Is Risk a 4-letter Word?

Financial FAQs

Barron’s columnist Alan Abelson asked just that question this week after the general decline in stocks, and 900 plus point drop in the DOW. Have investors become so cautious because of Europe’s debt problems and the uncertainty of our recovery that they no longer are willing to invest in this recovery? Banks are holding record amounts of deposits because investors are investing little and consumers spending less.

Actually risk comes from the French risqué, to be daring, according to Larousse—so that nothing ‘risqué’ is nothing gained. In fact, the French expression for Dare-devil is Risque-tout (or being totally risqué).

So being risqué is taking a chance in a dare-devil way. Hence periodically wild gyrations in stock prices should come as no surprise—at least to those in for the long haul, like marching towards retirement. Risk = both the potential for gains and losses, but any uncertainty lowers the tolerance for risk.

The good news is that stock prices do behave according to certain parameters. One such is inflation. To paraphrase Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon, economists generally maintain stock (and bond) prices are always and everywhere inversely related to inflation. Robert Thibadeau is one such economist. His historical graph of stock prices vs. inflation shows that stock prices tend to fall with high inflation, as happened in the 1980s, and rise with low inflation, as happened after 1998.

So it is good news that inflation has fallen in past months. Economist Paul Krugman fears it could fall further, however, which might give us something like Japan’s so-called ‘lost decade’ of no growth. But stock prices have been rising in this low inflation environment, which might counteract that tendency to slower growth.

In April, overall CPI inflation dipped 0.1 percent after edging up to 0.1 percent the month before. Core CPI inflation was flat for two months in a row. Year-on-year, overall CPI inflation eased to 2.2 percent (seasonally adjusted) from 2.4 percent in March. The core rate slipped in April to 1.0 percent from 1.2 percent the prior month. One may argue with the CPI, but the Fed also looks at the Personal Consumption Expenditure deflator, which measures overall prices. And even though year on year, personal income growth for March rose to 3.0 percent, rising from 2.2 percent in February, annual headline PCE inflation in March is 2.0 percent, while annual core PCE inflation was steady at 1.3 percent. This has helped to increase real, after inflation, disposable income.

So the combination of lower inflation and higher personal incomes should keep consumers spending and stocks rallying that will prevent a ‘double-dip’ recession. Recessions are always and everywhere a deflationary phenomenon. I.e., prices fall because of a fall in demand, which means a slack economy, which leads to higher unemployment. But why do stocks tend to rally with low inflation? It is a sign that investors appetite for risk is returning, in anticipation of a recovery.

And the latest signs are that investors are again investing and consumers spending. This is the major reason stocks have recovered. And as we reported last week, based on analysts’ 2010 earnings estimate, the ‘forward’ price-to-earnings ratio of the S&P 500 has slipped to 13.7 percent from 15.3 percent less than one month ago, below the historical 100-year average for stock prices—another reason to be daring.

Harlan Green © 2010

The Debt Fallacy

Financial FAQs

The European debt crisis has re-triggered the debate over budget deficits, and even whether Europe’s problems could trigger a ‘double-dip’ return to recession in our own economy. The contention is that Europe will be burdened with debt for years to come, which slows their economic growth.

What has Europe to do with our own economy? It is mainly the relationship between currencies. When the euro is high, then our exports are cheaper, helping manufacturing employment in particular. So the reverse case boosts European exports and reduces ours. And the euro’s value has plunged as investors fled to dollar denominated investments.

But a more general debate is whether governments should incur additional debts to cure such financial crises as we are now weathering. Keynesian economists say that government stimulus spending is crucial to any recovery, since it boosts demand for new products and services. But that only happens if it is directed to consumers—who account for up to 70 percent of economic activity.

So-called supply-side policies boost the producers by giving tax cuts directly to investors and businesses, in the hopes that it will induce businesses to expand and create more jobs. However, that didn’t happen during the last recovery. The 5 million jobs created from 2000-08 was the lowest total since WWII.

Nobelist and New York Times columnist Paul Krugman came up with an interesting conclusion on just that subject. Were we better off under the supply-side policies of President Reagan in the 1980s who wanted to funnel more money to the supply-side, or of Clinton in the 1990s who wanted it to go to consumers, was his question.

“Here’s what I think,” said Krugman, “inflation did have to be brought down — and Paul Volcker, not Reagan, did what was necessary. But the rest — slashing taxes on the rich, breaking the unions, letting inflation erode the minimum wage — wasn’t necessary at all. We could have gone on with a more progressive tax system, a stronger labor movement, and so on.”

The stimulus spending is definitely working. The Congressional Budget Office reported the latest results of the $787 billion American Recovery and Reinvestment Act (ARRA) under this headline:

New CBO Report Finds ARRA has Preserved or Created up to 2.8 Million Jobs

While the report focuses primarily on the first quarter of 2010, CBO also includes new projections of the Recovery Act’s jobs impact through 2012. It finds that in the current quarter (the second quarter of 2010), there are 1.4 million to 3.4 million more jobs in the economy because of ARRA, and it predicts that ARRA’s jobs impact will peak this fall, when there will be 1.4 million to 3.7 million more jobs because of the legislation.

This is in line with the latest unemployment report, which showed 290,000 payroll jobs created in April, following a revised 230,000 advance in March, and 39,000 rise in February. April's boost topped the market estimate for a 200,000 gain. Net combined revisions for March and February were up a 121,000-including turning February from negative to positive. But the key number is private payrolls as Census hiring added 66,000 to April's jobs, compared to adding 48,000 the prior month. Private nonfarm employment increased 231,000, following a 174,000 rise in March.

The real key to refuting the ‘debt fallacy’ is the benefit government stimulus does for consumers’ pocketbooks, and that is also looking better. Consumers are getting healthier— at least financially, as income gains enable them to spend and save more, with inflation almost non-existent. The headline PCE price index was unchanged in April-easing from up 0.1 percent in March. The core rate also was soft, gaining only 0.1 percent and matching both March and the consensus forecast.

