Our Critique of the Debt Ceiling Decision

Note: This text was first published in the August 2011 edition of the Economic Outlook newsletter available through Forest2Market.


Perhaps the most prominent domestic economic event during July and early August involved Congressional approval of an increase in the federal debt ceiling. After a crescendo of often acrimonious debate, the debt ceiling was raised by $2.4 trillion in exchange for $2.1 trillion in budget cuts over a 10-year period. We followed the debate rather closely because we believe sovereign debt, including that of the United States, will inflict an increasing toll on economies across the globe. We were unimpressed by the debt ceiling agreement for a number of reasons, three of which are discussed below:

· First, spending will rise rather quickly (the debt increase is intended to tide the Treasury over only through the 2012 election) whereas the cuts will be spread out over the next decade (only 2 percent occur prior to the 2012 election).

Admittedly, phasing in the cuts makes some sense in light of the U.S. economy’s fragility. While we believe reducing the federal deficit and debt is necessary, we disagree with those who advocated draconian cuts as a recipe for immediately unleashing economic growth. The federal government’s contribution to GDP is variously estimated at between 9 to 16 percent, and deficit spending currently represents roughly 50 percent of that amount. Eliminating between 4.5 to 8 percent of the economy (half of the 9 to 16 percent) would initially result in a severe economic downturn. That reality seemed to have been lost in the debt-ceiling squabble.

· Second, if we could believe the small initial spending cuts were a means to navigate the difficult economic shoals, we would not be as critical. In too many past budgets, however, future cuts have been promised in return for higher near-term spending, only to never see the cuts materialize. As if to drive home that point, the debt shot up by $239 billion – eating up nearly 60 percent of the first tranche of $400 billion in new borrowing authority that was supposed to last through mid-September, and causing the debt to top 100 percent of GDP – one day after President Obama signed the bill.[1,2,3] By contrast, the proposed cuts are largely illusory; capping expenses related to fighting the wars in Iraq and Afghanistan and savings in interest on the public debt because of the lower deficits were counted as cuts.[4] Such accounting gimmickry caused one pundit to wonder why one could not assume $1 quadrillion in savings by not declaring war on Mars.[5] Moreover, the alleged cuts will only slow the rate of future spending increases.[6]

· Finally, the spending reductions were divided into two categories: $917 billion that all parties agreed to before the bill went to the president, and another $1.2 trillion to be specified later. Congress will create a Joint Select Committee (some have called it a potentially unconstitutional “Super Committee” and a “Politburo”[7]), comprised of six Democrats and six Republicans, that will be tasked with identifying the other $1.2 trillion in additional cuts. Should Congress fail to go along with the Committee’s recommendations, automatic cuts of $1.5 trillion will be triggered; those reductions would fall most heavily on the military and Medicare payments to doctors. Many are concerned the committee could raise taxes, which could put more hurdles in front of the struggling economy.[8]

To sum up, then, Congress agreed to a $2.1 trillion slowdown in the rate of spending increases during a 10-year period in which expenditures are projected to top $45.8 trillion – i.e., a 5 percent hypothetical reduction. Casey Research’s Bud Conrad produced a graph comparing the initial $917 billion in “cuts” to projected outlays. As one can see from the nearby chart, the cuts are miniscule compared to expenditures.[9]

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Congressional Budget Office projections assume the United States will add another $7 trillion to the federal debt by 2021. However, if the federal government continues to borrow, as it does now, 43 cents of every dollar it intends to spend, that translates instead to an additional $20 trillion in debt. Being “mongrels” insofar as we do not subscribe completely to any particular school of economic philosophy, we nonetheless agree with the Austrian school that “debts do matter;” hence, we consider either scenario to be unsustainable. And we are not alone: “We are less than three years away from where Greece had its debt crisis,” David Walker, former U.S. comptroller general, told CNBC. Long before 2021, Walker believes we will reach a Greece-level debt-to-GDP ratio of 150 percent. “We are not exempt from a debt crisis,” Walker said. “We’re never going to default, because we can print money. [However,] we have serious interest rate risk, we have serious currency risk, we have serious inflation risk over time. If it happens, it will be sudden and it will be very painful.”[10]

Walker’s comments echoed those by the Bank of International Settlements (BIS), known as “the central bankers’ central bank,” which cautioned in a paper published in mid-July that “overall, risk premia on government debt will likely be higher and more volatile than in the past. In some countries, sovereign debt has already lost its risk-free status; in others, it may do so in the future.” The BIS warned that while the United States, Great Britain and Japan had so far been less affected by sovereign risk concerns, they were not “immune,” given their sharp increase in public debt ratios in recent years.[11]

In the case of the United States, at least, that immunity appears to be weakening. Last November, fledgling Chinese rating agency Dagong Global downgraded U.S. treasury bonds after the second round of quantitative easing commenced;[12] that downgrade was largely dismissed as a political move and ignored. In mid-July, however, rating agency Egan-Jones followed Dagong Global’s lead. Egan-Jones said its action, which cut U.S. sovereign debt to the second-highest rating, was not based on fears over the country not raising its debt ceiling. Instead, the cut was due to the U.S. debt load standing at more than 100 percent of GDP.[13] That downgrade was ignored as well, probably because Egan-Jones is not one of the “Big Three” agencies.

