Tuesday, August 16, 2011

Brief political note: American governance today

Right now Americans are watching a three ring political circus.

In one ring we have Congress, now taking a well-deserved vacation after playing around with the debt ceiling, triggering an unprecedented downgrade, and causing global turmoil. Great work, guys. Enjoy the beach.

In the next ring, we have the Commander-in-Chief and Leader of the Free World taking a field trip with his extensive entourage through the underpopulated parts of the Midwest, doing photo-ops with ethanol farmers. He may visit a windmill or lithium diode factory, if David Plouffe can find any out there among the silos and Dairy Queens.

Our president is using his ethanol tour (hopefully his bus runs on clean Iowa corn) to push a number of his “jobs” initiatives, the centerpiece of which is extending unemployment benefits into eternity. Why do unemployment checks create jobs? Because they’re spent. By this logic, the more people out of jobs, the more jobs will created (food stamp printing plants, community organizers, jobs counselors, social workers, retraining consultants and sociologists who will explain that government annuities don’t reduce the incentive to work)*.

But wait, the president says that “when he goes back to Washington” (after spending two weeks at Martha’s Vineyard dodging the Clintons), he will unveil a “detailed” jobs plan. He’s been keeping it secret for all these years; thank goodness he’s finally decided to allow us to see it. I can’t wait.

And in the third ring we have the 2012 GOP “hopefuls”.  I will spare you the Snow White and the Seven Dwarfs witticisms that we always hear at this time of the cycle (they were probably wittily saying something similar in 1804).

But seriously, the Tea Party has screwed everything up. The party of Robert A. Taft has become the party of Sarah Palin, Michelle Bachmann and Rick Perry. The whole point of elections is to (1) win them; and (2) and then make America a better place for its citizens to prosper.

The Democrats have their own albatrosses to bear: the ever-expanding list of tribal caucuses, and plenty of left-wing nut jobs. (Good news, Congressman: Guam has not yet capsized).

But the Tea Party is screwing up the GOP nominating process by demanding that candidates sign up to a right-wing laundry list that will render them unelectable in November. Romney has been right to ignore the Tea Party; he wants to win, not to lose heroically.

And now let’s take a look at the Tea Party’s “substance”. Hmm. Allow the US to default. Abolish the central bank. Abolish paper money and put the US back on gold (at $1700 an ounce, that would be quite expensive, but a windfall for for Russia). Drag Ben Bernanke down to Texas in order to lynch him as a traitor (that would be the Texas governor in dressed up in cowboy boots, a tuxedo and a large toupee).

It is that last item, this irruption from the tobacco-stained gums of the toupeed Texas governor that motivated me to write this post. Here is bit of the governor’s down home Texas wisdom concerning the Governor of the Federal Reserve Board:

“If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous -- or treasonous in my opinion.”

I am speechless. What can you say to that mixture of bullying arrogance and cretinous stupidity? He is like W without the class. "This guy"? That would be Chairman Bernanke to you, Rick.

I think the only way to maintain calm at a time like this is to pull Mencken off the shelf and get some perspective: it’s supposed to be a circus. I just wish foreigners didn’t have to watch it. They may not get the joke.

Now look. No one should be an academic snob. Lincoln did not graduate from Harvard. But educational achievement is a relevant datapoint, nonetheless. Here is Governor Rick’s academic resume:
“Perry attended Texas A&M University, where he was a member of the Corps of Cadets, a member of the Alpha Gamma Rho fraternity and was elected senior class social secretary and was also elected as one of A&M's five yell leaders (a popular Texas A&M tradition analogous to male cheerleaders). Perry graduated in 1972 with a 2.22 GPA, earning a bachelor's degree in animal science.”

