Posted tagged ‘The Economy’

US Government Debt – Non-Debate of Know Nothings

February 27, 2013

One of the most frustrating things about the US government, at least to anyone who actually tries to pay attention, is that there is never any debate and the statements made by the opposite parties seem to all be made without any attempt to actually understand the issues at hand.

If you have an interest in being informed about the US Government debt situation and the alternate courses of action for resolving the situation, there is now an alternative for you to listening to the non-debate by know nothing politicians.

Wharton is making a set of 15 essays from scholars in law and economics about the US debt history, applicable laws and the potential consequences of alternate strategies for resolution available.

This 250 page book is available free here.

These essays come from a conference hosted by Wharton in 2012.  Here is the introduction to the book describing the conference and the resulting essays.

The opening panel explored the functions of U.S. Treasury instruments and the Treasury market in the United States and beyond.  U.S. Treasuries play a unique role in the national and global economy. Richard Sylla put their current role in historical perspective,  observing that U.S. government debt obligations from their birth in  the revolutionary days have been much more than another means to finance the government: they cemented the political union, served  as a currency, backed the banking system, and helped attract foreign  capital.  William Bratton,  Richard Herring, and  Zoltan Pozsar then discussed the Treasuries’ role in the modern financial system,  including corporate finance, banking and shadow banking in the  United States and around the globe. While other reserve currencies and assets may eventually displace the U.S. dollar and the U.S. Treasuries, none are readily available at this time, and some that have  served as substitutes in the past (notably agency securities) ultimately rely on the credit of the United States.

The second panel considered constitutional, statutory, and contractual dimensions of U.S. government debt.  Michael McConnell opened with an examination of the U.S. Constitution as a fiscal  framework based on legislative control of taxing, spending, and borrowing. Howell Jackson then returned to the statutory debt ceiling  controversy, lifting the curtain on a plausible sequence of events had  the President and the Congress failed to compromise as they did at  the eleventh hour in the summer of 2011. In addition to Jackson’s  essay, this volume contains a policy brief by Jeremy Kreisberg and  Kelley O’Mara detailing the Executive’s options for honoring U.S.  government payment obligations with the debt ceiling unchanged. Richard Squire  concluded with thoughts on the market in credit  default swaps on U.S. government debt.

Peter Fisher gave the luncheon keynote, where he brought his perspective as former U.S. government debt manager, central bank official, and market participant to bear on the themes of the conference. Echoing the first panel, his remarks urged closer attention to the  sources of demand for U.S. Treasuries both at home and abroad. He  surveyed the experience of Britain in the 19th century and Japan in  the late 20th to identify some of the demand factors that help account for the ability of countries with very high debt burdens to avoid default.  The focus on demand in the U.S. banking, shadow banking,  and global financial systems suggests cautious optimism about the Treasuries’ prospects going forward.

The first afternoon panel revisited the questions of U.S. ability and willingness to pay, which has been debated heavily in policy and academic circles. A sovereign’s ability to pay is a function of its ability to generate revenues, which depends, among other things, on  the economy’s capacity to grow and on the government’s political  capacity to collect taxes. The line between ability and willingness to pay can be notoriously fuzzy. Deborah Lucas examined the structural sources and magnitudes of U.S. fiscal imbalances and the policy  changes needed to avoid them. While conceivable, default remains unlikely; however, risks from rising healthcare costs, slow productivity growth, a spike in interest rates, and contingent liabilities can tip  the outcome.  James Hines observed that while the United States imposes a smaller tax burden than other large wealthy economies,  its greatest unused tax capacity is in expenditure taxation that would  alter the current distributional bargain.  James Kwak put the U.S. fiscal challenge in historical and political perspectives, analyzing the  structural and policy steps needed to address the debt problem, and  the political capacity of the U.S. government to take these steps.

