Dr. Sherry Jarrell

Debt Crisis Panel Discussion

The BB&T Capitalism Center at Wake Forest University hosted a Debt Crisis Panel and I was asked to moderate.  I've attached the link and think you will find it very informative, and very sobering. 

http://capitalism.wfu.edu/videos/nationaldebtpanel/

The Insanity of Government Spending

Until Congress and President Obama can find the discipline to cut (non-defense) spending, all spending increases must stop. Otherwise, obviously, we will be stuck with them forever -- this year's additional spending will become the spending Congress refuses to cut NEXT year.  

 

Fed's Pledge of Low Rates -- Good News or Bad?

The Federal Reserve pledged on August 9th to maintain near-zero interest rates through the summer of 2013.   This was an unprecedented move by policymakers and one has to wonder what they were trying to accomplish by committing themselves now to a specific policy for the next two years.

The federal government really has only two tools for influencing the macroeconomy -- fiscal policy and monetary policy.  By committing themselves now to a specific interest rate target, they have essentially neutralized one of those two tools.   

I see the announcement as an admission on the part of the Fed that they are unable to further stimulate the economy by lowering interest rate targets.  The rates are already as low as they can go; there is no room left for trying to stimulate the economy with actions.  All they have left is talk; tell the market that they are going to keep the rates low.  It's a fairly impotent policy, not just because it's just talk, but because the pledge is vacuuous:  if conditions change, I certainly hope and expect that the actual policy will change as well.

And we have to recall what a low interest rate policy actually means:  the Fed will have to increase the money supply at whatever rate is required to satisfy money demand -- which is beyond their control -- at the target interest rate.   The Fed is clearly banking on (no pun intended!) money demand remaining anemic, otherwise the very increase in money supply which is intended to keep interest rates low would push nominal interest rates up due to inflationary pressures.   

From where I stand, the Fed's handcuffing itself to near-zero interest rates over the next two years smacks of both desperation and gloom.   They are desperate to wield monetary policy, to "do something," even when rates are already as low as they can go.  And for the Fed to commit to near-zero rates over the longer term says very clearly that they do not expect the economy to recover for some time.

S&P Ratings - They either mean something or they don't

You cannot have it both ways. Either the bond credit ratings mean something, or they don't.  Public officials cannot point to the AAA ratings as evidence of good policy, then lambast them as "inaccurate" and "flawed" when they drop to AA+....or below.  

It is a fact that the ratings agency does not originate information; it simply gathers and interprets data that are publicly available to all of us.   The rating itself, however, is unique in that it summarizes a particular agency's forecast of how likely the US government is to repay its debt and sustain its borrowing needs.  

Don't get me wrong -- there is a LOT of information out there about the risk-adjusted rate of return on US debt to be digested.  But we don't have to re-examine it from the ground up -- we need only look at the marginal changes, the most recent developments, the direction of change, to update our expectations, and -- in my view -- to understand easily why S&P downgraded the debt.  

I think most of us realize that all government spending is financed by the private economy but I'm not as sure that everyone realizes that the return on government debt is also enabled by the productivity of the private economy.   The more productive the private economy, the higher rate of real return we can afford to pay on U.S. debt, and the more willing others are to buy our debt.  Being able to generate a return on debt is a good thing -- it's a sign of a healthy economy.   

Then there is the other side of the equation: the required return on debt from the point of view of the lender. The lender assesses the risk (or likelihood or uncertainty) that they will get their money back (and that the "money" is worth the same per dollar....so we are ignoring inflation just to simplify things).   The less certain they are, the higher the return they are going to demand before they buy the debt.  This required rate of return is a cost to the economy -- a higher cost eats away at profits, and makes the economy less productive, less able to reinvest, employ capital and labor, and grow.  

In the simplest terms, government spending is supported first by taxes and then, when those run out, by borrowing.  The debt ceiling debate made it clear that Washington was unwilling or unable to reduce or curtail government spending, which was on its way to starving the private economy of the sufficient earnings, liquidity and financing to continue to be productive.  The wealth creation capacity of the private economy is vast and impressive and has somehow miraculously employed labor and capital and supported AAA rating returns on government debt for a very long time, but it's not limitless.  

No, the ratings do not originate information. They simply publicly confirmed what many of us who understand and respect what private enterprise does day in and day out saw coming:  the current level of government spending is unsustainable. The private economy cannot take much more of the oppression and costs imposed by government policy, taxes, fees, regulations and -- perhaps the most troubling and insidous of all -- the public denigration and disparagement of the private economy, Wall Street and capitalism by our President.

 

It will be very interesting to see if this was a surprise to the markets.  

It's Official: Geithner knows NOTHING About Economics

I'll let Geithner's own words display his ignorance about the source of economic wealth creation in our economy and the size and sign of the Government spending multiplier.  Patently unbelievable: 

Geithner, continuing, argued that if the administration did not extract a trillion dollars in new revenue from its plan to increase taxes on people earning more than $250,000, including small businesses, the government would in effect “finance” what he called a “tax benefit” for those people.

“We're not doing it because we want to do it, we're doing it because if we don't do it, then, again, I have to go out and borrow a trillion dollars over the next 10 years to finance those tax benefits for the top 2 percent, and I don't think I can justify doing that,” said Geithner.

Not only that, he argued, but cutting spending by as much as the “modest change in revenue” (i.e. $1 trillion) the administration expects from raising taxes on small business would likely have more of a “negative economic impact” than the tax increases themselves would. http://www.cnsnews.com/news/article/geithner-taxes-small-business-must-rise

The Sad State of Macroeconomics Theory

I have to get this off my chest.  Macroeconomics is not economics at all.  What little sense it makes can be traced directly back to the bits and pieces of microeconomic that is uses along the way.  

Macroeconomics is basically nothing more than glorified national income accounting with a lot of politics thrown in.  And accounting is the antithesis of anything finance and economcis.

I believe that Keynes was looking for a theory that would support his idea for how to fix a depressed economy.  And his work is what justifies most of the government's fiscal policy to this day.  

The problem is that his view of the macroeconomy is incomplete, illogical and, most troubling, it is static.  

Reader's Question: Is Bernanke the problem?

Reader Randy Tanner asks "Is Bernanke the problem?"  in response to a recent article by Vasko Kohlmayer titled Why Isn't Peter Schiff Head of the Fed? In that article, Kohlmayer makes the case that over the period 2002-2007, while Ben Bernanke was saying that the economy was strong, Peter Schiff was warning us about the coming housing bust, rising unemployment, and falling dollar.  

The short answer is no, Bernanke is not the problem, not in the way Kohlmayer implies, at least.  The Fed did not cause the financial crisis.  I personally do not like everything about the way the Fed responded to the crisis, in particular their purchase of toxic assets, but they did not cause the crisis.  

And, no, Schiff should not be running the Fed, even if I believed that successfully predicted falling housing prices, rising unemployment, and a weak dollar. Which I don't.  But again, not in the way you might think.

Being a good economist does not require one to predict the state of the economy during a certain window of time.  In fact, the very best forecasters know to not even try to predict economic activity beyond the next quarter.   

No, what good economists understand is cause and effect, and most of that occurs at the level of the firm, the consumer, or the transaction.  Extrapolating that to the level of the economy involves so many countervailing factors that "predicting" what will happen at the macroeconomic level is not really meaningful.  In other words, you can find someone out there at any point in time making predictions about macroeconomic outcomes who will end up being "right."  Eventually.  On some level.  And this does not help us to make better policy, to allow the economy to be as healthy and productive as possible.

Let me give you a specific example to help make my point.  And I agree at the outset that Randy's point is a difficult one to argue against, and that my point is fairly subtle.   What I believe was perfectly predictable was the impact of the political decisions that mandated easier and cheaper access to home ownership, and charged Fannie Mae and Freddie Mac with implementing those policies.  When the government inserts itself between suppliers and demanders, as it did with these policies, it distorts the price signal and gets either too much or too little of that economic activity.  

So what happened here?  Because of the mandates, banks made loans to individuals that they would not have otherwise, largely because Fannie Mae and Freddie Mac were standing in the ready to buy those mortgages from the banks and get them off the banks' books.  So the banks did not have to bear the risk of those homeowners defaulting on the loan.  Therefore, those mortgages were underpriced.  And if the interest rates had been higher, where they should have been, less creditworthy individuals (which include high income individuals overextending themselves with a second mortgage as well as low-income individuals overextending themselves with too much house) would have not have applied for the loan in the first place.  

If you lower the price of an activity, the demand for that activity rises.  So the mandates led to a situation where a larger-than-sustainable fraction of existing mortgages were high risk, were susceptible to foreclosure should the economy take a turn for the worse. THAT is what is predictable, not that the economy in fact took a turn for the worse.   

Left to their own devices and profit-incentives, banks are perfectly able to price mortgages and absorb the risk that a fraction of those mortgages will go belly up.  And the private economy is perfectly well equipped to pool those mortgages, combine the funds, and issue and fairly price various mortgage-backed securities.  

The problem centers on the fact that a politically motived player in the form of Fannie Mae and Freddie Mac used our tax dollars to pursue a social agenda instead of a dollar of profits.  Mr. Schiff seems to overlook this fact as a primary contributor to the financial crisis, and Mr. Bernanke, though I suspect is fully aware of the issues surrounding Fannie and Freddie, is not responsible for what Fannie Mae and Freddie Mac do, and must enact predictable monetary policy regardless of their actions.  

Again, I do have issues with the Fed's actions over the last few years, and I do worry about inflation and the loss of autonomy of the Fed to the brutish attitude of the Treasury, but those are separate issues in my mind from the supposed ability of Mr. Schiff to predict the housing crash and the financial crisis of the recent past.  