If the best you can do at A&M is a 2.2 in animal science, you really should not be seeking to lead the Free world. You should be judging Longhorns at the State Fair.
*Food stamp czar Tom Vilsac:
I should point out, when you talk about the SNAP program or the food stamp program, you have to recognize that it's also an economic stimulus. Every dollar of SNAP benefits generates $1.84 in the economy in terms of economic activity. If people are able to buy a little more in the grocery store, someone has to stock it, package it, shelve it, process it, ship it. All of those are jobs. It's the most direct stimulus you can get in the economy during these tough times."

Monday, August 15, 2011

What a nominal world!

No one who is not living in Zimbabwe, North Korea or Ukraine thinks in real terms. So long as inflation is moderate, we think in nominal terms. We say “Hey, honey, I got a raise today!”, not “Hey honey, on real terms, I'm barely treading water!”  This is called the “money illusion”, except that, as long as inflationary expectations are in check, it is not an illusion; it is an economic law.

I will now advance the Mahoney Theorem which is appropriated from Scott Sumner, who hasn't yet trademarked it:
When an economy with sticky wages (aka, the West) is mired in a low-growth, low-inflation situation (i.e., low nominal growth), real growth and employment are functions of nominal growth. Nominal growth is therefore a precondition for real growth and employment growth. And the monetary authority is therefore responsible for employment growth.

Why is this? Well, obviously the money illusion, which works so long as inflation is moderate. But, just as importantly, moderate inflation allows nominal wages to rise while real wages fall, in order to regain competitiveness. In the modern economy (other than Hong Kong, where wages are uniquely flexible) nominal wages never fall and normally rise (see: minimum wage laws). The only way that labor can be made competitive in an adverse trading environment is real wage decreases. (And currency depreciation, another topic.) When nominal business revenues rise, nominal payrolls rise. When nominal revenues stagnate, nominal payrolls (at best) stagnate.

Right now, the whole world (besides witch-doctor economies such as Zimbabwe, North Korea and Ukraine) is in the grip of that seventies religion: price stability. We are fighting the last war. Yes, double-digit inflation is bad, a given, no argument, why are we still talking about it! But do we really want price stability,  0% inflation? No. We want moderate inflation in order to provide the correct incentive structure for investment and employment. My desired formula is 3% inflation and 3% real growth, for nominal growth at a healthy 6% (which, BTW, would allow us a 6% deficit and stable debt ratios).

There may be an island-living, survivalist tribe of neo-Keynesians who would still argue that “money doesn’t matter”. In other words, that contractions and expansions of the money supply are irrelevant in the determination of real growth. To which some monetarist once replied, “Well, if that’s true, then why couldn’t all the world’s trade could be conducted using a single penny?” QED. Money matters.

Sunday, August 14, 2011

Bernanke grabs the steering wheel

Excerpted from the FOMC’s August 9th statement:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman (New York); Elizabeth A. Duke (BOG); Charles L. Evans (Chicago); Sarah Bloom Raskin (BOG); Daniel K. Tarullo (BOG); and Janet L. Yellen (BOG).
Voting against the action were: Richard W. Fisher (Dallas), Narayana Kocherlakota (Minneapolis), and Charles I. Plosser (Philadelphia), who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period [without specifying duration].

This is big news. In the Greenspan era, the FOMC voted unanimously for whatever the chairman wanted. In the Bernanke era, the FOMC has had at most two dissenters (Warsh or Hoenig, both now thankfully gone). It was pretty clear that, in order to maintain “institutional credibility”, Bernanke wanted to minimize public dissent. (So as not to give the Ron Pauls of the world any more meat to chew on.)

What this has meant in practice, is that the hawkish minority have had leverage over the expansionary majority, thus interfering with Bernanke’s desire to grow M2 until he saw growth and inflation moving up and unemployment moving down. He wanted the Fed to do what he had wanted the BoJ to do ten years ago: target outcomes, not inputs.

I see last Tuesday as a breakthrough because it signals that Bernanke has given up on consensus-building, and is prepared to move ahead with continued unconventional policies on the basis of a working majority in the committee.

