How can you believe in markets when they seem so wrong?

To be more specific, world stock markets sprinted like scantily clad beach volleyball players on July 26^th and 27^th purportedly because both the Fed and the ECB gave signals that they are ready to save the planet from space invaders. Well not exactly space invaders but that is not out of the question. I can just see Mario Draghi dueling with ET! Because of actions and statements from these two mighty central banks, the world seems to be reassured the worst will not happen to our shared global marketplace. Evidence of this reassurance was the Dow’s climb to back over 13,000. Why would investors buy stocks at higher prices unless they were optimistic that things will get better and that stock values will increase even more? This is the market working – central banks act brave – people get more optimistic -- people buy stocks – and stock prices rise.

Just because markets are working it does not mean that markets are always correct. When I was a toddler in graduate school I learned about something called rational expectations (RE). My colleague at Indiana, Jack Muth, invented this idea and several macroeconomists (notably Thomas Sargent, Robert Lucas, Robert Barro, and others) were adding the RE hypothesis into otherwise dumber macroeconomic models (that assumed adaptive expectations). The cool thing about RE is that it assumed that people learn. That is – we are not consistently fooled. If Chuck Jolly sneaks up behind you in fifth grade and pulls your pants down enough times – you eventually learn to avoid Chuck Jolly or find a stronger pair us suspenders. In macroeconomics RE states that on average over time the public is able to forecast prices correctly. The words ”On average” mean that you learn. Sometimes you forecast too high. Other times you guess too low. But as an average over time you learn from your mistakes and get is about right. That doesn’t sound too crazy unless you think people are simply irrational and don’t much care. In that case I do not know what assumption to put into a macroeconomic model.

The point of the last paragraph is that there are no assumptions in useful economic models that assume that the public guesses right all the time. Thus, one can believe in the power of markets and still believe that the strong response in the stock markets was simply off base. RE says that when markets learn that they were wrong, then the market will adjust. In the case of the July performance cited above, it seems to me that the stock markets will soon reverse.  As a retiree who will live off the value of whatever stocks are left in my portfolio, I take no joy in making this point.

So why am I so pessimistic about the results of the Fed actions?

It is true that central banks have a lot of ammo. Central banks can inject trillions of dollars or euros at will and it’s as easy as slipping on a banana peel. So it is true that central banks can easily slip a bunch of money into banks. It is also true that in doing so, they can influence some interest rates. So if they buy a bunch of slip-shod mortgages, it is likely they can force the interest rate on slid-shop mortgages down a notch or two. If they buy Spanish bonds they can do the same. They can also promise to keep interest rates low until hell freezes over. In doing this they can try to convince people that the central banks will make it as easy to borrow tomorrow as it today. So why am I not skipping down Kirkwood whistling a happy tune?

First, look around you. There is no lack of money in banks and interest rates are not high enough to stop anyone from borrowing money. In the USA you can borrow gobs of money to buy that 19 bedroom house you always wanted as an assistant professor with a wife, 1.2 children, and a pet boa. This week you could borrow that money for 30 years at about 3.5%.

Second, pushing that rate to 3.2% by adding another trillion or so in dollars/euros will do nothing to get the economy moving. You can put more gas in the car but if it is on the side of the road with a dead battery, going from quarter of a tank to half a tank just isn’t going to do anything.

Why aren’t banks lending more money? One reason is that people are deeply in debt and they don’t want more.  Even devoted greens won’t buy another Chevy Volt if they are worried about the weak economy. Another reason is that the banks know the economy is weak and they do not want to be back where they were in 2008 when a weak economy wiped out their assets and made them look dumber than a bunch of rocks.  Notice the predicament here. If bankers and their customers were optimistic then there would be more lending and spending and the economy would grow. So if the Fed/ECB can make them more optimistic the whole problem is solved. But it doesn’t work that way now because there really is a dead battery and we all know it. If banks watch the Fed pour more gasoline into a car with a dead battery – it will make them MORE pessimistic not less! RE says that we learn. RE says that the central banks are making us worse off with their Dirty Harry approach to defending our jobs.

So what about this dead battery? What is really wrong? I don’t think any of this is a secret. Numerous governments in Europe are simply in trouble and this is leading to very slow growth if not a recession in Europe.  We use the term “fiscal cliff” to describe a pending fiscal disaster in the USA but the same problem is plaguing Europe. A fiscal cliff implies an unusually large reduction in government stimulus that would greatly reduce spending in an already weakened economy. China has its own problems as do many once hearty economies like Brazil, South Korea, and the Virgin Islands. Even Alfred E. Neumann knows that monetary policy is not the solution to a fiscal cliff.

There is no sense beating a dead horse. Monetary policy is being used to provide hope instead of a solution. Monetary policy is being used because we do not know what else to do. It is like the battery is on back-order and we don’t know when it will be delivered. So putting more gas in the car won’t hurt and it might make the driver feel a little better. But it is kicking the can down the road. Neither the EU nor the US is going to improve without serious attention to real problems. Private debt has to move towards normalcy. Banks need clearer guidance about what they can or cannot do in this uncertain environment. Governments have to bravely address their own debt problems without encountering a severe fiscal cliff. Business firms need more clarity about financial, health, environmental and other regulations. Central banks could hand out $1,000 gold bars to middle class people all over the world but that would do little to improve the economy or confidence about it. Since there is no thundering herd of politicians trying to solve any of these problems it is hard to see the stock market being happy much longer. 

Clintpublicans Did It. The CLIBUSHTA Urban Legend

Assigning blame is something we all do. It was the other guy who broke the expensive vase. There is nothing new in political candidates claiming success for everything good and shouldering blame for nothing. But the world is not that simple. National political and economic outcomes are surely the composite of many factors manifesting over many time periods.

One specific instance of credit/blame that I hear with regular frequency is the two-part conclusion that (1) President Clinton raised taxes, created a budget surplus, and that was good for the US economy while (2) President Bush lowered taxes, created a budget deficit, and that was bad for the economy. The truth of these statements have current application because some folks would like to make the point that raising taxes on the rich today will reduce the government deficit and would be a good thing for the US economy.

This blog post looks a little deeper at this urban legend about Clinton/Bush/Taxes or what I will refer to below as the CLIBUSHTA. In economics you get rich and famous by writing things on napkins or making up names like stagflation and disintermediation. So let’s see if CLIBUSHTA sticks.

The first thing I would like to note is that Clinton had a majority in both houses of Congress from 1993 to 1995. He was President for eight years from 1993 to 2000.  (see this source for congressional numbers from 1867 to 2009  http://arts.bev.net/roperldavid/politics/congress.htm ). During the remaining six years of his term the Republicans had majorities in both parties. We can label the 1993 legislation that raised top income tax rates to 36% and 39.6% as belonging to Clinton. But upon losing his majority the policy in the remaining years required bipartisan support.

My second point has to do with the behavior of the government budget balance during the Clinton years. The bipartisan Congressional Budget Office did a study (http://www.cbo.gov/publication/41238 ) which examined government budget positions between 1959 and 2008. There you find quarterly figures that show the US budget turning to surplus in the first quarter of 1998 and staying in surplus until the third quarter of 2001. Thus, Clinton-era budgets were in deficit during all the quarters of his first term and the first year of his second term. The budget turns surplus in his 6^th year in office and remains in surplus until the end of Bush’s first year in office.