The markets began to pay a bit more attention, though, when Moody’s assigned a “negative” outlook to its U.S. rating in mid-July and Fitch made noises about possibly following suit. “Further measures will likely be required to ensure that the long-run fiscal trajectory remains compatible with a Aaa rating,” Moody’s said.[14] But then Standard & Poor’s delivered a “slap across the face” on 5 August by lowering its long-term U.S. debt rating from “AAA” to “AA+” along with a negative outlook[15,16] because the $2.1 trillion in budget cuts negotiated in the debt ceiling agreement were only about half the amount S&P had said in April were necessary to prevent the downgrade.[17,18,19,20] Dagong Global was quick to claim vindication, saying “S&P has proved what its Chinese counterpart has done is nothing but telling the global investors the ugly truth.”[21] At the time of this writing, the main reaction from the U.S. Treasury was to criticize S&P for not incorporating the Treasury’s more optimistic economic growth assumptions into its computations.[22]

The effects of S&P’s downgrade will probably take some time to be fully realized; in fact, given the economic turmoil in the Eurozone, yields on U.S. treasuries have fallen since the downgrade, rather than increasing as many may have expected (due to the higher degree of risk associated with the downgrade). The drop in yield since the announcement has brought much gloating in the financial press about the meaninglessness of S&P’s downgrade.[23] Most analysts acknowledge, however, that the lower yields reflect money “hiding out.” Although the U.S. economy does not look pretty, the Eurozone debt situation is even uglier, and so investors are parking money in U.S. debt until the investment situation stabilizes.

To a certain extent, the downgrade may not carry much weight if Moody’s and Fitch leave their ratings unchanged. In the grand scheme of things, wrote Michael Pento of Euro Pacific Capital, the rating agencies’ verdicts could ultimately prove largely irrelevant anyway. Yes, Pento wrote, “the fallout could be devastating to money market and pension funds that must hold AAA paper” because those institutional investors would have to dump the downgraded assets for whatever price they could get. “But an even worse outcome will occur when the real debt downgrade comes from our foreign creditors, when they no longer believe the United States has the ability to pay our bills.”[24]

Reducing Sovereign Debt through Financial Repression

Pruning the United States’ massive (and growing) debt down to a manageable size will not happen overnight, and a paper by Carmen Reinhart and Belen Sbrancia outlines the measures the U.S. government might employ (based upon historical precedent both in this country and elsewhere) to accomplish that task. Collectively, these measures are referred to as "financial repression" (FR). The specifics of FR have taken different forms in each of the economies where the techniques have been used, but they shared four characteristics: 1) inflation; 2) governmental control of interest rates to guarantee negative real rates of return; 3) compulsory funding of government debt by financial institutions; and 4) capital controls. We briefly discuss each point below.


1) Inflation. A deeply indebted government is likely to be tempted to reduce its debt by inflating its national currency. The rate does not have to be high so long as the government is patient, but the higher the rate of inflation, the more effective FR is at quickly reducing a nation's debt problem.

To eliminate debts incurred during WWII, the United States and Great Britain used the combination of inflation and other FR techniques to reduce their debts by an average of 3 to 4 percent of GDP per year. Given the magnitude of the debt this time around, a substantially higher rate of inflation than that experienced between 1945 and 1980 might well be necessary.

2) Negative Real Interest Rates. In theory, a government cannot inflate away its debt because the free market would demand higher interest rates to compensate for that higher rate of inflation. In practice, however, government regulations have often limited the maximum interest rates that could be paid. E.g., Regulation Q was used in the United States to prevent the payment of interest on checking accounts and to cap interest rates on savings accounts.

Regulation Q was largely phased out in the 1980s, but government control of short-term interest rates in the United States has been near absolute during the last decade. The Federal Reserve has openly used its power to keep U.S. interest rates (and hence debt service payments) as low as possible. There is no need for explicit interest rate controls so long as the Federal Reserve is able to maintain control. However, if the Fed begin to lose control (as we have been predicting it will), interest rate controls could return to the U.S. financial landscape.

As an aside, we note that investors in U.S. Treasury Bills (maturities of less than 1 year) are currently receiving negative real returns. Nominal rates ranged from 0.01 to 0.27 percent on 1-month to 1-year T-bills between 8 May and 8 June. Regardless of the inflation measure (implicit GDP deflator, CPI or PPI) all of these yields are negative in real terms. We believe this situation is due to the current uncertainty in global markets. Investors are willing to accept negative real returns rather than risk even larger losses in more volatile markets. Some of that sentiment seems to be changing, however, as China recently grabbed headlines when it was announced it had reduced its T-bill holdings by 97 percent from the peak in May 2009.

3) Involuntary Funding. In this step, the government imposes reserve or "quality" requirements on financial institutions that make holding substantial amounts of government debt mandatory -- or at least establishes overwhelming incentives for financial institutions to do so. Such requirements might be billed as mandating "financial safety" instead of the more accurate description of mandating the making of investments at below market interest rates to help overextended governments recover from financial difficulties.

4) Capital Controls. In addition to ongoing inflation that eats away the value of everyone's savings as well as the value of the government's debts, there is another necessary ingredient to FR: in Reinhart and Sbrancia's words, the "creation and maintenance of a captive domestic audience" -- i.e., mandatory participation.

In this step, the government employs techniques to prevent savers (or at least their money) from fleeing the country while systematically and deliberately destroying the purchasing power of their savings. These techniques might include explicit capital and exchange controls or other, subtler methods like tax and regulatory incentives for institutions and individuals to keep their investments "domestic."

