Tom’s Outlook
2nd Quarter 2009
The long run is a misleading guide to current affairs. In the long run we are all dead.
Economists set themselves too easy, too useless a task if in the tempestuous seasons
they can only tell us that when the storm is past the ocean is flat again” John Maynard
Keynes
That it is the tempestuous season there cannot be doubt. Perhaps the Obama
administration will be able to bring a surprisingly early end to the U.S. financial crisis it
inherited. I certainly hope so, but the ride is likely to be quite perilous before the sea is
flat again. The weakly economic indicators I monitor have plunged to their weakest
readings since the end of WWII. The good news is that they have stopped declining. The
bad news is that there is no sign of improvement; rather they have bumped along the low
readings first encountered in early February. This indicates that the recovery will not be
starting until at least the fourth quarter and that is looking iffy.
Recent research by economist Carmen M. Reinhart and Kenneth S. Rogoff indicate the
climb out of the hole we are in may well be arduous. The good news is that financial
crisis, even deep ones as we now find ourselves, do not last forever. Negative growth
episodes last on average just under two years. If you accept the National Bureau of
Economic Research finding that the recession began in December of 2007 then the
economy should stop contracting by years end. If you date the “ real recession” as
beginning in September of 2008 then the end of 2009 is less compelling.
These economists studied every financial crisis in the world since WWII. They found that
in severe financial crisis the average real (inflation-adjusted) price of housing declines by
36%, with duration of peak through trough lasting five to six years. Given that U.S. house
prices peaked at the end of 2005, this means that the bottom won’t come before the end
of 2010, with real housing prices falling another 10% or so from here.
Equity prices tend to bottom out somewhat more quickly, taking about three and a half
years from peak to trough and dropping an average of 55% in real terms. The S&P has
been an overachiever matching that decline with a couple more years to go. This may
have something to say about the prospects the next couple of years.
In terms of unemployment, the duration of elevated unemployment lasted over five years.
In the richer countries studied the rise in unemployment was less but the duration was
longer than for emerging market economies in the study.
Perhaps the most eye-popping numbers in the study is the staggering rise in government
debt most countries experience. Central government debt tends to rise over 85% in real
terms during the first three years after a banking crisis. This would mean another $8
trillion or $9 trillion in the case of the U.S. The main reason for this debt explosion is not
the cost a bailing out the financial system, painful as that may be. Instead, the culprit is
the collapse of tax revenues that accompanies a deep and prolonged recession.
We now understand why my favorite newspaper headline post last fall’s election was
“The Onion” headline “ Black Man Hired To Clean Up White Man’s Mess”.
It is not once nor twice but times without number that the same ideas make their
appearance in the world - Aristotle.
There are approximately 15,000 professional economists in the country and only a hand
full can produce any evidence that they saw the current disaster coming. Most of these
thousands of economists teach, and most teach a theoretical framework that is best
described as a worthless tautology. They believe in rational expectations: that economic
man behaves with impeccable logic, that in turn causes markets to be efficient and reach
a stable equilibrium. This has been proven yet again to be utter nonsense. Yet many are
providing advice as to what form economic stimulus should take, “ targeted and
temporary” are the buzzwords. I believe this is a misunderstanding of the problem. Swift
action is necessary, but will only result in”boy scout water” type flair up on the grill if
recovery policies are not continued for a number of years and fundamental change does
not take place in the economy.
The prevailing view is that the problem is lack of aggregate demand that must be filled by
government. While there are elements of this, the core problem is a mismatch between
the goods and services demanded by the economy and the mix of goods and services
previously supplied. I doubt it is useful to try to restore full employment by fiscal and
monetary means alone.
The severity of the present crisis is an opportunity to remedy deep-seated problems. The
fundamental (not proximate) cause of our economic plight is the imbalance in current
accounts - in particular between East Asia and the US during the past decade. The
combination of the reckless US financial system, vacuous fiscal policy and irresponsible
American consumers accommodated by east Asian mercantilism and dollar overvaluation
led to the US housing bubble and the associated rise in private consumption as
households borrowed against the rising value of their home.
The personal consumption’s share of real GDP rose from 67 percent in the late 1990’s to
72 percent in 2007. Developing Asia pushed its export share of GDP from 36 percent to
47 percent over the same time period. We need to reallocate resources out of
construction, finance and debt-financed consumption. Even if successful in increasing
demand with the stimulus, we will just be back to a balance of payments deficit in two or
three years that is 6% of GDP. This is not sustainable. We need to allocate away from the
bubble markets and into tradable goods and investment. Likewise developing Asia needs
to develop a robust social safety net and stimulus for internal private consumption to
lower savings rates. If we adopt a grow now and ask questions later policy we will only
be inviting bigger problems down the road in a few years. The goal of economic policy
here is to ease the transition away from the bubble sectors and towards the next wave of
expansion. To his credit President Obama’s stimulus package appears to have at least
some understanding of this need, as it is framed around essential investment in
infrastructure, alternative energy, health care, transportation technologies, and human
capital.