James Millstein suggested that asset sales—such as sales of mineral  rights—merit serious consideration as part of a package of debt reduction measures. His contribution drew on the history of sovereign asset sales, adapting it to the current needs of the United States.

The conference culminated in a panel discussion of a “thought experiment” laid out in Charles Mooney’s contribution: what if the  United States decided that it was in its interest to restructure U.S. Treasury debt? How might it go about it? What legal and policy options would the U.S. government have, what are the pros, cons, and  likely consequences of taking any of these steps?  His paper considers constitutional, statutory, market and transactional challenges to default and restructuring, and presents three options for a hypothetical  operation. At the conference, he laid out the strategy for across-the-board and selective exchanges of outstanding U.S. Treasuries for new  obligations, including the possible issuance of “Prosperity Shares,”  non-debt securities giving creditors a stake in future growth.  Donald Bernstein and Steven Schwarcz offered comments on the paper.  Bernstein was skeptical of recourse to the bankruptcy powers, and  pointed to the many hard policy challenges, including loss distribution and policy reform, that would remain unsolved even with  recourse to bankruptcy. Schwarcz noted further possibilities for restructuring, and obstacles to selective default. In addition, his contribution explored the problem of government financing through special purpose entities, and urged oversight to improve accountability.

Throughout the day, conference participants from different academic  disciplines and backgrounds engaged in lively discussion. We did not  strive for a policy consensus, nor did we achieve one. Our purpose in the volume, as it was in the conference, is to start a conversation  long overdue. We hope it will continue. If the conference convinced us of one thing, it is that the stakes in the future of U.S. government debt are too high to confine serious analysis and informed debate to legislative back-rooms and disciplinary silos.


Should we be concentrating regulatory attention on Systemic Risk?

January 1, 2013

Think of it somewhat like the town that just suffered a very bad winter season with huge snowfalls that they were unprepared for clogging up everything for weeks on end. They spend the spring fixing up and deciding what to do. Their conclusion is to have all town employees carry snowshovels at all times and to keep snow plow trucks patrolling the streets all day and all night through the entire summer. Sometime in early fall, they decide that was a waste of time and sell all the shovels and trucks by the end of the fall.

RISKVIEWS does not think that our situation will include any systemic risks that we will anticipate. We will not repeat the exact same mistakes. Systemic risk oversight will in the end be a fixed Maginot Line defense.

What we need is

  1. to figure out how to distinguish between creation of wealth by new innovation and by extraction from past innovation so that we can encourage the former and discourage the later. The former widely distributes increases in wealth while the latter concentrates it.  The former creates growth while the latter captures the benefits of future growth now – which means that we will not have them later.
  2. to understand leverage better. Look at the Minsky Financial Instability Model myself. Often, we are not honest with ourselves on the extent of debt. RISKVIEWS favors full disclosure over regulations. For example, firms should disclose the amount of debt that is implicit in derivative positions. And disclose the counterparties for that debt.
  3. to figure out how we are going to find the next big thing that will employ all of the people who are now permanently, structurally unemployed. We can keep hoping for something that increases wealth, something that merely decreases wealth less than the current situation or something that decreases wealth but employs people.
  4. to orient research into how to operate an economy in the long term with much less or no growth. Most of our economic expectations are built off of a constantly growing economy. With population about to start falling, we will necessarily experience much less growth. We don’t collectively even have any idea of what the shift to large retired populations will do to our economies.

The regulators need to focus on whatever is within their purview that gets in the way to accomplishing those things.

For the town above, that means storing the snow shovels to the winter and looking at the problems of the summer heat. They still need to keep an eye out for the next winter. But that does not mean it needs to be a primary focus NOW.

A Very Slow Emerging Systemic Risk – The Retirement Drain

August 12, 2012

This Systemic Risk is caused by the Central Banks. It is a pure and direct conflict between the “Real economy” and the “Financial System”. The Central Bankers have been taking actions to shore up the Financial System, i.e. the Banks, without any regard for this particular Systemic Risk. Perhaps they do not notice. This risk has never hit before.  But it is showing up almost daily in the press.  And it is massive.  It effects a generation of people.  And it is likely to be the most pressing worldwide financial issue of the next 30 years.