So it is true that we enjoyed government budget surpluses for three of the last four years of Clinton’s second term in office. The CBO has another set of interesting data that decomposes the actual recorded surplus (or deficit) into two parts:

(1)   the part that is caused by deliberate policy action (called the cyclically adjusted  budget position)

(2)   the part that is caused by the changes in the growth of the economy (called the cyclical budget position)

During the 12 quarters of the Clinton/Bush budget surpluses, the effect of deliberate policy action was shown to be a negligible contributor to the measured surplus. That is, in none of these quarters were Clinton’s tax changes or CLIBUSHTA tax or spending policies a major factor in the surpluses. But the story is even stronger than that. In eight of the quarters, the policy part was contributing to a government deficit. If it had not been for exceptionally strong economic growth in those eight quarters, the budget surpluses would have been deficits. Interpretation – intended policy was to have government deficits but strong economic activity swamped the intentions and created surpluses.

What was going on in those eight quarters? First, the economy was in a long and strong growth cycle that started in March of 1991 and did not end until March of 2001. This 10 year economic expansion started well before Clinton came into office in 2003. It had the unemployment rate falling throughout but it is notable that it went from 4.7% in early 1998 to 3.9% in the final quarter of 2000. During this time period incomes grew rapidly and tax revenues increased despite a host of tax reduction measures taken in Clinton’s second term.

Clinton fans could try to take credit for these eight quarters of government surpluses but it would be a real stretch. Taxing rich people more had very little to do with this tsunami of tax revenue. What about the third year of surpluses? During Clinton’s last year of office (2000) it made sense that policymakers would be less interested in employment and much more worried about inflation. It would make sense as well to move toward surplus-generating policies. And that they did. But even in that year the effects of the economy swamped the policy impact on the surplus. During those four quarters the policy component had less than half the impact of the economy on the surplus.

To summarize, there is very little evidence from either of Clinton’s terms that his policies or those of the CLINTBUSHTA during his terms had much if anything to do with the resulting government budget position. Or to say it another way—there is no evidence here to suggest that taxing the rich creates surpluses and strong economic growth. The truth is just the opposite and more simple – something before Clinton’s Presidency and before Clinton’s tax increase caused economic growth to accelerate and that lead to automatic increases in tax revenue and automatic decreases in government spending. Budget surpluses were caused by growth not by tax policy during the Clinton years.

Without going into a lot of detail one can extrapolate this same point to the dismal economic growth and large deficits of the early Bush years. After the Dot Com bubble burst, we had a recession that began in April of 2001. Bush did not cause that recession in April 2001 any more than Obama caused the recession in 2008. Bush’s budgets quickly went into deficit and it was mostly because of stimulus policy. The recession pushed the unemployment rate from a low of 3.9% to a high of 6.3% by the middle of 2003. Government deficits were automatically increased by the slowing economy but very large tax cuts and spending increases combined to increase measured deficits to the neighborhood of 4% of GDP.

Again the story is the opposite of the urban legend. The latter says that Bush tax cuts caused government deficits and were bad for the economy. But the truth is that during a recession few governments are able to withstand the demands for stimulus policies. Bush was no different. But it is not the tax cuts and the budget deficits that hurt the economy. It was a weak economy that led to tax cuts and higher deficits.

Whether we look at Clinton’s or Bush’s terms – the lesson is the same. The economy caused changes in the taxes and government budget positions. Higher tax rates did not cause surpluses and strong economic growth – lower tax rates did not cause budget deficits and weakened economic growth. To think that higher tax rates on the rich or poor today is a solution to our budget deficits and economic woes is to misunderstand CLIBUSHTA!

Mutual Interdependence Admits Relative Contribution

 The latest useless debate between Obama and Romney has to do with whether or not business owners or other successful business people did it on their own. Obama says that we all benefit from some help from somewhere. Romney interviewed business execs who pointed out how much they sacrificed to get where they are. This is like them debating whether my mother or my father was responsible for my birth. Geez guys, this is a no-brainer – this is another red herring (no offense to smoked kipper) to keep our eye off the ball.

No business executive could honesty say that he/she never got any help from anyone. We can be bright and driven but surely somewhere along the way a lion pulled a thorn from our paw. At the same time, in addition to friends and luck, success usually requires long and hard hours and family sacrifice. People who put in the time often get rewarded. People who don’t work so hard or who choose less risky occupations get less rewarded. Mentors often tell you that you have to be in the right line if you are going to receive the benefits of luck. You have to buy that lottery ticket if you are ever going to win the lottery. Young people find it hard to see why learning math is worth all that effort. Parents tell them to keep working because someday that effort will pay dividends. Those who do not follow that advice take themselves out of the math benefits line. 

While it is true that both sides are correct, the question is which one is “more-correct” when it comes to influencing the economy. That is, if you want to improve employment and output, where do you aim most of your policy? Here I am going to say a few things that seem very practical and normal to me – but I may stir the beast in some of my friends and family. But what’s a blog for if not to lose friends and gain enemies? J

An accounting or a snapshot of a mature business firm finds it with owners, managers, machines, real estate, and labor and 6,000 lawyers. There are a lot of components to make a business tick. Each is critical to the outcome. If one part fails to do its job then the business suffers. The human body has a lot of parts. If one loses a hand or foot then the whole body performs less well. This snapshot suggests that we all rise and fall together.

But depending on the specific company, there are parts that are more or less important when it comes to the overall functioning of the business. Some small firms in some lines of business may not need a lawyer. Those firms can get by with someone who wears a coat and tie, bathes daily, and looks and smells like a lawyer.

Other firms need an inventor or entrepreneur to get started and to continue being competitive. Let’s face it there are many lines of business today whose continued existence is based on staying ahead of the competition. In that kind of firm, a particular plant site or machine might not be so important. To stay alive that firm needs a particular kind of scientist or engineer or manager. Lose that professional and the firm and all its parts go under. Losing a machine or administrative assistant means a challenge. Losing a key professional means losing the firm.  

Many start-ups would have never gotten started without a capitalist. A capitalist is a saver who decides to take an equity or ownership position in a new company. This capitalist believes there is a chance that the new company will succeed but understands that it might not. Most new companies fail. Capitalists also provide money for existing companies and the equation is the same. They give their money for a return not knowing in advance how big that return might be. Capitalists are indispensable. Talented professionals and high tech machines matter little if the firm cannot adequately buy or finance them.

Am I putting you to sleep? Good. I am told that a lot of my friends don’t get enough sleep. I am happy to help. Now where was I?

You hopefully are getting my drift that depending on the company some components are more critical or important than others. Most basketball teams need five players but let’s face it – Lebron and Wade get paid more and are more important than the others.  Somehow the other members of the team get this fact and are not insulted by this reality.

Now we get back to Obama and Romney. Obama is right that it takes a village to help a company succeed. So we should pay attention to all the parts. But let’s not mistake the fact that many companies exist and survive because someone took the financial and personal and family risk. A worker or manager in that company is important but it is usually much easier to find another assembler or industrial engineer than it would be to replace the guy or gal who spent endless hours and gallons of perspiration getting the company started to begin with. To ignore this basic intuition is to put logic on its ear. It not only puts the cart before the horse but it puts the horse in the cart! And that makes the horse very uncomfortable.