It is possible to flip ten heads in a row; unlikely, but possible.  And the 10th toss does not predict the 11th.  They are independent events.   Predicting the 11th toss based on the preceding 10 makes as much sense as predicting that housing prices will fall because they are now high.  Neither prediction is based on economics.   But when you use tax revenues to subsidize high-risk mortgages, economics correctly "predicts" that more foreclosures and financial distress will occur than would have otherwise. That's a prediction you can count on.

 

 

Fannie Mae and Freddie Mac: Scary

Fannie Mae and Freddie Mac are at the very core of the most recent financial crisis. Without them, the crisis would not have occurred.  Fannie Mae and Freddie Mac get between lenders and borrowers and distort the pricing of their transactions.   Fannie Mae and Freddie Mac have, as their mandate, social engineering, not arms-length business negotiations conducted for mutual benefit.  They have no business worming their way around our economy.  

Fannie Mae and Freddie Mac continue to operate because they make politicians better off, not business people or consumers. Someone is getting their pockets lined.  I believe that when the real operations of Fannie Mae and Freddie Mac see the light of day, that you will be stunned by the sheer magnitude of the fraud, corruption, and destruction of wealth.

You heard it here first.  

For fabulous reporting on all things housing, including Fannie and Freddie, I follow Nick Timiraos on twitter (http://twitter.com/nicktimiraos).

We have it Exactly Backwards!

The next time you hear about the deficit, the level of government spending, or a new bailout program, please consider the following.   We have it backwards:  government spending should never justify collecting taxes.  Instead, collecting taxes should first be fully justified by the specific government spending.   If we cannot justify the government spending as absolutely necessary for the public good, then the dollar of taxes should never be collected.

Instead, today, taxes are routinely collected and THEN the politicians fight over how the taxes are going to be spent. In fact, government spends future tax revenues!

We have it backwards. The press has it backwards.  The pundits have it backwards. Congress has it backwards. The White House has it backwards.    The only debate out there seems to be about WHAT we spend the tax revenues on, instead of whether the tax revenues should be collected in the first place.  

I think if we put government spending to such a test, we would decide against most of it, and our taxes would fall to a level that supported a vibrant economy with low unemployment and stable prices. 

 

A Government Motors IPO?

Does anyone else see how perverted this story is?  A company which is 60% owned by the U.S. Treasury, in other words, 60% owned by taxpayers -- not voluntary shareholders, but TAXPAYERS, has hired a private investment banking company to take the company public. That is, to be sold to public stockholders.  For a profit.  Which is going to be distributed to whom?  The government.  Who took the company over by edict, essentially by force, ignoring lawfully binding financial contracts in the process.  Oh, yes, technically G.M. went through a "banktuptcy," but when one of the two involved parties is the federal government -- the one who makes up the rules of the game -- then it isn't a game anymore.  It's "do it, or else!"

GM Headquarters

Absolutely unbelievable.  This IPO should not be happening.  The bailout should not have happened. None of this should have happened.  If the company cannot generate a profit in the marketplace, then it should go bankrupt and its resources freed up to be used where they are most valued by the marketplace.

Gold or Money?

Is Gold Really A Superior Investment?

I'm sure you've heard about the steady rise in gold prices over the last several months. You may have also seen the advertisements from gold investment companies pushing the purchase of gold, or heard predictions about even higher gold prices as world currencies struggle.  And just yesterday, the world's first "Gold ATM" machine was unveiled in Abu Dhabi (Gold ATM Machine, Financial Times).

Gold dispensing machine in Abu Dhabi

We have to take a step back and ask ourselves about the true underlying value of gold.  Why is it valuable?  Because people demand it, and there is a relatively limited world supply.  Why do people demand gold?  It's not like gold will sustain you: you can't eat or drink it, nor does it have utility in and of itself.  No, the reason gold has value is because it can be exchanged for money which, in turn, can be exchanged for goods or services.  So the value of gold is derived from the very same place as is the value of money:  access to underlying goods and services. 

The actual value of gold, however, is entirely dependent on other people's demand for gold, given limited supply, much like fine art.  Unlike money, you cannot actually use gold for transactions:  have you tried to use a bar of gold at your local restaurant or car dealer, for example? Think about it: if for some reason gold fell out of favor -- let's say someone discovered it was toxic -- then gold would no longer be desired as an indirect means of exchange -- having to first be exchanged for currency -- and its price would drop to nothing, quite independently of the value of money itself. 

The value of money it also dependent on its demand, which in turn depends on the acceptability of the currency on the world stage as a unit of exchange.  Dollars are accepted as currency and retain their value as long as the underlying real U.S. economy continues to be productive, and as long as the world supply of dollars does not outstrip the world demand for dollars.

Dollars are suffering at the moment for two primary reasons:  the attack on private industry by Obama's policies, and the excessive world supply of dollars.  Both of these factors drive down the value of a dollar, and drive up the number of dollars that a bar of gold commands.

Gold bars

The "Wild" Swing in the Dow Jones: Some Perspective

Just to try to help put stock market swings into perspective, consider this:  

• the 347.8 point fall in the Dow Jones Industrial Average last week, from 10868.12 at the start of the trading day on Thursday, May 6, 2010 to 10520.32 at the close of trading, can be COMPLETELY explained by an increase in the perceived cost of capital from 12% to 12.23%.
• do the math.  Using the constant dividend growth model, a very simplified model of the market value of equity, or Market Value = Current Dividend/(cost of equity capital - dividend growth rate), and assuming a long-term average cost of U.S. equity capital of 12% and average growth rate of 5%, we find that the opening level of 10868.12 = 760.77/(.12 -.05), and the closing level of 10520.32= 760.77/(.1223 -.05).
• I think it is entirely possible that the chaos in Greece and surrounding nations, and the interconnections between worldwide supplies of liquidity and financial capital, that an increase in the perceived risk and uncertainty of the returns to equity from 12% per year to 12.23% per year makes perfect sense.
• The market's are working.  Market participants, from the individual investor using on-line trading at 2:00 in the morning from their living room to the most sophisticated computerized large-scale institutional trader, understands that a borrower's ability to pay back its investors depends on the real productivity and growth of private industry, whether the borrower is a company or a country.   

Are Derivatives to Blame?

Derivative securities are not inherently evil, though the media, and certain guest authors on this blog, would have you think otherwise. It seems that any type of investment that does not directly involve commodities is an easy target these days.

But derivatives are just another type of investment, those whose value is derived from some underlying security or asset or event.   Insurance is a type of derivative investment, as a matter of fact. If the bad event happens (a car accident, flood, or fire, for example), then a claim is made against the policy.  If not, the policy expires.   The value of the policy is derived from the insured asset or event.

If derivatives are bad, then so too is insurance.  If derivatives are bad, then so too are leases with the option to own.  If derivatives are bad, then so too is the equity in any type of company, small or large, private or public, including those that produce real products and commodities, for stock is nothing more than an option to buy the underlying assets of the company for the price of the face value of its debt.  If derivatives are bad, then so too are convertible securities and most every other type of financial innovation we’ve witnessed in the last 30 years, and for decades to come.

Where did U.S. Incomes Go?

I've taken the liberty of reprinting in its entirety a recent piece by Karl Denninger of Market Ticker on the state of U.S. incomes.  This piece helps underscore the inescapable reality that private industry drives our economy.

"It appears that the Federal Tit Pump is running out of power...

Personal income increased $1.2 billion, or less than 0.1 percent, and disposable personal income (DPI) increased $1.6 billion, or less than 0.1 percent, in February, according to the Bureau of Economic Analysis.  Personal consumption expenditures (PCE) increased $34.7 billion, or 0.3 percent.

Oh boy, now the $1.3 trillion in additional deficit spending is no longer contributing to personal income!  That's not so positive - indeed, it's not positive at all.

Private wage and salary disbursements increased $2.0 billion in February, compared with an increase of $16.6 billion in January.  Goods-producing industries' payrolls decreased $3.5 billion, in contrast to an increase of $5.2 billion; manufacturing payrolls decreased $1.4 billion, in contrast to an increase of $5.0 billion.  Services-producing industries' payrolls increased $5.5 billion, compared with an increase of $11.4 billion.

Goods down.... uh, where's our so-called economic recovery? 

Proprietors' income decreased $6.1 billion in February, the same decrease as in January. Farm proprietors' income decreased $7.1 billion, the same decrease as in January.  Nonfarm proprietors' income increased $1.0 billion, the same increase as in January.

Very little change in proprietor's income ex farming, but farmer income is down significantly.

Rental income of persons increased $2.2 billion in February, compared with an increase of $1.9 billion in January.  Personal income receipts on assets (personal interest income plus personal dividend income) decreased $16.5 billion, the same decrease as in January.

Rents up a bit, but dividends are down huge, continuing a trend.  This is not positive at all, and implies that assets are being sold to continue lifestyle choices.  This leads to a question that has begun to gnaw at me: Have we begun to cross into where boomers start pulling funds out of asset classes to live on?

Personal current transfer receipts increased $16.6 billion in February, compared with an increase of $29.8 billion in January.  The January change reflected the Making Work Pay Credit provision of the American Recovery and Reinvestment Act of 2009, which boosted January receipts by $19.8 billion. The Act provides for a refundable tax credit of up to $400 for working individuals and up to $800 for married taxpayers.  When an individual’s tax credit exceeds the taxes owed, the refundable tax credit payment is classified as “other” government social benefits to persons.

Government to the rescue!  $45 billion worth in the last two months, to be specific.  That's a direct $270 billion in handouts, or 2% of GDP - and that's only the direct handouts!  So subtract that off GDP and..... (oh, and don't forget the rest of the $1.3 trillion too.)