Personal income posted a solid 0.4 percent increase for April, matching the gain the month before. The April figure came in slightly lower than the market forecast for a 0.5 percent boost. Importantly, the latest increase is in what really counts as the wages & salaries component advanced 0.4 percent after rising 0.3 percent in March.

The good news is that consumers are finding more greenbacks in their wallets and this should support additional spending and the recovery. The consumer on average is now pulling its weight in the recovery, while inflation remains benign.

What about paying back the $11 trillion in public debt? We can follow the post-WW II scenario, when it was 120 percent of GDP. That debt was paid down quickly in the post-war recovery. Today it is approaching 90 percent, because this was the worst downturn since the Great Depression. So once again the key to a recovery is keeping consumers healthy with more jobs and higher incomes.

Among ARRA’s most effective provisions for saving and creating jobs, according to CBO’s estimates, are direct purchases of goods and services by the federal government, transfer payments to states (such as extra Medicaid funding), and transfer payments to individuals (such as increased food stamp benefits and additional weeks of unemployment benefits). CBO’s estimates indicate that tax cuts are less effective job producers, and tax cuts for higher-income people and corporations have very low bang for the buck.

Harlan Green © 2010

Builder Optimism Up

The Mortgage Corner

Builder confidence in the market for newly built, single-family homes rose for a second consecutive month in May to its highest level in more than two years, according to the latest National Association of Home Builders/Wells Fargo Housing Market Index (HMI). The HMI gained three points to 22 in May, its highest point since August of 2007.

A major reason may be the highest affordability level in years. Nationwide housing, bolstered by favorable interest rates and low house prices, hovered for the fifth consecutive quarter near its highest level of affordability since the series was first compiled 19 years ago, according to the National Association of Home Builders Housing Opportunity Index (HOI).

The HOI showed that 72.2 percent of all new and existing homes sold in the first quarter of 2010 were affordable to families earning the national median income of $63,800, slightly higher than the previous quarter and near the record-high 72.5 percent set during the first quarter a year ago.

“Builders surveyed for the HMI at the beginning of May were undoubtedly reacting to the heightened consumer interest they had just witnessed as the deadline for home buyer tax credits arrived at the end of April,” said Bob Jones, Chairman of the National Association of Home Builders (NAHB). “Builders are also hopeful that the solid momentum that the tax credits initiated will continue even now that those incentives are gone.”

Total housing starts were at 672,000 (SAAR) in April, up 5.8 percent from the revised March rate, and up 41 percent from the all time record low in April 2009 of 477,000 (the lowest level since the Census Bureau began tracking housing starts in 1959). Single-family starts were at 593,000 (SAAR) in April, up 10.2 percent from the revised February rate, and 65 percent above the record low in January 2009 (360,000).

The expiration of second-round housing stimulus pulled home sales into March and April at the very heavy expense of May, according to the Mortgage Bankers Association. Its mortgage purchase loan index plunged 27.1 percent in the May 14 week on top of the 9.5 percent plunge in the May 7 week to pull the index to its lowest level since 1997. These results point to very weak home sales for this month and a new weight on home prices.

But record low mortgage rates did give a big boost to refinance applications which jumped 14.5 percent. Mortgage rates, being pulled lower by safe-haven demand for U.S. Treasuries, are at their lowest level since November last year with 30-year loans down 13 basis points in the week to an average 4.83 percent.

Wider refinancing will help keep homeowners out of foreclosure and will limit distressed sales, but the purchase results point squarely to new risk for the housing sector and will raise talk for a third round of housing stimulus, says Calculated Risk.

Harlan Green © 2010

No More ‘Double-Dip’ Talk

Popular Economics Weekly

“Irrational Exuberance” author Robert Shiller in an eye-opening Sunday NYTimes op-ed maintains there is still chance of a double-dip recession. But it could happen over years, rather than months. “I use the definition of a double-dip recession that doesn’t emphasize the short term,” he says. “I see it as beginning with a recession in which unemployment rises to a high level and then falls at a disappointingly slow rate.”

The problem with such a definition is that only the Great Depression fits his description. The double-dip occurred in 1937, 4 years after the 1929-1933 depression, when most economists say President Roosevelt prematurely attempted to balance his budget! So is Professor Shiller guilty of his own irrational pessimism?

There is little likelihood of a double-dip for several reasons. Hiring is picking up in the wake of record corporate profits over the past 2 quarters, the huge amount of stimulus spending—some $3 trillion plus is just now taking effect and, confidence levels are not falling in spite of the current stock market correction.

Corporate profits in the fourth quarter surged to an annualized $1.270 trillion from $1.174 trillion the prior quarter, as we reported last week. Profits in the fourth quarter were up an annualized 37.0 percent, following a 68.0 percent jump the prior quarter. Profits are after tax but without inventory valuation and capital consumption adjustments. Corporate profits are up 51.8 percent on a year-on-year basis.

This is the major reason stocks have recovered. The New York Times’ Paul Lim says there are rising expectations for corporate profits among Wall Street analysts (i.e., their ‘animal spirits’ are rising, not falling). So based on their 2010 earnings estimate, the ‘forward’ price-to-earnings ratio of the S&P 500 has slipped to 13.7 percent from 15.3 percent less than one month ago. And Dr. Shiller maintains in his book, Irrational Exuberance, a price-to-earnings ratio of 13-14 percent increases the odds 15 percent that stock prices will increase rather than decrease.

It is true unemployment has remained high compared to past recessions, as we said last week. But payroll jobs in April grew a healthy 290,000, following a revised 230,000 advance in March, and 39,000 rise in February. And net combined revisions for March and February were up a 121,000—including turning February from negative to positive. Do we have to repeat the fact that payrolls have risen for four consecutive months and in five of the last six? April’s boost was the largest in four years, by the way.