Under QE1, after the Lehman crisis, the Fed was growing M2 at over 10%. After QE1 ended in 2009, M2 growth slowed to an anemic and deflationary 1%. That is why 2010 was such a disappointment: the Fed was prematurely “conservative”.  The Ben launched QE2 (which ended in June) and got M2 growth back up to over 9%.
I can’t imagine that he intends to keep the monetary aggregates stable going forward, especially with the recent market turmoil,  disappointing employment numbers, and fiscal tightening. I expect him to turn the pumps back on this fall.

I would also hope that he would wake up and stop paying interest on free reserves, which seriously impedes the Money x Velocity = Price x Transactions policy mechanism, by depressing Velocity. If he really wants to get things moving, he should charge the banks a fee (negative interest rate) for parking their money at  the Fed.

If he can grow M while stabilizing V, we will get the nominal GDP growth that we need to put people back to work and to stabilize the debt/GDP ratio.

Tuesday, August 9, 2011

Understanding sovereign credit ratings

John Moody invented bond ratings in 1909, focusing initially on railroad bonds (which were the bread and butter of the US capital market at the time). As time passed, he expanded his coverage to include corporates and, in 1918, munis and foreign governments. He did not rate foreign governments out of personal interest, but because his US subscribers were being sold new or seasoned dollar-denominated sovereign debt. (The London capital market was closed due to the war; New York remained open, without exchange controls.)

Moody's rating scale was originally based on railroads and industrials. He intended  for the rating scale to have room for large railroads and corporations in the Aaa category. When munis and governments were added, they were slotted into the same scale but with different definitions (some of which were very politically incorrect!).

Sadly, his track record with “government” ratings wasn’t so good. The Great Depression was very bad for munis, Latin America and central Europe. World War II was not good for defeated powers which hadn’t already defaulted.

I might add that the Depression wasn’t good for the US either. When the banking system collapsed in 1931-33, the bond market dried up, and the Fed was too busy trying to stem the gold drain to worry about the Treasury. Treasury almost defaulted in 1933 between the election and the inauguration. It had run out of money due to a huge deficit and lack of market access.

What’s interesting is that I know all this arcana because I have read John Moody’s investor newsletters during the Depression. He was all over this near-default, but maintained the Aaa throughout. I have to assume that this was for ordinal, rather than cardinal reasons. In a rank ordering of bonds in 1933, Treasuries were still on top and “money good”. Even when the US repudiated (3/33) the promise to redeem its bonds in gold, it remained Aaa.

The USA, on a cardinal basis, was not a great credit in 1945 with an enormous war debt, but, on an ordinal scale, it was the best in the world if you don’t count Sweden or Switzerland which saved themselves billions by staying out of the action. The UK looked even worse than the US, but was still Aaa and has always been, if my memory is correct. (I don't think the UK should have kept its Aaa in the postwar period, nor when it was begging from the IMF in the seventies.)

The global capital market closed in 1930, and did not reopen until over fifty years later.  When it did, and American investors were once again being sold soveriegn bonds, the agencies began to assign ratings to foreign governments selling dollar bonds in the Yankee market and the eurobond market. In the 1980s, sovereign credit methodologies were primitive and not very good. Mistakes (in retrospect) were made. 

Over the next thirty years, the quality of sovereign credit analysis steadily improved, as did the quality of the analysts and their methodologies (and their data). In the 1990s, the agencies dramatically expanded their coverage from a dozen countries to over 100, in order to establish "sovereign ceilings" for bank ratings.

To oversimplify, there are essentially three sovereign methodologies at the agencies: one for developing economies, one for high-income economies, and one for economies which either borrow in foreign currency (eurozone), are dollarized, or  are hard-pegged to the dollar (or any other foreign currency). All of the methodologies are tied to ratios and other data. As of 2007 (when I retired), Moody’s published the most comprehensive and uniform data, in its Country Credit Statistical Handbook. It is possible that S&P and Fitch now offer similar products but I doubt it; these things are very labor-intensive.