Nothing to see here folks, as in "no evidence of sustainability in the recovery."  We have a government that continues to "prime the pump" but there's no water at the bottom of the well to generate self-sustaining economic growth. 

by Karl Denninger

Premature Celebration of 9.7% U.S. Unemployment

The official unemployment rate of the U.S. economy remains at 9.7%,  and the underemployment rate increased to 16.9%.  These numbers represent a real tragedy for many Americans. 

While the White House tries to celebrate the creation of 162,000 new jobs last month, at least 48,000 of these are government jobs, specifically temporary census workers, who are doing unproductive work and are being paid with taxes collected from the rest of the private economy. 

Employment also increased in temporary help services and healthcare, but continued to decline in financial activities and in information, which is interesting given the recent comments by President Obama that the government takeover of the student loan program "took $68 billion that would have gone to banks and financial institutions."  That's a lot of private industry jobs, Mr. President.

Seems like there is more concrete evidence that, rather than creating jobs, the President's policies are costing the economy jobs.

Should you Invest in U.S. bonds? Part 3

This is part 3 of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

The yield on a bond is made up of several components. Some think of the return on a bond as the sum of the risk-free rate of interest (how impatient we are to get our money back, or how much we need to be compensated to delay consumption) and a risk premium (the additional return we require to compensate us for the risk of default, the risk the bond will be called, the risk of inflation reducing the purchase power of the repaid dollars, and many other sources of risk as outlined in the most recent article in this series).

Another useful way of thinking of the return on a bond is as the sum of the real rate of interest and the expected rate of inflation.  But what is the real rate of interest?  We never actually observe that rate, unless of course the inflation rate is zero and then the real rate is just the nominal rate set in the market.

It is useful, however, to think about what drives the ability of a company to generate a real rate of return to lenders, for this is essence of capitalism and risk-taking and creating economic value and growth.

Bond traders

A firm’s asset cash flows support the real returns to its lenders – all kinds of lenders (debt, equity, hybrid, and derivative security holders). A firm will want to borrow more, and is willing to pay a higher interest rate for those funds, the more profitable are the projects they want to undertake, or the greater the number of profitable projects. Profitability, in turn, is determined by the relationship between demand and supply:  how much does society value a good or service, and how many resources does the business use in producing the good or service.  As the marginal productivity or efficiency of a business goes up, it can afford to profitably fund more projects.  So the core driver of the real return on bonds is the strength of the underlying economic activity of the private economy.

Or, when viewed from the investor’s side, note that an investor will purchase a bond, or lend money to a company, if they expect to earn a return sufficient to compensate them, first, for delaying consumption and, second, for bearing the various sources of risk or uncertainty associated with the bond’s cash flows or return.

Bond’s in a weak or faltering economy will generate a lower return to lenders than bonds in a strong economy, absent inflation or any other material changes in the purchasing power of the currency.  Weak demand for goods and services means weak demand for financial capital which means low rates of return on financial capital.

The policies of the government can increase the borrowing costs of private industry.  Fiscal policy that increases taxes reduces the profitability of projects and undermines the ability of companies to pay coupons and repay principal.  Monetary policy that increases the money supply may lead to inflation, which also increases the cost of borrowing and reduces economic activity.

Lastly, and of the greatest concern of late, is the level of borrowing by the U.S. government.   Debt levels are at record highs, with no relief in sight. The AAA rating of U.S. debt is reportedly in jeopardy (Chicago Tribune editorial).  Both existing and new lenders worry about the ability of the U.S. government to repay. Yes, the can simply roll over existing debt by raising taxes or creating money to retire old debt and replace it with new, but the interest rate required by new lenders goes up as the ability of the private economy to sustain tax revenues falls and the risk of inflation rises (Moody's explains U.S. bond rating).

Both factors are in play now: an anemic economy with little hope that this administration will undertake policies that support business, and a ballooning money supply and weak dollar that undermine the purchasing power of the returns to lenders.  The returns to U.S. debt may still be healthy relative to those one can earn in other countries, but the spread is shrinking. The private economy remains fundamentally strong, thanks to the work ethic of the American people and the profit motive of the capitalistic system, but the policies of the U.S. government are straining those resources.

Should You Invest in U.S. Bonds? Part 2

Sources and types of risk in U.S. and other bonds.

This is part 2 of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

Recall that a bond’s price is the present value of its coupons (if any) and face value (or principal or par value).  Let’s keep things simple for now and consider a zero-coupon or “discount” bond.

One thing of interest to note first: As we move forward in time from the issue date toward the maturity date, and the number of periods between now and the maturity date falls, the price of a discount bond rises toward the face value of the bond, even with no changes in the interest rate.  At maturity, the price of the bond equals the face value. Only unexpected changes in the effective return on a bond can change the natural upward progression of its price toward face value between the issue and maturity dates.

This example makes clear that the (annual) yield on a bond, simply put, is driven by the difference between the price paid for the bond and the cash flows it generates, that is, the difference between “dollars out” today and “dollars in” later.

The “dollars out” are known because we pay a given price for the bond today.  The “dollars in,” consisting of coupons (if any) and the face value of the bond, are also “known” in that they are specified in a contract at the time the bond is issued.  The realized value of these dollar returns is, however, subject to many different sources of uncertainty or risk. A short list includes:

Interest rate risk: how sensitive the price of the bond is to changes in interest rates over the life of the bond.  Interest rate risk is higher for bonds with a longer maturity (more time for the unexpected to happen), a lower coupon (more of the value of the bond is tied up in the principal), and a lower initial yield (a 1 percentage point change in interest rates represents a higher relative change in low yields).  Floating-rate bonds have much lower, though not zero, interest rate risk.

Reinvestment rate risk:  Bondholders may reinvest their coupons at the then-prevailing rate of interest. As those market rates of interest change, the return on reinvested coupons becomes less certain. Reinvestment risk is higher the higher the coupons, the more frequently the coupons are paid, and the longer the maturity of the bond.

Bankruptcy Court: Destination for issuers in default

Credit or default risk:  the risk that the issuer will default on the payments of the bond, which reduces the number of “dollars in” relative to price paid, lowering the earned yield on the bond.   Credit risk is frequently measured as the credit spread over like Treasuries, which are assumed to have zero credit risk.  Credit risk includes downgrade risk, where a credit rating agency lowers the rating on an issuer as their ability to repay the debt is brought into question.

Call risk:  the risk that a callable bond will be called by the issuer. Since a bond is typically called only when it’s in the best interest of the issuer, the call feature is systematically harmful to the bondholder.  Prepayment risk reverses these risks:  prepayment is good for the bondholder, and bad for the issuer.

Exchange rate risk (that the value of the repaid currency will be lower), inflation risk (that the value of the repaid dollar will be lower), and event risk (natural disasters, corporate restructurings, regulatory changes, sovereign or political changes) round out the list of broad types of risks that drive bond yields.

Next time: why the types and level of risks are so difficult to measure and predict.

by Sherry Jarrell

Lessons learned as a Government Intern

When lending is motivated by politics, losses are not far behind.

Years ago, in the summer of 1980, I worked as an intern in the Federal Home Loan Bank Board at the Department of Agriculture.  I was a senior in college majoring in business and had been accepted to the University of Chicago doctoral program.  I didn’t want to take the internship because I wanted to take more courses over the summer to help prepare me for the rigors of grad school, but my college advisor had openly worried that I was far too serious for a young person.  He strongly encouraged me to accept the internship and take a break from academics before I immersed myself in graduate school, and buried myself once again in all things economics!

The U.S. Department of Agriculture was a major lender

I agreed, but only after I had arranged to take 6 credits of independent study in D.C.  I chose to examine the Negative Income Tax program, one of the largest social experiments in U.S. history. More on that at another time. Today, I want to talk about what I learned from being an employee of the U.S. federal government.

The first thing I learned was that the “problem” with government work is not the people; well, not all the people.  There was one man who spent his entire day going back and forth to feed quarters to the parking meter rather than pay for public transportation or do his work.  He represented the worst in government employees.  Most all of the others I met were hard-working and honest people, trying to do a good job and make a difference.

President George H. W. Bush

No, I learned that the real problem was with the way the "work" is done in government. I worked for the Federal Home Loan Bank Board (FHLBB) that summer, which was one of the largest lenders in the world.  The FHLBB was responsible for small business, rural, agricultural, and economic development lending. My job was to review loan applications from community groups, fairs, farmers’ markets, and various municipal organizations to make sure that they were complete.  We did not analyze the applicants for creditworthiness.  Instead, if the application was correct and complete, and satisfied the application process, it was approved.  The FHLBB, which was publicly trashed by the first President Bush as being largely responsible for the savings and loan crisis, was abolished and replaced by the Office of Thrift Supervision (OTS) under the Department of the Treasury in 1989.  The OTS eventually expanded its oversight to companies that were not banks, including Washington Mutual, American International Group (AIG),  and IndyMac,  all implicated in the current U.S. financial crisis.

AIG

Little did I know back in 1980 that I was witnessing, from the inside, a government lending process that would lead to the most significant financial crisis since the Great Depression. Looking back, the outcome was perfectly predictable: when politics replaces profits as the motivation of the lender, it should be no surprise that losses result.

The Hypocrisy of Finding Medicare Waste

I honestly cannot understand how President Obama can look the American people in the eye and tell them that Health Care reform will be paid for, in part, by finding savings and reducing fraud in Medicare over the next several years.

President Obama on Health Care Reform

If it is possible to operate Medicare more efficiently, why have we not done it already?  Why must doing it right wait for new programs and new legislation?  Why doesn't Congress first prove to the American people that it can operate a program efficiently and then come back and ask for more?

Because it can't, that's why not.   The plain and simple truth is that it cannot do so now, and will not do so in the future.  So why are we letting our elected officials get away with such a charade?