It’s hard to argue that we are still in recession with this string of gains, as we have said, even though the gains are mostly on Wall Street to date, with corporate profits soaring. Of course consumers don’t yet feel they are sharing in it, which is the basis for Shiller’s pessimism.

“From 2007 to 2009, there was widespread concern about the risk of an economic depression, but that scare has been abating”, he continues. “Since mid-2009, it has been replaced by the milder worry of a double-dip recession, as a count of Web searches for those terms on Google Insights suggests. And with that depression scare still fresh in our minds, sensitivity to the possibility of another downturn remains high.”

The Conference Board's consumer confidence report rose strongly for a second straight month, up about 5-1/2 points in April to 57.9. The gain is centered in expectations which jumped 7 points to 77.4, reflecting rising optimism over the outlook for business conditions and easing pessimism on the outlook for employment and income.

The assessment of the present situation also improved with the index rising more than 3-1/2 points but to a still severely depressed level of 28.6, reports Econoday. Pessimism is easing with fewer describing current business conditions as bad and fewer describing jobs as hard to get (45.0 percent vs. March's 46.3 percent). Other details show a jump in buying plans for cars and major appliances though buying plans for homes are still under water. Inflation expectations, despite the month's rise in gasoline prices, eased slightly.

So the recovery is finally beginning for Main Street. I like Calculated Risk’s chart on this. According to the Labor Department’s JOLT report (Job Openings and Labor Turnover Summary), there were 4.242 million hires in March (Seasonally Adjusted), and 4.016 million total separations, or 226 thousand net jobs gained. Notice that total job separations have been dropping since January ‘09, while the number of both job openings and hires has been rising since mid-2009, the probable end of this recession.

So even though the unemployment rate is declining slowly, it is already a long term trend, folks. And though the median duration of unemployment rose to 21.6 weeks from 20.0 weeks in March and the percentage of unemployed, marginally attached and part time is still above 16 percent of the workforce, it is mainly because more people are optimistic about finding a job (805,000 actually rejoined the workforce in April).

It’s true that short-term attitudes can change on a dime, as the DOW’s 900 point drop proves. But the longer term trend of “public thinking”, as Shiller calls it, seems to be greater optimism rather than pessimism. Just look at comparisons to other post-WWII recessions done by Calculated risk. It shows that the two longest jobless recoveries were during Republican administrations—Bush I &II—which were ruled by an ideology that opposed government stimulus spending. The Obama Administration has taken the opposite attack—pump as much government stimulus as possible into the economy to speed up the recovery. And it seems to be working.

Harlan Green © 2010

Payrolls Are Key to Recovery

Are the rise in payroll jobs a key to this recovery? An analysis of payroll jobs in April show a healthy 290,000 increase, following a revised 230,000 advance in March, and 39,000 rise in February. Net combined revisions for March and February were up 121,000—including turning February from negative to positive. A continued payroll jobs increase will put a definite end to this Great Recession.

Payrolls have risen for four consecutive months and in five of the last six. And April’s boost was the largest in four years. It’s hard to argue that we are still in recession with this string of gains, even though more than 72 percent believe so in a recent NBC poll.

Why the continued pessimism? Because the recovery has been so uneven. The payroll data reveal why. Gains were widespread in the manufacturing sector, but not in the service-producing sector, where most of the jobs are today. Goods-producing jobs increased 65,000 after a 55,000 rebound in March. Manufacturing employment surged 44,000, following a 19,000 advance in March. Construction jobs even continued a comeback with a 14,000 rise, after rebounding 26,000 in March. Mining jobs rose 7,000 in April.

Private service-providing employment did gain 166,000 in April, following a 119,000 boost the month before. Latest strength was in professional & business services, up 80,000; leisure & hospitality, up 45,000; and education & health services, up 35,000. But wages are still stagnant, though hours worked has picked up, as employers try to maximize profits by pushing their workers harder, rather than add to their workforce.

Wage inflation is ‘nonexistent’, in other words, but it is hard to tell initially if weakness is related to shifts in the composition of hiring, though that likely partially explains the weakness, says Econoday. Average hourly earnings were flat in April, following a 0.1 percent dip in March.

So what is holding consumers back? The biggest negative was the unemployment rate rising to 9.9 percent from 9.7 percent in February. Nonetheless, there is positive news from the household survey as the jump was due to an 805,000 surge in the labor force. April household employment actually jumped 550,000. Basically, discouraged workers see hope of employment and have jumped back into the labor force. Essentially, the spike in the labor force points to optimism on the part of workers.

Workers remain hopeful, in other words, but progress in bringing down the unemployment rate is going to be slow. The median duration of unemployment rose to 21.6 weeks from 20.0 weeks in March.

Recent improvement in jobs may be spilling over into greater willingness by consumers to spend—and, in turn, this is bolstering the recovery. In fact, personal spending strengthened and outpaced income. Personal Consumption Expenditures posted a 0.6 percent boost in March, following a 0.5 percent jump the month before. Spending was led by a surge in motor vehicle purchases as seen in a 3.6 percent spike in durables. Nondurables advanced 0.3 percent and services rose 0.2 percent.

It is probably corporate profits that will determine future job growth, as we said last week, and profits are soaring. Profits in the fourth quarter were up an annualized 37.0 percent, following a 68.0 percent jump the prior quarter. Profits are after tax but without inventory valuation and capital consumption adjustments. Corporate profits are up 51.8 percent on a year-on-year basis.

Other factors than employment and corporate profits spur economic growth, of course. Manufacturing has grown in large part because the weak dollar has caused exports to soar. Exports are up 3.2 percent in March and more than 20 percent in a year. And forward momentum is building as the ISM’s manufacturing new orders index continued its rebound to reach a strong 65.7, where 50 or less is no growth. New orders have been in positive territory for 10 straight months.