John Maynard Keynes is the known as the father of fiscal policy. If he were here today he
would tell that fiscal policy today is executed in a manner completely different from what
he had in mind. For Keynes, the most bang for the buck would be achieved via direct job
creation by the public sector. There is much useful work that needs to be done addressing
the needs of an aging population, fixing infrastructure and parks, and pollution cleanup.
Food kitchens, homeless shelters and other social services are under funded and
understaffed. There is no shortage of useful endeavors that could be undertaken.
There are12.5 million people unemployed and the number is growing. We could put them
to work for a fraction of what we are spending on economic stimulus. If we offered jobs
to everyone willing to work my guess is that about half of the unemployed would show
up for work. If we offered $10 per hour plus 30% for insurance and overhead it would
cost $26,520 a year to employ a person in the public sector. 6.25 million could be
employed for $166 billion. This is less than a quarter of the budget for stimulus that is
estimated to employ 3.5 million. The newly employed will spend their incomes. That
will kick-start private sector activity. As a consequence the public sector would shrink
rapidly in subsequent years as private firms hire employees for better paying jobs.
We have seen a debate again recently whether such policies worked in the Great
Depression. Economist Marshall Auerback has set this record strait and shown us the
way:
[Roosevelt’s] government hired about 60 per cent of the unemployed in public
works and conservation projects that planted a billion trees, saved the
whooping crane, modernized rural America, and built such diverse projects
as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much
of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge
complex, the Tennessee Valley Authority and the aircraft carriers Enterprise
and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools,
13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and
a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s
entire rural school system, and hired 3,000 writers, musicians, sculptors
and painters, including Willem de Kooning and Jackson Pollock.
Roosevelt employed people on a vast scale. The unemployment rate was brought down
from 25% in 1933 to 10% in 1936. The mistake was made in 1937 when he tried to
balance the budget too soon. The economy relapsed into recession. In 1938 new deal
spending was relaunched and the unemployment rate was brought back to ten percent,
before spending picked up for the war. We have much to learn from history if we will
only make the effort.
I believe that banking institutions are more dangerous to our liberties than
standing armies... The banks and corporations that will grow up around [the
banks] will deprive the people of all property until their children wake-up
homeless on the continent their fathers conquered. Thomas Jefferson (1743
– 1826)
As bad as the economic situation is about 98% of the economic activity that was
happening last quarter is still in process. So the economy here has not lost a great deal of
purchasing power. For the most part Americans are not slowing consumption because
there incomes are falling but because they are frightened and because they need to make
up for investment losses. An aggravating factor is credit rationing by risk adverse lenders.
What the economy needs is to work on the two key factors that are causing the risk
aversion. The key problems are mortgage foreclosures and the major banks.
The Obama administration is following the mistaken policies of the previous
administration by trying to solve both problems with the government checkbook. In the
bubble years in the housing market house prices climbed over 30% above their long-term
trend. As we have discussed several times before research by Jeremy Grantham has
shown that every bubble has deflated back to its original trend. It is an impeccable record.
So unless you want the government (meaning you) to pay that 30% to homeowners or
financial institutions there will not be enough money available to fill this gap. In addition
I doubt if there is the political will to spend even a fraction of what will be necessary. If
you want an explanation of why, catch Rick Santelle of CNBC rant on U-tube.
Luckily we don’t need a lot of the government’s money to deal with the problem, but we
do need the government’s clout. I don’t think the problem can be dealt with forgiving the
debt of some and not others. A program that will work in slowing the process, and
provide some insurance against prices over shooting trend to the downside, would be to
allow judges in foreclosures to restructure mortgages by reducing the principle and thus
payments for the owners in return for adding the reduced amount to the back end of the
mortgage as an equity participation to the lender. The participation would be paid when
the property is sold or would follow the borrower until it is paid.
By my calculations we are not even half way through the foreclosures from the bubble.
We are hearing less, because we are in the eye of the storm, as the majority of sub-prime
loans have worked their way through the system. Beginning later this year and peaking in
2011 a huge wave of option ARM’s (many interest only and some with negative
amortization) and Alt-A loans are programmed to reset. The underwriting on these
vintages was every bit as bad as the sub-prime vintages and most of these were written at
the height of the bubble when house prices peaked. Given the state of the economy prime
and agency ARM loans will probably also be a problem. If we don’t have an affordable
plan as suggested above we can expect a second round of extreme economic difficulty
commencing next year which could lead to a double dip recession even if the economic
stimulus plan is a success.