I just don't understand it.

Latest US Growth Rate

The U.S. GDP grew at an annual rate of 5.9% in the last quarter of 2009 which may look good at first glance, but when we dig a little deeper, we find some concerns about the implications for sustainable growth.  A large fraction of this reported growth came from businesses selling off accumulated inventories, which has more to say about past production than current. Exports were also a significant source of fourth quarter growth, driven in large part by a weak dollar.  Of course, a weak dollar is a very mixed blessing for the economy, and is hardly a sign of a strong or recovering economy.
 

Real residential fixed investment increased 5.0 percent, helped along by the extension of the home purchase tax credits from the federal government. 

Real nonresidential fixed investment increased 6.5 percent. This figure nets out nonresidential structures, which decreased at a troubling rate of 13.9 percent, and equipment and software, which increased 18.2 percent. Investment in equipment and software consists of capital account purchases of new machinery, equipment, furniture, vehicles, and computer software; dealers’ margins on sales of used equipment; and net purchases of used equipment from government agencies, persons, and the rest of the world. Own-account production of computer software is also included, which is production performed by a businesses or government for its own use.  

Again, the underlying figures show that those variables most associated with building a sustainable productive capital base for the economy – nonresidential fixed investment –are declining at an alarming rate. This, combined with a 9.7% unemployment rate and the specter of rising debt levels, energy prices, and taxes, paints a picture of a slow to non-existent recovery to a robust economy any time in the next year. 

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

Does Fed Rate Influence Consumer/Business Interest Rate?

Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans?  If you took the word of the average business news commentator, you would think not.  But the answer, of course, is yes.   

One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.

A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid.  The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty -- including the risk of inflation -- raise the level of the risk premium commanded by lenders in the market.  As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.

So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate?  Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.  

Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase.  The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.

Why Did the Fed Raise the Interest Rate?

What does it mean when the Fed raises the interest rate? It helps to first understand how the Fed raises the rate, which may surprise some people.  The Fed does not "set" the interest rate as it might, for example, by declaration or edict or by fixing prices.  No, it targets a higher interest rate by contracting the money supply until that money supply intersects the market demand for money at a higher market-clearing rate of interest.
 

How does the Fed reduce the money supply? Typically by conducting open market operations, which is the purchase or sale of government securities by the Fed.  To raise the money supply, it purchases new government securities, paying for them by creating--out of thin air--reserves for the commercial banking system. To reduce the money supply, it sells securities which shrinks the amount of deposits in circulation in the economy. In other words, it reduces the liquidity or amount of credit in the system.  This is equivalent to reducing aggregate demand for the goods and services in the economy. (Yes, you heard right; an increase in the money supply increases the aggregate demand for goods and services by businesses and consumers.)

Raising interest rates is a contractionary policy decision.  It is designed to slow down the economy, reducing output and employment, and raising the equilibrium prices of goods and services in the economy.  Why would the Fed choose to contract an already anemic economy?  To head off inflation, which has its own set of insidious costs and distortions that significantly hurt the economy.

The Fed has always had to tread a very fine line between increasing the money supply enough in the short run to minimize the depth and length of a recession, but not increasing the money supply so much that it creates inflation in the longer run.   Excessive money growth is what causes inflation.  And over the last two years, the U.S. has witnessed a record-shattering increase in the money supply as policymakers struggled to deal with an unprecedented financial crisis.

I have been saying for months that this behemoth money supply would inevitably lead to significant inflation unless steps were taken to shrink it.  I believe the Fed has now begun to take those steps.

Oh, the Irony: The Market Speaks, and Obama Has to Listen!

In a recent article, Moody’s announced that because of the U.S. federal government’s excessive spending and historic debt levels, it might have to reduce the Aaa rating of U.S bonds (http://thecitysquare.blogspot.com/2010/02/us-aaa-bond-rating-threatened-by-obama.html and http://risingpowers.foreignpolicyblogs.com/category/multipolarity/)
 

What this means in practical terms is that the cost of borrowing by the U.S. government will rise, which will increase spending via more borrowing or higher taxes or more money creation to pay for the higher interest costs.  Sound like a vicious cycle to you?  

Has anyone noticed the absolute irony of the world capital market having a seat at the table that assesses the viability of Obama’s policies? Obama has spent the last year denigrating free markets, and has laid the blame for the credit crisis squarely at the feet of those "greedy capitalists." Now he has to deal with a rating agency, which plays a pivotal role in the functioning of those very capital markets, evaluating the creditworthiness of the policies of the White House and its Budget Director, Peter Orszag.  

How wonderfully ironic! 

 

Every Economist, Mr. President? No, sir!

The President seems to believe that he can say whatever he wants and no one will hold him accountable. He now claims that "every economist, from both sides of the aisle, believes that the stimulus program created jobs." http://www.washingtonexaminer.com/opinion/blogs/beltway-confidential/Obama-says-every-economist-back-claim-stimulus-saved-or-created-two-million-jobs-83550017.html

I am an economist, Mr. President, and I know, based either on simple first principles of economics, or on a more rigorous controlled study of labor markets in each major sector of the economy, that the unemployment rate would have been much lower today had the stimulus program never occurred.  

You are either woefully unaware of the facts, Mr. President, or are purposefully distorting the facts. Neither is good.  When are you going to realize that just because you say something does not make it so. The world does not contort itself to support your version of the truth.

Do not put words in my mouth, sir.

The Farcical Freeze

President Obama's proposal to freeze parts of federal government spending over the next three years is a lot like a smoker buying a truckload of cigarettes today, then promising to "freeze spending" on cigarettes tomorrow.  He can keep smoking for years to come without spending another dime.

Federal government spending has increased so much over the last year -- by some estimates at a rate of 34% (http://www.usgovernmentspending.com/year2009_0.html#usgs302 -- that in December of 2009 the debt limit had to be raised to $12.4 trillion to help absorb a record-shattering $1.4 trillion deficit (http://www.washingtontimes.com/news/2009/dec/25/senate-oks-rise-in-debt-limit-to-124-trillion/).

The promise to freeze spending is actually a guarantee that spending will remain at record high levels for the next three years.  It effectively prevents a reduction in federal spending. 

How disingenuous of our President.  

 

Actual Unemployment is Worse

Keep in mind, even as the number of first-time claims for unemployment insurance rose again this week, that the 10% U.S. unemployment figure understates the actual number of unemployed. Even the 17% underemployment figure, which includes those who are either unemployed or who are working part-time but would like to work full-time, fails to include many of those who have lost their jobs but, because they fail to qualify for unemployment, are not being tracked.  I know several such people personally; one has been unemployed for over a year. 

My point?  Structural unemployment is a serious economic issue.  But the solution is not to funnel more unemployment benefits to the unemployed.  The best thing the government can do is to reduce the barriers it has erected to a vibrant economy, including oppressive taxes, fees, paperwork, bureaucracy, and regulations that repress business productivity and raise prices.  By reducing these explicit and implicit costs, there is absolutely no doubt that the private economy will be able to employ more workers as it produces more output at lower prices. 

The best thing we can do as private citizens and neighbors is to treat each other right.  Keep the economy moving.  Put in a good day's work.  Volunteer or learn a new skill if you can't find a job.  Fill a need.  Buy smart.  And, finally, elect business-friendly local and national politicians.  It matters. 

Capitalism and the Daimler-Chrysler Saga (Part 3 of 3)

This is part 3 of a 3 part post on the saga of the ill-fated 1998 merger between Daimler and Chrysler.

The Daimler-Chrysler merger was troubled from the beginning. Investors sued over whether the transaction was a 'merger of equals' or a Daimler-Benz takeover of Chrysler. A class action lawsuit was settled in August 2003 for $300 million. A lawsuit by activist investor Kirk Kerkorian was dismissed in April 2005, but claimed the job of the merger’s architect, Chairman Jürgen E. Schrempp, who resigned in response to the fall of the merged company's share price. The merger was also the subject of a book Taken for a Ride: How Daimler-Benz Drove Off With Chrysler, (2000) by Bill Vlasic and Bradley A. Stertz.

It is questionable whether the merger ever delivered promised synergies or ever successfully integrated the two businesses. As late as 2002, DaimlerChrysler appeared to run as two still-independent companies.  In 2006, Chrysler reported losses of $1.5 billion.  In 2007, it announced plans to lay off 13,000 employees, close a major assembly plant, and reduce production at other plants in order to try to restore profitability.

It was all for naught.  In May of 2007, DaimlerChrysler announced that it would sell 80.1% of Chrysler to Cerberus Capital Management of New York, a private equity firm specializing in troubled companies. Daimler continued to hold a 19.9% stake. Daimler paid Cerberus $650 million to take Chrysler and associated liabilities off its hands, an amazing development given the $36 billion Daimler paid to initially acquire Chrysler. Of the $7.4 billion purchase price, Cerberus invested $5 billion in Chrysler Holdings and $1.05 billion in Chrysler’s financial unit. The de-merged Daimler AG received $1.35 billion directly from Cerberus but invested $2 billion in Chrysler LLC itself.

On April 27, 2009, Daimler AG agreed to give up its remaining 19.9% stake in Chrysler LLC to Cerberus and pay as much as $600 million into the automaker's pension fund.  On April 30, 2009, Chrysler LLC filed for Chapter 11 bankruptcy protection and announced a plan for a partnership with Italian automaker Fiat. On June 1, Chrysler LLC stated they were selling some assets and operations to the newly formed company Chrysler Group LLC, with Fiat retaining a 20% stake in the new company.

