Tuesday, September 24, 2013

Trumpet of Doom? Fed Tapering in 2013

Cartoon by Jim Gibson

What to say about Fed policy? The Fed surprised the markets last week by not starting a tapering program. Apparently Miley Cyrus also surprised the markets by not taking proper dancing lessons. Anyway, the result was that the stock market surged on that day and interest rates fell. The next days saw a reversal but stocks remain at record levels.

Why do markets seem to love bad policy? Wait you say – stalling on tapering is not bad policy. The markets know that a tapering program today would be terrible for the markets.  After all, the US economy has a zillion problems and therefore the Fed is the only game in town. The Fed cannot risk the recession that might ensue if they started tapering. That is the story I keep hearing. While I buy that many investors believe this story, that doesn’t make it right. Tapering is the right thing to do despite stock market hyperventilation.

So let’s pretend this popular story is a big ribeye and dig in. Let’s talk about the many problems that make the FED worry about recessionary risk.  One thing mentioned is the government standoff. Maybe there will be a budget shutdown. Another problem is Syria and how future developments might affect oil flow and energy prices. Then there is long-term government budgeting that promises a rising national debt. What about a declining labor force? And Kim Kasrdashian?

There are many problems that threaten a recession. They are as real as that roll around your belly. But let me ask you this. Can you name many months or quarters in the past 50 years in which we were not plagued by similar risks. How many months or quarters in the last 50 years were we absolutely sure a recession was not around the corner? I would say not many.  I also ask you how many times we were five years into a recovery and we were still worried about a double dip recession? Again, not many. 

So why the paranoia today? One reason for the continuing worry is that we had one helluva financial global meltdown. It was not your mother’s recession. This was a perfect storm recession from which some people believe or believed we would never recover. But we did recover. While we are not happy with the strength of the recovery and its impacts on employment, income and poverty, the economy has recovered and grown. These years of growth should reduce some of the paranoia. But not all of it. We are not growing properly and something needs to be done.

A lack of money in the economy is clearly not our problem and therefore seemingly endless monetization of the economy is not what needs to be done. If pouring a container of water on a grease fire does not work then why would pouring two containers of water on a grease fire work better? Notice that we have had substandard economic results despite unprecedented infusions of money. So now we are going to do more? The reason the monetary solution worked in 2008 but not today is because the problem in the US today is not monetary. Keeping interest rates low might be good for the stocks, houses, and cars, but if we keep this up many of us will be leaving pretty houses each morning and driving our nice cars to the unemployment office. Fed policy can feed some sectors but right now what we need is stronger balanced growth.

The President said he wants to grow from the middle out.  I seem to have no trouble growing from the middle out but that’s a different thing. If he wants balanced growth then I am on his side. Balanced growth means, I think, that we pay attention to our real problems. And we have plenty of them. But the difficulty is that we have a government that doesn’t work. These guys and gals can’t even agree on how many Martinis to have for lunch.  So why list again all those problems. Those yokels are not going to solve them anyway.

So that’s the basis of well-deserved paranoia. There is a way to put out a grease fire. But it takes a metal lid, baking soda, fire extinguisher, etc. If you do not have any of that stuff, then it makes absolutely no sense to pour water on the fire. It just makes it worse. That’s our situation in the US. Money has no remedial power for our current problems yet since the government has abdicated its role we keep asking the Fed to pour water on the flames.

But there is still this lingering question – Davidson if you are right then why aren’t you rich? The stock market blessed the Fed’s decision to put off tapering. Those people thought it was a good move. My only answer is that the stock market is only one response to the Fed’s actions…and a few days of changes are hardly evidence of anything.  Investors have benefited from a stock market that has recovered and is now entering new record high values. Who can blame investors for responding positively to more of the same?  But what about the thousands of business organizations that are not doing the wave right now? After the QE bonanza why are banks still sitting on hoards of excess reserves? Why are firms reluctant to borrow? Why are workers dropping out of the labor force?  Those actions speak louder than one day’s change in the Dow Average. Those behaviors are crying for a non-monetary appropriate solution.

Okay so maybe extending the current Fed policy is not helping but won’t tapering be too much for the economy to take now? I don’t think so. If you take away something that doesn’t add anything how can that lead to a subtraction? Taking away QE does not mean the Fed cannot increase the money supply. But QE is adding almost a trillion dollars of reserves each year. Even if the economy was growing at 5% it would not need that much more money each year.

