Will Volcker Rule Change Wall Street?

Financial FAQs

Paul Volcker, former Fed Chairman under Presidents Carter and Reagan and economic advisor to President Obama, has at 83 years of age coined a new term, the “Volcker Rule”. It is in the form of findings by the Financial Stability Oversight Council, set up under the Dodd-Frank Bill to consider rules that will rein in Wall Street’s speculative activity that was the main cause of the Great Recession.

The statute seeks to make explicit what types of proprietary trading will be permitted, but the section is open to interpretation by bank regulators. A key issue for regulators is whether they can identify whether a bank made a trade on behalf of a customer, which is permissible, or for its own account, which is not, says CBS Marketwatch.

Why such a need? Because congressional testimony revealed that traders such as Goldman Sachs regularly played both sides of a ‘bet’—i.e., order by clients to buy or sell an asset. They would tout the benefits of an investment to clients, while its own traders in many cases knew it was “crap”, and then bet against that same investment by shorting or otherwise taking out insurance that paid off if the investment failed.

That was particularly true with subprime mortgages, where its traders knew the default rates would be high, and its bond ratings not really the AAA ratings given by the likes of Moody’s and S&P. We now know Goldman Sachs and others made $ billions on such bets that those investments would fail.

The findings also recommended that banks do not own hedge funds or other financial entities that do high risk trading, and that chief executives attest to the effectiveness of their internal compliance efforts to enforce the Volcker Rules.

How liable were commercial banks and investment banks such as Goldman Sachs for the Great Recession, whose initial cause was the busted housing bubble? Subprime mortgages were only a small part of the problem, and real estate in general never made up more than 7 percent of economic activity. But the tremendous amount of overinvestment in housing—1 to 2 million per year were built in excess of actual demand—was multiplied by the unregulated derivatives’ markets that sought to profit from the artificial demand created by so much housing speculation.

And banks became so enamored with what they considered foolproof investments—housing prices had never actually dropped since WWII, and the mortgages backed by them were insured not to fail. Problem was that it was all borrowed money—even the insurance that backed those mortgages. And so the bubbles burst—first housing, then stocks, then the credit house of cards that supported them.

Was there actual criminal behavior that caused the house of cards to collapse? Of course, since derivatives’ traders in particular had a fiduciary duty to their clients to tell the truth, and avoid the conflicts of interest inherent in representing both their clients and their employers. Both are prosecutable offenses and fraudulent behavior.

But it is up to the Justice Department and SEC to prosecute them. Their actions are documented in the 500 plus page report and many accompanying pages of testimony by those involved. There are also tremendous damages documented in the report, which means injured parties can sue in civil courts as well. But we hope the Justice Department will lead the charge with criminal charges. Otherwise it will be business as usual on Wall Street.  If only civil penalties are levied, stockholders will again be picking up the tab.

Harlan Green © 2010

Real Economic Change—Thinking in Win-Win Terms

Financial FAQs

Everyone seems to be playing the blame game this political season. Did Obama deliver the change in Washington he promised? Both conservatives and progressives are unhappy with the slow growing economy; and joblessness rate still hovering around 10 percent. And no one is quite sure who to blame—Obama or Bush II; too much government, or too little?

But rather than play the blame game, why not correct the causes of so much instability, which can lead us out of the swamp of debt that has resulted? There is a much deeper reason for the malaise, in other words. Most of us have not seen a rise in either our incomes or wealth since the 1970s. And this in turn has led to a deep seated pessimism and loss of confidence in both our private and public institutions.

The 1970s coincided with the end of our longest war in history at that time—Vietnam. The fact that two more wars are draining our resources, and could ultimately cost upwards of $3 trillion, is also a contributing cause to the current sluggishness. Monies and resources diverted from producing butter to guns, means those resources are wasted, and are not recycled back into the economy to create more wealth.

Economists have studied the costs of wars, but not the effects of income inequality. Yet we are suffering from the greatest redistribution of wealth since 1928. And such inequality is probably the major cause of our worst economic downturns—the Depression and just ended Great Recession.

