Monday, December 17, 2012

The Bank Of Japan Will Defeat The New Government

“Mr. Abe's economic platform consisted of more fiscal stimulus spending, to be financed by the Bank of Japan directly buying government bonds. In other words, printing money to bring inflation up to a new target of 2%-3%, compared to the BoJ's current target of 1%. But the central bank has expanded the money supply enormously, and demand for credit is so weak that it has been unable to stop deflation.”
---WSJ editorial, “Japan’s New Old Hawk”, Dec. 17th 2012

The Journal is giving the Bank of Japan credit for something it didn’t do. It is unclear where the Journal gets its monetary data for Japan. I get mine from the Fed, which show that money growth in Japan has been weak for twenty years, frequently going negative. M1, M2 and M3 growth rates have been bouncing around a very low mean of around 1% over those years. At present, under the BoJ’s supposedly reflationary policies, broad money (M3) is growing at 2.2%. Nominal GDP and industrial production have declined sharply since the crash.

The Journal is right that the BoJ has been unable to stop deflation, but that is due to its dogged pursuit of deflationary policies. It is now ten years since Ben Bernanke first explained to the Japanese the mechanics of NGDP targeting; only now is the government considering such a program. Twenty years of deflation and deficits have been wasted. Reflation is now the only way out for Japan, given its massive indebtedness.

The newly elected Japanese prime minister, Shinzo Abe, has embraced the advice that Bernanke gave Japan ten years ago: to target not interest rates, but either nominal growth or a target level of NGDP. Abe says that he will establish a monetary council, outside of the BoJ, that will set a 2% inflation target and a 3% NGDP growth target. If the BoJ ignores the council, he will take away the bank’s legal independence (long overdue).

I don’t know how to react to Mr. Abe. Most of what Japanese politicians say is meaningless. Japanese governments have been whining about the BoJ for fifteen years, so what’s new? My gut skepticism toward the Japanese political system suggests that one should not hold one’s breath waiting for a meaningful change in Japanese monetary policy. Furthermore, in typical Japanese fashion, the “radical” Mr. Abe has not called for a radical policy:  3% nominal growth will not change Japan’s debt dynamics when its fiscal deficits remain large (and will grow bigger under the new government).

Japan needs a radically reflationary policy now, not baby steps which are too little and too late. Bernanke advocated targeting the level of NGDP that would have occurred had the desired growth path not been interrupted. For Japan, that would be roughly 12% higher than today’s NGDP, not 3%. Mr. Abe is merely demanding that the BoJ do a tiny bit better than it has been.

Furthermore, students of Japanese politics will know that it will only take days for the Japanese media to proclaim Mr. Abe a failure and an embarrassment, no matter what he does or doesn’t do. In a year he will be gone, and the BoJ will still be there, “fighting” deflation.

This means that the Japanese economy will remain stuck in idle for another decade, the yen will remain strong, and the Nikkei (EWJ) will go nowhere.

Saturday, December 15, 2012

2013: The Year Of Printing Money

Assuming that the Fed implements QE3 as announced on Wednesday, I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now. By yearend, I expect nominal GDP growth to have accelerated from its current 4% to a level closer to 5%. I am therefore bullish about both economic growth and equity prices.

The quantity theory of money holds that nominal GDP growth is a function of money growth, and that money growth is a function of the size of the central bank’s balance sheet. Therefore, the central bank is able to control the level and growth rate of nominal GDP.

However, these are not constant relationships. As interest rates decline, so does monetary velocity, such that it takes proportionately greater increases in the money supply to produce comparable GDP growth. And similarly, the relationship between the central bank’s balance sheet and the money supply is also not linear, particularly as interest rates approach the zero bound. Keynes called these phenomena the liquidity trap in which monetary policy loses its power as the central bank “pushes on a string”.

While monetarist economists concede that these relationships are not linear, they do not accept that a central bank can ever lose its power to grow nominal GDP. And it is a bit ironic that the same voices that argue that monetary policy has lost its efficacy also argue that quantitative easing will lead to inflation. They argue that monetary policy is (a) powerless; and (b) powerful. They are wrong on both counts: monetary policy never loses its efficacy, and the current program of expansion will not lead to high inflation (just as the prior rounds of QE did not, despite dire warnings from the hawks).

No one can reasonably argue that a central bank cannot inflate its currency such that nominal GDP will grow. We have witnessed this phenomenon many times since the invention of fiat money in 17th century France. The central banks of Zimbabwe and Ukraine have been poster children for the power of the printing press, and have both succeeded handily in greatly expanding the size of nominal GDP.

As Bernanke argued to the Japanese, in extremis, there is nothing to stop the central bank from dropping money on the citizenry from the air. In 1933, when FDR decided to inflate the currency, he began to raise the dollar price of gold by arbitrary daily increments until he saw the overall price level begin to rise. He didn’t know very much about monetary policy, but he understood that by printing money he could cause inflation.

Now let’s look at the facts today. Since the crash, the Fed has engaged in two rounds of balance sheet expansion. (Note: I am using the Fed’s balance sheet and the monetary base interchangeably; they are very close in dollars.) In QE1, the monetary base grew by about $1 trillion. In QE2, the base grew by another $700 billion. In QE3, the Fed plans to grow the base by additional $1 trillion. Overall, the monetary base will have grown from $800 billion pre-crash to around $3.6 trillion by next Christmas (while inflation has remained subdued).