In the 10 years from 1998 to 2007, the average increase in the US money supply (the version called M1) was $30 billion per year. The highest annual increase of $77 billion was in 2003. In 2012 the US money supply increased by $301 billion. We injected in 2012 more than 10 times the amount of money we usually need in one year – and we did that after increasing the money supply by $267 billion in 2011. It looks like 2013 will find another huge dose. This stuff does not disappear. It accumulates. We have enough money out there to support economic growth for about 30 years! We don't need more money -- we need bankers who want to lend it and firms who want to borrow it!

Tapering will not cut off liquidity in the US economy! I can’t be sure how the markets will react right after an announcement to taper, but I will bet a week’s supply of JD that after the initial reactions we will find ourselves with another Y2K…much ado over nothing. Get on with the tapering Ben and Janet.

Tuesday, September 17, 2013

Rising Mortgage Rates will not Kill the Housing Recovery

Cartoon by Jim Gibson

I do not know how many credit market columns I read last week that announced, lamented, and frantically worried about rising mortgage interest rates. It is as if a young couple fretted about the fact that their baby was reaching 22 pounds. For you people not from the US a pound is a unit if weight similar to a stone or a rock.  Most babies start at about 6 pounds and keep gaining weight until they become tackles for an NFL team. It is perfectly natural for the child to reach 22 pounds at some point.

According to the press, interest rates should not be allowed to grow up.  I will admit that US interest rates got very low. In fact a graph of the 30 year Conventional Mortgage Rate (let’s call this interest rate Mort) shows that Mort has not been lower since 1965.  http://research.stlouisfed.org/fred2/graph/?id=MORTG  Despite recent increases in Mort, he is still below every single data point since 1965 except the very recent time period starting from August 2010.

So rates are rising but they are rising only in comparison to about two years of historically low rates. Imagine living through a time period when the temperatures in Miami in July were 180 degrees F. You would have to admit that 185F in Miami in July is not normal. But then imagine when the temps went to 170F everyone started to worry about a coming freeze. People started cancelling vacations in Florida because they thought it would be too cold. Crazy right?

The graph of Mort is very clear. Starting in 1980 when interest rates rose to very high levels, the trend has been downward. That is right, for almost 35 years, Mort has been getting lower and lower. Of course there have been cycles around the trend and that means there have been times when Mort rose. But every upward phase was always followed by a downward one – one that left rates even lower than when the phase started. Consider these average Mort rates ---
            1985 to 89   10.7%
            1990 to 94   9.2%
            1995 to 99   7.6%
            2000 to 04   6.7%
            2005 to 09   5.9%
            2010 +        4.2%

As I write today Mort is about 4.5%. So it is higher than the 3.4% at the end of 2012 and the 4.2% average since 2010, but it is now considerably lower than any of the averages of the 5 year periods since 1965. It is also much lower than the average of recent years before the world recession.

Why are we so worried about Mort? The answer is that we are really worried about his cousin Heloise (Housing Starts). Heloise has not been well. Heloise is a shadow of her former self but has been improving of late. After coming in at a low ebb of 478,000 units in spring of 2009, Heloise has been rising hitting about a million starts in March of this year but settling in at a pace of over 850,000 starts since.

There is a worry that if Mort rises more that this will diminish Heloise. But this does not make any sense because it leaves out all those other variables that might impact the demand and supply for housing. Even at one million units per month, Heloise is more than a million starts below the previous annual peak and is probably only 60% of what might be considered a past normal result. Heloise remains weak despite super-record-low Mort. That means that there must be something else besides Mort that is bothering Heloise.

That something else is the same list of things that is keeping the general national recovery at a slow pace and restraining employment. Among the items in that list is an unfinished reform agenda that leaves banks and households uncertain about the future of housing, banking, energy, healthcare and more. Interest rates can and will increase.  But that should not be an alarming factor. It should be just the opposite. The rise in interest rates is signaling a stronger economy.  The risk of another major financial recession is slowly receding into the past. Output and incomes are rising. Employment is increasing, albeit slowly. This foundation means that the housing market will not vanish just because mortgage rates hit or exceed 5%. 

While we might not feel lucky the gradual US and world economic recovery will be a good thing for Mort and Heloise. As Europe, Japan, China, and emerging nations expand at a gradual rate, this puts less pressure on commodities and other markets and should keep inflation in check for a while. This will keep Mort in check as well. Note from the history cited above that trend Mort has come down for almost 35 years. Much of that can be explained by a secular decline in inflation and inflation expectations. So a key to Mort and Heloise happiness is keeping those inflation expectations damped.