We now know income inequality has reached levels of 1928-29, the beginning of the Great Depression. Economists Thomas Piketty and Emmanuel Saez, among others, have documented its growth (See Feb. 2003 Quarterly Journal of Economics). Such extreme inequality created a credit bubble that burst and so led to a sharp diminishment in aggregate demand, which economists express as a formula, but which is approximated by U.S. Gross Domestic Product data.

The relationship is intuitively simple, yet was hard to verify before Piketty and Saez, et.al., did their research. As more income flowed to the top income brackets, middle and lower income classes had to borrow more to keep up their consumption patterns. And the easy credit available with the housing bubble accelerated that borrowing, to the tune of $2.3 trillion extracted from housing in the last decade. But the excess housing supply produced during the bubble caused housing values to crash, losing more than $4 trillion and counting of the $11 trillion in housing assets.

Marriner Eccles, Roosevelt’s Federal Reserve Chairman, first put his finger on this problem of inequality as a cause of the Great Depression.

“… a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”

Hardest hit have been families living in deep poverty. Today that is defined by the Census Bureau as incomes of less than $22,000 per year for a family of four. In fact, the number and percentage of people in deep poverty hit a record high in 2009, with the data going back to 1975. Nineteen million people were living in deep poverty in 2009, up two million from 2008, according to the U.S. Census Bureau and CBPP.

Yet we know there is enough wealth for all. The historical personal income rate of increase for all American households is 5.6 percent per year, so no income segment has to see a reduction in income. In fact, modern economic theory says as much. When incomes are more fairly distributed—whether via progressive taxation or other wealth equalizing policies (such as part of an adequate social safety net), the economy grows faster for everyone.

Put more money into consumers’ pockets (i.e., the lower and middle class income brackets that spend the most), and we all win, in other words. It creates greater aggregate demand—i.e., effective demand for not only more goods and services, but investments that create jobs. And effective demand can be created from either the public or private sector.

So there is a Win-Win solution to the poverty problem, if we allow a more level income field. This win-win policy is a truth most explicitly formulated by John Maynard Keynes, the economic theorist most reviled by those who oppose most forms of government spending—except for defense, of course.

It is also a solution to the wildly fluctuating financial markets that have impoverished so many. In fact, if we realize the potential for growth inherent in the U. S. economy, we might not be having such a debate between the have and have-nots. One example is the controversy over social security solvency. The headlines say its Trustees predict it will run out of money in the 2040s. Yet the reality is that if the average annual Gross Domestic growth of the last 75 years, including the Great Depression (which is 3.5 percent per year) were continued, social security would not run out of funds—ever.

But its Trustees have chosen to use a more conservative projection of 2.6 percent out of fear that our ageing population will diminish revenues—one of 3 included in the Trustee’s annual report—which has only happened during the worst downturns. The lesson is that if we focused on policies that nurture sustainable economic growth, social security doesn’t become a problem in 2043.

That is why wealth redistribution should be discussed, because it is a way of ensuring sustainable growth. Not only the middle class, but most income segments have seen a decline in their real (after inflation) incomes since the 1970s—except for the top one percent income bracket.

For example, according to the Center for Budget Policies and Priorities, between 1979 and 2007:

• The top 1 percent’s share of the nation’s total after-tax household income more than doubled, from 7.5 percent to 17.1 percent.
• The share of income going to the middle three-fifths (or 60 percent) of households shrank from 51.1 percent to 43.5 percent.
• The share going to the bottom fifth of households declined from 6.8 percent to 4.9 percent.
• The share going to the bottom four-fifths (80 percent) of the population declined from 58 percent to 48 percent.

The Great Recession is but one example of the consequences of such a continued degradation of middle and lower income brackets. There is no good economic or political reason for such inequality to continue, if we want more sustainable—and predictable—economic growth. But first we have to win over the Win-Lose crowd who don’t believe the U.S. economy is capable of growing as much as it has over the past 75 years. Then it will be a Win-Win solution for all.