This point applies to many companies—large or small, new or old. Betty asks me what I do all day now that I am retired. Much of what I do is read the FT and the WSJ as I sip a nice JD – and learn about companies. Okay I also fume about Paul Krugman’s latest brain-fart but I spend a lot of time reading about companies. Every time I do that I thank my lucky stars that at age 21 I decided to never work in a business. I don’t have the nerve or the stomach to run a business. It is a dogfight out there folks. Ask the owners at Nokia or Research in Motion how they are doing financially. Ask the guy who just started a new restaurant in your town how much he is raking in.

 

Some workers are lucky. All they have to do is come to work and follow the company manual and not smoke funny cigarettes in the parking lots at lunch time. They have an "investment" in their company and they depend very much on that employment but in no way does that compare to what others put in. Some distant and rich investor might have a billion dollars tied up. The entrepreneur may have planned, dreamed, and put his/her life on hold for years to get the company up and running.

Note: I recognize that some firms are run by incompetents. Some of you read the last paragraph and fumed about the fact that you are a key employee and if given the chance you would run the company better after you fired the existing management. You might be right. My point in no way supports the existing management.  My point underscores that some productive inputs are more effective and important than others. When firms get this backwards then they do not succeed. You are proving that point. It must be very frustrating to work in a company like that. Luckily you have the freedom to argue your point or to move on to another company to show that you are right.

While this might seem normal and practical to me some of you are already saying that I have given the working class or the middle class short-shrift. I don’t mean any insult and have tried to say above that all parts are important and valuable to a company. I also fully understand how the income distribution has changed and I know that many middle income Americans have lost ground.  My concern, as is yours, is the best bath to help these Americans improve their lives. It seems backward to help them at the expense of investors, entrepreneurs, and innovators. It seems more sensible to focus on the mutual dependency among the parts. Let’s make sure rewards for entrepreneurial activity are commensurate with the risks. Let’s make sure that our companies can compete as effectively as possible. Let’s improve our education and training. Let’s remove impediments to hiring and firing workers. Let’s take away all those loopholes and stupid illegal and immoral relationships between business and government.

There is a way to move this country out of recession. We do it by valuing mutual dependence with a mature understanding about what it takes to both create and sustain competitive labor and product markets. We all work hard but that does not mean that some are not more vital than others. Our policies should celebrate this fact and not pit one side against the other with inane arguments about whether someone got help or not. 

LIBOR: The Biggest Financial Scandal Ever?

Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article recently appeared in the Korea Times.

Barclays, a 300-year-old British Bank, just paid a $453 million fine for manipulating LIBOR. Why the big fine? LIBOR (the London Interbank Offered Rate) is the most important short-term interest rate benchmark in the world. More than $10 trillion of securities and $350 trillion of derivative contracts are tied to LIBOR. Do the math and it is easy to see what impact a 1-basis-point change (one hundredth of one percent) could have with trillions of dollars involved.

The problem is that LIBOR is not a market-based rate but one set daily by survey. Each morning at 11:00 a.m. London time, 18 banks are asked the rate at which they could borrow from other banks in 15 maturities, from one day to one year, and in 10 currencies. Thomson Reuters aggregates the rates by rejecting the four highest and lowest and calculates the average LIBOR from the remaining 10 rates. This process is repeated 150 times for the 15 maturities and 10 currencies. Once calculated, the LIBOR figures are published and disseminated throughout the world. The most important of the 150 rates is the three-month dollar LIBOR.

LIBOR acts as a benchmark or reference rate for trillions of dollars of financial securities such as credit cards, corporate loans, home mortgages and just about any security that has a floating interest rate, as well as derivative contracts such as interest rate and currency swaps are tied to LIBOR. The impact of changes in LIBOR to borrowers and lenders is significant. For comparison, a one basis point (.0001) change on one $1 trillion of securities is $100,000,000. Given the $300 trillion to $400 trillion conservative estimate of securities and derivative contracts that are tied to LIBOR (some estimates are as high as $600 trillion), the amounts involved are huge.

Barclays had manipulated its LIBOR figure hundreds of times from 2005 to early 2009. Some were at the urging of its traders to help positions they had in derivative contracts and other securities. Also, during the financial crisis of 2008-2009, the bank purposely lowered its LIBOR bid because a higher rate at which banks could borrow would signal higher default risk. The banks that were too big to fail were under severe pressure at the time and any sign of weakness would have prompted massive withdrawals and/or a call for more collateral as counterparty risk was perceived to have increased. An interesting question is how involved or complicit were regulators during this time? They also were under tremendous pressure at the time to stabilize the whole financial system.

One thing you can count on in finance is contagion. The scandal has already spread from Barclays to other large banks that are under investigation or face lawsuits alleging LIBOR was manipulated. In Britain, the Financial Services Authority is involved, in the U.S. the Department of Justice and Commodities Futures Trading Commission, and Brussels in the E.U.

The LIBOR mess will be in the news for years to come. But it is not the only financial instrument to set rates by survey. There is TIBOR (Tokyo Interbank Offered Rate) and EURIBOR (Euro Interbank Offered Rate) that are similar to LIBOR. Many swap prices are also set by survey as well as other financial instruments.

LIBOR is the most important short-term interest rate in the global financial markets as the 10-year Treasury bond yield is for longer-term interest rates. The problem is that LIBOR does not reflect market prices or transactions as does the 10-year U.S. Treasury bond yield. Going forward, LIBOR and its equivalents should be based upon actual rates and prices at which banks have lent to or borrowed from one another, not estimates. At this time, LIBOR transactions are not publicly reported so there is a lack of transparency. There may not be current prices each day for all 150 LIBOR quotes but reported transactions should be the starting point, and that data used to fill in the blanks for those quotes not having transactions.

LIBOR has been around since the 1980s and has become one of the most important rates in the financial markets with huge financial implications for consumers, corporations and governments. And the market has been under suspicion of being manipulated for several years, but regulators never seriously investigated until recently. It is obvious that the present process of computing LIBOR is deficient. Given the amounts involved, the incentives to manipulate it are too large. Banks should not be able to profit from the level of LIBOR set by the banks themselves.

LIBOR may end up being the largest financial scandal of all times, given the trillions of dollars impacted by the rate. As mentioned previously, LIBOR will be in the  news for years to come. But what a global financial calamity it would be if LIBOR were to collapse. Hopefully in the future a better process can be devised to set a benchmark short-term interest rate that all lenders and borrowers can have confidence in as a real rate and not an artificial rate.

There may be alternatives to LIBOR. Some would suggest U.S. Treasury bills which are owned globally and traded in a liquid and efficient market. But they are subject to the creditworthiness of one country as opposed to 18 global banks. Another possibility would be to use the repo rate, which is the rate for financing securities. The borrower puts up securities for collateral for a loan and agrees to repurchase them at a later date at a specified price. So don’t be surprised if something replaces LIBOR.