Lest one be tempted to think financial repression is nothing but a far-out conspiracy theory, Mohamed El-Erian believes it is a distinct possibility. "It is a world where several governments in advanced economies, and the United States in particular, opt for financial repression and mild inflation as the major way to accommodate their deteriorating debt dynamics," El-Erian wrote in a report published on the firm's website. Such a situation may occur now because almost four years since the start of the financial crisis, "the world has seen little meaningful reduction in the size of the excess liabilities accumulated" beforehand, El-Erian said. "Rather than be addressed in a convincing manner, most of the excess liabilities have simply been shifted around the system, and importantly to public balance sheets and taxpayers."

Our perception of financial repression is that its tactics are likely to be employed gradually and over the long term. Of more immediate concern is how the markets will respond when the Fed ends its quantitative easing program at the end of June. Are the private sector and/or foreign governments going to be in a position to pick up where the Fed leaves off in terms of buying Treasuries (assuming Congress lifts the debt ceiling so more debt can be created)? We doubt it, in light of the realization that the Fed has been buying between 75 and 85 percent of the Treasuries offered since the end of 2010. The implications of such a scenario are that, with the largest buyer of Treasury debt sitting on the sidelines and no other parties able (or at least willing) to plug the gap left by the Fed's departure, interest rates might finally turn higher as bond prices fall from lack of demand.

Of GDP Growth and Deflators: Smoke and Mirrors?

The Bureau of Economic Analysis (BEA) kept its estimate of the annualized growth rate of 1Q2011 gross domestic product (GDP) essentially unchanged at 1.8 percent, but shifted some components’ contributions around. For example, personal consumption expenditures (PCE) were nearly 0.4 percent weaker than previously reported while private domestic investment (PDI) was stronger by about the same amount -- thanks to increases in fixed investments and inventory building. Although both exports and imports grew relative to the prior (advance) report, the changes left the contribution of net exports (NetX) to the overall growth rate virtually the same as the original estimate. Government consumption expenditures (GCE) also changed very little.

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Largely ignored among all the ink spilled discussing the importance of declining government expenditures, changes in trade, and consumer spending in causing the drop from 4Q2010’s 3.1 percent growth rate was a huge shift in the GDP deflator used to remove the effects of price inflation from nominal GDP: from a 0.4 percent annualized change in 4Q2010 to 1.9 percent in 1Q2011. That represents a quarter-to-quarter increase of 375 percent in the broadest measure of price inflation across the U.S. economy. The following is admittedly simplistic, but had the 1Q2011 change in the GDP deflator remained at 0.4 percent, the advance GDP would have come in closer to 3.3 percent than the reported 1.8 percent.

We are not complaining, though, because the growth rate also could have been much worse. The Consumer Metrics Institute (CMI) has been observing that changes in the GDP deflator have been unusually small relative to corresponding changes in both the consumer (CPI) and producer (PPI) price indices for the past couple of quarters. Because the GDP deflator corrects for price changes at both the consumer and producer levels, one might expect the change in its value during any given quarter to lie between the concurrent changes in the CPI and PPI. As we show below, that has been true on average but changes in the GDP deflator have often exceeded those boundaries during individual quarters.

To test whether CMI’s contention is true, we computed annualized quarter-to-quarter percentage changes in the GDP deflator, the CPI for urban consumers, and the PPI between 1Q1950 and the present. We then subtracted the quarterly CPI and PPI percentage changes from the corresponding changes in the GDP deflator; the differences were negative when the GDP deflator’s percentage changes were smaller than those of the CPI and/or PPI, and positive when the GDP deflator’s percentage changes were larger than those of the CPI and/or PPI (the nearby table contains an example of these calculations).

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As mentioned above, the average differences between the changes in the GDP deflator and changes in the CPI and/or PPI have been quite small over time (evidenced by the proximity of the symbols to zero during the 1Q1950-to-4Q2009 period in the figure below). However, wide disparities have often occurred during individual quarters (shown by the length of the range bars radiating from the symbols in the figure below). In some recent quarters (e.g., 2Q and 3Q2010) the GDP deflator’s percentage change has essentially equaled that of either the CPI or PPI, but in other cases the differences have been marked. 1Q2011 is a good example of the latter: In less than 4 percent of the quarters since 1Q1950 have the differences between the percentage change in the GDP deflator and the percentage change in the CPI been more negative than in 1Q2011; only once (in 1Q1974) was the difference between the percentage change in the GDP deflator and the percentage change in the PPI more negative. Hence, we conclude CMI’s contention is valid.

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Who cares, you say? Then consider this: Had the 1Q2011 change in the GDP deflator more closely resembled that of the CPI, the BEA’s estimate of growth likely would have been just barely positive; if more like the PPI, the economy would have been shown as contracting.

This issue is equally important during upcoming quarters. What is the probability that changes in the GDP deflator will continue to be so small relative to those of either the CPI or PPI? We think that probability is quite small. So, if changes in the GDP deflator come back into closer alignment with changes in the CPI or PPI and price inflation picks up speed as we expect, reported real growth will disappear under that statistical “double whammy.”

Smokey Bear Economy

    Reintroduction of fire 45 years after last burn                           

    Photo: Dale Wade, Rx Fire Doctor, Bugwood.org;

     Source: http://www.forestryimages.org/browse/detail.cfm?imgnum=1404030

Is it all and only about “Aggregate Demand”?

I admit it. My mind works in strange ways. A recent example of off-beat connections started when reading reactions to Christina Romer’s Princeton University remarks made this past weekend. One of her remarks that perhaps has received the most attention was about the “title that was not”:

… [the] levels of overall and long-term unemployment are not a separate, structural problem, but largely a cyclical one. It reflects the fact that we are still feeling the effects of the collapse of demand caused by the crisis. Indeed, at one point I had tentatively titled my talk “It’s Aggregate Demand, Stupid”; but my chief of staff suggested that I find something a tad more dignified.