Harlan Green © 2010

Where is the Consumer—Part II?

Financial FAQs

We have further confirmation that consumers have begun to spend again with all of 2010 retail numbers now in. We are also seeing employment picking up, and inflation remaining low, which is stretching the meager increases in consumers’ incomes.

This is because holiday sales over the last two months have been quite good.  But there are several stories in the details. Overall retail sales in December rose 0.6 percent after jumping 0.8 percent the month before.

A key source of strength in recent months has been autos which advanced 1.1 percent in December, following gains of 0.2 percent in November and 5.4 percent in October. For the latest month, excluding autos, sales were not quite as strong, rising 0.5 percent. With moderate pent up demand, this category likely will keep retail sales on an uptrend in coming months.

Motor vehicle sales have soared back to 2008 levels, as we have said, and look to climb further in 2011. Consumer spending continues to be concentrated in vehicle sales, which rose two percent in December to a 12.6 million annual rate vs 12.3 million in November.

Higher oil prices are wreaking havoc with overall inflation numbers.  But energy price pressures have had little impact on core CPI inflation, says Econoday. The CPI in December jumped 0.5 percent, following a modest 0.1 percent rise the month before.  The December boost was the largest since a 0.7 percent surge in June 2009.  Excluding food and energy, CPI inflation was just 0.1 percent, equaling the rise for November.

Year-on-year, overall CPI inflation rose to 1.4 (seasonally adjusted) from 1.1 percent in November. The core rate, however, eased 0.6 percent from 0.7 percent. On an unadjusted year-ago basis, the headline number was up 1.5 percent in December while the core was up 0.8 percent. 

Disposable income growth (i.e., after taxes) slowed in November after a sizeable October boost, and has flattened out since its initial spurt in May 2010. But consumer spending was relatively healthy heading into the holiday shopping season. As in recent months, core inflation is quite soft and still below the Fed's target range. Personal income in November rose 0.3 percent, following a 0.4 percent boost in October. However, the wages & salaries component was sluggish, edging up 0.1 percent after jumping 0.5 percent in October.

The ‘real’ question is when wages & salaries growth exceed inflation with the increased hiring. That hasn’t been the case for most of the past 30 years, which is why consumers have gone so heavily in debt.  Year on year, personal income for November posted a 3.8 percent gain, compared to 3.9 percent in October. In fact, it is only because inflation is muted that incomes are improving at all.

Harlan Green © 2011

Existing-Home Sales Surge

The Mortgage Corner

Existing-home sales in December increased for the fifth time in the past six months, according to the National Association of Realtors. This was due both to lower mortgage rates and a drop in prices. Existing sales, which are completed transactions that include single-family, townhomes, condominiums and co-ops, rose 12.3 percent to a seasonally adjusted annual rate of 5.28 million in December from an upwardly revised 4.70 million in November, but remain 2.9 percent below the 5.44 million sold in 2009.

NAR chief economist Lawrence Yun said sales are on an uptrend. “December was a good finish to 2010, when sales fluctuate more than normal. The pattern over the past six months is clearly showing a recovery,” he said. “The recovery will likely continue as job growth gains momentum and rising rents encourage more renters into ownership while exceptional affordability conditions remain.”

Besides lower home prices, record low mortgage rates continue to encourage home buyers. The 30-year conforming fixed rate is down to 4.54 percent for an approximately 1 point origination fee. The NAR’s composite Affordability Index in is also in record territory at 184.5 percent. This means that a household with a median income of $61,819 could afford a home 184.5 percent higher than the median home price.

Total housing inventory at the end of December fell 4.2 percent to 3.56 million existing homes available for sale, which represents an 8.1-month supply at the current sales pace, down from a 9.5-month supply in November. The months of supply will probably increase over the next few months as sales slow a little, and inventory increases, says Calculated Risk. Inventory levels still remain high, however.