In short the sky is not falling. Interest rates are going to keep rising as the economy gradually recovers. Housing will not be unduly troubled as housing demand marches back to more normal monthly starts. But a gradual recovery is not enough to guarantee success. Much would be improved by a return to sane monetary and fiscal policy. Removing stimulus means anchored inflation expectations. A sustained recovery is impossible without it. 

Tuesday, September 10, 2013

The G20 Blame Game

As the world puts Syria under the microscope you might need a little change of topic to keep from going mad. So I decided to write about my gall bladder. People my age spend at least 74% of their time talking about their physical ailments and while I feel pretty good today I could share a lot of medical information with you. But as I was researching shingles and Dupuytren’s contracture I ran across an article about the G20.
Apparently the G20 is meeting in Russia and there were many photos of Mr. Obama and Mr. Putin playing darts with hand grenades. Since most of you think the G20 is the latest sports car made by Pontiac I thought it might be helpful to explain what was going in Russia with the G20 and why we should care.

The letter G in this context refers to the word Group and the word Group applies to countries that want to discuss politics and international relations. G2 is used when the US and China get together to chat about common issues. More popular is the G7 which includes the largest and most wealthy countries in the world when they do not want to include China in their meetings. This includes such stalwarts as the US, UK, Canada, France, Germany, Italy, and Japan.  The Canadians usually bring the beer. Eh. 

Anyway, the G7 has been meeting to solve global problems since 1975 and most people would agree that this group of overweight and sex addicted world leaders have solved almost no problems except for increasing Canadian beer exports. But they do meet regularly and have spectacular meals and the meetings are always followed by much back-slapping and a published summary of meeting accomplishments and common goals. For example hardly a meeting goes by when the G7 does not underscore their sincere interests in global harmony and world peace.

At one meeting it was pointed out by one G7 member that there are other countries that have gone beyond national potty training and ought to be included as formal members of the group. Since the name of the group was G7, they were met with an immediate mathematical challenge of how they could have more than 7 members and still be called the G7. I think it was France who suggested that they add Russia to the group and call it the G8. Problem solved!

As you can imagine, once Russia was added, the other members of BRIC – Brazil, India, and China -- felt lonely, rejected, and insulted and demanded that they be added to the G7 as well. Of course, this caused a stampede of other countries like South Africa, South Korea, and South Carolina who demanded they be included. So far we now have 19 countries in something we proudly refer to as the G20. Apparently the European countries didn’t get enough face time so they added the EU as the 20th member. If your head is spinning at this point you may refer to the authority of all authorities – Wikipedia – for more information about the G20 at http://en.wikipedia.org/wiki/G-20_major_economies

The interesting thing about this most recent meeting in Russia is how the focus is on the US – and not just because of Syria, spying, and Miley Cyrus.  One issue has to do with US Federal Reserve policy. You know as a loyal reader of this blog that the Fed is talking about thinking about discussing and voting on the possibility that we might begin at some uncertain point in the future and in amounts not to be discussed in mixed company the idea of tapering. Tapering is now a four-letter word that brings out the worst fears in us. As a result of tapering discussions, the Eiffel Tower tilted and Al Gore admitted he did not in fact invent the whole Internet or fantasy football.

While I jest the truth is that the mere suggestion of reducing the rate at which we are dumping money into the US economy (think of water going over the Niagara Falls into a small cup) has already caused US interest rates to start rising upwards and hot money to flow away from many countries – and of course away from many G20 countries. The result is a chorus of countries singing in unison Amazing Grace. But I jest again. These countries sound like a chorus but the song is something more like the Everly Brothers’ Bye Bye Love or Hank Williams’ Your Cheatin’ Heart.

Despite triumphant announcements in 2008 that the emerging markets were finally de-linked from the US business cycle, we have seen how optimistic and wrong such pronouncements were. First they complained that the US was putting too much money into the world economic system. All that money was floating overseas and causing havoc in their financial systems and driving up their currency values. Now they complain of the opposite. Just the mention of tapering in the US and money is exiting these countries in waves. This is driving down their currency values. Apparently they are not as de-linked as they previously thought.

What are we to think about all this howling?  First, we are guilty as charged. One does not have to live in an emerging nation to dislike a very unstable US monetary policy. We in the US disliked how the Fed flooded the US economy with liquidity and then has gone well beyond the prudent point to begin withdrawing this stimulus. The Fed has generated a lot of uncertainty and unnecessary economic gyrations so that banks can sit around with mountains of excess reserves and the Fed serves as Obama’s lap dog dutifully running out into the street and collecting as many bonds as the government can sell.