Romer described various prescriptions for what she diagnosed as the U.S. economy’s principal malady: too little demand. I don’t want to spend time reviewing the prescriptions but rather the diagnosis --- is it really “It’s Aggregate Demand, Stupid?”

The Legend and Legacy of Smokey Bear

Now, here’s where the off-beat connection comes in but first some context is needed. For the better part of a century a sizable effort within U.S. forestry was aimed at preventing wildfire by aggressively locating where it started when it started and putting it out as soon as possible to limit its damage. Foresters were treating the “effect”, wildfire, if you will. Who could be against putting out wildfires? After all, didn’t you see the Walt Disney movie Bambi and all the woodland creatures who lost their homes due to fire? Didn’t you ever hear the story of Smokey Bear, the little bear cub who was orphaned by a forest fire? Everyone could agree --- we need to stamp out wildfire!!

The good news, at least initially, was the effort to stamp out wildfire from the forest was largely successful. However some troubling things began to happen. Trees began to grow more slowly and eventually became weak enough they were overtaken by disease and epidemic insect infestations. The reason why? Without periodic fire vegetation accumulated to such an extent the site was no longer able to support healthy growth by the plants and trees growing on the site. The weakened trees were more susceptible to other pests.  Some trees died and all were weakened. Eventually a careless moment or a lightning strike started a fire. When these dead and dying trees, along with the abundance of underbrush, finally caught fire there was so much vegetation to burn in many cases the fire couldn’t be controlled. Often the ensuing devastation was mind-boggling – worse than had ever been seen before. The term of art was “uncharacteristic fire”.

Thus, forestry learned that in many ecosystems to keep the forest healthy periodic fire was necessary. Fire still caused damage and still posed dangers but trying to exclude fire entirely was not possible and when it occurred after it had been excluded for an extended period of time the set of dominos it toppled led to unspeakable negative outcomes. And so, fire had to be re-introduced into many forests to begin to restore a healthy balance.

Applying Lessons from the Forest

So what does this have to do with the recession? Only that I fear for too many years economic policy makers have tried to avoid or minimize the impact of the economy’s version of a wildfire – a recession. During a business cycle growth proliferates but eventually the rate of growth begins to slow as “imbalances” occur throughout the economy. A recession, while unquestionably causing damage, also clears the way for new and sustainable growth in the future.

However, in an economy interest rates can be kept low so the cost of borrowing is minimal. Tax credits and subsidies can induce investment that would otherwise not pencil out to produce more. Special programs can foster development in chronically depressed areas to add to production but often the investment survives only as long as the special program is in place. In each of these cases the aim is to increase productionm which in this context is analogous to demand --- if you will, to extend the forestry metaphor --- pour on more fertilizer to get more growth. It’s the Smokey Bear Economy --- keep the forest green and growing and stamp out all wildfire. I see in Romer’s comment, “It’s aggregate demand, stupid,” an example of this type of Smoky Bear economy philosophy. Sometimes you can’t simply foster new growth by whatever means possible; sometimes you need to bring growth back in line with the fundamental capacity of the land, or by analogy, the fundamental capacity of the economy.

Industrial Production, Capacity, and Capacity Utilization

To me this point of emphasizing production and not appropriate alignment was highlighted again with the recent release of industrial production and capacity utilization. Of the pair much attention is given to the return of higher production levels throughout the U.S. economy. Pundits from across the spectrum talk about it: it’s increasing (good), it’s not increasing fast enough (bad), will it increase faster than it has been (hope), will it ever increase enough to bring the economy back to where it was before (despair), etc. Personally, I’m glad U.S. production is increasing; it’s what is necessary to meet both domestic and foreign consumption demands.

However, what of the other part of capacity utilization --- capacity levels? While analysts discuss capacity utilization, usually it is only to point out it is low and because of that there is economic slack and so the risk of price inflation is remote. Full stop. However, usually not much is said regarding capacity itself. What has been happening to capacity during the current economic recovery?

Dangerous Fuel Build-up?

As can be seen in the graphic below, capacity utilization has been rising since June 2009. Capacity utilization increases either by more production from the same capacity, the same production from less capacity, or some combination of both increased production and lower capacity.

I set out to sort out on a proportionate basis how much of the capacity utilization increase was due to increased production and how much was due to capacity declines. This can be seen in the column chart on the right-hand side of the graph. Initially 92 percent of the improvement in capacity utilization was due to increased production and only 8 percent lost capacity. However, since that time the proportion of the increase in capacity utilization attributable to lost capacity has been steadily increasing. In March 2010 cumulatively 14 percent of the improvement since June 2009 is due to lost capacity while 86 percent due to increased production.

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But something else caught my attention as I reviewed the numbers: what capacity utilization has done over the past decade, shown on the the left hand side the above graph. The blue-gray horizontal line in the graph above signifies the average capacity utilization for the period 1987 to 2007 (recession started in December 2007 so I excluded 2008 to present from computations). Notice that during this decade capacity utilization crossed the “average line” at the start of the decade and then only barely touched the line again in 2006 and 2007. Otherwise the rest of the decade capacity utilization has been below the 20-year average starting in 1987. Typically with an average you’d expect some of the data points to be above the line and some below the line. But here for practical purposes capacity utilization this entire decade has been below average.

