Dr. Sherry Jarrell

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

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.

 

 

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. 

 

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

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.

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.

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.