Sunday, January 27, 2008

Is the U.S. In A Recession?

No, and we wouldn't be headed for one if Bernanke would keep his hands off the economy.

Even by the newspaper definition of recession, the U.S. is not in one. The media definition of a recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters. That has not happened. In fact, the economy is growing. The third quarter GDP for 2007, the latest round of reduced data so far, grew by an annualized 4.9%. This is up from the second quarter annualized growth rate of 3.6%, which is better than the 3.4% growth of 2006. According to my economics book (Economics by McConnell and Brue 2008), a recession is a period of decline in total output, income and employment. The downturn, which lasts 6 months or more, is marked by widespread contraction of business activity in many sectors of the economy.

Some economists prefer to look at individual indicators like manufacturing orders, wages, wholesale inflation rate, supply chain data and employment rate to name a few. Well, the unemployment rate is 5%, which is considered full employment. A rate like the 4.5% that we saw at the end of 2007 is considered a tight labor market--which could also be inflationary as wages rise. As of November 2007, manufacturing and trade inventories were up 1.6% over October, which was up .7% from September. New orders for manufactured goods were up 1.5% from the previous month. New orders for manufactured durable goods were up .1%. Here's the real good news: according to the Bureau of Labor Statistics, non-farm business sector productivity (output per hour) was up 6.3% third quarter 2007. Hourly compensation was up 4.2%. That means labor costs were down 2%. In the manufacturing sector output rose by 5% and wages rose by 1.5%. Now before anybody starts yip yapping about how wages are not keeping up with productivity growth, understand that there are other factors that affect productivity growth. The main one is technology. Others include capital investments and education/training, all of which will make a worker more productive. The bottom line is--economic data is good even if the stock market waffles around wildly.

The stock market would theoretically be one measure of economic performance if it wasn't so driven by emotion and craps shooters. But since this is apparently the only measure Bernanke is looking at as he slashes interest rates, why is the market flapping around so? It all boils down to the subprime credit problem. The subprime defaults were a small, small problem in the overall mortgage market and microscopic in the total debt of the American consumer. The subprime fallout should have been limited to the people involved in this sector and not effect to any appreciable degree the overall economy. But the subprime got its tentacles everywhere because of collateralized debt obligations, or CDOs. The purpose of CDOs, like mortgage backed securities, is 1) to spread the risk around a large pool of investors and get it off the backs of the actual lenders and 2) make more money available for loans. These are good goals, but a variety factors affected their values. Many CDO products are held on a mark to market basis, which is the act of assigning a value to a position held in a financial instrument based on the price of the current instrument. The final value of a futures contract that expires in X months will not be known until it expires. But the failure of risk models used by credit rating agencies and failure to monitor credit performance by institutions that bought these investments paralyzed the credit markets because these futures contracts couldn't be valued. Major loss of confidence in the validity of process used by ratings agencies to assign credit ratings to CDO investments and cash flows led to a collapse of liquidity.

So followed the stock market. But the market was to see even worse thnaks to perosnal debt. Greenspan's monetary policy created the housing bubble. This was highly praised for boosting the housing and construction industry which was in turn credited with keeping the economy afloat after the Clinton years. But a bubble is artificial in that it must be inflated by something and so it was thanks to Greenspan's monetary policy of too loose for too long. Homeowners assumed that the equity in their homes was real so would never fall. They borrowed against the equity in their homes. Consumers maxed out their credit cards because the low interest rate lowered these rates. Sure, the economy could do well excessive consumer spending since 2/3 of the economy is driven by the consumer. But debt for that purpose is foolish. To borrow for investment is generally OK, but to borrow to consume and use up is just plain dumb. It drives the economy in the short term but eventually that money must be paid back. And ballons pop.

So followed the stock market. Bernanke has radically cut the interest rate. News media has reported that the "subprime crisis" has grossly affected overseas markets and investors in this country are losing confidence. The fear is that holders of American dollars will dump them and move to places with better investments. That would further depress the dollare and be extremely inflationary in the U.S. So, true to government bureaucratic thinking, Bernanke "did something." He cut the interest an unheard of 3/4 of a point. This has the effect of weakening the dollar and being inflationary. And it did nothing to help the stock market. Bernanke apparently assumes thought lower credit card rates will encourage more consumer debt and boost housing prices and get people borrowing against the equity in their homes again as prices rise due to demand because of cheaper mortgage rates. But the guy who lives according to his means gets rewarded with smaller earnings thanks to too low fixed income interest rates. So the Fed says let's just spend our way out of recession with even more debt than before that ended in threats of recession. There that ought to work.

We never learn.

Thursday, January 10, 2008

Folly of a Politically Managed Economy

According to the Bureau of Economis Analysis, United States real gross domestic product (discounted for inflation) grew by an annualized 4.9% in the third quarter 2007. That's even better than the 3.8% growth rate reported for the second quarter of 2007--good growth despite the ever weakening dollar and rising oil prices. Yet the media and various financial pundits relentlessly predict imminent recessionary doom due to the "housing crisis" unless the government steps in with a massive bailout for lending institutions and defaulting homeowners. The political pressure must be very great because even Fed Chief Ben Bernanke has succombed repeatedly to pressure to reduce the federal funds rate despite being the boss of a completely independent national banking arm. But the macro-problems of bailouts and Bernanke's thinking, beyond screwing people who have wisely adhered to the Shakesperian maxim of "neither a borrower nor a lender be," is the increasing tendency toward greater central planning of the economy.