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I dug a little deeper and put together the next chart (see immediately above). On that chart I calculated the “compound growth rate trend” of capacity and production to maintain the 20-year average rate of capacity utilization. Then I plotted the actual capacity and production against those trends for the period 1987 to 2007. What becomes readily apparent is capacity has been well above trend for most of this decade.

To make the areas of surplus and deficit more obvious I plotted those alone in the next graphic (see below). What leaps off the page was capacity did not significantly decline either during or in the immediate aftermath of the 2001 recession. As a result capacity utilization swooned as production, while above trend, fell off more quickly than capacity did. In essence for much of the decade we had too much capacity to support the demand, i.e. production. We were only starting to get capacity and production aligned with average utilization rates ---- usually at a business peak we’d expect utilization rates well above the average --- when the current recession hit.

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My conclusion is there was too much capacity at the start of this recession even before production plummeted due to the recession. Back to the forest metaphor: too much fuel on the site to allow healthy growth to occur. So, to imagine that “all” that needs to happen is to build back production levels to achieve utilization rates suitable for sustainable business models given pre-recession capacity levels I believe is unrealistic. Something has to change --- and I believe it already starting to change. Recognizing the change and adapting to it will be a key to successful business performance in the future.

The Legend and Legacy of “It’s Aggregate Demand, Stupid”

There has been much written about low interest rates were responsible for both the housing and consumer credit bubble. However, low interest rates also prolonged the life of many manufacturing assets that would have been otherwise shut down. How many assets were re-capitalized by private equity firms during the first half of the decade using a generous dose of low-interest debt? Further, low interest rates dropped hurdle rates on capital projects resulting in yet more capacity being built. Keep piling on the growth, keep putting out the fires and presto: the Smokey Bear Economy.

However, the problem is the Smoky Bear Economy is now choking; it can’t sustain itself. Take recent reports of increases in consumer spending. This is something of a dilemma to understand as incomes haven’t increased, unemployment remains high, and consumer debt continues to decline (see page 3 of April 2010 Macro Pulse). So how are consumers purchasing more in light of these numbers? Some argue it’s because of strategic default – people electing to stop paying mortgages with the expectation of some government-sponsored workout and diverting the mortgage payment to purchases. One naysayer to this theory, when asked to account for the increase in retail spending despite the aforementioned apparently contradicting data, offered the following “best guess” : 1) tax refunds; 2) Pent up demand (psychology) 3) Government transfer payments; 4) New hires.

To this I say take your pick --- strategic defaults, tax refunds, pent up demand, government transfer payments --- it’s probably some of all of this. I agree the economy will continue to grow through much of 2010; after all, despite reports that would imply most of the impact of the stimulus is already past, I still believe most of the impact is yet to come. According to the government’s website tracking stimulus spending as of 60 percent of the funds have yet to be paid out as of April 9, 2010. You simply cannot pour $470 billion (the amount remaining to be spent) of stimulus into an economy and not see an effect. The point is, beyond new hires, which given latest employment figures I expect are offering little support in this regard, very little of what is currently happening can be considered sustainable.
 
Recently housing starts and new home sales are up --- but most commentators acknowledge a sizable share of the improvement at present is with an eye toward a tax credit. The sideways movement of the housing market since the middle of last year occurred while the Federal Reserve subsidized the mortgage market to the tune of $1.25 trillion. Not sustainable. Usually the magnitude of economic growth coming out of a recession is proportional to the depth and severity of the recession --- the deeper the recession, the more robust the recovery. But not this time. The spurt of growth we had in 4Q2009 (5.6% based on the last revision) was principally due to a slow down in the rate inventory was de-stocked during the quarter (see page 1 of March 2010 Macro Pulse). That doesn’t look sustainable.
 
Re-introducing Fire in the Forest

My take of the U.S. fiscal and monetary policy landscape is policy makers don’t want to re-introduce fire back into the forest, they only want to stimulate more growth, i.e. they want more production while minimizing the loss of capacity. However, fire comes sometimes whether it’s wanted or not and the Great Recession is now re-introducing fire to the economy to “clear the forest” for future healthy growth.

As noted above, the loss of capacity in improving capacity utilization has been growing in importance since last June and I expect this trend will continue to accelerate. Let me offer one line of evidence from the CPI and PPI (finished goods) data. The PPI index represents the cost of materials for firms producing goods for sale to consumers. The CPI represents the cost of consumers buying goods. When the PPI increases faster than the CPI profit margins are squeezed and ultimately less competitive capacity will be lost. The average year-over-year change in CPI from the start of the recession (December 2007) to March 2010 is 1.9 percent; the corresponding average for PPI is 2.4 percent. While this difference between the two seems modest at first glance, the PPI rate is 26 percent higher than the CPI rate and when compounded over time the impact becomes significant. However, what is even more important is the margin difference is widening as of late (see March 2010 Consumer and Producer Price Indices: Bottle Rockets and Duds); since November 2009 year-over-year change for both have been positive, with CPI averaging 2.3 percent and PPI averaging 4.3 percent. Profit margins are being squeezed and as a result the pace of capacity curtailment is quickening.

Ironically, it is the policy makers’ actions that are setting the stage for the re-introduction of fire to this economy. Early in the crisis the Federal Reserve reasoned if it lent to financial institutions at low rates those institutions would lend to businesses and consumers, again at low rates, and this would re-stimulate the economy. However, with the federal government’s appetite for debt and the heightened risk of default by businesses and consumers due to recessionary pressures financial institutions chose to lend to the federal government, not the private sector. As a result, the financial sector’s profits are soaring on the margin between borrowing at very low rates from the Federal Reserve and lending back at higher rates to the Treasury. Meanwhile businesses faced with mounting costs and few sales are faced with the grim prospect of shutting down, exacerbating unemployment as their employees lose jobs. Capacity declines. Fire is re-introduced, even if unintentionally.