The money supply (M2) has grown by almost $3 trillion since the crash, for a total growth of 40%. Since the crash, nominal GDP has grown from $14 trillion to $16 trillion, an increase of 14%. The Fed’s plan is that by growing the monetary base by about a third in 2013, nominal growth will accelerate to a level that would allow unemployment to decline to from its current 7.8% to a targeted 6.5%.

Since the immediate recovery period after the crash, NGDP has been growing steadily at a subpar 4%. This third round of monetary expansion, if pursued, should lift that rate to a level above 5%, which is still less than robust but closer to potential (NAIRU).

If the Fed pursues QE3 as announced, inflationary expectations should rise next year as bond prices fall. This should be bullish for equities as returns from the “risk off” trade decline. With cash yielding zero and falling bond prices, equity inflows should rebound.

The equity risk premium today is still attractive at over 4% (earnings yield minus bond yield) and appears to be in solid value territory in a historical context. As the appeal of bonds diminishes, equity valuations should rise and the risk premium should decline.

My advice for 2013 is: Don’t fight Bernanke.

Wednesday, December 12, 2012

Thank God For Bernanke

The FOMC met this week and made the following announcements:

1. The Fed believes that, without further QE, economic growth will not be strong enough to generate sustained improvement in labor market conditions (i.e., unemployment below 7%).

2. The Fed will continue purchasing additional MBS at $40 billion per month, and will also purchase longer-term Treasuries at $45 billion per month, for a monthly increase in the Monetary Base of $85 billion (3%), or $1 trillion annually (36%).

3. If unemployment does not decline to 6.5%, the Fed will continue its purchases until such a decline is achieved. However, that does not mean that QE3 will necessarily end when unemployment goes below 6.5%.

4. To support continued growth, the Fed will maintain its zero-interest rate policy (ZIRP) for a “considerable time” after the QE program ends and the economic recovery strengthens. (A “considerable time” is understood to mean not before mid-2015.)

5. The ZIRP will continue at least as long as the unemployment rate remains above 6-1/2%, inflation is no more than 0.5% above the Committee’s 2.0% longer-run goal, and longer-term inflation expectations continue to be well anchored (e.g., the TIPS-Treasury spread remains low).

How should we Kremlinologists interpret these announcements? The good news is that Bernanke has managed to hold together his near-consensus in favor of unconventional monetary policy:
1. The Fed will continue QE, and will pursue ZIRP at least until 2015.
2. The Fed has announced an explicit unemployment target of 6.5%, which is the first time that it has operationalized its full employment mandate.
3. The rate of the Fed’s pace of asset expansion will more than double and will,  if pursued through the end of the year, represent a material increase (36%) in the Fed’s balance sheet and the monetary base.
4. The Fed will add purchases of Treasuries to the QE program, which settle much faster than MBS and will have an immediate impact on the monetary base.
4. The Fed is prepared to tolerate a higher-than-target rate of inflation in order to achieve its unemployment target.

The markets have reacted mildly to the announcement, with Treasury yields and gold prices rising to reflect slightly higher inflationary expectations.

However, this announcement should not be interpreted as a decisive victory of Bernanke and his doves over the FOMC hawks. That is because the Fed continues to tie its hands by (1) limiting the scale of its intervention to a modest level compared to prior QEs; and (2) limiting inflation and thus nominal growth. Were the Fed to go all the way and target a nominal GDP level (i.e., a nominal GDP of $X), it would not only tolerate but actually desire above-target inflation. As long as the Fed places a higher priority on its inflation target than on its employment target, it may never achieve the employment target, or at least not very quickly.

This helps to explain the market’s muted reaction. Yes, the monetary base will now start to grow for the first time since QE2 ended in mid-2011; that is bullish for nominal and real growth (especially helpful if the US goes over the fiscal cliff next month). But nominal growth will be limited to the sum of real growth and a maximum of 2.5% inflation, whether or not maximum employment is achieved.
In my opinion, that’s not good enough to get us where we need to go, and it is insufficiently radical to decisively move the needle on inflation expectations.

Bernanke keeps telling us that monetary policy is not a panacea; he is right that timid policies are not a panacea.

However, today's announcement is definitely progress, and the Fed is now intellectually and operationally far ahead of its global peers. And I might add that once the Fed actually begins to grow the monetary base by $85B/mo, that should go a long way toward cushioning the fiscal cliff.

Monday, December 10, 2012

The Super Marios Have Failed

“The underlying pace of monetary expansion continues to be subdued...The December 2012 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.”
--ECB president Mario Draghi, Dec. 6th, 2012

Here’s a brain teaser. Look at the two Marios, Monti and Draghi. No one would deny that they are exceptionally intelligent and perceptive people. Any country or central bank would be happy to have either of them at the helm. They are both Ivy League-trained economists (Monti at Yale, and Draghi at MIT). Either of them can think rings around most European or American politicians.

And yet, they are both pursuing policies that can only end in disaster, not only for Italy, but for Europe. I can’t believe that I could possibly know anything about economics or monetary policy that they do not; that is a truism: they know everything. So how do we explain the reckless and suicidal policies that they are pursuing today? I can offer a political explanation for their behavior and a psychological one, but neither are adequate. Politically, neither has sufficient authority to reject deflationism and to embrace reflation. Psychologically, Italian technocrats like the two Marios labor under the northern prejudice about the Latins, that they are lazy and hopelessly corrupt. It is understandable that these incorruptible technocrats would like to prove that the Latins are not constitutionally inferior to the Protestants and can live with a hard currency. Those are reasons but not very persuasive ones.