Outsourcing Common Sense and US Jobs

President Obama quoted others in calling Romney and his past colleagues at Bain Capital “Pioneers at Outsourcing.” The President smiled and puffed out his chest as he proclaimed that in contrast he was the one who saved the auto industry.  Romney denied that either he or Bain Capital were responsible for outsourcing. But given the chance he did not take the opportunity to stand up for free trade. Thus they both want us to think that outsourcing is something evil that hurts US employment. As an aside, I think they used the wrong word – outsourcing instead offshoring. Their rhetoric works better for locating businesses abroad. But I suspect they like neither offshoring nor outsourcing.Both appear to hurt US employment. But keep reading please...

One quick thing to ask the President… he proudly bailed out the auto industry.  Is there any other industry that has done more offshoring of jobs? Does GM not have a plant in virtually every country of the world? Why is he so proud of saving the auto industry when he is so against offshoring? Has he vilified GM for all those jobs created abroad rather than at home? Why is it okay for GM to offshore but not okay for Bain to help other companies who want to offshore?

Those of you who are very worried about employment in the USA want your politicians to stand up for jobs in America. The disappointing labor department report last Friday underscored our concern for jobs.  But please, both these guys are agreeing on the wrong thing. Yammering against globalization is just wrong. It is very wrong.  Obama continues to take his eye off the ball. Employment suffers in the US because we have no fix for finance, housing, and a fiscal cliff. Yet he finds something new to talk about each week – he will talk about anything that diverts our national attention from what matters.  Romney does not do much better. I don’t care if he worked for Bain Capital or Micky D’s – I want a clear exposition of what he is going to do as President. Neither of these guys lived normal lives with paper routes and lemon-aid stands. I doubt either one would know the right end of a lawn mower.  Get over it. Both are running. What are they going to do once they get into office? This offshoring thing is a red herring.

Both these guys think they can score points with workers by pointing out that outsourcing/offshoring (o/o) hurts national employment. But stopping o/o is not going to save US jobs. It is important to see that o/o is not much different than importing goods and services from abroad. If we o/o or if we import we are buying things that are produced abroad rather than at home. On the surface it sounds pretty bad to import or to outsource. But luckily that is not the whole story.

We cheer for our good guys when export sales increase. When a firm on US soil sells more peanut butter to China, we acknowledge the extra jobs that are created in the US. Imports do just the opposite. Imports are goods that we buy and consume here that are produced abroad by workers in Brazil or Spain or Botswana. Clearly if those goods were produced at home this would create more job opportunities for Americans. But what has the president done about imports? During his watch US imports from the world increased from $2.54 trillion in 2008 to $2.66 trillion in 2011.  In 2011 US exports to the world were $2.1 trillion so we had a net deficit in goods and services of more than half a trillion dollars. That half a trillion dollars represents the difference between jobs gained through exports and jobs lost through imports. That’s a lot of jobs.  Why isn’t Mr. Obama traveling around in his fine bus ranting about all those imports? Clearly neither he nor previous presidents wanted to stop this trade deficit. It has gone on for decades. A Buy America program has done almost nothing to reverse all this.

Why is it okay to let imports replace US jobs but not to let o/o do the same? The answer is that it isn’t okay. Globalization is a two-way street. We all realize that you can’t have exports without imports. You can’t have in-sourcing without out-sourcing. A policy to reduce imports or o/o would surely hurt our exports and the desire of foreigners to invest here. Worse yet, it would be very inefficient and costly. Many imports reveal our own decisions to specialize. Importing things where we have no real business edge makes no sense. It would simply mean less choice and higher prices.  That is not what we are after.

Along similar lines, it makes sense to produce abroad rather than at home.  China and other parts of Asia are growing rapidly. They need a lot of goods to support the growth. Given the distance and cost of traversing it – it often makes sense to produce for those markets in Asia. Producing in the US would be more costly and we might lose in the competition with Asian, German, and other firms who also want to serve those markets. The reason the President doesn’t rail again GM plants abroad is that he knows that a global foot print makes GM a stronger company and more able to sustain its jobs at home as it spreads employment and production around the globe.

Why has Obama been so silent about the recent decision of Airbus to locate a production facility in Alabama? Obama does know that Alabama is one of the 57 US states, doesn’t he? I realize Alabama is a right-to-work state but even non-union workers count in the national employment statistics, don’t they?  Why did Airbus decide to locate in the US? Did they do it to irritate French workers? The Wall Street Journal says the location decision was made because Airbus wants to be able to produce for the US government. To be competitive in government procurement a company must have factories in the US. Is it not possible that many US companies locate abroad for similar reasons – whether they serve government or private purchasers? Isn’t Airbus made stronger by locating a plant for US buyers in the US? Are not jobs in France and other places in Europe made that much more secure because Airbus is stronger? So it makes sense for France and other countries to o/o.

Let’s take a look at offshoring in a comparative sense. You will see below that the US is just doing what everyone else is doing. We are clearly not alone.   In 1990, the US owned $732 billion in foreign capital (Foreign Direct Investment, FDI*. A more complete definition of FDI is given below.) That is, US cumulative purchases over many decades of foreign productive capital across the globe amounted to $732 billion. That amounted to 13% of our GDP in 1990. We have since experienced more than 20 years of rapid globalization and now own $4.8 trillion capital abroad. That amounts to an almost 7-fold increase. FDI was 32% of GDP in 2010. Offshoring is very evident for the US.

The below table compares the US to 10 other countries and the EU: (this data comes from the United Nations Web Table 8. FDI outward stock as a percentage of GDP, 1990 to 2011. Stock values are in trillions of dollars). http://archive.unctad.org/Templates/WebFlyer.asp?intItemID=6018&lang=1

The stock of FDI owned by the EU was almost twice as large as that for the US in 2010.  The listed countries own from $340 billion (Switzerland) to $1.7 trillion (UK) of FDI in other countries. What matters more, however, is how large the ownership compares to the size of the country.

For the Netherlands, FDI was 123% of the economy in 2010.  The US position was 32% which ranks it about 9^th in this list – at par with Australia. Only Japan and Italy have FDI lower as a percent of the economy than the US.

Consider the increases in dollar value since 1990. The US FDI increased 7 times. That sounds like a lot but over these 20 years only Japan had slower growth in FDI at 4 times. Spain’s FDI increased 41 times! The median country’s FDI increased 8 times. Spain, France, Switzerland and the EU all found FDI increasing in double digits.

Globalization means investing at home and abroad. Countries that don’t do it will lose out on opportunities and will not compete well. Between 1990 and 2011 US non-farm employment increased by 23 million jobs. Private sector jobs increased by 19 million. The New Age of Globalization saw American jobs at home increase by more than 20%.

                   Stock      FDI        Fold increase

                    FDI         %GDP       Since 1990

                    2010      2010

EU            $8.93tr      57%               11times

US              4.84        32                    7

UK             1.69        72                    7

France        1.52         62                  14

Germany     1.42         44                    9

Netherl         .89        123                   8

Japan           .82         15                    4

Spain            .66        46                  41

Canada        .62         41                    7

Italy              .48        24                    8

Austral         .40         32                  11

Switzerl        .34         80                   8

  

*FDI is meant to capture the value of purchases of companies abroad for the intent of management control. It does not include purchases of foreign stock that are made for the purposes of only financial investment. That is, most international bodies distinguish between FDI and portfolio investment. FDI involves the purchase of companies through merger, acquisition, or simply enough shares to lead to some managerial control. It also includes greenfield sites which would include building a new plant or business firm in a foreign country.