Fire Survival Skills

So if this is what is ahead what needs to be done to perform in such an environment? Extending the metaphor, while it is unavoidable, and even necessary, it is a dangerous gambit to have fire re-introduced after years of unchecked growth; a sudden wind gust or wind shift could result in what had been a seemingly contained fire suddenly become an inferno engulfing otherwise healthy portions of the economy. The keys to survival are being alert to subtle changes in conditions, being aware of surroundings, establishing firebreaks where possible and having protection equipment "on standby", having pre-planned exits, and reacting decisively.

Specifically, in the process of “reintroducing fire” to the U.S. economy it is important to understand "fuel and weather conditions". They are different than they were over the past 30-odd years. Those differences include elevated levels of public debt, a less dominant position for the U.S. economy globally, higher energy costs, and demographic changes with baby boomer generation transitioning into what has been traditionally retirement age (registration required). To briefly flesh out one of these conditions, the developed world is carrying significantly higher levels of public debt. Currently interest rates are low but they won’t stay low (more in the next paragraph). When rates increase the cost to service that debt will skyrocket and governments will cut back on services. As a result I expect infrastructure will falter in places: roads, communications, transport, and above all, interaction with government agencies which will be stretched thin. Expect that whatever you have to get done will take longer to get done than it used to and plan for it.

Along these lines supply chains will be tested and sometimes break. Consequently risk management, anticipating uncertainty, and planning for it will be an essential success factor. In the future low cost will only be truly low in the context of appropriate consideration of risk. Prior leverage rules will no longer apply as interest rates rise so managing debt service will be a critical success factor. Interest rates will increase whether the Federal Reserve wants to raise them or not. While I believe other factors will be at work as well the most fundamental is this: there is and will be simply too much demand for debt, both public and private around the globe, to imagine the Treasury will be able to borrow the massive amounts of debt it needs to run the federal government without interest rates increasing.

In terms of markets, the focus will be on competitiveness not gaining market share. Also, I believe the U.S. dollar will enter an extended period of weakness relative to the experience of the past two decades. China will diversify its U.S. dollar holdings and whenever the dollar shows momentary signs of strength China will sell (or not buy) until the dollar loses enough value China stops selling (or starts selective buying), preserving the total value of its portfolio while diversifying. That means currency exchange rates will likely yo-yo more than they have in the past. However, because the trend will be a weaker dollar there may be opportunities for exports that were not viable in the past due to currency risk. These must be weighed against supply chain risks and higher energy costs but I do believe success will often include more market diversification than was the case in the past.

Finally, isolating, enhancing, and leveraging sustainable competitive advantage will be the difference between surviving or being consumed. Doing this effectively requires decisive reaction. I purposely say “reaction” because fire is unpredictable; there are clues, there are danger signs, but the unexpected does occur and occurs suddenly. At those times reacting, and reacting decisively is essential.

The U.S. Economy's Gordian Knot: Real Estate

The Legend of the Gordian Knot

If you’ve ever tried to untangle a “bird’s nest” of fishing line on a reel you can relate to trying to untie the “Gordian Knot”. The Gordian Knot is a reference to a Greek legend. The legend claimed the person who successfully undid the “Gordian Knot” would rule. Many tried to untie the knot to no avail until Alexander the Great took a different approach --- he cut the knot with his sword.


Real Estate Loan Outstanding Value
vs. Real Estate Market Value:
a Gordian Knot for the U.S. economy?

Successfully resolving the lingering effects of the burst U.S. real estate bubble could be described as one of the “Gordian Knots” of the U.S. economy. The issue is the amount of outstanding debt collateralized by real estate during the real estate bubble. The problem is that since the loans were issued the market value of the loans’ collateral has sunk, or the loans are "underwater".

This is creating problems for both lenders as well as borrowers. For example, last week the Financial Times reported there were growing tensions between banks and their auditors over the divergence in the value of their commercial real estate loan portfolios and the collateral market value of those properties under current market conditions. Also last week Bank of America announced a program to begin reducing the principal on residential loans meeting certain criteria. A few days after the Bank of America announcement the Obama administration proposed a new program (see here and here for descriptions) to incent lenders to reduce the principal loan value to unemployed borrowers that meet certain criteria.

To get a handle on the magnitude of the "underwater" issue we compared the decline in real estate market values to the decline in what the Federal Reserve reports as outstanding real estate loans at commercial banks. It’s important to realize that commercial bank real estate loans compose about 27 percent of the total U.S. mortgage debt outstanding ($3.8 trillion of $14.3 trillion as of year-end 2009; see "Loans" in graph below, gray shade in legend, right axis); however, the percentage decline in total U.S. mortgage debt outstanding and in real estate debt outstanding at commercial banks has been similar. Using Case-Shiller index as a guide for residential properties values and Moodys/MIT index as a guide for commercial property values we contrasted the decline from peak values for each market value index as well as the outstanding real estate loan value. To simplify comparisons between the changes in value for outstanding real estate loans ("Loans" in graph, red line, left axis), the residential market price index (CSHPI in graph, left axis), and the commercial real estate market price index (CPPI in graph, left axis) we re-indexed each series with the maximum point of each series = 100.