On June 10, 2009, the sale of most of Chrysler assets to "New Chrysler," formally known as Chrysler Group LLC, was completed. The federal government financed the deal with $6.6 billion in financing, paid to the "Old Chrysler.” The transfer does not include eight manufacturing locations, nor many parcels of real estate, nor equipment leases. Contracts with the 789 U.S. auto dealerships who are being dropped were not transferred.  Not a hint of the disastrous Daimler-Chrysler merger remains.

Capitalism and the Daimler-Chrysler Saga (Part 1 of 3)

In a paper co-authored with Rick Harris, Tom McInish and Bob Wood, we explored the Daimler-Chrysler merger of 1998 to examine the interplay between disclosure rules in the U.S. and corporate governance standards in Germany.  Here is an overview of what we found.

Large shareholders typically control European and Asian industrial giants, leaving minority shareholders less than well protected.  In several studies of the legal protection afforded minority shareholders across 27 countries, German shareholder protection ranked among the very worst. In the early 1990s, Daimler-Benz, one of the largest firms in Germany, was no exception.  In 1993, with Deutsche Bank owning 24% of the equity, Mercedes AG Holding 25%, and the Emirate of Kuwait 14%, its controlling shareholders decided to cross-list Daimler-Benz on the New York Stock Exchange (NYSE).

All foreign firms that cross-list [list their shares for sale in more than one country] in the U.S. subject themselves to stricter disclosure standards.    In addition to listing on a major U.S. stock exchange, Daimler was required to file financial statements with the SEC and report any material non-financial information as well.   Cross-listed firms are also followed more closely by U.S. stock analysts and the business press.  These legal disclosure requirements and additional scrutiny by the investing community improved both the quantity and quality of information available to all shareholders about Daimler.

By early 1998, the cross-listed Daimler shares were widely held and actively traded worldwide, including significant volume originating in the United States. In September of 1998, Daimler and Chrysler shareholders, majority and minority owners alike, overwhelmingly approved a merger creating DaimlerChrysler AG (DCX) through an exchange of the cross-listed share for the first “global registered share” (GRS).  The so-called “merger of equals” was widely expected to realize both operating efficiencies and, via the informational transparency of the GRS, improved access to international capital markets.

Part 2 tomorrow.

Engine of Economic Growth is Sputtering

The engine of world economic growth is sputtering.  The most clearevidence of this is the lack of new business formation in developed nations across the globe.  Over the last year, the number of entrepreneurs starting new businesses in the wealthiest of nations dropped 10% from the 2006-07 level; in the U.S., that number fell by 24%. http://www3.babson.edu/Newsroom/Releases/globalgem2009.cfm

The contaminants in the fuel line are oppressive government policies that increase the cost of doing business, increase unemployment, and raise the risks to the current labor force of quitting their jobs to try to start new businesses.  

At a time when government should be encouraging venture capitalists and the formation of new business, it is instead putting on the brakes to this source of economic growth in the form of cap and trade, compensation regulations, fees on banks, and myriad other explicit and implicit new taxes.  In 2009, nearly half of U.S. employment was generated by small businesses; U.S. companies started through venture capital employed more than 12 million people, or 11 percent of private sector employment, and generated $2.9 trillion in revenues, or 21 percent of U.S. GDP.  

Fully 100% of economic growth is created in private industry.  Government simply redistributes that wealth, destroying some portion of it in the process.  Never have we needed non-interventionist government policies more.

Senate Version of Health Care Reform IS a Tax increase!

The latest from Washington on Health Care Reform is the Senate's version which taxes insurance companies on plans valued at over $8,500 for individuals and $23,000 for couples.

President Obama has defended the tax as a way to drive down health costs.  "I'm on record as saying that taxing Cadillac plans that don't make people healthier but just take more money out of their pockets because they're paying more for insurance than they need to, that's actually a good idea, and that helps bend the cost curve," the president said in an interview with National Public Radio just before Christmas. "That helps to reduce the cost of health care over the long term. I think that's a smart thing to do."   http://www.cbsnews.com/stories/2010/01/07/politics/main6066223.shtml  

Huh?  Mr. President, you need an Econ 101 primer. Let's begin now, with supply and demand: s

Supply is an upward-sloping marginal cost curve, and includes the taxes and fees a business must pay to the government.  By imposing this tax, the supply curve of insurance companies will shift up and to the left, as shown in the graph, representing a higher cost per unit of insurance coverage.  The demand curve slopes down, so when intersected by a more costly supply curve, the final price to consumers rises and the amount of insurance coverage falls. Period. End of story. Indisputable fact.  And nothing Obama or the Senate says will change this fact, though they will try. 

More Political Shenanigans on Health Care Reform

This topic may seem to be more about politics than economics, but anything related to health care reform is squarely rooted in the most important of economic issues:  the costs of doing business, the size of the government, and the potentially oppressive role of government in private industry. 

To that end, the following is a must-read, and should make you angry, no matter what your political persuasion.  http://bostonherald.com/business/healthcare/view.bg?articleid=1224249&format=text

In this article, we see how the Senate Democrats are going to do whatever it takes to get their version of health care reform through, even if it comes down to essentially stealing votes.  Could the timing of this Massachusetts special election, to replace the temporary replacement put in for the late Senator Edward Kennedy, be one of the reasons that the Senate wants to rush this reform through before the President's State of the Union Address, typically set for mid-January, though the White House is curiously reluctant to commit to a date....  ?

Troubling U.S. Unemployment Figures

The U.S. unemployment rate remains at a 26-year high.  This is troubling for two reasons. One, the struggle and suffering of the unemployed (and underemployed) and the impact on the world economy. 

Two, the mixed signals it gives policymakers.  I worry that the White House will think that it needs to do "more" of what it's been doing, and will dismiss any negative comments about its economic policies as a knee-jerk reaction to the unemployment figure when I, in fact, would be saying the same things if the unemployment figures had improved.  It would be a harder sell, true, but that doesn't change the facts.

The reason?  Because I believe we would be in a better position today, with lower unemployment -- no matter what the current unemployment rate -- and higher growth, had the stimulus program never been initiated.  I base this on my understanding of the fundamentals of how the economy works, how businesses create value, and how labor makes itself indispensable to industry.  

And none of these areas were helped or improved by the economic policies of this President. 

The Deficit and the Money Supply

As the New Year begins, many writers are looking back on the events of 2009.  Many are focused on the impact of the bailout and stimulus programs on the U.S. economy.   While some credit those programs with ending the U.S. recession, others worry about the resulting deficit and the ability of the government to sustain this level of spending into the future. 

I, for one, believe that the economy would have been better off without the bailouts and the stimulus program.  But proving that claim is a difficult task, not just for me, but for anyone trying to address the question.  

I have a research project under way that I hope will lead to a better measure of the impact of government spending on GDP, but it will be some time before those results are in.  In the meanwhile, I want to help to clarify some economic issues that underlie much of the debate about the stimulus and the deficit.

First of all, the deficit is defined for the fiscal year only.  It is a one-period measure.  The deficit for 2009, for example, is total 2009 government spending (including interest on debt, which is the cumulated book value of deficits) minus total 2009 government "revenues."   Government revenues consist of taxes plus the proceeds from asset sales (http://www.govsales.gov/HTML/INDEX.HTM). 

Second, the U.S. deficit is our trading partners' surplus.  Our borrowing is their lending.  There is nothing inherently wrong or weak about the U.S. running a deficit, or selling Treasury bills or bonds to finance spending.   

Typically, the Treasury avoids using the Federal Reserve's balance sheet for its tax collecting and check writing activities, expressly to avoid tainting Monetary Policy with Fiscal Policy, or "monetizing the debt."  Of late, however, under Geithner's leadership and Bernake's followership, that distinction may be blurred beyond recognition.  The current level of the money supply, given fairly stable reserve requirements and discount window policy, is largely determined by open market operations (OMOs), or the purchase (or sale) of newly issued Treasury bills and bonds with newly created Fed reserves; i.e., the famous "the Fed creates money with the stroke of a pen" or, these days,"with a click on the keyboard."

Pre-Geithner, the Fed created money strictly through OMOs and changes in reserve requirements and discount window activities, with the goal of supporting GDP with the appropriate interest rate target without excessive inflation. Now, it's worrisome how much policy independence the Fed seems to have retained.  In a real economy crisis with rampant unemployment, should the Fed "do something?" And what if those actions exacerbate inflation? Now what is our policy priority:  lowering unemployment or lowering inflaton?

No easy task here: find just the right level of money supply growth that will find the right level of short term interest rates without over- or under-stimulating inflation.

Q3 GDP Revised Downward - Again

What a shock.  U.S. GDP is not growing at 3.5% per year, as originally reported, and celebrated with much fanfare from President Obama about how the stimulus program was working.   It is not even growing at the revised 2.8% annualized rate reported a couple of weeks later.  The latest re-revised figure is 2.2%.

Nearly the entire 2.2% annualized growth, or 3rd quarter growth of 0.55%, is driven by the cash for clunkers program, the government spending program (also called the stimulus program, but I have a big problem with that particular name), and the extended tax credit for first time home buyers. Which means that this increase in GDP is not only entirely temporary and fleeting, but will cause lower GDP later.  The cash for clunkers program did not create more overall demand for cars; it simply pulled some of the future demand for a new car into today, all the while wasting millions of tax dollars on administering the program, and putting some dealerships out of business in the process.   The spending program simply shifted profits from businesses to support other segments of society, all of which is temporary and destroys the productive capacity of the economy for many periods to come.  The extended tax credit to first-time home buyers is a real head-scratcher.  A curious time to redistribute funds from the producers in the economy to finance a program which lowers the cost to those home buyers who would not have the funds to buy a home in the first place....second wave of home mortgage foreclosures, anyone? 