This is the Retirement Drain issue.  It is the opposite of a bubble.  It will be a constant drip, drip, drip of the assets of the retirees being liquidated to fund their living and medical expenses.  Looking backwards, it is quite possible that financial commentators will eventually decide that the two bubbles of the last decade or so are a direct consequence of the extra savings in the run up to the Retirement Drain.  Too much money that out ran the capacity of the world economy to invest productively.

But the current central bank actions are and will continue top have a very serious impact on this cycle.  The central banks have been doing all that they can to depress interest rates.  They may get what they want from that action, but they are making the Retirement Drain much worse.  The low interest rates are a transfer of wealth from the savers to the spenders in society.  From the old to the young in general.  At some point, the old will spend down their assets.  The selling of financial and real assets over the next 30 years will be putting immense pressure on prices for both over that whole time.  Just as the working lifetime of this generation of retirees has featured a general upward swing in the world economy, the retirement phase will see a massive disinvestment and the concurrent drop in world economic activity.

And the current low interest rates are making it more and more likely that the accumulated savings of the folks who did put aside money will be insufficient.  So folks will eventually sell all of their assets and then finally need to be supported by their children and grandchildren’s generations.

The problem is fundamentally demographic.  The failure of this generation to produce enough children to support them in their retirement results in the situation that the retirees will be supported by fewer and fewer working folks.  Just as a major portion of the boom of the last 50 years was actually a demographic phenomenon.

Almost all of the major economies of the world will be facing this problem sooner or later.  That is what makes it Systemic.

Let’s hope that we do not willfully deny the problem.

Are Home Prices Low – or Just Right?

April 24, 2012

Today the Case Shiller index is again released.  Woe is us say the pundits.  But are we again making the mistake of comparing to the wrong base?  Did any of the appreciation of the last 10 years make any sense?  Is there any reasonable expectation that homes will be going back to their values of 2007?


Looking at CPI inflation since home prices took off, we see that inflation has averaged about 2.5%.  And with 2.5% inflation in home prices since 2000, the index should be at 135.  Which is just about where it is. 

So maybe home prices are just right now.  Maybe they make sense for the first time in 10 years.  Maybe we just need to recalibrate our expectations. 

The same sort of analysis can be done with equities.  Much press was made off the fact that at some point in the last two years, equity markets stood at the exact same level as 10 years ago, or even slightly lower.  However, ten years earlier, equities were near the peak of the tech stock bubble.  So making any long term conclusions about the viability of equity investing based upon the prices at the top of a bubble is just wrong headed. 

Both houses and stocks are bad buys at the peak of a bubble.  Neither should be expected to beat inflation by 10% per year.   Long term returns should never be based upon bubble peaks but it may be the case that bubble troughs are simply bringing prices back to sensible levels. 

And since this is a blog about risk – it is necessary to point out that expectations for returns that were formed during bubble periods are very risky when the party is over.  

Wrong decisions come from unrealistic expectations.

How Much Debt is Too Much?

August 13, 2011

It seems limitless.  The amount of debt that a AAA firm can guarantee.  But it really isn’t.  It seemed limitless to AIG.  So limitless that they were willing to hire a bunch of traders to trade off the AAA of AIG to make an extra $25 or $50 million a year.  Eventually, AIGFP became a major part of the firm’s profits.  But to keep contributing to the growth of the earnings of AIG, they had to take on more and more.  To put the AAA more and more at risk.  Until, one day, it was too much.

So it seemed for a AAA country.  There seems to be no evidence that anyone thought that there was any limit to the amount of debt that the US could take on or guarantee.  At least not since Rubin was in charge at Treasury.  Wars and Tax cuts and Prescription Drugs and bank bailouts and auto bailouts and stimulus spending and taking on the debts of Fannie and Freddie.  No end, and seemingly no consideration that there was any limit.