The national median existing-home price for all housing types was $168,800 in December, which is 1.0 percent below December 2009. Distressed homes rose to a 36 percent market share in December from 33 percent in November, and 32 percent in December 2009.

“The modest rise in distressed sales, which typically are discounted 10 to 15 percent relative to traditional homes, dampened the median price in December, but the flat price trend continues,” Yun explained.

A parallel NAR practitioner survey shows first-time buyers purchased 33 percent of homes in December, up from 32 percent in November, but are below a 43 percent share in December 2009.

Investors accounted for 20 percent of transactions in December, up from 19 percent in November and 15 percent in December 2009; the balance of sales were to repeat buyers. All-cash sales were at 29 percent in December, compared with 31 percent in November, but up from 22 percent a year ago. “All-cash sales have been consistently high at about 30 percent of the market over the past six months,” Yun said.

Sales were led by a 16.7 percent surge in the West, followed by 13 percent in the Northeast, 11 percent in the Midwest and 10.1 percent in the South.

Harlan Green © 2011

How Do We Boost Economic Growth?

Popular Economics Weekly

There is a tremendous misunderstanding of how to boost economic growth, and this is hurting the recovery. Conservative politicians want to cut taxes and government services, while progressives want to use government to boost growth. Yet it really doesn’t matter who does the boosting. The results are the same.

The best way to understand growth is with a concept used by economists, aggregate demand, that we have mentioned in past columns. Aggregate demand can be thought of as income and assets earned by consumers, private business, the financial sector and government. And it can be either hoarded in mostly MZM accounts (Money at Zero Maturity—i.e., earning 0 interest), as it is now, spent on things, or invested in facilities that produce more things.

Our economy has become seriously skewed during the past 10 years because corporate profits zoomed, while household incomes have not even kept up with inflation.

This is not the column to discuss the whys, including why so much income has migrated to the top 1 percent income bracket. But the result has been that most corporations haven’t invested in their employees. Which is why aggregate demand—the source of economic growth—has suffered mightily.

We know that consumers make up 70 percent of GDP growth, for example. So because their incomes were stagnant, they had to borrow to maintain their standard of living. And because they indebted themselves so heavily while their incomes remained stagnant, most have not been able to boost their spending during the recovery.

So business spending, which makes up the other part of aggregate demand (along with government spending) hasn’t been expanding because of so much excess industrial capacity. We know that excess capacity is still a problem today, as evidenced by the latest industrial production numbers.

Overall capacity utilization is improving, rising to 76.0 percent in December from 75.0 percent in November.  It is at its highest since a reading of 77.9 percent for August 2008, but is still far below the 82 percent long term average.

Industrial production posted a healthy 0.8 percent gain in December, following a 0.3 percent rebound in November.  However, the boost was led by a monthly 4.3 percent surge in utilities output, following a 1.5 percent increase in November.  By market groups, strength was widespread.  Production of consumer goods increased 1.0 percent in December; business equipment, 0.6 percent; nonindustrial supplies, 0.1 percent; and materials, 1.0 percent.

And because most profits have not been flowing back to average consumers, employers are not producing enough to warrant hiring more workers. That is the major reason for the entire government stimulus—to boost aggregate demand. The $787 Billion American Recovery and Reinvestment Act (ARRA) was in fact not enough to bridge the so-called lost output gap between potential and actual GDP growth over the past 2 years. The Fed’s purchase of government securities has held down interest rates, enabling businesses to borrow cheaply, and preventing real estate values from going into free fall.

Then what is the answer on how to create sustainable aggregate demand? The major push should be reestablishing the middle class that has been so decimated by loss jobs and much of its wealth—both in stocks and real estate. New York Times’ David Leonhardt is one of the few pundits to voice this concern in his most recent column, “In Wreckage of Lost jobs, Lost power,” in which he laments the loss of labor’s bargaining power.