The Poor Pay Czar: Comment and Reply

Patrice Ayme posted the following comment on my earlier post titled "The Poor Pay Czar:"

1) Self referential loops have proven a problem in logic. Should not they be a problem in the market, or is it that the market has nothing to do with logic? The CEO class, in the USA, is self referential. 2) Europe has now more big companies than the USA. Still, big European executives are paid at least ten times less than their USA equivalents. How come the market is so different in Europe? Is the fact that more compensation in Europe goes to talent located on lower rungs of companies, related to the higher performance of European companies in the last decade? After all, the total compensation being finite, paying more for talent at the CEO level means paying less for talent just below. An interesting aside is that CEO in the USA are much taller than average. Are size and compensation the only way they can dominate their subjects? A few years ago, Renault was all set to buy General Motors. At the last minute, though, Renault executives learned that GM executives intended to pay themselves more than ten times what Renault-Nissan executives were paid. So Renault scuttled the deal. US taxpayers are left with the bill: more than 60 billion dollars, no? (And GM will fail within a year or two.) It is true there are markets, and they can deal. But they are more or less free. There are not just markets. There are also classes too, and they can dominate, with extra market mechanisms. The CEO class in the USA sits on each others’ boards, determining each others’ compensations. In some other countries, this sort of incest is more limited (in others, it’s worse: China). In Germany, union representatives sit on boards. Generally those who really love their jobs will do them for free. Too much compensation is actually a distraction. And bad markets, thus exists. They are not just bear markets, they can lead to captive markets, and oligarchies… 

My reply to Patrice: 

Patrice —

Your view of markets is flawed, perhaps fatally so.

The U.S. labor market, for example, provides just the right incentives for individuals to work hard in order to improve the quality of their lives in ways that free people see fit.

There are some issues with that market in its current form, like minimum wage legislation and unions, but overall the U.S. labor market works quite well, particularly when viewed dynamically, through time, instead of as a snapshot at a point in time, as you seem to do.

Your comments ignore the fact that most CEOs work their way up through their companies, or in other companies, for many years, putting in long hours, sacrificing time at home and with family, in order to rise to the top, to take on the huge responsibility of guiding an organization to sustainable profits.

Right this moment, people are toiling away in industry at lower salaries, or in school at no salary, honing their skills, building relationships, learning about their industry, coming up with better ideas. A select few of these people will one day rise to become the CEO of a company, many of which do not even exist today. CEOs earn whatever the labor market, in its objective, efficient way, as disciplined by laws preventing fraud and by the instantaneous referendum on value creation represented by an active capital market, deems is justified.

Yes, there are temporary glitches in the functioning of the labor market, like Enron. Yes, there are unethical executives, like Maddoff.

But the fate of Enron, its executives, and Madoff is glaring proof that the markets in the U.S. work to ferret out the thieves and reward hard-working entrepreneurs and business people.

Parenting the Government: More Q and A

Patrice Ayme continues:

Hi Sherry:
I made several points. Indeed by “public utility” I allude to public as in res-publica.
Funny you said that a “national interstate roadway system” should be paid by taxes. As I said, in France, it’s private, and paid by the proverbial ‘end user’. So much for France being socialist and USA private profitist. Please forgive the neologism.

I gave the example of waterworks. Private French companies lead worldwide in that domain. That means French (local) government use taxes to pay them. But recently some government realized they could get more services by doing the work themselves. So, in this case, they start as before: taxes. But then, instead of paying some giant private French water company, they pay municipal workers and engineers to do the work. Cost less (less taxes), better service.

Call that an anti-Jarrell universe. A mystery, like anti-matter. How could that happen? Very simple: think about it: the municipal government does not have shareholders (just stakeholders) and does not have to pay dividends, and does not have to increase the value of the shares by showing profits. It actually has no profits to make. So the end user (the denizen of said city under his city government) saves money (i.e., taxes), improves services.

This example, of course carries to health care. France has also a competition of public and private health care systems, large pharmaceutical companies, etc… And has done more face grafts (in public hospitals) than the rest of the world combined… and the first successful gene therapies (also in public hospital), etc. Was is it not to like? If profitist ideologues in the USA were not so greedy, they would see the necessity of having a strong public sector, be it only to keep the private sector honest.

By the way, French politicians are regularly condemned for corruption, and it’s not because they are richer than their colleagues in the USA, by a long shot…

My reply:

Ah Patrice….here we go again! For one, I did not say that government “should” pay for a national highway system, I said that we do pay for a national highway system. A positive statement, not a normative one.

I guarantee you that in any universe – not just the Jarrell one – the true cost of anything paid for by the government with tax dollars is understated by several orders of magnitude. And, possibly, overstates benefits. It is simply factually incorrect to say that the cost (the true economic cost as measured by the use of resources) of providing the service is less when provided by the government. The one-period ACCOUNTING cost put on paper by some government office, as reported to the press, and swallowed whole as fact by readers, may be less. But it is literally, factually impossible for the true costs to be reduced by inserting a redistributive middleman between consumers and business.

You also fail to understand the relationship between stock prices and economic value. You should step back, slow down, and consider the following. Let’s get dollars and stock prices and dividends and profits out of the equation entirely and just think about the amount of goods and services provided versus the amount of resources used up in the production of those services. Measure it however you want — quality of life, health of the citizenry, happiness, kumquats. Now ask yourself which is the most “efficient”method of providing final goods and services, where efficiency is measured, as it should be, as the number of units of output of the good and service provided per unit of resources used up in production process. The “dividends” and “capital gains” in this analogy are the EXTRA value created from a capitalist system; take one input, create 2.5 outputs, added value is 1.5. The government as provider creates zero extra value, if we are lucky, and negative value, if we are realists: take that same input, chew up half its value in bureaucracy, buying votes, and redistributing the consumption decisions of a free people toward something they would not choose to purchase in the first place (otherwise, why the government program in the first place?), and produce 0.5 total outputs, a loss of 0.5. The social loss from moving from capitalism to collective command and control is 2: from plus 1.5 to negative 0.5.

Yes I am including spending on defense and clean air and roads. When we spend on collective goods, we use resources less efficiently. This spending infringes on our economic freedom, but some goods and services are necessary to protect and preserve the system that enables that economic freedom.

You and I can and most certainly do disagree on where to draw the line on what goods and services the government should provide over the objections of a free people, but we cannot disagree on facts. Your claim that government provision of goods and services is less costly than private industry is factually incorrect.

Parenting the Government: Comment and Reply

From Patrice Ayme on www.Learningfromdogs.com:

Agreed about too much taxes without adult supervision…

Now something related to think about. Why not make American freeways private? The US government could sell the Interstate system, making lots of profits (are not profits the best thing?), then the private owners would make even more profits. No more taxes to pay for the roads, etc… One could extend that to the army. Make the army completely private, headed by the operators of the ex-Blackwater, I mean “Xe”. Army guys would be encouraged to make profits, as their predecessors in France around 1200 CE (interestingly called “Les Grandes Compagnies” = The Great Companies”).

And so on.
In France, freeways are actually private, and toll. But of course they were built and paid for by private capital (protected by law recognizing them as of “public utility”). It works well, nobody is complaining: superior surfacing, no holes, no debris, and advanced freeway architecture, differently from American freeways.
The high speed train network is according to similar lines.

Superior economic organization is all within that concept of PUBLIC UTILITY.

Profit is not the superior economic organizing principle. Public utility is.

Pirates made profits, so did Roman governors and Persian Satraps, or Carthage.

The USA can learn a lot from its sister republic, France. Another example is waterworks. Starting around 1850, private water companies grew in France. They soon became extremely profitable, and several private French water companies are now the largest water companies in the world.

This worldwide success did not escape the attention of typically suspicious French citizens. Some city engineers noticed that they could do the same cheaper. So, paradoxically, a rebellion against the French water giants has started in France, and some city governments are now running, cheaper and better their own waterworks, after wrestling back control from the private water giants.

It is not whether it is private for profit or government for public which matters. what matters is the maximization of public utility. At least in a democracy. In a banana republic, it’s different, true.

My reply:

Patrice: Just to clarify before I comment, by “public utility” you mean the benefit of the whole of the public? And your focus is on what is being delivered or consumed and how much good that does for the citizen?

I assume your point is the superiority of government supplied goods and services — specifically as it is done in France — over the profit motive of private companies. Again, you miss the point that the government would have no resources to spend without private industry. All the government does is to shift profits around in the economy. Now some of that shifting, like from private profits to public goods (and by public good I mean one where the consumption of the good by one individual does not reduce availability of the good for consumption by others; and that no one can be effectively excluded from using the good, like clean air, national defense or, effectively, a national interstate roadway system), is necessary and desirable. We, as a country, defined the need for public goods in our Constitution, but we have strayed very far away from that ideal over time, to our detriment.

The Fed is paying banks to NOT lend!

The President of the United States recently pressured the heads of the nations’ largest banks to increase lending to small business and homeowners (http://tinyurl.com/ycjrzcp).  Obama claimed that the banks, as recipients of federal bailout funds, had an unusually heavy responsibility to take such measures in order to create more jobs and help nurse the economy back to health.  All of this was done very publicly and with much fanfare.  Worldwide press coverage was universally favorable.

Seems reasonable, doesn’t it?

But it is not.  You are being duped.  I can’t tell whether whoever writes this stuff for Obama knows the truth and skillfully skirts it, or just writes flowing prose with no connection to the truth that curries voter buy-in by blaming Wall Street and Corporate America for all that’s wrong in the world.