Manifesto to Macroeconomic Nonsense

Alan Blinder and then Paul Krugman (with Richard Layard) wrote articles that showed up in the last week of June – one in the WSJ (The Long and short of Fiscal Policy) and one in the FT (Time to Speak Up: Manifesto for Economic Sense). They basically say the same thing. Krugman and Layard go a little farther since they are recruiting like-minded economists to show support for their manifesto. Please do not humor these guys.

Since both articles amount to the same thing let me try to summarize their arguments. Policymakers who disagree with Krugman and Blinder are “inflicting massive suffering.” This suffering comes from too much austerity. National demand needs to be stimulated, preferably by hiring more police, firemen, and teachers supplemented by more spending on national infrastructure. The government needs to make up for the lack of spending on the private side. Larger government deficits can be sustained by most countries but would damage long-term economic growth if not reversed at the right time sometime in the future. There are no supply constraints – the problem today is simply not enough spending.

I think this is a bunch of hooey (silly or worthless talk) and hardly deserves a response but it is either this or working in the yard in 105 degrees.

First question I ask is: What austerity?  I wrote a post on that a few weeks back (May 22 Austerity is hot) and showed there is not really much austerity going on except in Greece. Mostly we have seen historically strong government stimulus.

Second, they lament austerity in the US. But the numbers show nothing but government deficits and rising debt as far as the eye can see. Surely these two economists know the difference between stocks and flows. EVERY year a government has a deficit means an economic stimulus. While it is true that a smaller deficit yields a smaller stimulus, it remains that $1 trillion or so of deficits is having a walloping impact on aggregate demand. Saying there is austerity in the US now is like telling someone to eat a quart of ice cream to lose weight.

Third, in virtually no US budget that I have seen is there anything amounting to spending cuts. We all know that spending was increased dramatically at the onset of the recession.  Taking spending back to normal levels would not be a cut in my book. But even that is not happening. Spending continues to grow from these bloated levels.

Fourth – so while I agree that private spending is holding back, I seriously doubt that more government spending is the answer to our problems. We have plenty of government spending thank-you.

Fifth – these guys say that people who disagree with them are old fogies who fail to embrace the new and relevant economics. But what are they embracing? Keynesian economics is not exactly the Justin Bieber of economics.

Sixth, what they are embracing is a remedy that simply does not fit the patient. “Nurse, give the patient more heart medicine. But Doctor, the patient hurt his big toe. I don’t care, give him heart medicine.”

These mouth-breathers say that governments did not cause the recession. They are correct though decades of growing national debt definitely didn’t help us prepare or deal with a financial crisis. What caused the recession some 5+ years ago was housing and finance. Do these guys not see that lacking remedies for these problems, the economy is NOT going to improve?  Do they not see how much trouble Europe is having because of sovereign debt increases? Do they not see that promising a return to fiscal balance at some unspecified time in the future is like your daughter’s 16 year old boyfriend telling her that he will disengage just before the big moment arrives?

Seventh, these guys dismiss supply constraints as they obsess about demand. Yes demand is weak. But demand is weak because banks won’t lend and because firms won’t borrow or hire. Banks won’t lend and firms won’t hire because they don’t see government solving the housing and financial problems. In fact, many think them think the government is making the financial problems worse as they throw a Spiderman net of regulation over business activity from healthcare to investment.

Krugman and Layard (and Blinder) want you to sign a manifesto (a ticket on the Titanic). I suggest you send them free passes to the Betty Ford Clinic. They need a time-out to get off this Keynesian high. 

The Death of Equities?

Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared yesterday, June 25, 2012.

 The Financial Times published an article last May about the end of the cult of equities.  If you are a member of the equities cult, you believe that an investment in equities will provide a superior risk-adjusted return in the long term relative to bonds. Even though risk may be greater, the equity risk premium (equity returns minus bond returns) will more than compensate for the additional risk. Equity returns come from two sources, dividends and capital appreciation. While dividend yields were low by historical standards, investors believed that most equity returns would come from capital appreciation.

Because equities are riskier than investment-grade bonds, for decades dividend yields exceeded bond yields. That all changed in 1956 when 10-year U.S. Treasury bond yields exceeded equity dividend yields for the first time in the U.S. going back a century. Bond yields exceeded dividend yields from 1956 to 2011-2012 when the relationship reversed after more than half a century. Recently the S&P 500 dividend yield was 2.2 percent versus the 10-year bond yield of 1.6 percent.

So the cult of equities started in the 1950s and certainly accelerated in the 1980s and 1990s as equities became the asset class of choice for institutional investors such as pension funds and endowment funds and individual investors through direct ownership of equities or indirectly through mutual funds, which grew rapidly during this period. Individual equity exposure also increased through their pension plans.

What started the cult of equities? One word: performance. From the beginning of 1950 to the end of 1955, equities, as represented by the S&P 500, provided annual returns of 25.2 percent versus 1 percent for long-term corporate and government bonds. As a legacy of WWII, the Federal Reserve, much like today, had suppressed long-term interest rates until 1950. As long-term interest rates rose, bond prices declined and annual returns were minuscule and less than inflation.  As the stock market crash of 1929 and the Great Depression became distant and faded memories, the appetite for equities increased.

Equities continued to outperform bonds from 1956 for the rest of the 20^th century, although bonds did as well as equities in the 1970s. From 1956 to the end of 1999, equities provided annual returns of 10.4 percent versus 6.0 percent for long-term corporate and government bonds. Inflation ran about 4.7 percent annually during this period, so real (inflation adjusted) returns were lower.

So what has caused investors to lose their appetite for equities? Again, one word: performance. The first decade of this century experienced two devastating bear markets in which investors lost at least half of their stock market wealth. The first bear market was a result of the dot.com bubble and an overvaluation of stocks in general. The S&P 500 peaked at 1527 in March 2000 and hit bottom at 777 in October 2002, a decline of -49.1 percent. Five years later, the S&P 500 hit a new peak of 1565 before it started a dramatic decline of 56.8 percent to 677 in March 2009. This was the worst bear market since 1929 and the first since then to have been caused by a financial crisis from the collapsing of credit and housing bubbles.

The end result has been an ugly first 11 years in this century for equities. From 2000 to 2010, the S&P 500 had an annual return of only 0.4 percent versus annual returns of 8.0 percent for long-term corporate and government bonds. Given annual inflation of 2.4 percent during this 11-year period, real returns were negative for the first time since the 1970s. Today the S&P 500 is still well below its March 2000 peak.

In addition to mediocre equity returns since 2000, equity volatility has also been at historic highs. The combination of low returns (negative real returns) and higher risk has been the primary factor for increasing investor risk aversion and decreasing appetite for equities. But not the only one. Other factors would include the financial crisis and the Eurozone crisis, increasing economic uncertainty, increased globalization, regulatory reform in the financial sector, tax rules favoring bonds over equities, high-frequency trading and the flash crash in 2010, less liquidity in the market and the growth of government debt and deficits. So institutional and individual investors have reallocated billions of dollars from equities to bonds and other financial assets since the financial crisis of 2008-2009.