On the surface, firms like Countrywide have laid people off amid losses and have demanded that the government (taxpayer) take care of their (irresponsible blunders) losses. Hedge fund managers are screaming about bankruptcy and demanding that the Fed drop interest rates as low as necessary to reinflate the housing bubble to cover their losses. The entitlement champions are shrieking about the difficulty of getting home loans and all the unfortunate Americans who will lose their homes if the government (taxpayer) doesn't pay for it. Isn't owning a home a right, they insist? No my children, it is a privilege and a great responsibility--as everything should be in a society where people want to be free to choose. Nowadays, responsibility for one's actions and choices is anathema to the crybaby '60's generation and the children they've raised.

The federal funds rate directly impacts lending and savings rates. If you're a borrower, you love lower rates; if you're a saver, you hate them. First, let's do the Reader's Digest review of basic macroeconomics. Economic growth in the U.S. is driven by consumer spending which accounts for 2/3 of it. So corporate America and the government want to make coming by money very easy for the consumer so that he can spend more. This necessitates borrowing more, unfortunately. When the consumer demands more, businesses produce more. When productivity goes up, the laborers' wages go up. To produce more, companies generally hire more workers. When demand outruns labor, the unemployment rate drops, prices go up and businesses make more profit, which hopefully reduces the unemployment rate.

The 17 rate cuts Greenspan authorized from 2001 to 2004 were intended to make money so cheap businesses couldn't refuse to borrow so that such debt would hopefully jumpstart the cycle I described above. But the unexpected consequence was the tremendous drop in mortgage rates that drove an almost panicky demand for housing. This was the primary factor that kept the economy afloat. However, it seems that the demand was artifially created because interest rates were too low for too long which created a real estate bubble.

Low mortgage rates cut into the profits of lending institutions, but because rates were low, demand for loans skyrocketed. I suspect that because lending institutions were earning volume based profits, due diligence for risky borrowers not only took a backseat, it ended up in the trunk. Lending institutions used teaser rates in adjustable rate mortgages (ARM) to entice subprime borrowers who should never have owned a home in the first place. But housing prices continued to climb and foolish people borrowed against the equity in their homes assuming the values could only continue to go up. When home prices dropped and the ARM reset--oops. You'd think that seasoned bankers, a normally risk averse bunch, would recognize that what goes up must come down. Now, finally, the banks and other lending institutions are tightening up requirements for their loans. Nothing like closing the barn door after the horse escaped.

Why are the hedge funds so upset? Didn't they hedge their bets? Let's do another Reader's Digest type of tutorial. In order to "create" more money for loans, financial institutions securitize loans. That is, loans are repackaged as investment grade securities and sold to investors. Due to the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Hedge funds create "derivatives" which are financial instruments based on the value of their underlying assets. So, in this market hedge fund managers created options and futures contracts assuming that the underlying value of these securities would continue to increase in value. These kinds of contracts allow for leveraging, which is a fancy term for borrowing against an asset in the hope that it will increase in value and hence make more money that investing only what you have. To illustrate, say a homeownver borrows against the equity in his home and dumps the money into a stock market that has been bullish for a while. He is betting that the market will continue its upward performance and he hopes to make a profit several times larger than the debt on his equity loan. The hedge funds' lost their bets--oops. The hedge funds among others have continued to pressure the Fed to reinflate the housing bubble and the Fed has obliged despite the fact that bubbles do not promote economic stability.

Is a bailout good economic policy? Some commentators believe that any measure that keeps the unemployment rate low is good policy. But government regulation cannot take the place of the function of a free market. The free market is smart--it knows how to correct and maintain overall balance, even if financial measures fluctuate a bit in the process. Government involvement distorts the market and starts an avalanche of unexpected results that will take much longer to correct, if that is even possible as government solutions add layer upon layer of bureacratic sediment.

The so-called "housing meltdown" and "financial crisis" (and other inflammatory descriptors) only affects 4% of borrowers. That means 96% of borrowers pay their mortgages on time. The subprime sector has only a tiny affect on the overall economy in absolute terms but economists and financiers talk about the trickel through effect of losses on investors and consumers. For example, investors may want to dump stocks and consumers want to hang on to their money for fear of job loss and loss of home equity. Since the beginning of the housing bust we have seen instability in the stock market that many analysts say is a direct result of the "housing financial crisis." But the enormous majority of stocks in the market have nothing to do with the housing market or the lending institutions.