It is hard to believe that they are fully conscious of the fact that the policies they are pursuing are wrong and that they are both guilty of misfeasance and nonfeasance. Somehow they have convinced themselves that austerity, deflation and depression are, in the long run, good for Italy and for the eurozone. After all, every northern country has gone through austerity at least once since 1980 and they have all emerged stronger and more competitive. Why shouldn’t the south? I have to assume that their thought-process is that starvation is painful in the short-run but beneficial in the long run. If so, then one must ask: how large must the pile of contrary evidence grow before they can admit error, or have they gotten in too deep to ever admit error? I can understand that it is hard to call off a war just as you are starting to lose.

I can appreciate Monti’s logic: he wasn’t installed by Europe into the Italian premiership in order to hijack the ECB or to exit the eurozone. He was installed to act as Europe’s local governor-general in order to ensure that Brussels’ orders were carried out to the letter, and that the corrupt politicians were unable to steal Europe’s money. Monti never had a chance to successfully revolt, although he tried (without success) at the June summit.

Now Monti wants to quit, and who can blame him? An honest professor in Italian politics is like Mother Teresa in Vegas. But I must say that one can only conclude that Monti has failed due to timidity or sheer exasperation.

Europe’s only hope is for the struggling countries to unite and to confront Germany, the Bundesbank and the ECB head-on. Monti, Hollande and Rajoy (and the others) simply must demand that (1) the ECB target growth and not depression, and (2) that the ECB buys the bonds of the peripherals without conditions or limits. If they don’t do that, then eurozone growth will remain negative, fiscal revenues will stagnate, deficits will grow, and credit spreads will start to back up. Just because the ECB’s bogus announcement of chimeric bond-buying has temporarily convinced the markets that all will be OK, it can’t last. Another market convulsion is just around the corner.

Which brings us to Draghi and his “friend” Jens Weidmann of the Bundesbank. Draghi, like all central bankers, has placed a very high premium on “institutional credibility” and consensus-building, and an apparently low premium on successful policies. Yes, the ECB has a single mandate (price stability)  that it is fulfilling extremely well, as Draghi keeps emphasizing. But does the ECB really have a mandate to recreate the Great Depression, to bankrupt the peripheral countries and to destroy the eurozone? Was that the intention of the treaty that Italy, Spain, Portugal and Ireland signed?

I can only conclude that both men are brilliant but weak. Monti is afraid of Merkel and Draghi is afraid of Weidmann: “We can’t alienate the Germans, Finns and Dutch!” Why not? What have they done for the eurozone lately besides enforcing starvation?

It is astounding to me that a central bank of the importance of the ECB can casually forecast a shrinking GDP, as if it were an exogenous variable, like bad weather. The ECB advertises its failure by its own forecasts. Apparently Draghi and Weidmann are satisfied with a prediction of a real recession and zero to negative nominal growth. If my numbers are correct, Italy’s GDP today is 27 billion euros smaller in nominal terms than it was in 2007, industrial production is down 20%, and youth unemployment now stands at 26%. This is taken to mean that the bank’s policies are “on track”. They must serve a lot of Kool-Aid at the ECB snack bar.

Saturday, December 8, 2012

Greece Will Defy Europe Yet Again

It looks like the latest Greek bailout deal is about to be put to bed. Greece has passed the required legislation, the deal has been okayed by the relevant donor parliaments, and the debt buyback required by the IMF is almost complete. All systems are GO for lift-off.

However, this latest deal is not just a xerox copy of the prior (failed) deals. At the insistence of the donors, it contains what appear to be some real teeth. In trying to reconcile the need to prevent Grexit while forcing Greece to comply with its demands, the Troika wants to do to Greece what the US used to do to Central America back in the good old days. Just as the US Navy would take over customs collection until its bonds were redeemed, the Troika will take control of Greek revenue and expenditures, or so it believes.

The new deal includes the following conditions:

1. Disbursements are conditioned on Greek fulfillment of its specific promises. For example, the upcoming disbursement of 9.3 billion euros requires that the Troika certify that the Greek government met a January deadline for implementing tax reform. (It is unclear if that means merely passing the legislation or actually changing the tax system, a crucial distinction in a country where legislation means nothing.)

2. In the event that Greece’s budget goes off the rails (as it always had in the past), automatic spending cuts will kick in.

3. The Troika will administer a segregated account for Greek revenue and aid money to ensure that debt payments have first priority.

These unyielding conditions put the Greek government in an awkward position: whether to defy the people, or to defy the Troika. If past is any indication, Greece will defy the Troika. The Troika represents International Capital, the eternal enemy of the Greek working class. As a tool of foreign capitalist interests, the Troika lacks political legitimacy. The Greek government has an affirmative obligation to defy such forces. (In Greece it is always May 1968.)

The question is not whether Greece will fail to comply, but how soon. Probably next month, given their past performance. Better to defy now, while Europe is still writing checks, than to wait for time to pass and the German parliamentary elections to loom larger. The closer the elections get, the worse it will be for Greece.

Will the Greeks get away with it? They always have.