First of all, the Federal Reserve is now paying banks to not lend. You heard that right:  the Federal Reserve is paying banks interest on both their required reserves, which are portions of deposits they are required to retain, and their excess reserves, which are deposits the banks could lend but haven’t (http://tinyurl.com/ybgnetk). Historically, the cost to banks of holding excess reserves has been the interest they would have earned if they had been lent.  Banks hold excess reserves as a sort of cash management tool; insurance that if the bank manager misjudged their customers’ demand for cashing checks, for example, the bank wouldn’t hit the headlines as the first bank since the Great Depression that “ran out of money!”  But that insurance cost them.

Now, the Federal Reserve is paying banks to hold excess reserves.  They are paying banks to not lend, while President Obama scolds them for not lending!  Either he doesn’t know about the Fed’s new policy, doesn’t care, or doesn’t understand. I frankly don’t know which is worst.

Secondly, how is increased lending supposed to create new jobs?  Bear with me here, because the bold, brash economic truth of the matter is a bit more complicated than the press coverage and the teleprompters would have you believe.

Profits enable growth: income growth, job growth, wage growth, new businesses, more choices, and a higher quality of life.   Profits are created when a business hires labor and buys or rents physical capital, combines them using processes, software, expertise, creativity, and risk-taking, and produces a product or service that a free society chooses to purchase. There is simply NO other way to create profits.    Now you need both a business to make the good, and a customer to buy the good, before you have profits.  But increasing demand alone does not create profits or jobs.  The way to see this is to imagine that we were at capacity output right now: increasing demand would simply increase prices, not output or jobs.

Lending to businesses – assuming they can generate enough cash flows to pay the interest charges -- fuels their demand for productive capital.  But the capital could sit in the corner gathering dust.  It is the profit motive of businesses – what they choose to do with the new capital that the lent dollars enabled – which incents business to hire more labor and produce more efficiently. Not a scolding from the President.  Particularly a President who has made it clear that he believes that “now is not the time for profits”(http://tinyurl.com/y8g4nn7); that the greed and excess of fat cats on Wall Street led to the financial crisis (http://tinyurl.com/ydrhp3s); and that insurance companies take advantage of Americans (http://tinyurl.com/yb4yrmg).  Not a President who presides over a Congress which is spending at record rates and raising taxes on business at every turn.

Government Spending is like a McDonald's Burger

At times when money is tight and our resources are stretched to the limit, it pays to spend our money wisely.  That is why it makes so much more sense to reduce the costs imposed on private industry instead of increasing spending by government.  Industry takes their earnings and reinvests them to create sustainable wealth creation: they hire and train workers, conduct research, build and perfect machinery and robotics, and develop brand equity and a reputation for quality. All of these endeavors represent lasting value creation. What is spent on these things this year will continue to create revenues, wages, and profits for years to come.

Government spending is pure consumption.  It is temporary and fleeting.  It keeps the beast alive for one period, and then the process has to start all over again next period. When we approve a massive spending bill, it covers government purchases of goods and services for the next year, maybe less.  In one end; out the other, with nothing left to show for it, except a hungry program that needs to be fed again next year, and the next and the next.  Government programs in and of themselves never produce lasting value; only in conjunction with private industry is any wealth or value created. And even then the government purchases have pushed aside, prevented, crowded out, or priced out purchases that would have been made by the private economy.

So, please, keep this in mind whenever you think of any type of government spending or tax increase: it is here today, gone tomorrow. 

An Overview of Macroeconomics

    Macroeconomics is the study of aggregate supply and demand, and looks both internally 

to the workings of the economy and externally to how a domestic economy interacts with others 

worldwide.  Macro builds on the principles of microeconomics, which is the study of prices and 

quantities of individual goods and the markets where these goods are produced and sold. In macro, 

"price" refers to some index of the prices of domestic goods and services, and "quantity" refers 

to some measure of the value of domestic production or "output." One common measure of output is 

gross domestic product ("a measure of the productive activity of a country computed on the basis 

of the ownership of the factors of production"). A country's standard of living is usually directly 

correlated with its real output, or the value of total output corrected for inflation. 

    Unlike microeconomics, macroeconomics started with the idea that prices and markets do not 

continuously resolve all of the coordination requirements of a modern economy. Such "failures of 

coordination" (Keynes) seem likely when one views the economy as the collective sum of thousands of 

microeconomic markets. For example, although most economies around the world have experienced generally 

positive trends in their gross domestic product, short run positive and negative deviations (recessions 

and, in more dramatic examples of the failure of coordination, depressions) around the trend line, or 

"business cycles," are common. 

    Inflation is the rate of change of the average level of prices, where the price level is 

usually measured as a price index.  Inflation rates are typically quoted in annualized percentages.  

In normal times, the inflation rate is procyclical: it rises in periods of high growth and declines 

in periods of slow growth.  Unemployment, by contrast, is usually countercyclical. The U.S. inflation 

rate was as likely to be negative as it was positive before World War II; since then, price levels 

have risen fairly consistently.

     Financial markets play a key role in macroeconomics.  It is here that resources are collected 

from savers and lent to producers for investment in the real economy.  The real economy stands in 

contrast to the nominal (or financial or monetary) economy.  The real economy is concerned with the 

production and consumption of goods and services; the nominal economy deals with the trade in assets, 

such as monetary and financial instruments.  Physical investment, which is the acquisition of the 

physical means of production by firms, provides one channel by which financial markets affect the real 

economy.

    Two fundamental approaches to macroeconomic policy have arisen, both of which are concerned 

with how to manage the inevitable failures of coordination between the micro units in the economy. 

Demand side: the use of government demand to smooth out fluctuations in the economy, mainly to avoid 

protracted recessions. Supply side: improving the efficient utilization of labor and capital resources

to enhance the productive capacity of an economy.

    One can also usefully separate the approaches to macroeconomic policy into laissez-faire and 

interventionism.  Keynesians are frequently characterized by the view that markets are imperfect and 

that government holds an information advantage and should engage in active policy interventions in the 

economic activity of the markets.  Monetarists see politics and bureaucracies as barriers to government 

attempts to deal successfully with market failures, which they see as just one step toward a self-correcting 

market mechanism.   Monetarists tend to reject activist policies because of uncertainties, policy lags, and 

government incompetence.

    Which of these two approaches are currently in favor depends on the state of our knowledge of the 

causes and effects in macroeconomics and also, perhaps largely, on politics.  The close link between the 

state of the economy and politics is summed up by the "misery index," which has no scientific basis but so 

closely predicts the political fortunes of incumbent governments that most believe it does contain substantive 

information about the electorates’ views on how well the government has managed the economy.  The misery index 

is the sum of the inflation rate and the rate of unemployment, two measures of national performance that are 

easily understood and monitored by the voting public.  Incumbents tend to be thrown out when the misery index 

is rising.   Economies are alike in that they hold their governments responsible for the health of the economy. 

Where they differ is in how hands-on the government should be (a "normative," as opposed to a "positive," 

statement) in making things better!

The Poor Pay Czar

The poor pay czar is lamenting his task: how to limit the pay of executives at companies receiving a bailout without undercutting the ability of the firm to secure talented management.  "It's a delicate balance!  Very difficult indeed."  Well, Mr. Czar, difficult for you, maybe, but a piece of cake for the labor market.  That's exactly what the labor market does, day in and day out, quite naturally.  

Compensation should not be the purview of an appointed administrator serving at the pleasure of the executive branch of the U.S. Government.

Yes, President Obama! Cut taxes!

President Obama said a good thing yesterday.  He proposed cutting taxes to small business to help spur job creation and economic growth.  This is good. Very good. Here's why:

Beyond the theoretical justifications for cutting the capital gains tax, how much wealth would actually be added to the economy if we cut the current capital gains tax rate of (an average of) 15%? I estimate that every dollar of capital gains collected by the government costs the US economy approximately $6.80 in economic wealth.   This is how I came up with this estimate.  

For every $100 in corporate earnings, a 15% capital gains tax represents $15 that the firm could have either distributed as dividends (for a 0% net growth rate in next period’s earnings), or reinvest in the company to generate future growth (with a growth rate of 20% per year considered healthy).  Most experts agree that a reasonable estimate of a sustainable annual growth rate in earnings is somewhere between these two extremes, say 5%. 

I combine this 5% growth rate with a ten-year investment horizon and a discount rate of 12% per year (using the 80-year average rate of return on the S&P 500) and find that the Present Value of the annual savings of $15 in capital gains taxes is $102. So every dollar of Capital Gains protected from taxes produces approximately $6.80 ($102/$15) in new economic wealth for our economy.

This increase in economic value enables economic growth in America, while also creating more jobs for Americans as companies create more revenues to allocate to new hires and higher salaries.  Every dollar that is collected by the government in capital gains taxes could have supported an additional job instead. In an economic time when the unemployment rate nears 10%, cutting the capital gains tax and increasing the production value of our economy is critically important. 

Parenting the Government

Okay. If you tried this ploy on your parents, you wouldn't get away with it.  If your kids tried it you, you wouldn't fall for it either.  So why are the American people letting the Government get away with this ploy?  I don't know. And I don't get it.  Maybe there is just so much going on that it gets lost in the mix. Maybe it's because of the deceptive and disingenuous way it's being presented by Pelosi, Reid, and Obama.  

Here's the ruse:  "Give us more of your money today, and we will reduce tomorrow's health care costs. We will increase efficiency.  And we will do all of this without increasing the budget deficit!"  

Yeah, right.

What exactly is stopping them from reducing health care costs and improving the efficiency of health care delivery now? Why do they need more money today to accomplish these things tomorrow? What magical powers does the next dollar of tax collections have that the current ones don't? 

Exactly.  None.  So when Congress asks to increase taxes and the deficit in order to fix health care tomorrow, let's respond to them as we would our clever but errant children: Ask to see some proof today first. 
 

You know how that will turn out. And so does Congress. That's why they just keep promising the moon.  What I don't get is why we continue to let them get away with it.  