Case-Shiller stands about 30 percent below its peak as of January 2010. In the case of commercial real estate the drop is larger --- about 40 percent. Currently both indices are roughly at the levels seen in the latter half of 2003. While the commercial real estate market represents about one-quarter of the total U.S. mortgage market it comprises a higher percentage, closer to 40 percent, of the real estate loans at commercial banks according to the Federal Reserve’s March 2010 H9 report.

However, while market values currently stand between 30 to 40 percent below peak levels the outstanding loan value has dropped by less than 3 percent from its peak value through January 2010. By our rough calculation a reasonable estimate of $1.5 trillion in outstanding loan value that has been added since the latter portion of 2003 that is no longer collateralized due to the drop in the real estate market is a little more than $300 billion. We expect this same proportion of “loan value at risk” could be extrapolated to the broader mortgage market; while the balance of the mortgage market has a higher proportion of residential properties, which have seen relatively less loss in value than commercial property, we also expect the balance of the mortgage loan portfolio carries a greater proportion of higher risk residential mortgages and so compensates for the difference in residential/commercial mix in the portfolio. Thus, the roughly $300 billion in the commercial bank real estate loan portfolio would translate into $1.1 trillion for the entire mortgage market, or about a 8 percent of the entire portfolio.

A Sign Post toward Sustainable Recovery

Until this divergence between loan value and market value is substantially reduced it will be difficult for the housing market engage in sustainable recovery. Lenders are reluctant to lend when faced with the prospect of large capital losses on existing loans. For many prospective buyers they have to sell their current home before purchasing another home and if their current home is less than the loan value they are obligated to come up with the difference or declare bankruptcy. Declaring bankruptcy of course affects their ability to qualify for another loan for some time. Further, for lenders, if they begin foreclosing on delinquent loans and then trying to sell them they expand the supply of homes, dropping market values further and compounding their problem with other loans in their portfolio.

Cutting the Knot

We do believe there could be an analogous “Gordian” solution: rather than trying to untie the knot you cut it. As an example we sketch out one possibility that may work in some cases:

• If the borrower and lender agree to a modified foreclosure process, patterned to some degree after a short-sale, and then execute a leaseback by the borrower some progress could be made on cutting the knot. It will probably be necessary to involve some intermediary to facilitate the transaction who ends up actually owning the property and leasing it. The original borrower will lose whatever equity they have in the property and the lender will have to write off the difference between the outstanding loan value of the property and the sale price at the time of the short-sale (i.e. those who entered into the transaction each shoulder some of costs of it not turning out as they had originally expected).
• The leaseback is written at the value of the short-sale so presumably the monthly lease payment is less than the previous monthly mortgage payment, helping keep the original borrower and now lessee solvent.
• By keeping the house leased and off the market the market supply is not expanded, mitigating additional market value erosion.
• By making lease payments the lessee is able to repair at least some of the credit damage the short sale inflicts (the damage is probably less than a bankruptcy however).
• In our view this approach also has the advantage of not requiring further government intervention into the markets.

While such solutions are not painless they may represent a less painful way than the approaches undertaken to date. It can be argued the current methods have halted the decline in the housing market and allowed it to stabilize. However, they have failed to solve what seems an otherwise intractable problem and without a solution it is unlikely there is a sustainable recovery in real estate. Our concern is with continuing high unemployment, increasing public debt, and the prospect of higher taxes in the near future the economic recovery will stall and ultimately reverse itself, deferring a lasting solution anytime soon. Further, we believe there is a very real prospect the market, rather than the Federal Reserve, will begin dictating interest rates and should they begin to climb the knot will tighten even more.

Ignoring E.F. Hutton

The New E.F. Hutton?

I grew up in the age of classic TV commercials. Who could forget Life cereal’s “Hey Mikey?” Or Wendy’s “Where’s the Beef?” And then there was the E.F. Hutton’s ad campaign with its slogan, “When E.F. Hutton talks, people listen."

E.F.Hutton -- its prestige tarnished by scandal -- is long gone, ultimately swallowed by other competitors. However, if there’s a firm that seems to have inherited the mantle of the slogan, “When E.F. Hutton talks, people listen” it may be PIMCO. When either of PIMCO’s co-leaders, either Bill Gross or Mohammed El-Erian, make public statements about their outlook, those comments are analyzed and dissected by the financial and investing media, searching for clues about what PIMCO may be thinking.

"Don't Care." What did he mean?

Gross posts a monthly newsletter on PIMCO’s site that provides plenty of fodder for the investing media but March 2010’s issue, titled “Don’t Care,” left people scratching their heads. The WSJ’s Marketbeat blog was indicative of the common reaction:

PIMCO bond guru’s monthly letter is usually good for a tidbit/modicum of insight into the mind of the one of the world’s most influential fixed income investors.

Well, this month’s edition from Bill Gross entitled “Don’t Care,” offers a little less insight and a little more drivel than usual.

“Don’t Care”? What’s this all about? Well, if we take a look at his closing paragraph it’s pretty clear: he doesn’t care about mere talk; he wants to see action on the part of governments that promise to deal with their debt load before he lends money to them (emphasis in excerpt below was in the original):

PIMCO’s “Ring of Fire” remains white hot and action, as opposed to cocktail blather, is required to maintain or regain trust in sovereign credits approaching the rocks. Just last week Bank of England Governor Mervyn King said that it would be difficult to cut government spending quickly, but that there needs to be a clear plan for doing so. Not good enough, Mr. King. Don’t care. Show investors the money, not vice-versa. An investor’s motto should be, “Don’t trust any government and verify before you invest.”