In addition to investors losing interest in equities, corporations have also been reducing equity in their capital structure by repurchasing stocks, and raising billions of dollars in the bond markets, whether needed or not, because of historically low interest rates. The implications of the de-equitization of the financial system can be serious. Equity is the risk capital in a financial system and the absorber of economic shocks. Less equity will result in a more volatile economic system. Plus emerging companies usually publicly access the capital markets first in raising equity capital via an Initial Public Offering (IPO). Despite the publicity, good and bad, associated with the Facebook IPO, fewer companies are going public, annual average of 130 since 2001 versus 503 in the 1990s, which could eventually have a major impact on economic  growth. And investors have fewer choices today; the number of publicly traded companies has declined since 2000.

What should equity investors do going forward? If you are a contrarian or value investor, the Financial Times article could be good news. Many remember the BusinessWeek article in 1979 titled “The Death of Equities.” The 1970s were not a good decade for equities or bonds. Nominal equity returns were 5.9 percent annually, similar to long-term bonds, but inflation was 7.4 percent, so real return were negative for both bonds and stocks. The BusinessWeek article was widely quoted and publicized, but after the 1981-82 recession, the stock market enjoyed returns of 18.5 percent annually from 1982-1999, one of the best periods in stock market history. The media have a long history of bad-timing articles, perhaps this time also. A 1950s scenario of raising interest rates may benefit equities relative to bonds.

Investing in equities always involves uncertainty. There have been many unexpected events since 2000 impacting equity returns in a negative way: the dot.com, credit and housing bubbles; two recessions, one severe; the financial crisis; the Eurozone crisis; and acts of terrorism and wars, to mention a few.  Hopefully there will be fewer such events in the future and investors will regain their appetite for equities. Equities are one of the few ways in which investors can participate in the economic growth of companies and countries. A healthy equities market in which investors have confidence is important for the economy.

Old cults never die, they just fade away for a while; maybe the cult of equities is just lying dormant like in the 1970s, ready to spring back to life after a couple of years. Long live equities.

Can you kick a cliff down the road? Let’s kiss and make up.

Have we somehow gone beyond rational argument? Have we taken differences beyond a logical extreme? Are we about to self-destruct for no good reason? These are the kinds of things I keep hearing. You have to admit that in the US, the so-called fiscal cliff borders on insanity. The news is that congress wants to kick the cliff down the road. Can you kick a cliff down the road? If Congress decides to simply extend bad policies until well into 2013 will that really be the best we can get out of these goof balls? Remind me please. How much are we paying these guys to jeopardize our futures?

Recall the hitch-hiking scorpion that stings the turtle in mid-steam and they both drown. As he is going under the scorpion admits that he had to sting turtle because that’s what scorpions do. But we are not scorpions. We are people. We have brains. It makes little sense to play games with the fiscal cliff if other options are available.

Obama supporters say that Romney is not good Presidential material. Apparently they think he was a bad governor and a mean businessman. Romney supporters say Obama is not qualified to be president. They point to the dismal state of the economy today.  But please! Argue if you will about their relative successes in life and their specific qualifications. But please, both of these men are running for president. Why waste time with hateful and impertinent allegations? This argument about qualifications has very little to do with solving our immediate issues.

We voters agree on a lot of important things:

·         We agree that too much national debt can cause economic problems. We also agree that tolerating recessionary conditions for too long can be wasteful and unnecessary. 

·         We agree that tax revenues are well below normal. We also know that government spending is decidedly above normal. We know that using one or the other in isolation to solve deficit problems is probably not feasible.  Raising tax rates will surely slow the economy. So will reducing government spending.

·         We know that many poor people have circumstances where government support is the only remaining option. We also know that there are also many people called poor who are not and who could probably live without as much government assistance. We also know there is inefficiency and fraud in many government programs.  

·         We know there are many people who need society’s help with healthcare. We also know that healthcare costs are rising at rapid unsustainable rates and severely impact people of middle incomes.

·         Neither party’s goal is to destroy America. Both want to see the country succeed in economic and non-economic terms.

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I could go one with the many more shared beliefs. We also cherish our freedoms, our great cities, our supportive neighbors, or brave soldiers and so much more. In addition, I think most of us believe it is a waste of time, energy, and emotion to argue at a feverish pitch while our problems just seem to get bigger and bigger. Both sides are dug in –come hell or high water.

Instead of acknowledging and emphasizing the validity of all these share beliefs, we seem to delight in picking one side as the winner and spend our time belittling those who chose the other team.  We have fallen to a point where we would rather jump into a heated fight than rationally, creatively, and dispassionately weigh the facts and find ways to accomplish our joint goals. It is fun to scream for your team at a football game.  But the morning after the football game means little to society while the morning after the next election can mean everything? Are we as dumb as the scorpion?

Hopefully I am wrong but it is difficult to see many leaders in either party earnestly trying to solve problems. Most have agreed that nothing can be done before the election.  They spend more time trying to shame their opponents than governing.  Does it make sense to pay them for the coming months as they avoid doing their jobs? How did we get to such a ridiculous position? What is the problem? Here are some very unpleasant realities to chew on…

·        

There are no real solutions to these problems. Society tries but will ultimately fail anyway. It doesn’t matter who leads the country next year – he will fail anyway.

·         There might be a real solution but it is very complicated. This recession is not your Mother’s recession. Americans cannot handle complexity. Americans respond only to colorful and brief sound bites flowing from the mouths of very attractive quasi-experts. 

·         Any solution will definitely create redistributions of income and/or wealth. Those who see this process going against them will fight for their assets regardless of any long-run benefits that might come to them and others.

·         The press earns money by selling advertising. The higher the pitch and the bloodier the fight the more soap gets sold.

·         Professors, consultants, bloggers, and other experts want to sell their time and words but realize that given the above it makes no sense to explain long trains of information and statistics that support complicated centrist positions. It is not easy to differentiate the professors from the 6 pm news.

·         Companies, labor unions, and other recipients of government largess support only simple positions that help them continue to receive targeted assistance.

·         More?

It seems pretty hopeless, except for one fact. If things get bad enough for long enough self-motivated people will begin to see that their own behaviors are self-defeating. Many people will discover a correlation between their own gradual economic demise and things like intellectual laziness, inattentiveness, selfishness, and politicians who seem never concerned about finding real solutions. This hapless recovery is not enough for most of us to see the landmines of our own ways. How much more will this country have to suffer before we get it? What disaster will have to occur before we elect people who will not feed this frenzy of ignorance and selfishness? Divide and conquer makes a lot of people rich but impoverishes the rest of us. That is, until we clearly see the game. Then, maybe we will have a chance and won’t need to kick cans or cliffs down the hill!

More “Gooulish” Nonsense about European Fiscal Integration

Austan Goolsby wrote in the WSJ on May 30, “A Fiscal Union won’t fix the Euro Crisis.” I first thought that since he is a professor at the University of Chicago that we might be kindred spirits. But that is not the case. While we agree about the ineptness of a proposed European fiscal union we seem to come at this agreement from very different angles. I dislike the fiscal union because it would create too much pressure towards populist expansionary policies across Europe. He dislikes it because he thinks it won’t do enough to supply a coordinated European government stimulus.  