So we can all be critical of the US Fed. But wait – don’t the other guys have some responsibility? After all, it appeared that they were less reliant on the US economy when China became the Miss Piggy of global commodity demand… or when they diverted much of their international trade to a growing list of other countries as globalization created more international opportunities. Perhaps some emerging market ire should be aimed at China for its failure to continue 10% plus economic growth or to Europe for having almost no coordinated economic policy despite being called a “European Union”. In short, these emerging market countries might spread their dissatisfaction beyond US monetary policy.

But if we are going to play the blame game – let’s not forget that these emerging nations have some responsibilities when it comes to economic growth. Globalization makes possible huge gains as emerging nations exploit comparative advantage and compete for manufacturing locations and exports on a global scale. But as the last 20 or more years have shown, to benefit from those opportunities these emerging nations had to be competitive. This meant that they had to transform what were often highly centrally planned economies into more decentralized capitalistic systems. These countries deregulated prices and wages; they privatized many formerly state-owned enterprises; they changed laws so that property could be protected and they allowed foreigners to own domestic assets and companies.

Some countries have moved farther along the transformation curve than others. Depending on the politics, some have taken two steps backward after moving forward. And this lack of completion of transformation is very telling. When the US catches a cold many of these countries get pneumonia. Why? Because we all know that these countries do not have balanced economies. All their eggs – so to speak – are in one or a few baskets. It is great when you create a lot of employment and income by selling copper to China. But when China slows its purchases from you, it is not so great. You can’t love hot money inflows one day and then deplore them the next when funds flow out. Hot money is hot money. If you allow your economy to rely on hot money or on China then you have to take the good with the bad. Or somehow find more balance.

It is this balance that is so elusive to an emerging market. If exports to China or hot money flows create great benefits, it is tempting to want to keep the benefits flowing. But this growth strategy is unreliable and risky. Most countries strive for self-sufficiency while they enjoy the benefits of international trade and investment. But economic broadening comes slowly and often means slower growth as the economy adjusts from the very risky unbalanced model to one that is more stable. Broadening also means tough  new policies that essentially replace government edict and protectionism with capitalism and competition. It is easy to blame other for your misfortunes but these major emerging markets have no one to blame but themselves. Blame the Fed if you want to but get on with the transformation process.

Tuesday, September 3, 2013

Don't Stop Believein' by Guest blogger Jerry Lynch

Jerry Lynch has been an economics professor at Purdue for over 30 years.  He also served as Associate Dean and Interim Dean of the school in various past fits of insanity.  He has returned to teaching the core Macro Policy class in the MBA program and is pleased to have this blogging opportunity to spout off.

Don’t Stop Believin’
                Just a city boy
                Born and raised in South Detroit
                He took the midnight train goin’ anywhere

The headline news just one month ago, now usurped by the crisis in the Middle East, was that the City of Detroit had filed for bankruptcy claiming to be unable to meet the payments to its creditors.  One of the questions asked when it first filed was whether or not it was legal for a city to file for bankruptcy.  That question seemed to be answered on a federal level when the city of Stockton was allowed to file last April.  However, a state judge ruled that the Detroit bankruptcy petition violates the Michigan state constitution. 

The declaratory judgment came in lawsuits filed by Detroit pension funds, retirees and workers, which sought to prevent a bankruptcy filing that would ultimately impair retirement benefits in violation of constitutional protections for those benefits.

Legally Detroit is at an impasse now on its bankruptcy proceedings.  While the legal wrangling is of interest to many, of more interest to me as an economist is the role that pension funds played in getting Detroit to where it is.  Let’s start by exploring pensions in general, then look to the specific case of Detroit, and finish with a little speculation about how far this might go in terms of other municipalities meeting their pension obligations.

There are essentially two kinds of pension plans, a defined benefit plan and a defined contribution plan.  In a defined benefit plan the benefit that a retiree receives is based on some formula that typically includes years of service times some multiplier per year times some final earned value.  For example, a pension may pay 2.5% per year worked times the last year’s earnings.  If someone worked thirty years then their benefit would be 30 (years) * 2.5% (per year) * last year’s earnings or 75% of their last year’s earnings.  There are many variations on this in terms of the multiplier or last year versus average of the last x number of years.  However, all defined benefit plans carry this in common -- Once you are retired, your employer/sponsor will pay you that benefit for as long as you live.  The complete liability for the program falls on the employer/sponsor.