Friday, December 7, 2012

Moody's Will Downgrade The UK And The US

On Feb. 13th of this year, Moody’s changed the rating outlook on the UK’s Aaa rating from Stable to Negative. Moody’s said at the time that:
“A combination of a rising medium-term debt trajectory and lower-than-expected trend economic growth would put into question the government's ability to retain its Aaa rating. The UK's outstanding debt places it amongst the most heavily indebted of its Aaa-rated peers, alongside the United States and France whose Aaa ratings also carry a negative outlook.”

On Nov. 14th, Moody’s stated that:
“We will need to assess the Aaa rating and negative outlook in the first few months of 2013, in light of what the government’s Autumn Statement reveals about the [government’s] assurances that the debt trajectory will stabilise and start to decline within the rating horizon.”

On Dec. 5th, HM Treasury published its Autumn Budget Statement which provided revised projections for government revenue, expenditure, borrowing requirements and debt trajectory for 2013-18. The UK Office for Budget Responsibility analyzed these projections and compared them with the coalition government’s 2010 “fiscal mandate”.

The OBR concluded as follows:
"We now expect Public Sector Net Debt (PSND) to peak at 80% of GDP in 2015-16, compared to a peak of 76% of GDP in 2014-15 in our March forecast. PSND is pushed higher as a share of GDP by weaker nominal GDP growth, higher net borrowing, and technical asset reclassifications. The Government now appears more likely than not to miss its ‘supplementary target’, which requires PSND to fall as a share of GDP between 2014-15 and 2015-16. We now predict that PSND will rise by 1% of GDP in 2015-16, falling by 0.8% a year later. In the absence of the reclassifications, we estimate that PSND would be stable as a share of GDP between 2015-16 and 2016-17, and then fall in 2017-18."

So it would appear that Moody’s will have to decide early next year whether to (1) confirm the UK’s Aaa rating with a stable outlook; (2) place the UK’s Aaa rating on review for possible downgrade; or (3) extend the negative outlook.
The somewhat negative conclusions of the OBR would seem to provide sufficient rationale for a review and subsequent downgrade to Aa1, which is what I expect.

I say this after having looked at the UK’s key statistics and ratios at HM Treasury, the Fed, Moody’s and the Economist. What I saw wasn’t very pretty. Admittedly, data is backward-looking. But there is no evidence to date of an inflection point in the key numbers having been achieved, and no reason to expect one anytime soon. When a simple extrapolation predicts a crisis, it is hard to accept a projection that includes an upside-down hockey stick in the out-years without a compelling story to go with it. That story depends on economic growth.

For the UK’s debt trajectory to correct, the UK will have to do more than trim expenditures--it will have to grow its economy in nominal terms in the high single-digits. Right now, UK nominal growth is far below take-off speed, and real growth is negative, that is to say, shrinking, which is not good for debt ratios. The fiscal deficit remains very large (7-8%, depending on who’s counting) despite three years of fiscal austerity.

The UK’s problem is the world’s problem: inadequate fiscal revenue growth, caused by an incompetent central bank that thinks that the welfare state can survive with revenue growth in the low single digits. Indeed, the coalition government has nothing to do with the problem, aside from tolerating Mervyn King and his bank’s incompetence. Central bank independence is second only to the monarchy as a British institution.

I will concede that the UK is the European equivalent of New York State, with vast unproductive regions supported by a volatile financial sector located on a single square mile. By living off the golden goose, other industries are neglected and suffer adverse terms of trade caused by an overvalued currency. The country’s fate is in the hands of the City, which hasn’t recovered from the crash.

But that doesn’t excuse the failure of the BofE to act appropriately during and after the crisis. If one were to rank central banks on their badness, I would place the BofE third, after the BOJ and the ECB, and ahead of the Fed which is only half-bad. Indeed if I am not mistaken, the genius Mr. King raised interest rates when the crash was gathering downward momentum, undoubtedly to prove his cojones and to ensure the bank’s “credibility”.

So I do not blame the government for the coming review and subsequent downgrade, but I think it’s coming. After removing France’s Aaa and placing the US Aaa on review for downgrade, it would be hard for Moody’s to argue that the UK’s rating is fine. Its numbers are as bad as those of France, and much worse than those of Canada and Australia (now a global paragon of sovereign creditworthiness).

The US’s Aaa is in Moody’s crosshairs now as well, since Moody’s review for downgrade is focusing on the ability of the ruling circles to achieve a decisive program of deficit reduction and debt-trajectory stabilization. That would of course be the fiscal cliff, which no one seems to be defending as a policy option. Assuming something wonderful doesn’t come out of the lame duck session, Moody’s will probably downgrade the US to Aa1 in the first quarter. While I think that would be a big mistake from an expected loss perspective, it would be consistent with Moody’s sovereign rating criteria.

Wednesday, November 14, 2012

Greece: The Troika Needs To Dump The IMF

Well, the Greek mess is still unresolved. The ECB has been stepping on Greece’s oxygen tube to force the Greeks to capitulate to all of the Troika’s demands, in exchange for another EUR 30 billion. The government has complied by jamming through compliant legislation (at great political cost). But that is not enough to unlock the Troika’s money box.