Harlan Green © 2010

Our ‘Trickle Down’ Recovery

Popular Economics Weekly

Even though so-called ‘trickle-down’ economics that was popularized as Reaganomics in the 1980s has lost popularity—it was deregulation that caused the credit markets to go wild, after all—some vestiges are still evident in the current recovery. And that is because most of the stimulus aid has gone to Wall Street—both as TARP funds and the $2 trillion spent by the Federal Reserve to keep down interest rates—with the hope it would trickle down to Main Street.

To date, it is the banks that have benefited most from those low rates. Their profit margins have increased, since they are able to borrow at almost zero cost while lending at prevailing retail rates. But the merest trickle is getting to consumers and small businesses, and so Main Street.

The most recent evidence is the Federal Reserve’s monthly Consumer Credit report. Credit for both credit cards and installments debts—excluding mortgages—shrank 4.4 percent in 2009, the largest amount since records were kept. Borrowing for cars and other goods that require installment debt have grown slightly, but revolving debt has now shrunk to 2005 levels, indicating that more credit cards are being cancelled than originated.

The incentive-driven surge of car sales in March by dealers made for what is actually a welcome increase in outstanding consumer credit, up $2.0 billion vs. a $6.2 billion contraction in February. Even the news on February is a little better as the contraction was revised upward to minus $6.2 billion from an initial reading of minus $11.5 billion. March non-revolving credit, reflecting car sales, jumped $5.2 billion to offset another contraction in revolving credit, this time minus $3.2 billion. The contraction in non-revolving credit is a reminder that consumer confidence, despite an improving jobs market, is less than spirited.

Corporations are another sector that has benefited from the stimulus aid. Low interest rates have kept down their borrowing costs, amid soaring profits. Yet they have barely begun to hire, after shedding more than 8 million jobs during the recession.

Corporate profits in the fourth quarter surged to an annualized $1.270 trillion from $1.174 trillion the prior quarter, said the Commerce Dept. Profits in the fourth quarter were up an annualized 37.0 percent, following a 68.0 percent jump the prior quarter. Profits are after tax but without inventory valuation and capital consumption adjustments. Corporate profits are up 51.8 percent on a year-on-year basis.

Unemployment remains stubbornly high compared to past recessions, as we said last week. Payroll jobs in April grew a healthy 290,000, following a revised 230,000 advance in March, and 39,000 rise in February. Net combined revisions for March and February were up a 121,000—including turning February from negative to positive. Payrolls have risen for four consecutive months and in five of the last six. And April’s boost was the largest in four years.

It’s hard to argue that we are still in recession with this string of gains. But the gains to date are mostly on Wall Street. Corporations have profited as much from cutting their overhead, including worker layoffs.

Consumers don’t feel they are sharing in it yet, as evidenced by consumer sentiment. But maybe the improving jobs market will change attitudes.

The Conference Board's consumer confidence report rose strongly for a second straight month, up about 5-1/2 points in April to 57.9. The gain is centered in expectations which jumped 7 points to 77.4, reflecting rising optimism over the outlook for business conditions and easing pessimism on the outlook for employment and income.

The assessment of the present situation also improved with the index rising more than 3-1/2 points but to a still severely depressed level of 28.6. Pessimism is easing with fewer describing current business conditions as bad and fewer describing jobs as hard to get (45.0 percent vs. March's 46.3 percent). Other details show a jump in buying plans for cars and major appliances though buying plans for homes are still under water. Inflation expectations, despite the month's rise in gasoline prices, eased slightly.

So is the recovery finally beginning for Main Street? Econoday puts out a very interesting graph that shows total employment. The headline showed the unemployment rate rising to 9.9 percent from 9.7 percent in February. Nonetheless, there is positive news from the household survey as the jump was due to an 805,000 surge in the labor force. April household employment actually jumped 550,000. Basically, discouraged workers see hope of employment and have jumped back into the labor force. Essentially, the spike in the labor force points to optimism on the part of workers.

But progress in bringing down the unemployment rate is going to be slow. The median duration of unemployment rose to 21.6 weeks from 20.0 weeks in March and the percentage of unemployed, marginally attached and part time is still above 16 percent of the workforce, the worst number since the Great Depression. And so the trickle down recovery is just that—improvement for Wall Street and the corporations before Main Street.

Harlan Green © 2010

Goldman’s Defense--Innocent Fraud?

Financial FAQs

The U.S. Senate has finally begun debate on financial reform, but only after eye-opening testimony at Senator Carl Levin’s Permanent Subcommittee on Investigations by Goldman Sachs’ executives, who claimed that hedging their bets on subprime mortgages was perfectly legal, while not believing that telling clients what they thought of the securities or derivatives sold to them was relevant.

Why their belief that they were innocent of any fraud? This is when economic theory gets mixed up with ideological belief systems. Economist John Kenneth Galbraith labeled it “The Economics of Innocent Fraud” in his book of that title (2004, Houghton Mifflin, Boston). “Most progenitors of innocent fraud…are not deliberately in its service. They are unaware of how their views are shaped, how they are had. No clear legal question is involved. Response comes not from violations of law but from personal and social belief. There is no serious sense of guilt; more likely, there is self-approval.”

The inherent conflict in Goldman’s case was that of the classic inside trader, who believed that free, unregulated market forces should determine investor behavior. We now know that unregulated ‘free markets’ are a vehicle for manipulation by insiders. Goldman had inside information that their buyers didn’t—i.e., that there was a great likelihood the underlying subprime mortgages might have very high default rates. And as ‘market-makers’, their function as a pure trader was to find buyers for sellers and vice versa, without evaluating the underlying worth of the assets being traded.

