated and efficient and employed population.

RFK once said (in a 1968 speech): GDP "counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage.  It counts special locks for our doors and the jails for the people who break them.  It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities.  It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.  Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play.  It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.  It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.  And it can tell us everything about America except why we are proud that we are Americans."

Wednesday, April 18, 2012 - Euro Debt, Iceland, the IMF, and Forgiveness

DOW – 82 = 13,032
SPX – 5 = 1385
NAS – 11 = 3031
10 YR YLD -.03 = 1.98%

OIL – 1.43 = 102.77
GOLD – 8.00 = 1643.00
SILV - .08 = 31.73
PLAT – 5.00 = 1581.00

Spain's non-performing loans as a proportion of total lending jumped to 8.16% in February, up from 7.91% in January and the highest level in 18 years. Data from the Bank of Spain show that Spanish banks are burdened with about 176 billion euros of "troubled" real estate assets and that 21% of the 298 billion euros of loans linked to property developers are non-performing. Despite the increase in the country's bad loans, the yield on Spain's 10-year bond fell to a 1-1/2 week low of 5.72% on optimism over tomorrows auctions of 2-year and 10-year Spanish securities.

Will Europe and its increasingly ugly currency, the euro, get out of the crisis in one piece? This is probably the biggest question for the global economy right now. There is increasing concern that Spain and Italy will eventually default. Maybe the euro will survive but nobody seems confident of that right now. And it appears Europe is facing an economic depression which will diminish living standards and create social unrest and take years to work though. A best case scenario is years of stagnation. Actually there is another solution and we'll get to that in a few moments.

The fate of the euro has global consequences. Europe is the largest marketplace in the world. When Euro-countries and companies and the general population pull back and stop spending and investing and buying, it won't take long for the effect to be felt in the United States.

The problems with the Euro are structural; a currency union without an accompanying political union. Seventeen individual states all share the same money, but still chart their own budgetary courses. Over the past few years that meant the global marketplace was expected to treat Greece and Germany as equals. The idea was that the risks were the same because the currency was the same. The currency masked the fundamental differences that distinguished the fiscal soundness of individual member states, giving less-disciplined governments access to too much credit. And now the PIIGS, (Portugal, Ireland, Italy, Greece, and Spain) are buried in debt.

One solution is to allow the European Central Bank to issue bonds for the entire Union backed by all members. Germany doesn't like the idea of putting its credit on the line. Maybe the Germans have a fear of inflation built on the hyper-inflationary past of the Weimar Republic. Maybe the Germans have some moralistic reason to think they are financially superior, more economically worthy. Whatever the reason, the response is to impose austerity. Tighten the belt. Put the brakes on the economy. Unfortunately the prescription for starvation is not a diet. Austerity ensures that Europe cannot grow robustly, enhancing the debt burdens of weaker states. The cure is as bad as the disease. Europe will not shrink its way to prosperity.

Italy’s prime minister has abandoned the notion that Italy can balance its budget during a deepening recession. Slow growth, not profligate public spending, is the No. 1 problem in Italy. And in Spain, where a recession is causing a wave of loan delinquencies and defaults. Investors are bailing out of Spanish government bonds for fear the government will be overstretched trying to save Spanish banks.

Italian Prime Minister Mario Monti is the technocrat who is supposed to get Italy’s finances back on the straight and narrow. After meeting in Rome today, his cabinet announced that it’s now projecting the federal budget to show a deficit equal to 0.5 percent of gross domestic product in 2013, worse than a previous forecast of a 0.1 percent deficit. Prices of Italian bonds dropped on the news.

The International Monetary Fund is starting to catch on. They realize that it is one thing to throw money at the wayward banks, but it is another matter to get the money moving through the economy. And they have come to realize that households burdened by debt will not go out and spend. Last week, the IMF targeted household debt reduction policies. You probably haven't heard much about it because it involve debt forgiveness and mortgage write-downs. The IMF issued a report using Iceland as an example. Iceland defaulted and they have recently forced banks to accept reductions in mortgage interest payments of up to 40% and many distressed households had a portion of the debt written off. The economy there has now recovered remarkably since its bank-led collapse in 2008.

It found that countries, like Ireland, that saw house prices and household borrowing skyrocket, saw a longer than average period of recession after the bursting of the housing bubble. A large part of this protracted recession it said is due to households trying to reduce their debt levels, which in turn leads to less spending in the economy, driving the recession deeper and further. In the case of Iceland the situation was more difficult, due in part to the much bigger proportion of the population that was affected, and to the wide presence of foreign currency mortgages.

The government and the newly constructed Icelandic banks developed a template to be used in case by case restructuring discussions between borrowers and lenders. The templates facilitated substantial debt write-downs designed to align secured debt with the supporting collateral (that is, bring the loan into line with the value of the house) and align debt service with the ability to repay.

The IMF found that such case by case negotiations safeguard property rights and reduce moral hazard, but they take time. As of January of this year, only 35% of the case by case restructuring applications had been processed. To speed things up, Iceland has introduced a debt forgiveness plan which writes down deeply underwater mortgages to 110% of the households' pledgeable assets.

It noted that only when a comprehensive framework was put in place and a clear expiration date for relief measures announced that debt write-downs finally took off. As of January 2012, 15 to 20% of all Icelandic mortgages have been or are in the process of being written down.

In the US in the 1930's the Roosevelt administration introduced the Home Owners Loan Corporation, which bought distressed mortgages from banks with government bonds, with federal guarantees on principal and interest. It then restructured these mortgages to make them more affordable to borrowers.

80% of the restructured loans (some 800,000) were protected from repossession by the measure, and the mortgages were subsequently sold on over time for a nominal profit at the time the program was brought to an end in 1951. The mortgage purchases amounted to 8.4% of 1933's GDP in the US.

The IMF said "a key feature of the HOLC was the effective transfer of funds to credit constrained households with distressed balance sheets and a high marginal propensity to consume, which mitigated the negative effects on aggregate demand" caused by the recession and need for household deleveraging.

The main mechanism to make loans more affordable was to extend the term of the mortgage - sometimes doubling the term - and converting it from a variable to a fixed rate. In a number of cases the HOLC also wrote off part of the principal to ensure that no loans exceeded 80% of the appraised value of the house.

Austerity is not the solution. Increasing debt to pay for unsustainable debt is not the answer. When debt is unsustainable you can't grow your way out of it and you certainly can't shrink your way out of it.

I've told you for a long time that when debt becomes unsustainable there are three outcomes: slow default, quick default, or default due to war or catastrophe. There is actually one more outcome – debt forgiveness. It is rare, but it might actually be the answer.