Whereas employment in most other developed countries, including Japan and Russia, is much higher than in the U.S., corporate profits are lower. This is because U.S. domestic workers’ bargaining power has been severely diminished, in part because of laws that give employers the advantage in hiring and firing. And Germany and Canada, who barely had a recession, encourage companies to cut work hours for all during slowdowns—called ‘short work’—rather than lay off some, so that the pain of reduced incomes is spread over the entire workforce.

There are many other ways to cure insufficient aggregate demand, such as more progressive taxation. For instance, the top income tier during the Eisenhower years had a 95 percent tax rate on its top income bracket. This had the effect of siphoning off money from the wealthiest who spend the least percentage of their income, and putting it into the more productive use of building infrastructure, such as the interstate highway system, or education, or into more research and development.

Also, a better-run health care system would reduce health costs, which are double per capita in the U.S. vs. other developed countries. This would have several benefits, including increasing the competitiveness of U.S. made products, while boosting workers’ benefits and incomes.

There is still almost $3 trillion in lost output—the difference between actual and potential GDP growth caused by the recession, as we said. But unless we get over the conservative-progressive divide on how to bridge that gap, we won’t be able to generate sufficient aggregate demand that will bring back the jobs and salaries lost during the worst downturn since the Great Depression. U.S. workers don’t care which sector generates jobs during recessions, so neither should politicians.

Harlan Green © 2011

What is the Fed’s Next Move?

Popular Economics Weekly

Minutes of the last January 14 FOMC meeting were just released, and may give us a hint how long the Fed will continue to support its QE2 quantitative easing program. The key words were, "Members noted that, while incoming information over the intermeeting period had increased their confidence in the economic recovery, progress toward the Committee's dual objectives of maximum employment and price stability was disappointingly slow."

Chairman Bernanke has also said in a prior speech that it would be years before employment returned to more normal levels. What is that level, which should give us a clue to when the Fed will cease with credit easing, and begin to raise interest rates?

Right now, the Fed is concentrating on the maximum employment mandate, since they see little sign of inflation. This is not the case with food, energy, and health costs, which have been rising fairly steadily. Historically, inflation hasn’t kicked in until the unemployment rate has dropped to the 6-7 percent, from its current 9.4 percent rate. In fact, many more are partially employed and wages are still stagnant, which means that consumers, who make up 70 percent of all spending, are without the means to spend and so cannot drive up prices.

The real news was the 103,000 additional nonfarm payroll jobs created in December—113,000 on private payrolls less the net loss of 10,000 government jobs. And prior months were revised upward, so that 1.1 million total jobs were created in 2010, and more than 7 million remain unemployed, as we said last week.

Wage inflation remains anemic, however.  Average hourly earnings in December edged up 0.1 percent, following no change the previous month.  On a year-ago basis, average hourly earnings growth slowed to 1.9 percent from 2.1 percent in November, suggesting little wage pressure on inflation.

Turning to the household survey, the unemployment rate unexpectedly fell to 9.4 percent from 9.8 percent in November.  Analysts had called for 9.7 percent.  The rate declined in part due to a notable drop in the labor force, suggesting the unemployment rate will rebound when discouraged workers return.

More crucial are the percentage of unemployed and “marginally attached”—i.e., parttimers. The expanded rate of underemployment—the so-called “U-6” alternative measure—slipped to 16.7 percent from 17.0 percent in November but has remained very high throughout 2010.  This measure adds in part-time workers for economic reasons, discouraged workers, plus those not looking for work but would take a job if offered one.  Finally, the median duration of being unemployed continued to creep higher at 22.4 weeks from 21.7 weeks in November.  The long-term unemployed are going to have a more difficult time finding new work as job skills deteriorate or do not keep up with employer needs.

There was some hope in the Labor Department’s Job Openings and Labor Turnover Survey (JOLTS). There were 3.2 million job openings on the last business day of November, the U.S. Bureau of Labor Statistics reported today. The job openings rate was essentially unchanged over the month at 2.4 percent.