Of course there were other conflicts of interest. Goldman was both an unregulated securities’ trader and an investment bank regulated by the Federal Reserve, which gave them a source of very cheap funds (i.e., because tax payer guaranteed). Until the Depression era Glass-Steagall Act was repealed in 2000, commercial banks regulated by the Fed could not also be securities’ traders. The reason was that stock, bond, and derivatives’ trading was a very risky business where caveat emptor prevailed—‘buyer beware’, in other words.

This was precisely why Senate members used the Las Vegas casino analogy at the Goldman hearings. Bets were being placed on which direction the subprime market would go, without the bettors having any ‘skin’ in the game—i.e., no equity or ownership interest in the underlying securities—just like placing a horse racing bet. It was gambling, in a word, but Las Vegas gamblers knew they were gambling as Nevada’s Senator John Ensign said at the hearings, whereas Wall Street investors did not at the time.

And, more importantly, because derivatives’ trading was unregulated, no one knew how much was bet for or against subprime mortgages at the time. It was being transacted through a shadow-banking system specifically set up to escape regulation. Whereas horse race bettors know exactly what the odds are, because regulations require the odds to be publicly posted.

The result was that traders’ profited, but those pension funds and foreign banks that had no real knowledge of the risks inherent in such trades did not. That is why this ‘last bastion of free enterprise’, as some traders call it has to become more transparent. Financial markets are now as interconnected as our environment. What happens in one part of the financial environment can affect other parts not directly involved.

The environmental analogy is apt here. Financial markets have become an internationally connected financial ecosystem subject to ‘pollution’ with toxic securities, just as our environment has become polluted with toxic chemicals. The world has become ‘flat’ and interconnected, said columnist and author Thomas Friedman, precisely because information is now transmitted at light speeds in our new digital world.

The Darwinian world’s survival of the fittest analogy was true 100 years ago when Capitalism was an infant struggling to survive in a post-feudal age world where ownership was still in the hands of the few—whether monarchs or military dictators. But once the Industrial Revolution prevailed over the feudal age, laws regulating private property rights and controlling predatory behavior became necessary.

In fact, markets only function well when there is transparency. Otherwise assets become mispriced, bubbles formed, and greater losses ensue. Nobelist George Akerlof knew this best when he did ground-breaking research on how asset markets really function. He studied the Lemon used-car market, of all things, which before it became regulated meant buyers had no knowledge whether a new or used car was a lemon—had some undetectable defect, in other words. And because buyers therefore discounted the price of those unguaranteed cars, it drove sellers with vehicles of better quality out of the market.

And that is why state vehicle Lemon Laws now require some guarantee or warranty of quality for each vehicle for sale. Professor Akerlof’s seemingly innocuous research, along with that of Joseph Stiglitz and Michael Spence won them the 2001 Nobel Prize in the Economic Sciences “for their analysis of markets with asymmetric information”, and proved that insider trading will always harm markets, if not regulated.

Professor Akerlof, also the co-author with behavioral economist Robert Shiller of “Animal Spirits”, has been very vocal about the need for regulations and laws to keep up with financial innovations. One of his favorite sayings first appeared in a New York Times editorial.

“If you let your toddler out of her playpen, you need to watch her more carefully. This wisdom is known by every American parent but has been systematically ignored in economic deregulation…Now is the time to remember the lessons of the playpen: increased scope for action must be accompanied by increased regulatory oversight.”

JK Galbraith’s innocent fraud is the reason ideology may trump economic reality. Those AAA ratings on subprime mortgage securities were an illusion, fostered by Goldman’s traders that generated tremendous profits. There is a ‘snake oil’ element in all financial markets that free market ideologues are loath to admit. “…those employed or self-employed who tell of the future financial performance of an industry or firm, given the unpredictable but controlling influence of the larger economy, do not know and normally don’t know they do not know.” Those predictions “are thought to reflect economic and financial expertise. And there is no easy denial of an expert’s foresight.”

Harlan Green © 2010

Why Financial Reform?

Financial FAQs

It is becoming clearer that economic self-interest under the guise of trickle-down economics no longer rules in the debate over financial market regulation. There must be regulations that protect the self from itself, and the predatory behavior of others. The SEC’s charge that Goldman Sachs committed fraud in marketing Collateralized Debt Obligation insurance on the worst of subprime mortgage pools is the opening salvo in a campaign to make the players who almost drove financial markets over the cliff responsible for their deeds.

“The SEC suit again Goldman, if proven true, will confirm to people their suspicions about the total selfishness of these financial institutions,” said Wall Street historian Steve Fraser, as quoted in the New York Times. “This is way beyond recklessness. This is way beyond incompetence. This is cynical, selfish exploiting.”

Even President Bill Clinton said recently on ABC’s “This Week” that had he known the damage that unregulated derivatives could wreak on an unsophisticated public as well as sophisticated investors, he would never have backed the 1999 legislation that deregulated them. “I have said many times since then, I made a mistake.”

And even economists are beginning to see the light. A Cambridge, U.K. conference sponsored by currency trader George Soros is looking for other systems that might take us away from economic self-interest. Britain’s chief regulator said, "We need a fundamental challenge to recent conventional wisdom…a dominant conventional wisdom that markets were always rational and self-equilibrating."

Some of the difficulty in pinning down responsibility has been misconceptions about a capitalist economy, said 2001 Nobelist George Akerlof. There is always an element of ‘snake oil’ in all financial markets, which tend to be overlooked even by regulators. What is overlooked is their agenda, such as the ratings’ agencies underestimation of risk, or regulators’ inability to spot a Bernie Madoff. Regulators such as the SEC were either too overworked, or too unsophisticated in not looking under the covers of many offerings. And rating agencies were paid by the companies issuing the securities, hence tended to soften their risk analysis so that even some subprime-based securities were rated AAA.