Here’s his reasoning. First, his data shows that a fiscal union among the 50 US states means that US states routinely subsidize each other.  For example, Minnesotans routinely bail out Mississipians through the magic of a federal government. Goolsby worries that a European fiscal treaty would allow any country to easily veto that kind of inter-state redistribution. Thus in a European fiscal union Goolsby worries the austerity hounds would win. I am concerned about the opposite.

Second, Goolsby blames the woes of Ireland, Greece, Spain and others on the monetary union. He notes that since the monetary union began German’s real wages have grown slower than productivity while the opposite happened in the peripheral countries. Thus, the monetary union – according to Dr. G (how many times can I type Goolsby?) – has made the peripheral countries less competitive. This might not be so bad but the monetary union prevents these countries from overcoming this competitive disadvantage through currency devaluation. Dr. G laments that without an exchange rate the only avenue left for these countries is “moving, inflating, struggling, or subsidizing”. Thus he wants the stronger European countries to either subsidize the weaker ones or he wants them to inflate.

Wow. Can we check the facts please? The US federal experiment succeeds because some states subsidize the rest? That is Dr. G’s main explanation for decades of US growth? The only choice for Europe to improve the lot of Italians and Greeks is inflation/subsidy from Germans and Finns? The implication is that the countries that have benefited from monetary union should be the ones doing the subsidizing and inflating. This is the secret ingredient necessary for EU growth?

From Dr. G’s analysis one should find in the years after 1998 when the monetary union began, the peripheral countries were weakened while Germany and some of the others were strengthened. I found a table of real GDP growth figures for OECD countries (  http://www.oecd.org/document/3/0,3746,en_2649_34109_2483901_1_1_1_1,00.html ) with data for the years from 1987 through 2007). There is little support for Dr. G in a pre- post- comparison of real GDP annual growth around the year 1998:

·         Finland’s growth rate was higher after monetary union (2.2% per year versus 1.7%)       

·         France’s growth rate was about the same in both time periods at about 2.2% per year

·         Germany’s average growth rate fell from 2.6% per year to about 1.6% per year after monetary union

·         Ireland’s growth rate fell very marginally after monetary union from 6.1% to 5.8% per year

·         Italy’s average annual real GDP growth also fell marginally from 1.9% to 1.6%.

·         The Netherlands’ growth was helped by monetary union – from 2.5% to 3.1%

·         Portugal’s growth rate almost halved from 3.4% per year to 1.8%.

·         Spain improved considerably after monetary union – from 2.7% before to 4.6% per year afterward.

Germany and Spain’s performances are just the opposite of G’s conclusion since Germany seems to be weakened while Spain was improved by monetary union. Using data on standardized unemployment rates across these same countries shows that except for Portugal, Eurozone countries were greatly improved by the monetary union. For example, Spain’s unemployment rates averaged well above 15% in the years before 1998. Afterward Spain’s unemployment rates averaged about 10% and fell to 8.3% in 2007. It is true that trade patterns after 1998 changed international competitiveness within the Eurozone – but these changes are not mirrored in overall economic indicators like output and employment.

The most outlandish ghoulish assumption, however, is that somehow economic growth and prosperity has much to do with national stimulus and subsidization. I know of no growth theory that supports such an unwarranted conclusion. Growth is all about marshalling inputs and using them in increasingly productive and innovative and competitive ways.  In today’s cynical and skeptical environment stimulus and subsidy are even less useful. There is a widespread concern about more stimulus since governments are deeply in debt and so little has been accomplished in the way of competitive restructuring of financial, product, and labor markets.

Back to the main point about increased fiscal integration of Europe. Dr. G is right – a tighter fiscal cooperation among the 17 Eurozone countries would not be a good idea for Europe. But the reason for the failure is not that it would bring too little stimulus and subsidy. It is precisely the opposite.  Such a democratic project among the nations of Europe would soon produce a majority for the same kind of populist policy trash that now dominates the US. I wouldn’t wish that on anyone! A fiscal union is not warranted by monetary union nor is it in the best interests of any of these countries. 

Will the US Recovery Experience a Fourth Anniversary in 2013?

Two Guest Bloggers this week on the topic of the current US economic recovery. The first is by Tico Moreno (Current Reality is the precise Result of Current Policies). Directly following is the contribution by Buck Klemkosky (Happy third Anniversary).

CURRENT REALITY IS THE PRECISE RESULT OF CURRENT POLICIES

 by Tico Moreno

“Tico Moreno is the owner/manager of a coffee service company that operates in Ft. Myers and Naples, FL. Prior to moving to Sanibel Island FL he worked in Venezuela where he was a promoter and president of a 1,500 Ha. shrimp farm, was involved in planning and logistics in the banking and beer sectors, and was a professor of management at a University. He has a PhD in Engineering Management from Clemson University.”

The May employment figures released by The Labor Department were disappointing. From January 2009 to May 2012 the civilian non-institutional population 16 years or older has increased from 234 million to 243 million, an increase of 9 million, but the number of people employed has remained the same at 142 million. If the same % of the population that was employed in January 2009 were employed in May 2012, the total number employed would be 147 million, so we have a net of 5 million missing jobs. This weak employment scenario is precisely the one to be expected as a consequence of the policies being applied over the last three years. Let’s see:

Monetary policy has been to artificially keep interest rates low. Artificial application of tools will bring about artificial results. We are familiar with the recent experience of what happens when we artificially keep the price of money under what the market rate would be, given our propensity to save. Production beyond what people would purchase is stimulated. Last time around it was production of housing. No telling what bubble is being stimulated this time. Last time the market reacted very efficiently to the carrots and sticks of the time and produced housing in extraordinary numbers. Had the Fed not made available the cheap fuel, bankers would have not been able to make as many housing loans. This time, so far as we know, what has increased is the cost of food and energy, but there is no substantive growth.

Fiscal policy has been Keynesian: increase spending by the Federal Government in the hope that that spending will stimulate the economy. But the government is no magician that can create prosperity; it can only redistribute it. For it to spend one dollar the government has to subtract that dollar from somewhere, a move that has the effect of reducing growth somewhere else. The net effect is no growth and deficits. An alternative approach is a supply-side oriented one: make the economy grow by reducing tax rates and regulations. This approach may increase the deficit initially, but in the end the induced economic growth brings about more revenue to the government. The choice between Keynesian and supply-side economics is not only theoretical. The evidence of the real world abundantly supports the success of the supply side approach and the failure of the Keynesian approach. Witness the Kennedy and Reagan supply-side induced growths, and the Hoover-FDR Keynesian failure to get the economy going in over 14 years of trying. In fact even now, the paltry growth we are experiencing only started after the certainty that the so called Bush-tax-cuts would be extended, a supply-side move.

We are currently experiencing the exact effect caused by the current economic policies.

HAPPY THIRD ANNIVERSARY

 by Buck Klemkosky

Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared yesterday, June 4, 2012.

June 2012 marks the third anniversary of the end of the Great Recession, the most severe of the 11 U.S. recessions since WWII – although the 1981-82 recession was comparable. Conventional wisdom is that the strength of a recovery is related to the depth of the recession. That has not happened three years into the U.S. recovery.

How bad has it been? The growth in real (inflation adjusted) Gross Domestic Product (GDP) has been 2.4 percent since the start of the recovery in July 2009, about half of what real GDP growth would normally be three years into a recovery. The growth rate also lags the long-term (1997-2007) U.S. GDP growth rate of 3.4 percent.