Source: IMF World Economic Outlook

People also operated as if debt does not matter.  They were living high off of the “house as ATM” thinking.  Without thinking that they were adding debt.  Few people realized that if you have a $1 million house and a $1 million mortgage that you were not the same as someone without a house and without a mortgage.  The 100% leveraged house had tremendous percentage upside for the homeowner, but also tremendous downside.  Again, few realized that they were $1 million exposed to housing price fluctuation and that they were also exposed to a huge amount of earnings risk.  If their earnings went down, they were still liable for the mortgage.

It was all what Minsky called Ponzi thinking.  During the Ponzi phase to the economy, many people would make choices to expand their debt with the presumption that they would take out future loans to pay off the debt.  During this phase, some or if the phase lasts long enough, most of the investments are not at all self supporting.  New debt can only be sustained by future borrowing that is needed for both the payment of principle and interest.  Sounds crazy, but a significant amount of the mortgage debt that has given so much trouble was written on exactly that basis.

Minsky had two more phases.  The speculative phase is where normal investment activity in the economy could support the interest payments on the debt that financed it, but the loans would need to be rolled over to provide support for the principle.  Commercial real estate is usually financed on this basis, in good times and bad.

The hedge phase in where the business investments are able to support repayment of both principle and interest.

Minsky described the economy as shifting between the three phases.  He thought that the Fed had enough control over the banks to keep the economy from staying in the Ponzi phase for too long.  The Ponzi phase would often be accompanied by inflation so the Fed, even if they did not buy into Minsky’s theories, would move to put a stop to the extreme overleveraging of the Ponzi phase.  (But if you remember, they did not this time.)

So how much debt is too much?  Certainly when the amount of debt gets into the Ponzi stage, it is too much.  Personally, I like to keep my personal debt in the Hedge range.  But businesses and countries that are more eternal than RISKVIEWS may think it best to maintain a Speculative level of debt.

RISKVIEWS would suggest that businesses and countries need to look at their debt levels over a cycle.  So that they should avoid the excesses of Ponzi borrowing in good times and in fact stay closer to the Hedge end of Specultative borrowing in the best of times so that the borrowing increases in the worst of times does not push things into the Ponzi phase.

That is really the underlying issue that is facing the US and EU about sovereign debt levels.  They ran up too much debt in the good times, towards the Ponzi end of Speculative and the extra spending and lower income of the bad times have run them into Ponzi levels.  And at the bottom of the cycle, it is difficult to envision getting back to a lower speculative level.

‘This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success and say, as their predecessors have for centuries, “This time is different.”  from This Time is Different: Eight Centuries of Financial Folly, by Ken Rogoff and Carmen Reinhart

Major Regime Change – The Debt Crisis

May 24, 2011

A regime change is a corner that you cannot see around until you get to it.  It is when many of the old assumptions no longer hold.  It is the start of a new set of patterns.  Regime changes are not necessarily bad, but they are disruptive.  Many of the things that made people and companies successful under the old regime will no longer work.  But there will be completely new things that will now work.

The current regime has lasted for over 50 years.  Over that time, debt went all in one direction – UP.  Most other financial variables went up and down over that time, but their variability was in the context of a money supply that was generally growing somewhat faster than the economy.

Increasing debt funds some of the growth that has fueled the world economies over that time.

But that was a ride that could not go on forever.  At some point in time the debt servicing gets to be too high in comparison to the capacity of the economy.  The economy has gone through the stage of hedge lending (see Financial Instability) where activities are able to afford payments on their debt as well as repayment of principal long ago.  The economy is in the stage of Speculative Finance where activities are able to afford payments on the debt, but not the repayment of principal.  The efforts to pay down debt will tell us whether it is possible to reverse course on that.  If one looks ahead to the massive pensions crisis that looms in the moderate term, then you would likely judge that the economy is in Ponzi Financing land where the economy can neither afford the debt servicing or the payment of principal.