Secondly, no one seemed to even understand the consequences. A string of unprecedented financial innovations created institutions that “don’t take into account the kind of communities we want to build”, said economist Robert Shiller in a recent New York Times Op-ed. Yet as leaders of their respective institutions it was certainly their job to foresee any downside consequences. There were certainly precedents, such as the creation of extreme asset bubbles in Japan. In fact, the Federal Reserve had worried about Japanese-style deflation in the early 2000s, the result of Japan’s own busted real estate and stock bubbles.

On the contrary, the biggest players only saw the upside. Greenspan in fact trumpeted the advantages of exotic (and unregulated) derivatives that spread the risk more widely, that he thought lessened the dangers of default. Yet Greenspan of all people should have foreseen the crash.

I remember well that he encouraged risky mortgages by recommending adjustable rate mortgages as preferable to fixed rates because their interest rates were lower, even though he admitted at hearings he only borrowed at fixed rates! A housing bubble was most unlikely, he said, because home owners couldn’t buy and sell their homes like stocks. Their transaction costs were higher, the housing market was less liquid—and moving costs were considerable.

This was when the Fed had been holding down short-term interest rates in 2003-4 almost as low as today in a bid to fight Japanese-style deflationary fears, and boost a recovery that hadn’t yet added one net job from the end of the 2001 recession. Because inflation was so low then—below 1 percent—the cost of money was in fact less than zero, which made it advantageous to mortgage with little or no down payment.

Why could some of the “smartest guys in the room” so miscall the worst downturn since the Great Depression? Greenspan for one, a disciple of Ayn Rand, believed that free markets embodied the highest moral order (his words). What made it moral? Greenspan, as Ayn Rand, et. al., believed that free market forces were the most efficient and impartial allocator of resources. So when crises did occur, they functioned as a market clearing device, and any attempt to mitigate their effects only prolonged the adjustment to new circumstances. Such crises embodied the forces of ‘creative destruction’ and shouldn’t be tampered with, in other words.

This is why many conservative economists who decried the stimulus spending said “let the banks fail”, so that bad debt can be wiped out. Creative destruction—the replacement of failing businesses with more vibrant ones—happened in nature, so why shouldn’t it be allowed to happen in the urban jungle?

The problem was that Greenspan’s ideology was outdated, and had become group think. The invisible hand of Adam Smith was no longer sufficient to control market forces that had become complex beyond understanding. Bubbles were caused by ignorance of fundamentals, including fundamental market forces that could go easily out of control when greater risk taking was encouraged, with no limits on borrowing.

Household incomes had been steadily shrinking in real (after inflation) terms since the 1970s, except for a short while in the 1990s, so the housing bubble and easy credit encouraged many households to spend borrowed money to keep up their standard of living, a standard that was now beyond their means.

A sustainable economic system in today’s world has to take more than individual self-interest into account, since more than the individual is affected. Financial markets are today intimately linked, so that markets may collapse world-wide if leaders are not held accountable for their risk-taking. Alan Greenspan made a choice of individual gain without regard for its consequences when he chose to ignore the housing bubble. But the captains of industry-and government-have to be held accountable for the welfare of all those affected by their actions as well.

Harlan Green © 2010

The Case for Sustainable Economics-II

Financial FAQs

Behavioral Economist Robert Shiller said in a recent New York Times Op-ed said, “We need to invent financial institutions that take into account the kinds of communities we want to build. And we need to base this innovation on an approach to economics that captures the richness of human experience—and not efficient-market economics.”

Dr. Shiller is one of many economists decrying the lack of sustainable financial institutions that have led to so many recessions, including the current Great Recession—sustainable institutions that build communities rather than destroy them. Their lack has been mainly because they targeted the wrong economic goals—productivity over sustainability, or efficient markets (i.e. markets with minimal oversight) over markets that attempt to sustain longer-term economic growth.

We seem to have mastered the means of production, as economist John Maynard Keynes predicted in his 1930 treatise, “Economic Possibilities for our Grandchildren”, yet not how to put such growth on a sustainable path that benefits future generations rather than indebting them. As the originator of an economic theory that advocated government support during the Great Depression, Keynes believed that markets did not cure themselves without widespread suffering. The “animal spirits” of a populace that was discouraged by prolonged unemployment had to be boosted by governmental job creation measures in order to boost economic growth, if private sector employers weren’t hiring.

In other words, most modern economic theory has concentrated on producing the maximum amount of goods and services (hence emphasis on efficient markets), but ignoring their social welfare aspects. I.e., how sustainable is such a system that venerates individual effort (i.e., self-interest), but ignores its results? When whole communities are destroyed by a succession of bursting asset bubbles—it was first the dot-com bubble in 2000, then real estate bubble, and now the credit bubble bursting that has almost destroyed our banking system—then it is time to begin looking for a more sustainable economic system that preserves assets for our grandchildren.

Economists, sociologists and psychologists in particular are beginning to look at systems that capture the “richness of human experience” advocated by Dr. Shiller. One pioneer is economist Hazel Henderson, who helped to found the Calvert family of eco-friendly mutual funds. She also created the Calvert-Henderson Quality of Life Indicators (at http://www.calvert-henderson.com) that helps to measure what makes up a better quality of life. Its education component highlights why U.S. elementary education has flagged—the U.S. is ninth in the list of eighth grade math and science scores, for instance—behind nos. 1 and 2 Singapore and Taiwan, and what should be done to remedy it.

The research of behavioral economists such as Dr. Shiller are also debunking the efficient markets’ economists who generally advocate privatization (and deregulation) of financial institutions in the belief that individuals are the best regulators of their own behavior. Behavioral economists find that most people either do not have the time or knowledge to make intelligent financial decisions without some regulation to govern errant behavior. Former Fed Chairman Alan Greenspan once famously said,

“It is not that humans have become any greedier than in generations past. It is that the avenues to express greed had grown so enormously.”

Though private enterprise is the foundation of capitalism, and its source of wealth, we now know it only enriches the few without adequate regulation and governmental oversight.