The Insanity of Medicare 2.0

We've all heard this definition of insanity: doing the same thing over and over again but expecting a different result.  

Here, in a nutshell, is the insanity of the current U.S. health care debate:

1. Medicare, the government's single-payer wealth redistribution health care program, is quickly going bankrupt.  No one disputes this fact.  

2. When President Obama refers to "cutting costs of healthcare," he is referring to cutting the Medicare budget. Period.  No increased efficiencies, no improved services, no reduced market-clearing prices. No, cutting costs refers to reducing the fraction of the U.S. government's tax collections devoted to Medicare.

3. The new Health Care Plan is fundamentally a new Medicare program. Let's call is Medicare 2.0.

4. Medicare 2.0 is being funded in large part by cutting the current Medicare budget item. We are supposed to ignore the fact that the funds cut from the current Medicare program will be spent on Medicare 2.0.  

5. The Medicare 2.0 plan shifts as much as 25% of its (under)estimated costs (e.g. payments to physicians) to other accounts.  The costs are still there; these obligations would still need to be paid by the government under the proposed legislation, but Congress is hoping the public won't "count" the shifted costs if they slap another name on them, further fostering the illusion of "lowering costs of health care."

5. Medicare 2.0 will also go bankrupt but, as a larger, more far-reaching entitlement program, the impact on the U.S. budget will be larger and more far-reaching.

Corporate Executives, I need your input!

Hello All,

I need some backup from corporate executives! Please have a look at the sequence of comments and replies in the thread on "Anger over Executive Compensation" on www.learningfromdogs.com,

http://learningfromdogs.com/2009/11/28/anger-us-compensation/#comments

where I am one of five co-authors who are attempting to discuss important issues with integrity and thoughtfulness. The comments this post are receiving are decidedly one-sided.  Henry Mintzberg's recent piece in the Wall Street Journal calling for the end to all corporate bonuses didn't help much.

http://online.wsj.com/article/SB10001424052748703294004574511223494536570.html

So, I need for you to add your insight and input! Please comment!  Thanks.

Let's Introduce Obama's left hand to his right!

As I was perusing the business press this morning, an article caught my eye:  “That would make a great post!” I thought to myself.  I continued reading through the rest of the articles, intending to go back to the one that piqued my interest to compose a comment.  Of course, when I went back, I could not find it!

But in the process of looking for that particular paragraph, I noticed something troubling. Something that, should my students’ papers include the same, would bring their score down by a full letter grade, if not more.

That troubling observation can be summed up in two words:  internal inconsistency.  My students and I don’t agree on everything, and don’t have to.  They can take any point of view in their written assignments in my class, but their views must be well-articulated, free of factual error and, perhaps most important of all, internally consistent.

The internal inconsistency of the policies coming out of Washington discussed in the news gave me a bit of a headache. While one article stressed the problems with winding down the massive mortgage-related asset accumulation at the Federal Reserve, another discussed the Treasury Department’s efforts to push banks and other mortgage companies to provide more relief to troubled homeowners.  While one article concluded that all executive compensation bonuses should be outlawed, another discussed how President Obama was reaching out to those very chief executives for advice on how to save jobs.  The Federal Reserve strives to ease credit while paying banks to hold onto their excess reserves rather than lend them out. The business section contains a half a dozen articles on programs and legislation – from health care to cap and trade -- that will increase taxes, and one or two articles on how businesses are having to cut back, convert full-time employees to part-time contract workers with no benefits, just to survive.

We need leaders in Washington who can step back and survey the whole of the landscape, who can see that the policies being promoted by Obama’s left hand are slapping up against those being waved about by his right. 
   

We shouldn’t be spending money to rescue bad mortgages when the policies of the government created those bad mortgages in the first place.  We shouldn’t be punishing private business executives while pretending to ask them for advice that the White House had absolutely no intention of following in the first place.  We shouldn’t be raising taxes and the other costs of doing business when we need private industry to keep our labor force gainfully employed. 

In fact, full employment is the key.  Focusing all policy, all efforts, all spending, on allowing free enterprise to do what it does best – hire labor and capital to produce goods and services that private consumers want and need -- is the solution to the problem. 

For example, gainfully employed people who go to their local bank to get a mortgage will be assessed on their true credit-worthiness without some Treasury Department official breathing down the next of the lending officer and telling them they have to extend credit for the greater good.    With full employment, foreclosures fall to normal levels.  Mortgage-backed securities are priced correctly.  There are no toxic assets for the Federal Reserve, in cahoots with the creative-accounting-extraordinaires at the Treasury Department, to pile onto their balance sheet. And the Fed would not now be undergoing experimental reverse-repos (WSJ20091130) to try to unwind the massive increase in assets (from $800 billion to $2.5 trillion by the time it’s over) without further upsetting the credit markets, fueling fears of latent inflation, and undermining the strength of the dollar. 

Ah, the internal inconsistency— better yet, the ETERNAL inconsistency -- between business and politics. 

U.S. Growth Rate Revised Downward

As expected, the Commerce Department http://www.marketwatch.com/story/us-third-quarter-economic-growth-revised-to-28-2009-11-24 has revised downward its estimate of the U.S. growth rate from the third quarter of 2009. Citing weaker consumer spending than originally estimated, the annualized growth rate is now 2.8%, down from 3.5%, far too weak to make any progress on the employment front. 

Commercial Real Estate and the U.S. Financial System

The U.S. banking system remains vulnerable to sizeable potential losses as the housing market struggles to recover.   Estimates of these losses range from $500 billion to $1 trillion. The Federal Reserve Board is especially concerned about the impact of commercial real estate on many regional and small banks across the country.  Occupancy and rental rates continue to decline dramatically as 2009 draws to a close, and the worst seems yet to come. 

Commercial real estate loans on banks’ balance sheets total almost $1.1 trillion dollars.  With near-term commercial real estate losses topping $100 billion, the Wall Street Journal estimates that as many as one-third of small and mid-size U.S. banks could experience financial distress. 

 
 

Troubled banks restrict lending until they can raise more capital.  In this illiquid market, expect banks to fight for survival by raising lending rates, shortening maturities, and lowering loan amounts.  Credit will continue to shrink in the U.S., which spells big trouble for any economic recovery. 

 

Housing and the Recovery

As an economist, I am frequently asked for my predictions on when the economy is going to turn around.  Have we reached the bottom?  Have we begun to recover?  Might we go into a second, perhaps more severe recession? 

Those are tough questions to answer.  Business cycles are notoriously difficult to predict.  In fact, about the only thing we know for sure is that no two business cycles are alike. Each is unique in some significant way. 

Changes in the housing market may be one of the most meaningful indicators of a recovery, because housing stability is such a fundamental indicator of how households are budgeting their income.  Notice that I did not say that the level of homeownership was a useful indicator; instead, I look to changes in the housing market, either away from or toward an apparently sustainable and affordable supply of homes, for evidence of where in the business cycle the economy may be.

Despite record low mortgage rates and first-time home buyer credits, the U.S. housing market remains anemic.  Rising foreclosures in several major metropolitan areas will keep housing prices low for some time to come.  The U.S. currently has about 1.7 million excess housing units available.  Typically, about 1.3 million new households are formed in the U.S. per year.  But with the unemployment rate topping 10%, new household formation will fall to about 1 million per year.  If new home construction remains at its current level of about 600,000 units per year, it will take over 4 years (1.7 million/400,000) for the excess supply of housing to be absorbed and housing prices to recover. 

Recovery rates will be much slower in some markets, such as in Florida, Nevada, and California, but I believe that the rest of the U.S. along with most other developed economies are looking at a three- to four-year period of time before housing and thus the overall levels of output return to their pre-recession levels. 

Why the Anger over Compensation?

It came up again in conversation today:  someone was offended and upset over the level of compensation of some senior executives in the U.S. economy.   I have to admit I just do not understand the anger. And I have a fundamental lack of respect for the arguments that have been served up thus far in support of the position. 

I have tried to resist drawing the conclusion that the anger is born of envy, but I am very close to throwing in the towel on that one.  Why should we begrudge anyone who earns a healthy salary, especially in an economy that provides each of us the opportunity to aspire to the same?

Even if there were reasonable ways around the practical issues and costs associated with legislative caps on salaries -- how to set them, who sets them, using what measures, what value judgments -- it simply makes no sense.  It is the antithesis of a competitive market economy where individuals have the incentive to learn, grow, work hard, and succeed.  It ignores the role played by capitalism in creating a strong and vibrant private economy that provides endless opportunities for all who want to put in the hours and the effort to succeed.  

U.S. corporate governance rules provide the framework for determining the compensation for senior executives, and it works remarkably well.  Each shareholder, or owner of the company, gets one vote on material issues such as reorganization. The Board of Directors is responsible for hiring and firing senior management on behalf of the shareholders.  If the shareholders do not like the decisions of the board, including those that set the level and form of compensation for senior management, they have at least two, very effective choices. They can either sell their shares in the company or they can vote to replace the board members.  The board can take several steps if, after negotiating the compensation package for senior management, the executive fails to perform. The board can withhold the bonus, renegotiate the terms of the contract, or fire the executive.  Then the long, mostly objective arm of the competitive labor market will determine the market-clearing value for the skills and experience of the recently fired executive.  

One thing I've never quite understood is why the market doesn't seem to exact more punishment on senior executives who run their companies into the ground.  Maybe there is an old boys network that looks out for ex-executives; maybe my observations are biased; maybe I notice only those cases where failed executives rise again.  But it's an empirical question, in any case; we can gather data on the issue and study it objectively.   

Regardless of the conclusions of such an analysis, however, decisions about executive compensation must remain in the labor market where your ability to produce economic value still reigns supreme over your ability to curry votes and political favor.