The unemployment statistics appear to be better than GDP growth, but they are deceiving. During the Great Recession, 8.8 million jobs were lost and 4.5 million jobs created thus far during the recovery, so there are fewer jobs in the U.S. today than in December 2007 when the recession started. Even though employment is still several million below its peak, the unemployment rate has dropped from a peak of 10.1 percent to 8.1 percent today.

Why the significant drop in the unemployment rate? The big reason is the drop in the civilian labor participation rate which measures the number of people (16 years of age and older) who are working or looking for work versus the number in the total population. The labor participation rate has dropped from a peak of 67.3 percent in 2000 to the current rate of 63.6 percent, the lowest since 1981-82. The continued decline is unusual in an economic recovery because more people usually seek employment as the economy improves.  Since the recession ended, the rate has fallen from 65.7 percent to the current 63.6 percent, thus the lower unemployment rate.

While the potential number of workers has increased during the recovery, the number leaving the workforce has increased even more, taking down the unemployment rate. So where have all the workers gone? Some of the baby boomers (those born between 1946 and 1964) may be retiring early, marginal workers may not have entered the workforce because of slow job growth and stagnant wages, and more are opting for government subsidies. Medicaid spending, disability payments and food stamp usage have all risen sharply under the Obama administration. The bottom line is that no one has a good grasp of the numbers and why people are leaving the workforce.

There are numerous reasons why the U.S. economic recovery continues below average. First, the Great Recession was caused by the severe financial crisis of 2007-2008. As a result, households have had to pay down debt, and banks have had to increase their capital base by extending less credit. Evidence shows that recoveries from financial-caused recessions are slower than other recessions because of the deleveraging that has to occur. It may take more time for this to work its way through the system, so slow economic growth may be the norm in the U.S. and Europe for several more years.

As the experience of Japan has demonstrated, asset bubbles such as in housing can impede an economic recovery. U.S. home prices have fallen about one-third from their 2006 peak because of the speculative bubble in housing prices and over supply of houses. Usually construction, housing and commercial, leads an economy out of a recession, but not this time. Construction jobs are still 25 percent below their 2007 peak in the U.S. So until housing prices stabilize and the excess capacity is worked down, this important segment will be a drag on the economy.

The U.S. corporate sector is sitting on more than $2 trillion in cash and cash equivalents. They are investing less in plant and equipment than normal in a recovery. Why the reluctance to invest? The main reason is economic uncertainty caused by the problems in the Eurozone, a slowdown in China, regulatory reform, healthcare costs (including Obamacare), the so-called fiscal cliff facing the U.S. in 2013 when the Bush tax cuts expire and mandatory spending cuts to the U.S. budget take place, and escalating public-sector debt. Because of below-normal corporate investment and gains in productivity, manufacturing jobs in the U.S. are still 15 percent below their 2007 peak.

What can be done to stimulate the U.S. economy? Probably not much. Monetary policy has pretty much been played out with historically low interest rates, several rounds of quantitative easing, excessive bank reserves, and massive amounts of liquidity. Fiscal policy also is constrained. The U.S. has already borrowed more than $5 trillion to cover fiscal deficits since the start of the Great Recession. Some may argue that there has not been enough stimulus, but $5 trillion has resulted in GDP growth of less than $1 trillion. The bond markets are also closely monitoring public-sector debt and will quickly raise bond yields if government debt and deficits appear unreasonable.

What the U.S. economy needs more than anything is confidence. Confidence that government can  control spending and deficits, that consumers can spend but also not take on too much debt, that banks can provide credit again but also manage risk, and that regulatory reform is reasonable and not anti-business. Otherwise, it is difficult to see what will get the U.S. economy back to a normal growth rate. The worst economic recovery since WWII may continue on its present path. Or worse, it may result in another recession, and there may not be a fourth anniversary of the recovery to write about. Time will tell.

Negative Real Interest Rates Cannot Exist. Or can they?

Imagine going into a bank to borrow some money for a new car. The banker tells you that the interest rate is -3%. You look around the room for the Candid Camera camera and Alan Funt and then ask the banker to repeat what he said. So he speaks slowly so you will understand. If you borrow $10,000 from the bank today and pay the loan off in full at the end of the year – the bank will give you $300.

You immediately get very skeptical. Usually a car loan is quoted at something more like a +10% interest rate and will require that you pay back the $10,000 plus another $1,000 in interest. As such negative interest rates are not part of your usual experience and therefore require a second look.

There are two dimensions to every credit transaction. If in the above case the borrower is getting rewarded for borrowing then the creditor is getting a penalty. So right off let’s agree that negative interest rates tend to favor or incent the borrower – but do the opposite for lenders. So if this was a rugby match the side with jerseys marked borrower would be cheering. The lender side would be weeping in their Fosters.

But before going on to that excitement, we need to make a distinction between market and real interest rates. Right now, most market interest rates are not negative though some are. However it is true that many real interest rates are negative.  

First, market interest rates. How can some market interest rates be negative? Most banks are not quoting negative market rates on loans or deposits. But bonds also offer interest rates. A bond has a rate written on it – it says that if you hold this bond on such and such a date then you will receive the coupon return. So if you buy a $100 bond (you lend $100 to the borrowing company or government) with a coupon return of 4% then you would receive $4 per year. If this bond matures in one year then you will have received $104 back for your $100 investment. That sounds pretty cool. But if you sell that bond on a day when not many people want to buy you might accept $95 for it. In that case Buck, who bought this one-year bond, paid $95 for a security that will give him $104 at year’s end. He expects to earn 9.5% on his $95 investment.  A week later Buck sells the same bond on a day when the market is crazy for bonds. Myra buys the bond for $105 that day. At the end of the year she expects to get $104 back for her $105 investment. Way to go Myra! You get a -1% return on your $105 investment.  

Why would Myra or anyone else buy a bond with a negative return? One reason is that she likes the color of the print on the bond. A more important reason is that Myra looked around and noticed that most stocks, bonds, and real estate were very risky investments. While -1% doesn’t look very good in historical terms, it might look great compared to what she might get back from an investment today in a bank in Greece.

At this moment we don’t see too many cases of negative market returns. What we see more of is negative real interest rates. On Friday the market closed with the following market rates for US Treasuries – 1-year at 0.17%; 10 year 1.45%, 30-year 2.52%.  These are very low market rates. But for all these cases the real returns are negative. Why? Because a real return states the return in terms of purchasing power over goods and services. To obtain a real rate we subtract the expected future expected inflation rate from the market interest rate. How much annual inflation do you expect in the prices of goods and services in the next year? 10 years? 30 years? We could quibble but let’s just say that it seems reasonable that over any of those time periods the prices of goods and services will rise by at least 2.52%. If so, then as of last Friday there was a very negative real rate on 1-year bonds; at least a -1% real return on 10-year treasuries; and a wash for the 30-year bonds.

What is the upshot?

·         This is a time of great global financial risk and US Treasuries are the go-to asset

·         Market and real interest rates have gone so low recently because of market forces – not because the Fed drove them down.

·         This leaves very little for Fed policy to do now. Would it really help if the Fed drove these rates even lower?

·         Meanwhile borrowers are pretty happy and creditors are not.