Europe, for reasons that are unclear to me, won’t keep the money pumps going unless the IMF is on board as a full participant. The IMF says that Greece’s debt trajectory is unsustainable, the understatement of the century. The IMF wants Greece’s official debt to be reduced to a sustainable level. (Greece’s private bondholders have already been whacked). In other words, the challenge is not only finding a way to come up with more money, but also persuading somebody to forgive debt at the same time. The IMF and the ECB can’t forgive debt, and the Germans refuse to forgive debt.

It would seem to me that the simplest solution would be to leave the IMF behind, and just lend Greece the EUR 30 billion from the ESM. Clearly no one really cares whether or not Greece's debt situation is sustainable. But for whatever reason, Europe wants to keep the IMF on board. Therefore, Europe (the EFSF/ESM) will have to write down its claims on Greece. Merkel and Schaueble say no to this because they wish to maintain the illusion that the German taxpayer is lending and not donating to the Greeks (who chose not to pay taxes).

We’ve been through so many Greek crises before that it is hard to get too excited about this one. In every case in the past, the geniuses in Brussels have come up with a way to prevent the Pandora’s Box of an uncontrolled Grexit. Now they have a simple choice: either kick the can down the road for another six months, or come up with Plan B for a controlled, non-catastrophic Grexit.

As I have discussed before, the IMF cannot be “fixed” by Europe because Europe doesn’t control it. The US (Obama and Boehner) has to agree to whatever Lagarde wants to do. That suggests to me that if Europe wants to forestall Grexit, she will have to jettison the IMF and change the Troika into a Duo.

If it were up to me, I would be moving toward Plan B, with a fully developed plan to allow Grexit while feedingthe Greek people and preventing a European banking crisis. If the Germans would allow the ESM to recapitalize banks directly, this could be accomplished without exacerbating the sovereign debt crisis.

Wednesday, November 7, 2012

Obama's Re-election: The Bright Side

As a believer in free markets and limited government, it is dispiriting to see the American people (50% of them anyway) choose European social democracy. However, there is a silver lining to the black cloud of Obama’s re-election: some of the Democratic party's policy positions are good. Obama is a mitigated disaster, and we can take some comfort in that.

Social Issues

First, the Democrats are more liberal--read libertarian--on the social issues. They do not want to revisit the criminalization of abortion, which would be a disaster for all concerned (I know: my godfather was on the NYPD abortion squad). The Democrats are generally more supportive of an enlightened drug policy, as opposed to the current prohibition that keeps the drug cartels, the prison guards and the DEA in business, and which is turning Mexico into a failed state which exports its illiterate peasantry. 

I wish the Democrats had the guts to advocate drug policy reform, but they don’t, probably because of the prison unions and other corrupt influences. It would be a great day for liberty if some future president could zero out the DEA and all of its infantry, weaponry and foreign adventurism. Forgive me for pointing out that the DEA is also 100% unconstitutional.

Monetary Policy

Second, the Democrats understand monetary policy much better than do the Republicans. It is an indisputable fact that the GOP is opposed to QE and to the reappointment of Bernanke as Fed chairman. The GOP is the party of hard money and flirtation with the gold standard. The US will never be able to correct its debt trajectory as long as it pursues European-style deflation. Growth is the only way to balance the budget and to grow the denominator of the D/GDP ratio. I have much more confidence in Obama’s choices for Fed governors than Romney’s. I hope that Obama reappoints Bernanke or a a man of similar excellence.

Foreign Policy

Third, Democratic foreign policy is much less imperialist than the Republicans'. The Republicans enjoy America's superpower status and seek to rule the world. The Republican party managed to start two disastrous wars in a part of the world where American troops should never be deployed, and where our strategic interests are debatable. Certainly, we have failed to achieve whatever our strategic objectives might have been. That is, unless our strategic objectives were to make Iraq an islamic republic, to endanger the oil kingdoms, and to give the stone-age Afghans better rifles. That we achieved. 

Obama’s “no boots” policy with respect to Libya and Syria has been prudent. I do blame him for stupidly overthrowing Mubarak and Qadaffi, but the GOP was no wiser. The GOP has a preference for intervention and elective wars which appears incorrigible. Obama is less likely to go to war with Iran than Romney, and he will be better positioned to rein in Netanyahu.

Defense Policy

Fourth, the Democrats are much less in thrall to the military-industrial complex than are the Republicans. The Pentagon is a  parasitical growth that manages to suck $600 billion out of the American taxpayer every year. That needs to be reduced. 

But the scandal is not so much the waste and corruption as it is the perverse incentive to seek out military conflict and imaginary enemies. The US military to this day remains equipped to fight a conventional land, sea and air war against the Soviet Union, which hasn't existed for twenty years. What are we planning to do with all of those carrier battle groups? Why are we spending $600 billion on the F-35 fighter? What or who are our hunter-killer submarines pursuing? Why are we provoking the Chinese with new bases in their backyard? I have little confidence in Obama’s ability to get control of the “defense community”, but even less when it comes to the GOP.


I certainly do not mean to suggest that the foregoing “silver lining” can adequately compensate for the corrosive crypto-marxism of the Obama regime. In my opinion, antimarxism is the highest form of political morality, while marxism and all of its malign offshoots is inherently evil and destructive of liberty. The marxism at the core of the Democratic ideology is indeed evil, but not all of the party’s policy positions are incorrect. Let’s take comfort in that.

Sunday, November 4, 2012

The Fiscal Cliff: There Is No Alternative

The US is in the midst of a fiscal crisis caused by the combination of reduced revenue due to the 2008-09 recession and increased expense caused by the 2008 fiscal stimulus bill. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history (and utterly inconsistent with the AAA credit rating criteria of Moody’s and S&P).