All this seems to be pointing towards a regime change regarding the level of debt and other forward obligations in society.  With that regime change, the world economy may shift to a regime of long term contraction in the amount of debt or else a sudden contraction (default) followed by a long period of massive caution and reduced lending.

Riskviews does not have a prediction for when this will happen or what other things will change when that regime change takes place.  But risk managers are urged to take into account that any models that are calibrated to historical experience may well mislead the users.  And market consistent models may also mislead for long term decision making (or is that will continue to mislead for long term decision making – how else to characterize a spot calculation) until the markets come to incorporate the impact of a regime change.

This may be felt in terms of further extension of the uncertainty that has dogged some markets since the financial crisis or in some other manner.

However it materializes, we will be living in interesting times.

It’s the Jobs, Stupid

March 29, 2011

Some time ago, economists noticed that people, or consumers in their terminology, are important to the economy.

What would we see if we assumed that it is not markets, or traders, or businesses, but people that was the only important factor in understanding the economy?

Here are some thoughts:

  • The Great Depression was a symptom of a problem that people had.  That problem was that there was no place in the economy for a large fraction of the population.  The introduction of the tractor and the combine harvester greatly improved the productivity of agriculture.  The flip side of productivity is a reduction in the need for laborers.  The massive unemployment of the Great Depression was not due to an irrational contraction in demand.  There was a rational contraction of jobs.
  • The efforts to stimulate economic activity during the depression failed because there was literally nothing for the vast numbers of unneeded farm workers to do.  Nothing that they had the training or the experience doing.
  • When WWII came, the war effort resulted in America becoming the factory of the Allied efforts.  Americans were trained en mass to work in the modern factories.  This changed the labor situation in the US drastically.
  • During WWII, the other large advanced economies in the world destroyed each other’s economies.  When the war was over, the American economy was able to quickly switch over to peacetime manufacturing and the global competition was busy rebuilding.  So America had a period of time to create a huge lead in its capabilities.  The manufacturing economy created great wealth and when the European and Japanese economies came back up to speed, there was more than enough for all to be wealthy.
  • Starting in the 1990’s another wave of productivity enhancement started with the internet and other electronic media.  At the same time, many of the advanced manufacturing jobs started to shift to China as it opened up to trade with the outside world.  The China wage for manufacturing was originally 10% of the American wage for manufacturing work.  India did the same for office work providing a source of office labor at 25% of the American wage.
  • In the first decade of 2000, the housing boom masked the situation.  Many people found that they had enough wealth to spend for what they wanted from the inflated values of their homes.  Many people were employed in the housing construction business, building homes that were ultimately found to be unwanted.  White collar jobs were also created by the housing boom selling houses and processing the mortgages that turned out to be so, so bad.
  • The Financial Crisis can be seen as another situation like the Great Depression.  There are no jobs for a large fraction of the population in several countries including the US.  Without jobs, because there is not enough work in those economies for their skills.
  • The unemployment problem will be not be solved by simple stimulus.  The manufacturing and construction skills of a large segment of the working age population are no longer valuable enough to support a middle class lifestyle in the advanced economies.
  • At the same time, there is a demographic issue.  Well known.  The retiring Baby Boomers may cause a major shift of spending further away from investing and into consumption.  Satisfying their needs will probably solve the short term employment issues in the economies of all of the advanced nations.  Growth of economies has been driven in part by growth of populations.  There is no model for operating a segment of the world economy with a shrinking population that is favorable to that segment.
  • The advantage that America had because of WWII has by now completely dissipated.

This related to risk and risk management because of the relationship between leverage and risk.  One of the solutions that has been a reaction to the slow growth is leverage.  And slow growth plus leverage is the recipe for disaster.  More on the relation of risk and leverage in another post.

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