In a defined contribution plan either you, your employer, or in combination make a defined contribution each month into a pension plan.  Typically your contribution is pre-tax.  Once you retire, you have that pot of money and can pretty much choose to draw it out any way you like.  Once you retire, your employer/sponsor has no liability for you.  You are on your own.

The defined benefit plan is going the way of the dinosaur in the private sector.  Employers do not want that liability. Shareholders in public corporations do not want it either as there is uncertainty about the present value of that future liability.  The defined benefit plan, however, is alive and well in the public sector as 88% of public employees are covered by a defined benefit plan.  The municipal employees of Detroit are “covered” under this type of program.  There are charges of abuse of the system in that employees will work a lot of overtime their last year of work so that the base for their pension is higher.  While that is no doubt of some concern, it is not the major reason why Detroit and other municipalities are in trouble.  A question you may ask yourself is, if I promise to pay you x number of dollars per year until you die, how much money will I need to set aside?  Good question, even if I had to prompt you to ask it.

Defined benefits programs can either be funded or unfunded.  In an unfunded program no assets are set aside and the employer pays out of current revenue as needed.  This is also known as PAYGO for pay as you go.  Up until the early 1970s about all defined benefit plans were unfunded.  Companies figured that revenue would keep growing and they would be able to pay pensioners out of those funds.  This is essentially how Social Security works but we’ll save that for another day.  As retirees started living longer the liability of the pension payments increased and the extent of underfunding grew.   Recognizing the impending storm the Employee Retirement Income Security Act (ERISA) was passed in 1974 that put restrictions on private pension funds and also required them to participate in the Pension Benefit Guaranty Corporation (PBGC) an independent agency of the government that insures pensions.  One of the restrictions imposed on private pension funds by ERISA was that an unfunded/PAYGO system would no longer be allowed.  Thus corporations, and probably also their employees, have to contribute to a pension fund even if it is a defined benefit program.  By the way, General Motors went from a defined benefit program to a 401(k) in the spring of 2012.  ERISA does not apply to public pension funds and they are not insured by the PBGC.

Back to Detroit.  Detroit has a defined benefit program that is neither unfunded nor funded.  It has what is the most common type of defined benefit fund today, an underfunded one.  Back to our question above, how much money needs to be set aside to fund the defined benefit obligation of Detroit and other municipalities?  The biggest uncertainty in all of this is the expected rate of return on the funds set aside to make future payments from.  If I expect to get, say, an 8% rate of return, I need to set aside a lot less than if I expect a 5% rate of return.   Detroit’s impending financial problems led Governor Rick Snyder to appoint Kevyn Orr as Emergency Manager of Detroit’s finances.  Mr. Orr, a former bankruptcy attorney for the Jones Day law firm in Washington DC, says the pension fund has underestimated the present value of its future liabilities by assuming a nearly  8% return on assets.  Not all of Detroit’s problems are related to its pension obligations.  The city’s population is half of what it was in the 1960s which has obviously reduced tax revenue.  It also has a history of corruption and overspending in awarding contracts, former Mayor Kwame Kilpatrick is awaiting sentencing in October 2013 for a pattern of extortion, bribery and fraud.   

Still, the pension fund is a large contributor to the problem.  Mr. Orr says Detroit has $18 billion in debt which includes $3.5 billion in unfunded retirement liabilities. The managers of the city pension fund said in a news release earlier this summer that they are no more than $700 million short.  Still not a comforting thought.  Their disagreement hinges on the expected return the pension fund will earn and thus what discount rate to use when bringing future liabilities back to their present value. A conclusion on how underfunded the pension funds are has more than academic implications as it will impact how much of a haircut both bondholders and the city’s pensioners are going to be asked to take.

News about Detroit’s troubles have temporarily taken a backseat to the conflict in the middle east and A-Rod’s steroid use but it is not a problem that will go away by ignoring it.  And, it is not Detroit’s problem alone.  Cities across the country with defined benefit programs assume they are adequately funded because they are assuming relatively high returns.  An argument over the appropriate discount rate to arrive at the present value of the pension liability will determine in large part what the payout of pension funds will be.  The Government Accounting Standards Board last year called for underfunded pension plans to use a discount rate in the 3 to 4 percent range. That is well less than most pension funds expect to earn and, if followed, will likely lead to pensioners receiving less in benefits.  Don’t expect this issue to be resolved any time soon.  As unglamorous as a defined contribution fund may be, at this point, be happy if you have one.