However, I speculate there’s a message in “Don’t Care” other than the one laid out plainly in the article. I don’t know for a fact, but suspect it may have something to do with the economic and investing community’s reaction to what Gross wrote in his February 2010 issue, entitled “The Ring of Fire.” In it Gross laid PIMCO’s take on sovereign debt risk around the globe. Being a fixed fund manager, assessing risk relative to return on debt is of paramount importance to PIMCO. Gross presented PIMCO’s concept of the Ring of Fire: countries with debt levels high enough there are heightened risks of seeing diminished economic growth. The countries in “the Ring” were most of the usual suspects: Greece, Italy, Spain, Ireland, France, Japan, and the U.K. Perhaps the shocker was who else was included in the Ring of Fire: the U.S.

Can't happen here!!
Reaction in the financial MSM was swift and generally dismissive --- some by name, some not. A NY Times Op-Ed entitled “Fiscal Scare Tactics” by Nobel laureate economist Paul Krugman captures the heartbeat of this sentiment. The column was posted on February 4, 2010, shortly after Gross’s February issue was posted on PIMCO’s website; although he doesn’t name Gross, Krugman dismissed assessments of the U.S.’s fiscal condition like Gross’ as “scare tactics”:

These days it’s hard to pick up a newspaper or turn on a news program without encountering stern warnings about the federal budget deficit. The deficit threatens economic recovery, we’re told; it puts American economic stability at risk; it will undermine our influence in the world. These claims generally aren’t stated as opinions, as views held by some analysts but disputed by others. Instead, they’re reported as if they were facts, plain and simple.

Yet they aren’t facts. Many economists take a much calmer view of budget deficits than anything you’ll see on TV. Nor do investors seem unduly concerned: U.S. government bonds continue to find ready buyers, even at historically low interest rates. The long-run budget outlook is problematic, but short-term deficits aren’t — and even the long-term outlook is much less frightening than the public is being led to believe.

Krugman was not alone in this dismissal. But, then, neither was Gross alone in his assessment. And so, I suspect at least in part, Gross wrote March’s news issue, because it was obvious many didn’t care to hear what he had to say, and he didn’t care what they were offering in response.

In the March issue Gross spelled out what he felt were some of the implications for countries continuing not to care about their debt (emphasis in excerpt below was in the original):

There has even been a developing debate in the press (and here at PIMCO) as to whether a highly-rated corporation could ever consistently trade at lower yields compared to its home country’s debt. I suspect not, but the narrowing in spreads since late November solicits an interesting proposition: Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.

So what does this have to do with the U.S. forest products industry?
There are at least three areas in which the prospect of sovereign risk, and particularly U.S. sovereign risk, could affect the U.S. forest products industry.

• There is a direct linkage between sovereign debt risk and U.S. mortgage rates. Mortgage rates of course are a key ingredient in housing affordability and thus an important component to any lasting housing recovery. Mortgage rates are more closely aligned with longer-term treasury rates than the short-term rates that generally grab the headlines. The perception of heightened risk on U.S. long-term debt will ultimately drive mortgage rates higher. Higher mortgage rates could stall the near-term housing recovery; longer term they could adversely affect the sustainable level of housing start activity.
• Higher long-term rates will dampen economic activity, slowing the pace of recovery, keeping unemployment high, and potentially threatening the U.S. economy with a double-dip recession. A double-dip recession will add to housing inventory through foreclosure (foreclosure and unemployment are correlated; see March 2010 Macro Pulse), creating additional headwinds to eventual recovery in housing and reducing general demand for wood-pulp based products.
• Higher interest rates could mitigate further U.S. dollar weakness and so make U.S. wood-based exports less competitive globally. Early in the current economic downturn exports were an important source of demand for pulp and paper manufacturers to mitigate in part the loss of demand in the U.S. For wood products manufacturers the weaker greenback reduced the share of limited domestic demand met by imports into the US.

Our view for the past 18 months has been that the global debt onslaught the world is facing over the next several years will force U.S. interest rates higher, particularly longer-term rates. That will happen either as a result of:

• Capital rationing between various countries’ public debt, private debt, and equities;
• Central banks expanding the money supply and prompting lenders to demand an inflation-risk, (or in extreme cases default) premium on their debt;
• Both of the above.

And, it will happen, whether the Federal Reserve moves to increase short-term interest rates or not. We believe an increase in interest rates given the fragile condition of the U.S. economy trigger the double-dip recession.
Epilogue
As a post script to all of this we found a Bloomberg news article from this past weekend (March 22, 2010) interesting, particularly as what it described occurred within a month of Gross questioning whether such a thing could occur. The headline and lead paragraphs are shown below, emphasis added:

Obama Pays More Than Buffett as U.S. Risks AAA RatingThe bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

The new E.F. Hutton is talking. Are you listening?

This one deserves our "WAHT Award" ...

Take a deep breath, pour yourself a fresh cup of coffee, start the song (right click and select open in a new tab or window to avoid navigating away from this page), and read the article.

Then ask yourself: How are business profits going to grow by 15 percent to lead the economy to stable conditions if 10-20 percent* of employable people, read that as consumers of those businesses goods and services, are unemployed?

Economists: Recovery is firmly on track

*Remember, it's not just the 9-10 percent unemployment that is currently being reported by BLS. People have been sliding off the unemployed list for some time because they've run out of benefits. In addition, there are those who have become discouraged looking for work and given up looking so they are not listed as unemployed any more either.