And so Lord Keynes concludes, “The strenuous purposeful money-makers may carry all of us along with them into the lap of economic abundance. But it will be those peoples, who can keep alive, and cultivate into a fuller perfection, the art of life itself and do not sell themselves for the means of life, who will be able to enjoy the abundance when it comes.”

The Case for a More Sustainable Economics

Financial FAQs

Recent events have shown that financial markets are still very susceptible to crashes, and economies susceptible to serious recessions, such as the recent Great Recession. But does that have to be? The fault doesn’t only lie with the irrational exuberance of investors who believe that markets (and housing prices) only go up. Such financial gyrations also come from faulty economic thinking, thinking that hasn’t changed for more than 200 years.

Adam Smith, the founder of much of what is called classical economics, thought that an “invisible hand” (i.e., a free market) created maximum conditions for the production of goods and services—which suited the small market economies that existed in 1776, and provided a theoretical blueprint for the Industrial Revolution then sweeping Great Britain. His theories helped to solve the problems of mass production, but not how those goods should be distributed. And that is where the science of economics has fallen down.

In fact, most recessions result from overproduction, including the Great Depression. The current Great Recession resulted from an overproduction of housing, as the 2001 recession resulted from overexpansion of the dot-com sector. That is really the definition of an overheated economy. Some kind of inflationary asset bubble is created, which eventually causes prices to plunge (or crash), which leads to a downward spiral in production and jobs.

Only now are economists beginning to think about the consequences of mass production. They are beginning to look for a more sustainable model for economic growth, one that isn’t susceptible to such wide swings.

Economist John Maynard Keynes was the first modern economist to address this issue. He said in an essay entitled, “Economic Possibilities for our Grandchildren (1930)” that, “assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not—if we look into the future—the permanent problem of the human race.”

We are 20 years away from that date, and yet how close to achieving his utopian prediction, when “…the economic problem, the struggle for subsistence, always has been higherto the primary, most pressing problem of the human race…”?

There is not much research to date on sustainable markets, meaning markets that leave some wealth for our grandchildren, as Keynes wished. The current Great Recession is an excellent example. It left a mountain of debt, due to a massive deregulation of the financial markets and the consequent massive overleveraging of debt.

Even the sustainability of social security and Medicare are in doubt, as well as the credibility of the U.S. Treasury’s ability to repay some $10 trillion in federal debt. We are not the most indebted of developed countries, as this map shows. But the near-failure of our financial system has highlighted the dangers of over-indebtedness.

There are other forms of sustainability beside responsible budgets that provide sustainable social safety nets, of course. There are sustainable production methods that don’t deplete non-renewable resources, and sustainable environmental practices that don’t emit toxic pollutants.

The most sustainable economic theory would still embrace an emphasis on increasing average household incomes, which has actually decreased since 2000 for those under 65 years of age. But that can only happen with an emphasis on job creation, which current economic policies and theories do not foster. In fact, household incomes have fallen back to 1998 levels, so severe has been this recession.

The main problem with the various job creation theories is their total disagreement on methods that create what is called aggregate demand, the engine for any economic growth. That is the demand for goods and services that must grow for producers to have the incentive to produce more, and so create new jobs.

So-called neo-classical (mostly conservative) economists still believe in Say’s Law, for example, that says if more ‘things’ are produced, it will create the demand, per se, which will in turn cause consumers and investors to want to buy/invest more. This is the faulty thinking that still underlies much of modern economics. It justified skewing tax breaks to producers and investors in 2001 while reducing government oversight, in the theory that with less restraints employers will automatically create new jobs.

But the main characteristic of a recession is that a surplus of things drives down prices, and so drives up unemployment, as we have said. This in turn reduces aggregate demand, which economists express as a formula:

where aggregate demand (Yd) is the sum of all personal consumption (C) + private investment (I) + government expenditures (G) + any net of exports over imports (X-M).

We know that during most recessions personal consumption, private investment, and exports tend to fall, so in order to create stable aggregate demand during such downturns government has to step up its spending. Only then will the economy be stimulated by putting enough money in the hands of consumers, who comprise 70 percent of economic activity.

This in turn means taking the focus off individual, self-interest, as a goal of economic development, and focusing on the economic self-sufficiency of families, communities and countries. By focusing on the welfare of the whole, economists can begin to focus on the welfare of future generations, as well as those of past and present generations.

Harlan Green © 2010

Case-Shiller--Home Prices Still Rising

This could be the year real estate begins to recover in earnest—at least in some regions. It is no surprise that states with the biggest real estate bubbles—such as Nevada, California, Arizona, and Florida—will take the longest to recover. On a year over year basis, the February S&P Case-Shiller same-home 10 city index is now up 1.4 percent from last February and the 20 city index is up 0.6 percent. This is the first time since December 2006 that both annual rates of change for the two composites have been positive.

But month-to-month prices decreased (SA) in 15 of the 20 Case-Shiller cities in February, mainly because the March surge in both new and existing-home sale will be in next month’s numbers. David Blitzer, Chairman of the Index Committee at Standard & Poor’s says:"These data point to a risk that home prices could decline further before experiencing any sustained gains. While the year-over-year data continued to improve for 18 of the 20 MSAs and the two Composites, this simply confirms that the pace of decline is less severe than a year ago. It is too early to say that the housing market is recovering”

“Existing and new home sales, inventories and housing starts all show tremendous improvement in their March statistics,” he continued. “The homebuyer tax credit, available until the end of April, is the likely cause for these encouraging numbers and this may also flow through to some of our home price data in the next few months. Amidst all the news, however, we should also pay heed to foreclosure activity, which have reached their highest level in at least the last five years. As these homes are put up for sales, we may see some further dampening in home prices.”