In November, about 4.118 million people lost (or left) their jobs, and 4.210 million were hired (this is the labor turnover in the economy) adding 92 thousand total jobs. Even with the slight decline in November, job openings are up significantly over the last year.

The bottom line seems to be that price stability is a moving target, and one that is difficult to define. But the Fed seems fixated on improving the jobs picture first, and worrying about excessive prices later.

Harlan Green © 2011

Will 2011Home Sales Rebound?

Popular Economics Weekly

Home building is set for a rebound in 2011, with single-family housing starts projected to climb 21 percent to 575,000 units, the chief economist for the National Association of Home Builders said recently. But the increase comes after a crash that has cut single-family construction 80 percent from its peak, meaning the impact won’t be felt for several years.

This is the most optimistic prediction of several housing reports. Residential construction has been increasing lately, but both the Case-Shiller Home Price Index and foreclosure picture are not yet improving. This signals that bloated housing inventories could be with us for awhile.

“You have to keep in mind that these housing increases are off a very low base. These numbers are still far, far below the levels we’d seen before the downturn,” said Frank Nothaft, chief economist for mortgage giant Freddie Mac and a presenter, along with the NAHB’s Chief Economist David Crowe, on an economic panel at the International Builders Show.

Construction spending has been improving for several months. Construction outlays in November posted a 0.4 percent gain, following a 0.7 percent boost the prior month, and have been up for three consecutive months. The gain in November was led by a 0.7 percent increase in private residential outlays, following a 3.9 percent surge in October.  Bottom line is this sector is no longer dragging the economy down, says Econoday.

The S&P Case Shiller index was somewhat pessimistic about prices—once again due to the huge inventory of unsold homes, including those foreclosures. Year-on-year, sales are up 0.2 percent for the 10-city adjusted index but are down 0.8 percent for the 20-city index which is being depressed by mid-single digit declines in Atlanta, Detroit and Portland. Phoenix, Charlotte and Seattle, also part of the 20 index, also show sizable on-year declines.

Existing home sales are back to the levels of 1997 / 1998 and new home sales fell to record lows in the 2nd half of 2010. Inventory increased 5.4 percent year over year in November and the months-of-supply (9.5 months in November) is well above normal.

Since approximately one-third of home sales are foreclosures or bank-owned properties, a declining foreclosure rate should help reduce inventories and so help prices. Although delinquencies might have peaked, the level is still very high and there are many more foreclosures in the pipeline, reports the Mortgage Bankers Association in its third quarter report.

“There is enormous pent-up demand in demographics — we didn’t form almost 2 million households during the recession, either people still living at home with mom and dad or doubling up. They are effectively out there waiting, the next ones looking to get into a new home or apartment,” Crowe said.

All of the improvement will depend on higher job creation, of course. If job creation accelerates to 200,000 or more a month by the end of 2011, as Crowe and Nothaft believe, that would set the stage for even bigger home-building gains through 2015.

Wage inflation remains anemic, however, as we said in this week’s Popular Economics Weekly column (‘The Fed’s Next Move?”).  Average hourly earnings in December edged up 0.1 percent, following no change the previous month.  On a year-ago basis, average hourly earnings growth slowed to 1.9 percent from 2.1 percent in November, suggesting little wage pressure on inflation.

More crucial are the percentage of unemployed and “marginally attached”—i.e., parttimers, says Econoday. The expanded rate of underemployment—the so-called “U-6” alternative measure—slipped to 16.7 percent from 17.0 percent in November but has remained very high throughout 2010.  This measure adds in part-time workers for economic reasons, discouraged workers, plus those not looking for work but would take a job if offered one. The parttimers ideally will migrate to permanent jobs as the economy continues to improve. The ‘magic’ number seems to be a 4 percent GDP growth rate, which if reached this year as even Fed Chairman Bernanke predicts, should succeed in boosting employment to near the required 200,000 per month in new jobs.

Harlan Green © 2011