So, why does S&P think that the USA is a worse credit than it was in 1945, and a worse credit than Johnson & Johnson? I would advance two reasons.

One is that the (salutary) development of prescriptive sovereign methodologies has resulted in an ontology which is unintentionally separate from the corporate scale in terms of expected loss. Can I prove it? No. But I feel it. And I’ll take a Treasury any day over J&J.

Another is that the cardinal aspect has gotten a lot stricter since 1933 and 1945. The ratios are the ratios, the CBO projection is awful, and that’s that. You’ve got to do what your methodology says to do.

But I will conclude with this observation: I don’t think that the UK, France or Switzerland are better credits than the US. The UK and Switzerland have large contingent liabilities (banks), and France has a socialist mindset. Our banking system is manageable, and few of our politicians (outside of Vermont) are avowed socialists.

Sunday, August 7, 2011

S&P out on a limb

Last week, I confidently predicted that S&P would not downgrade the US. I reasoned that to take what many will see as an extreme position would erode S&P’s credibility, especially when the other two agencies disagree. (Which, by the way, is an inadmissable reason to maintain a rating, but everyone has a subconscious).

The United States is a very complex sovereign credit, because it prints the global reserve currency, which creates artificial central bank demand for its bonds. Also, as Gavyn Davies points out in today’s FT:

The US cannot be forced to default on debt which is denominated in its own currency while it has huge untapped taxable capacity and a sovereign central bank to boot. It would only default because of the existence of a debt ceiling voluntarily imposed by Congress.

Aside from the optics, was S&P’s decision correct? That depends in part whether one believes that S&P rates sovereigns on the corporate scale. They say they do, but do they really? If one takes their stated methodologies at face value, the downgrade was warranted. They had laid out clear criteria in advance and the criteria were not met (a bipartisan deal to reduce the deficit by an amount sufficient to stabilize the country’s key debt ratios at a level consistent with AAA).

Did S&P do the responsible thing? Yes. Rating agencies are not allowed to have a published opinion that differs from the rating committee’s own internal opinion. When a rating agency downgrades a credit, the issuer suffers (see Enron, AIG, Greece). Rating agencies do not and may not consider the possible  impact on the issuer or on the capital markets. Otherwise no one would ever be downgraded. All issuers are not created equal.

What is the political backwash for the agencies? The usual nonsensical ideas: (1) regulate them more; (2) create more of them (with government money); and (3) reduce their “power”. This kind of talk has been going on since the agencies started downgrading NYC in the 1960s. It erupted after Enron/WorldCom, and again after the CDO mess. Always stymied by that obscure 1789 Constitutional amendment which says something about the press.

I do not see how a government can regulate an opinion provider (aside from fraudulent activities that would apply to all opinion providers). Right now the Italians are “investigating” the rating agencies for publishing opinions with which Sr. Berlusconi disagrees, or finds inconvenient.

I expect the political upshot to be basically nothing, other than the fact that this has embroiled the agencies in domestic politics in the middle of a national political campaign, which is not good.

The one upside is that this event bolsters the agencies’ argument that they are publishers and deserve First Amendment protection (which has been upheld in federal court on multiple occasions).

It is my hope that, down the road, if the SEC does go after the agencies, the agencies will challenge the constitutionality of the rating agency section of Dodd-Frank (which is unconstitutional).

Dodd-Frank is such a mess: (1) it seeks to remove rating agencies from regulations, which is good and returns them to being private sector opinion providers, like Morningstar; and (2) it directs the SEC to regulate the agencies, with all that implies about winks and nudges (not always subtle).
The Europeans have not been subtle about “incorrect” rating opinions. I have always wondered how many NSA-equivalents wiretap and intercept rating agency communications. Not whether, that’s not an issue, but how many.

Wednesday, August 3, 2011

I expect S&P to confirm the USA's AAA, with a negative outlook

Now that both Moody’s and Fitch have affirmed the AAA, I consider it quite unlikely that S&P will go out on a limb and unilaterally rate Treasuries at AA+. I remember when Moody’s took Japan to A2, it made the rating irrelevant in both domestic and foreign currency. Maverick positions hurt credibility (see: Central Banks, the IMF).