We also do not need great amounts of government money to deal with the failed large
banks. However, the government is the only entity with the legal authority to deal with
the problem. Throwing government money at insolvent financial institutions cheats the
taxpayers by substituting their money for losses that should have been born by stock and
bondholders. Washington Mutual was the largest bank failure in US history when it failed
last year. This was accomplished with no loss to taxpayers or customers. The FDIC took
Wa-Mu into receivership wiped out the equity interest, sold the assets along with the
customer liabilities. The bondholders received what was left.
This model with modifications will work with the insolvent big banks. Citibank is the
largest of the Zombie banks. At the end of last year it had assets of about $2 trillion, $132
billion in equity (there in lies the problem), $360 billion in long term debt, and $200
billion in short term borrowings. The debt plus equity adds to about 35% of the assets.
This indicates that there is a large cushion of protection for the depositors should Citi be
put into receivership. Since Citi is too big to sell we would have to hold it in receivership,
appoint new management and relaunch the company, without debt obligations, as a new
entity. Perhaps we could come up with an innovative name like Citibank. The
bondholders could be the new stockholders or could receive some proceeds from an IPO.
We are currently pouring massive amounts of money into these institutions from more
sources than you can keep track of (i.e. through AIG) to protect the stock and
bondholders of these reckless institutions.
Making the two reforms in our approach would go a long way toward restoring
confidence and reduce the duration and intensity of what is turning into a very severe
downturn and doing so without breaking the budget. However, the American version of
crony capitalism prevents a reasonable solution. Instead we are left with Geithner’s
smoke and mirrors attempt to shovel taxpayer money to stock and bondholders of the
major banks. This is just the Paulson plan to overpay for toxic assets with bells and
whistles added.
“ Reckless fools lost first because they deserved to lose and careful, wise men
lost later because a world-wide earthquake does not ask for personal
references.” Edwin Lefebvre 1932
The data continue to indicate that the stock market is undervalued but not strenuously so.
My preferred measure of stock market value (Current S&P 500 divided by ten year
moving average of real earnings) currently stands about 14 times earnings. While this is
below the long-term average of 16 it is still considerably above market lows reached in
1982 and 1975 most recently and 20’s 30’s and 40’s previously. I would expect buy and
hold investors, putting money to work today with a seven to ten year time horizon, would
have a market return of about10% annually. Shorter-term however may be more
problematic. The turbulence in the economy and the lack of cohesive policy action has
engendered little investor confidence. If we do see market weakness (back below 675 on
the S&P) value investors would find it profitable to gradually increase their exposure as
valuations become more favorable, and cutting back on advances that are not
accompanied by improvement in the overall economy and broad based market internals.
In the bear market from 1929 to the bottom in1933, stocks declined 89%, but there were
six rallies that netted returns of 20% or greater. Each rally failed as the economy
continued to weaken.
Just to make you feel better, almost no investment strategy (treasuries and the dollar
being exceptions) would have produced a profit during the last six months. Research
Affiliates charts performance across 16 classes of assets including bonds, stocks,
commodities and loans from different countries. In the crisis months last fall all 16 fell:
an equal weighted portfolio in all of these classes lost 20%. These investments haven’t
regained much on net since.
The most common of all follies is to believe passionately in the palpably
not true. It is the chief occupation of mankind.
H. L. Mencken (1880 – 1956)]
Peter Peterson the co-founder of the private equity firm The Blackstone Group
and his buddy Robert Ruben with the aid of the Washington Post are spending
a great deal of time and money trying to convince you that entitlement
spending needs to be slashed to restore fiscal sanity to the government.
A brief look at the arithmetic of entitlements is necessary since a great
deal of disinformation is left over from the Bush administration’s 2005
social security privatization fight.
Right now the federal government spends about 9% of GDP on social Security,
Medicare and Medicaid with about a 50-50 split between retirement and medical
care. The retiring baby-boomer generation will increase this share in the
future. If we look out to 2050 we will go from 3 workers today per retiree
to a little over 2. This will, other things being equal, raise spending on
the programs by about 4% of GDP (not 4.5% because Medicaid covers
non-elderly).
4% of GDP is a lot but hardly the end of the world. Many western democracies
have government expenditures as a percent of GDP over 10 percentage points
more than us. What makes the projections you see so dramatic is the assumption
that medical cost will grow at 2% faster than GDP. This results in the
conclusion that health care cost will grow to over 12% of GDP by 2050. It
is the excess cost assumption and not demography that produces the scary
numbers. If excess cost in health care cannot be brought under control it
will not only destroy the Federal Budget but also that of households as well.
It is also ironic that the people making the noise come from industries
(CitiBank and private equity) whose reckless greed will cause a doubling
of the national debt in our attempt to keep the nation out of the great
depression of 2009 but they don’t want to contribute to the retirement of
the elderly.
As always, comments and suggestions are welcome. They should be written on
the back of $100 bills and sent to Address redacted (I don’t want my Dad
fired from his job.)