I realize that monetary policy is the Fed Chief's legitimate purview, but it seems that he is using it in a manipulative manner to satisfy the political pressure of the few but powerful that run a relatively small part of the economy. As Greenspan did, Bernanke uses the stock market as a measure of the health of the economy. The value of a stock is affected by its earnings expectations, which are also driven by "irrational exuberance" or irrational pessimism. This is the folly in using the market as primary data for policy formulation. Monetary policy is not meant to drive the market or bailout bad investments; it is meant to create price stability which is a major factor in earnings expectations. In the meantime, wise savers are are forced to subsidize the hubris of the mortgage industry in the form of crappy returns on fixed-income investments.

At the same time, Bernanke seems to be ignoring one of the most basic laws in free market economics: savings equals investment. I wonder how much the Fed would have been needed as the lender of last resort, or how much more money would have been available for loans to good risks, if the savings rate in this country was much higher. I suppose it depends on the government's fiscal philosophy. Consumption drives our economy; debt drives it harder, so let's "spend our way to prosperity." But an economy built on consumer debt and profligate spending is like a house built on sand rather than rock--makes an unstable foundation. I believe balance between spending and saving with less emphasis on debt will drive the economy just as successfully and without so many of the boom-bust cycles that seem to be increasing in frequency.

Is a bailout in keeping with the principles of self-reliance, responsibility, and risk-taking that built this country? I am sorry for investors who have lost money but that is the risk when one is looking for rates of return that are substantially higher than risk free investments like T-bills. In a free market economy there will always be good invesment opportunities but "you got to take the bad along with the good" as my mother used to say. Hedge fund managers who have lost a bundle in the subprime carry the same burden. It's too bad there are some who will lose their houses because of default, but as my daddy always said, "if you can't afford it, you don't need it." The lending institutions that have been making these risky loans especially need to suffer the consequences in keeping with the principle of responsibility. Responsibility is the price of freedom. Refusal to accept it is inversely proportional to the freedom we will have. Sure, it's tempting to demand government rescue as largess to be reaped at will, but we as a nation will have to pay the proverbial piper one way or another. We have to get control of the pervasive greed in this country and get back to fundamentals like "slow and steady wins the race" and flee the selfish "I'm gonna git mine and git it right now."

But the worst, perhaps even unconstitutional, government interference in the free market is President Bush's plan to freeze ARM rates as part of the bailout. The Contract Clause appears in Article I, section 10, clause 1 of the U.S. Constitution:

"No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, expost facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility."

The framers of the Constitution added this clause due to fear that states would continue a practice that had been widespread under the Articles of Confederation—that of granting "private relief." Legislatures would pass bills relieving particular persons of their obligation to pay their debts. Interestingly, with all the yip yap the Democrats have been doing regarding the unconstitutionality of national security measures and the constitutionality of measures no where mentioned in the Constitution, they disregard this constitutional provision that is written in stereophonic black and white and make lots of noise about how the president has not gone far enough. What is far enough--gifting defaulters their homes at taxpayer expense?

By cutting the interest to satisfy the few, wise savers are forced to subsidize profligate behavior found in both the financial institutions and the borrowers. Government interference in the free market in the form of bailouts foreshadow a possible paradigm shift toward greater central economic planning. And we know how well that worked over a 70 year period.

Digg!





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Tuesday, January 08, 2008

Hillary's Tears

The news media has been trying so hard to make Hillary Clinton look like she is either lacking in humanity or lacking in strength. Throughout her campaign, she has shown herself as tough and as articulate, if not more so, as any of the male contestants on the campaign trail. Though I am not a Hillary apologist--I am no more for her collectivist economic proposals or her lifestyle socialism than I am for Stalin's--I believe the questionable media attention she has received concerning her emotional state betrays an underlying prejudice against her as a woman. She has been called "mannish," "lesbian" for her persistance and toughness and "lacking humanity" for her straight-faced speeches. All these labels are intended to diminish her to the point of making her seem an unviable candidate. A label of "feminine" is not likely to be helpful either because the connotative definition of the word precludes such attributes as decisiveness, self-control and risk-taking that are reserved for the male character only. I guess that's politics.

So what happens if Hillary should emote more than usual, as she apparently did yesterday when she received disheartening polling news in the New Hampshire primary? Various media pundits swear they saw her get "choked up" and "her eyes glistened" (if you looked closely enough and used your imagination) and they have not stopped harping on whether the "tears" were manipulative or genuine. If genuine, has she demonstrated her humanity or has she shown the weakness that is assumed innate in the female psyche (that makes women unfit for leadership duty)? Or was she just calculating and manipulative? She didn't make anybody happy, but I guess that's politics.

This whole media debate about Hillary's tears is like debating the physicality of ghostly ectoplasm. Neither exists. She did not cry, tear up or choke up. She calmly, and dare I say professionally, expressed her disappointment in the polls. But can you blame the (tabloid) media for spending so much air time on Hillary's "tears" since they rank with the Kennedy asssassination in national importance? With only the Iranian threats against U.S. warships in the Straight of Hormuz , riots in Kenya, fallout from Bhutto's assassination, nuclear Pakistan, nuclear Iran, nuclear North Korea, more threats from Bin Laden, more threats from Al Queda in Iraq, Bernanke giving in to political pressure.....to report on, it must have been a real slow news day.



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