There is no need to rehash the debate about whether President Obama or Speaker Boehner was responsible for the failure to reach a bipartisan “grand compromise” in the summer of 2011 during the debt ceiling crisis. In my opinion, Obama and Boehner were close, but both of them got too far out ahead of their House caucuses. Pelosi and Cantor each killed the deal: Pelosi, because it included Medicare reform, and Cantor, because it included a tax increase. What we got instead was the Budget Control Act of 2011. 

The BCA provided that if Congress failed to adopt the Simpson-Bowles fiscal consolidation plan, automatic expense sequestration would occur in calendar 2013. In addition, the deal to extend the Bush tax cuts was set expire in 2013. This combination of automatic cuts plus an automatic tax increase is the much-feared “fiscal cliff” that hits the US budget and economy two months from now, unless Congress decides differently.

The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. 

Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013–2021 period. By CBO’s estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO’s estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.

The Fiscal Cliff Is Necessary
In my opinion, the massive deficits of the past five years are neither moral nor prudent. The American people can be analogized to wealthy parents who, having spent all of their children’s inheritance, have also mortgaged their house and taken out a huge loan in the name of their descendants. We have spent trillions of dollars for partying on our children’s credit card. We have not only run deficits in recessions, we have run deficits during growth years. We have demonstrated a bipartisan inability to keep our fiscal house in order that keeps getting worse. This has already cost the US its AAA from S&P and will cost it Moody’s AAA as well, unless something like the fiscal cliff is allowed to occur.

I have no confidence that Congress can reach a lame-duck deal that will rein in our large and unaffordable deficits. I think that the only way to move toward fiscal discipline is to jump off the fiscal cliff in January. The CBO says that the economic impact would be a mild recession in 2013, followed by resumed growth. That strikes me as a very small price to pay for cutting the deficit in half, limiting future deficits, bringing down the debt ratio over the next decade, re-establishing the AAA ratings and laying the foundation for future prosperity.

There are aspects of the fiscal cliff that will have to be fixed, such as Medicare reimbursement, but aside from that I think that we can live with it as it is. It will ding defense and other discretionary spending, which is necessary in my view, especially given our inability to reform Medicare. And the CBO forecast includes no assumptions concerning any possible offsetting monetary stimulus from the Fed.

The following discussion of the “fiscal cliff” reflects the CBO’s latest ten-year budget outlook, published in August.

The federal budget deficit for fiscal year 2012 (ending 9.30) will total $1.1 trillion marking the fourth year in a row with a deficit of more than $1 trillion, or 7.3% of GDP.  Federal debt held by the public will reach 73% of GDP—the highest level since 1950 and about twice the 36% of GDP that it measured at the end of 2007.

The Fiscal Cliff Scenario
Substantial changes to tax and spending policies (the “fiscal cliff”) are scheduled to take effect in January 2013:
>Expiration of the Bush tax cuts;
>Sharp reductions in Medicare reimbursement rates;
>Automatic enforcement procedures (“sequestration”) to restrain discretionary and mandatory domestic and defense spending;
>Expiration of emergency unemployment benefits and of the  reduction of 2%  in the payroll tax rate

With those and other policy changes contained in the fiscal cliff, the deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4% of GDP), almost $500 billion less than the deficit in 2012.

Under the CBO’s “fiscal cliff” scenario (FCS), budget deficits are projected to continue to shrink—to 2.4% of GDP in 2014 and to 0.9% by 2022. With deficits small relative to the size of the economy, debt held by the public is projected to drop relative to GDP—from about 77%  in 2014 to about 58% in 2022 (which would be consistent with AAA bond ratings).

Most of the projected decline in the deficit occurs because revenues are set to rise considerably—from 16% of GDP in 2012 to 20% in 2014 and 21% in 2022. Between 2012 and 2014 alone, revenues in CBO’s “fiscal cliff” scenario shoot up by one-quarter as a share of GDP.

Outlays, by contrast, are projected to be a smaller share of GDP in 2022 under the FCS (22%) than they are in 2012 (23%). Discretionary spending is projected to decline relative to GDP throughout the next 10 years because of the caps on discretionary funding under the FCS. By CBO’s estimate, discretionary spending will fall to 6% of GDP by 2022—the lowest level in at least 50 years.

The Alternative Fiscal Scenario
To illustrate the consequences of possible legislative changes to the FCS, the CBO produced an alternative fiscal scenario (AFS) that incorporates the following assumptions: that all expiring tax provisions are extended indefinitely (except the payroll tax reduction in effect in calendar years 2011 and 2012); that the AMT is indexed for inflation after 2011; that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic spending reductions required by the Budget Control Act, which are set to take effect in January 2013, do not occur (although the law’s original caps on discretionary appropriations are assumed to remain in place).

That set of alternative policies (the AFS) would lead to budgetary and economic outcomes that would differ significantly, both in the near term and in later years, from those in the “fiscal cliff” scenario. In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under current law.

Under the AFS, deficits over the 2014–2022 period would be much higher than those projected under the FCS, averaging about 5% of GDP rather than 1%. Revenues would remain below 19% of GDP throughout that period, and outlays would rise to more than 24%. Debt held by the public would climb to 90% of GDP by 2022— higher than at any time since shortly after World War II.