The US remains a benchmark standard for “risk free”. The ceiling deal should result in a less frightening fiscal trajectory over the medium term. Therefore, it would be premature to downgrade before the process plays out in December.

I expect more threatening language, a negative outlook, but no downgrade.

Eurozone defaults: From unthinkable to mandatory

“I expect that [in addition to Greece] other euro area sovereigns, most likely Portugal and Ireland, will experience ratings defaults. The new European Stability Mechanism (ESM) that will replace the European Financial Stability Facility will have a sovereign default resolution mechanism. For sovereigns deemed insolvent, debt restructuring will be a pre-condition for access to ESM funds.
Private sector creditors share the burden of sovereign debt restructuring. Private sector involvement, so far on a supposedly voluntary basis, is on the map. I expect that before the end of the Greek programme, there will be deep coercive debt restructurings for Greece and other periphery sovereigns – without that it seems inconceivable their debt burdens can be lowered to solvency-consistent levels.”
--Wiliam Buiter, Citigroup Chief Economist, in the FT

There is a lot of really disturbing information in that paragraph. One year ago, we were told (condescendingly) by the EU and the ECB that defaults by eurozone members were unthinkable, and that any (Anglo-Saxon) discussion of the possibility was ill-informed and irresponsible. Everything was under control; it was just that foreign economists “don’t understand Europe”.

Well, it turns out that the foreign economists did understand Europe, because they knew that even the EU cannot suspend the laws of gravity and simple arithmetic. They did not drink the “Europe” Kool-Aid. Europe thought that if everyone would just shut up, the “market” would miraculously “believe in Europe” and credit spreads would retreat as fiscal austerity took hold.

Now we learn that eurozone default is no longer unthinkable: it is now a mandatory precondition of further bailouts. But the “market” is still expected to remain open to these issuers out of a sense “responsibility” or “solidarity”.

Well, the “market” consists of fiduciaries investing or lending other people’s money: their clients and depositors. It would be the height of irresponsibilty for an institutional investor to lend his clients’ money to risky countries which are expected to default. Which means that there is going to be only one source of bids for these countries’ debt: the EU and its various organs.

This means that the public debt markets will remain closed for Greece, Portugal and Ireland, and that they are rapidly closing for Spain and Italy. Either the ESM (Germany) will have to become their sole source of funding, or as Buiter implies, they get the ESM funding on the condition that they default and partially repudiate.

Once a country has defaulted (and partially repudiated), the capital markets will remain closed for a long time. Is the ESM going to be willing to fund the peripherals’ fiscal deficits (as well as their maturing bonds)? It might try to impose harsher austerity to force budgets into balance, but the political consequences would be dire. If they remain in deficit and the ESM says “no mas”, then the peripherals will have no choice but to balance their budgets (and their external accounts) while still defaulting on their maturing debt.

Developing countries have done this before, and developed countries did it in 1931-33. But the political consequences were in every case, a shift to the left or to the right. The political center did not hold because it had lost legitimacy.

I would hold out a little bit more hope for Ireland making it through because it is a Northern European country, it is competitive and has an educated and industrious workforce. Finland did it in the early nineties, they did not default and they are AAA.
And Eire is very small, so a bailout won’t break the bank, the way it would for Spain or Italy.

Can the US remain immune? Perhaps, especially if the economy grows and the fiscal trajectory becomes sustainable. Despite all the hoopla about the US having lost "global credibility", it remains the ultra blue chip in the debt market. Throught the latest crisis, Treasury prices have continued to be bid up. An S&P downgrade to AA+ may cause a blip, but I think it can be accommodated, just as it was in Japan, Canada, the UK and New Zealand.

But the outlook for the PIIGS is about as bad as it could be. The eurozone is not only a failure, but also a catastrophe which will play out over the next five years.