Both existing and new home sales jumped in March ahead of the expiration of special tax credits for homebuyers at the end of April. New home sales in March surged 26.9 percent to a 411,000 annual rate, bumping up the year-ago pace to up 23.8 percent from down 8.5 percent in February. The boost in sales whittled supply down and to 228,000 units from 233,000 in February. Relative to sales, homes on the market eased to a 6.7 months’ supply from 8.6 in February.

Existing home sales also gained in March but not as strongly as did new sales. Existing home sales rose 6.8 percent to an annual rate of 5.35 million from February’s 5.01 million. Gains were evenly distributed across regions. For the U.S., the year-ago pace improved to 16.1 percent from 6.8 percent in February.

Supply fell back to 8.0 months from February's 8.5, and the median price rose 3.7 percent to $170,700 with the year-on-year pace at 0.4 percent. First-timers were 44 percent of total sales, up 2 percentage points from February.

What about future activity? Both the Conference Board’s Leading Economic Indicators (LEI) and Consumer Confidence Indexes rose sharply in March, signaling strong growth overall this year. The Conference Board's LEI surged 1.4 percent in March, following a 0.6 percent increase the month before. Manufacturing gave the index a big boost with major contributions coming from a significant lengthening in the factory workweek and greater slowing in deliveries, ones that are likely to extend into the April report given continuing signs of strength from the sector.

The financial sector added significantly to the composite gain with sizeable contributions from the interest rate spread and stock price increases. Building permits are also a major positive for March and indications here, based on a big jump in the home builder index, are also positive for April.

The slide seen in the mid-month consumer sentiment index is not at all confirmed by the Conference Board's consumer confidence report which rose strongly for a second straight month, up about 5-1/2 points in April to 57.9. The gain is centered in expectations which jumped 7 points to 77.4, reflecting rising optimism over the outlook for business conditions and easing pessimism on the outlook for employment and income.

Just released minutes from the last Federal Open Market Committee meeting (that sets Fed policy) sounded more confident, also. It said,“Growth in household spending has picked up recently but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly; however, investment in nonresidential structures is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a depressed level.

While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

Harlan Green © 2010

Why Was Housing Bubble Ignored?

Financial FAQs

Historical hindsight is always 20-20, but why didn’t economists and the Fed act sooner to deflate the housing bubble? By waiting until 2006 to tighten credit, the Federal Reserve allowed overbuilding of the housing sector that resulted in the current oversupply of some 1 million homes.

Housing bubbles can be detected and treated if Fed officials and others had heeded their own research. One measure they looked at was the housing rent-to-price ratio, or ratio of housing rents to prices. When prices rise much higher in relation to rents, then we know those rises are not sustainable, but speculative.

The Federal Reserve was worried about a housing bubble as far back as 2004, according to Calculated Risk. But nothing was done about it under Alan Greenspan’s chairmanship. We now know why. Greenspan didn’t believe housing prices could rise to bubble heights. He maintained housing wasn’t as ‘liquid’ as other investments, and so subject to the same speculation as stock and bond values that created the dot-com bubble. But such proved not to be true when the Fed changed its monetary policy that brought in the low interest rates and easy credit lasting from 2004 to 2007.

The Fed was looking at a ratio calculated by one of its researchers that saw rents had plunged to less than 2 percent of housing prices in 2004, due to soaring home prices. “I don’t want to leave the impression that we think there’s a huge housing bubble,” said the Fed’s associate director of research. “We believe a lot of the rise in house prices is rooted in fundamentals. But even after you account for the fundamentals, there’s a part of the increase that is hard to explain”.

Even though economists such as Robert Shiller saw the housing bubble, as we reported last week. He told the Fed in 2005 that housing prices could plunge as much as 50 percent in some regions. And that has happened in cities like Las Vegas and Phoenix, with Detroit, Miami and Tampa, Florida not far behind.

Homeownership rates have also plunged from 69 to 67 percent of households, according to the U.S. Census Bureau, as more households return renting. Could the exodus of homeowners to renting turn into a flood? The homeownership rate was as low as 64 percent in 2004, and the historical average seems to hover around 65 percent. Is that the actual percentage of households who can truly afford to own? Time will tell.

First quarter GDP growth was 3.2 percent, the third consecutive quarter of economic growth. Both residential and non-residential investment are still a drag on growth with equipment and software pulling us out of the recession. But it looks like housing construction (i.e., residential investment) is poised to become a positive factor. Note that the recession probably ended in mid-2009, according to Calculated Risk.

The consumer sector is helping the recovery gain traction. Not only did income improve but spending accelerated. Personal income strengthened in March, gaining 0.3 percent, following a 0.1 percent rise the prior month. The heavily-weighted wages & salaries component increased 0.2 percent in March after edging up 0.1 percent in February.

Consumer spending rose at a faster pace due to a jump in motor vehicle sales. Overall, personal consumption posted a 0.6 percent boost in March, following a 0.5 percent jump the month before. The March figure equaled expectations but February spending was revised up from a 0.3 percent initial estimate. By components, durables spiked 3.6 percent in March, nondurables advanced 0.3 percent, and services rose 0.2 percent.

Personal income growth for March rose to 3.0 percent over last year, rising from 2.2 percent in February. Year-ago headline Personal Consumption Expenditure inflation firmed to 2.0 percent from 1.8 percent in February, nearing the upper limit of the Fed’s inflation target. The so-called core PCE inflation without energy and food prices was steady at 1.3 percent.

The Fed was caught up in the ‘group think’ of that time, which said that freeing markets to run their own course was the path to prosperity. Greenspan, et. al., wanted to foster faster economic growth without heeding the warning signs, in other words.

It turns out that asset bubbles can be detected, and surprise, surprise, ideology cannot trump reality, as much as Greenspan’s Federal Reserve attempted to mold the debate. We also see that the rent-to-price ratio has returned to historical levels, more evidence that housing prices have finally stabilized.

Harlan Green © 2010