The Economy Under The Fiscal Cliff Scenario
Under the FCS, the deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4% of GDP), almost $500 billion less than the shortfall in 2012. The CBO forecasts that such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5% between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9% in the second half of calendar year 2013.

Under the FCS, as the economy adjusts to a lower path for budget deficits, real GDP is projected to begin growing again in late 2013. The pace of economic expansion will average 4.3% from 2014 through 2017, CBO projects. As economic growth picks up, the unemployment rate is projected to decline to 8.4% in the fourth quarter of 2014 and to 5.7% by the fourth quarter of 2017.

The Economy Under The Alternative Fiscal Scenario
The AFS would lead to budgetary and economic outcomes that would differ significantly, both in the near term and in later years, from those in the FCS. In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under the FCS. The economy would be stronger in 2013: real GDP would grow by 1.7% between the fourth quarter of 2012 and the fourth quarter of 2013, and the unemployment rate would be about 8% by the end of 2013, CBO projects.

Under the AFS, real GDP would be higher in the first few years of the projection period than under the FCS, and the unemployment rate would be lower. 

However, the persistence of large budget deficits and rapidly escalating federal debt would hinder national saving and investment, thus reducing GDP and income relative to the levels that would occur with smaller deficits. The economy would grow more slowly over the 2018–2022 period than under the FCS, and interest rates would be higher. Ultimately, the CBO concludes, the AFS would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective.

So, my conclusion is that the alternative to the fiscal cliff is not a better-crafted but equally effective inflection in the debt trajectory, but rather no such inflection. The choice is thus between the fiscal cliff and ultimate ruin. Unfortunately, I expect the outcome to be much closer to the AFS than to the FCS, and ruin it will be.

Friday, November 2, 2012

Both Greece And Cyprus Must Capitulate Next Week

It now appears that when the German finance minister said on Wednesday that Cyprus had not engaged in substantive negotiations and had missed the deadline for a November deal, he was making an honest observation but was not speaking officially.  The word out of the Troika is that long-distance negotiations continue but with no progress. The parties are far apart and do not appear to be budging. The issues are labor law and privatization. Both issues are non-negotiable for both sides.

Cyprus is publicly begging the Troika to come back to Nicosia for more "negotiations"; the Troika's failure to return suggests that there is nothing to talk about until Cyprus gives in and agrees to what the Troika has “proposed”. As Schaueble intended, the Cypriots have become extremely nervous, but have yet to agree. They really should not call his bluff because, even if they somehow win Round One, he will make sure they lose in the end if not sooner. One can only imagine the level of his, shall we say, frustration with their attitude.

Schaueble said that nothing substantive had been accomplished, which is true. For Cyprus to meet the deadline for the Nov. 12th eurozone finance minister meeting, she will have to capitulate to the Troika on all issues this week. I think that Schaueble’s statement was calculated as a stark warning to both Cyprus and Greece that these are not as much negotiations as they are ultimata, and that Europe isn’t going to blink. The marxist parties in both countries must choose between capitulation or default.

In Greece, the wicket is just as sticky. There are three problems: (1) parliament must pass the labor reform demanded by the Troika, which it may not be able to do; (2) the labor law may be declared unconstitutional;  (3) the Troika will have to come up with an additional EUR 40 billion in new loans; and (4) the additional money and time have blown a hole in the IMF’s required debt stabilization plan, requiring a debt reduction scheme to offset the new debt.

Both Greece and Cyprus are scheduled to run out of money by the end of this month, so there really is a short deadline for the conclusion of "negotiations". The next two weeks should be action-packed as (1) Greek and Cypriot politicians realize that they are no longer negotiating and pass the required legislation; (2) their bailout plans are rapidly cobbled together for the ministerial meeting on the 12th; and (3) the financing issues are resolved. Only after the plans have been approved by the Troika and the eurozone will the small matter of German and Finnish parliamentary approval have be addressed (or cleverly finessed).

Thursday, November 1, 2012

Did Germany Just Throw Cyprus Overboard?

“Cyprus! Who cares about Cyprus?” you say. Well, you need to start paying attention now.

To recap for the inattentive: Cyprus (full-fledged member of the eurozone and current president of the EU) needs an emergency bailout because its banks are insolvent and it is running a very large and rapidly growing budget deficit. Its finances are out of control. It has no market access and its bonds are rated close to default. The banks are temporarily living off of liquidity support from the ECB, but the ECB isn’t supposed to lend to insolvent banks, so that cannot continue for much longer.

Cyprus applied to Europe for aid in June. The Troika visited Nicosia and proposed an austerity and reform plan on July 25th. The Eurogroup made it crystal clear that, for the Cyprus bailout to be considered this year, it had to be wrapped up and ready for the eurozone finance minister’s scheduled meeting on Nov. 12th. The Cyprus government, after waiting for two months, announced in October that it had rejected the Troika’s proposals and “invited” the Troika to return to discuss its counter-proposal. (Please see my post, “Cyprus Tells The Troika To Take A Walk”, Oct. 1st, 2012.) The Troika has not yet returned, and may never return.

From the Cypriot perspective, this was supposed to be a negotiation: the Troika proposes, Cyprus “rejects” and counter-proposes, the Troika returns, and then a compromise is reached. However, it appears that Cyprus may have overplayed its hand.

Instead of saying “thank you for these constructive proposals, let us work with you to make them better”, the Cypriots inexplicably decided to raise the Red Banner and to cast its negotiations with the Troika in the context of the international class struggle. Frankly, in describing the stupidity of this move, words escape me. Were the Workers of the World really supposed to rise up and defend the 13th month salary and the COLA?

Communist President Christofias informed Europe that he would defy the Troika’s demand to rein in wages and asked the other parties to support his position. “I’m certainly ready to take to the streets with the workers,” he reportedly said. A delegate from his party told the international communist party conference in Brussels that “we will not accept terms that will abolish working peoples’ gains and sell off for pittance public property to big capital.”

Since rejecting the Troika’s proposals, the government has been “calling on” it to return to Nicosia for “further negotiations”, since the Nov. 12th deadline was rapidly approaching. But today is November 1st, and Christofias and his FM are still waiting by the phone. They say that the Troika will arrive any day now, or maybe next week.

As readers know, it has been my view that Europe will hold its nose and write the check for Cyprus because because exit from the eurozone is “unthinkable” and “impermissable” (especially for the country which is the current president of Europe).

But now, right out of the clear blue sky, German finance minister Wolfgang Schaueble told the media this morning that Cyprus has missed the November deadline, and that the next opportunity to apply would be next year.

As everyone and his brother knows, Cyprus will run out of money long before then. That suggests that Schaueble, meaning Merkel, meaning Germany, meaning Europe has decided to throw Cyprus overboard. Can this be true? We’ll undoubtedly know more tomorrow, but I doubt that Schaueble was misquoted. I think we should assume that he meant precisely what he said.

I see three reasons for this shocker: (1) Europe is furious at Cyprus and can’t stomach their communist arrogance; (2) Cyprus really has missed the Nov. 12th application deadline; and (3) even if Cyprus had met the deadline, their application would have been DOA in the Bundestag. Failure to apply on time makes it easier to reject Cyprus’ application.

The larger question is: Does this mean that Merkel can’t get the Greek bailout through the Bundestag? If so, that means we are facing another Lehman event, since I am aware of no plan for an orderly Greek exit. Grexit, in my opinion, will include default, repudiation and redenomination. That’s a Black Swan, no matter how many times it has been mooted before.

Is this the assassination of the Archduke Ferdinand? I sure hope not!

Sunday, October 28, 2012

The Hellenics Play "Quien Es Mas Macho?"

For those who enjoy high-stakes financial drama, there is an exciting contest going on now between Cyprus and Greece as to who can push the Troika the furthest without turning it away for good. Neither country has yet been able to make the Troika “agree” to its “demands”, as if this were a business transaction between equals.

"The troika has not accepted the Democratic Left’s demands," the Greek finance minister informed the media. The DL, one of the coalition partners, has refused to agree to the labor reforms required by the Troika.

“The EU is obliged to change the ways and means of addressing the crisis,”  Cyprus president Dimitris Christofias grandly declared to his people, as if he had a say in the matter. The Troika got so frustrated with the Cypriots’ refusal to agree to labor reforms that it flew home and has not scheduled a return visit. Christofias said that he expected the troika to return "as soon as possible”. That was last week, and the Troika still hasn’t called him back to set a date.

Both countries are supposed to run out of cash in mid-November, so they are dancing on the edge of the precipice. They know that Europe will agree to almost anything to prevent them from leaving the eurozone, which they think gives them leverage.

They are playing a very risky game, because it isn’t Europe who has the final say on whether they get the money or not. That rests with the elected representatives of the very stingy German and Finnish people, who have reserved the veto power to themselves. A few emollient phone calls from Hollande or Monti, or a few desperate phone calls from Athens or Nicosia, are unlikely to sway many votes in Helsinki or Berlin.

The backdrop to these discussions is the fact that both economies are in free-fall, and that relying on their published statistics requires an act of faith that only a devout eurocrat could summon. I think that their economies are shrinking faster than reported; I think that their governmental cash receipts are declining rapidly despite tax hikes; and I think that their true fiscal deficits are frighteningly large and growing. I believe my deduction over their reported statistics.

If there is one thing that I learned in the credit business, it is that the financial statistics of bankrupt companies and countries always turn out to be, shall we say, not 100% accurate in retrospect. If you rely exclusively upon reported numbers, you may be seriously misled. Of course, in the case of Greece, it doesn’t take a Mensa member to know that they cook their books and prosecute  their statisticians for not cooking them adequately. In the case of Cyprus, I lack such anecdotal data, but I suspect the worst.

Anyway, D-Day is supposed to be November 12th, when the eurozone finance ministers meet in Brussels. The plan is that the Troika will have the Greek and Cypriot agreements in hand for the ministers to review. That is only ten business days from now, so suspense is starting to build.

We know that Merkel wants to present the Bundestag with a neatly-wrapped package deal for all of the bailouts at once: Greece, Cyprus, Spain. That can’t happen because the Hellenics need their money right now, whereas Spain hasn’t even applied yet. So Merkel will be forced to ask the Bundestag to OK the distasteful Hellenic deals on their own. That will be a bitter pill for the German people and media to swallow. Sadly, I am not an expert in Finnish politics, so I can’t handicap the parliament’s vote on the bailouts, but I have to imagine that they won’t pass by general acclamation.

Whose idea was it to give voters a say in such important matters?