Wednesday, April 28, 2010

Greece – GIIPS – Eurozone - Big Problem

Greece is now “high yield”, “junk”, “below investment grade”, at least according to S&P. What I mean by that is S&P now rates Greece’s foreign and local currency sovereign debt at the BB+ level (with a negative outlook), below the sometimes-coveted investment grade status, BBB- is the minimum. Why did S&P feel the need to do this now? Just covering its _ss – Greek debt was rated A- as recently as December 2009.

On to the Germans. What they are doing is actually quite striking: offering a bailout in order to appease markets so that international investors will pick up the Greek bill (never was going to happen anyway); and then telling markets that bond investors in Europe will take a haircut so that international investors won't pick up the Greek bill. I guess the light-bulb finally went on that there is a contagion brewing here because bunds are tight, while all Peripheries are wide.

The original bailout will likely be offered to satisfy Greece’s near-term obligations. However, in the meantime the probability that the liquidity crisis spreads across the GIIPS (Greece, Italy, Ireland, Portugal, and Spain) - especially Portugal with a 2009 current account deficit equal to 10.3% of GDP, making it shockingly susceptible to capital outflows - is rising.

We’re in crisis mode – the calm before the storm. I see the Eurozone disaster happening in three waves:

Monday, April 19, 2010

O.K., so the Senate rebukes the VAT for what exactly?

I don't normally do politics - and Congress should be worrying about the fragile recovery rather than the public deficit - but this is just ludicrous. Senator McCain drafted bill H.R.4851 that was actually voted on - in favor of, no less - to do the following:
It is the sense of the Senate that the Value Added Tax is a massive tax increase that will cripple families on fixed income and only further push back America's economic recovery.
Call me crazy, but by rebuking the Value-Added Tax, isn't the Senate effectively confirming support of higher personal income or corporate income taxes? I'm not a professional bill-sifter; but since taxes will (eventually) rise - the merits of which will not be discussed here - this is the only conclusion I draw. The mix of taxes does matter, something about which Stephen Gordon has written many times, so I will cite him directly:
So a stated preference for a small(er) government sector can only be justified on ideological grounds. A political party may campaign for a larger or smaller public sector, but the justification cannot be that this choice will have a material effect on national income or on economic growth rates.

What does matter is how those government revenues are generated. The subject of the optimal 'tax mix' of taxes on labour income, capital income and consumption has been the subject of an enormous amount of theoretical and empirical inquiry. The theoretical literature has reached certain broad conclusions:

1. Taxes on capital income generate the most distortions. In a small open economy, the elasticity of supply is very large (in principle, infinite), so small changes in the rate of return on capital can have large effects on investment.
2. Taxes on consumption generate the least distortions. Since they don't affect post-tax rates of return, they don't affect savings and investment decisions.

Interestingly, I completely disagree with the first part of the citation, as the size of the government can be too small and affects the level of aggregate activity. Bill Mitchell argued this quite eloquently just last week.

I digress; back to taxes. Stephen Gordon focuses on Canada, a small-open economy; but in glancing through the literature (two papers here and here, for example), these results seem to hold for larger economies as well. Furthermore, this literature looks a little "old" - I suspect that it will get renewed interest now.

As such, here is the case for McCain's bill against the VAT tax.

The chart illustrates the VAT tax rates across the OECD - of which the U.S. is the only member country without a VAT, so it is not included in this graph - plotted against economic growth. I know that there are just two variables estimated here, but the scatter is quite clear: there is no correlation. (The data are 2005-2007 averages, and you can download the data from the OECD Tax Database.)

Now here's an illustration in support of higher corporate income taxes?

The chart illustrates the Corporate income tax rates across the OECD plotted against economic growth. (The data here are from the same OECD database.) There is a very clear and negative correlation amongst the two variables. This supports a recent OECD study, of which I'll again cite Stephen Gordon:
An interesting recent OECD study on the optimal tax mix finds that a strategy of shifting away from income taxes - and especially corporate income taxes - in favour of consumption and property taxes has a positive effect on national income. (Shifting away from consumption taxes to income taxes has the opposite effect.)
Eventually, economic growth will warrant a transfer of excess private saving back to the government via rising taxes. But wouldn't you (McCain) want to at least consider the tax that doesn't adversely affect economic growth? Like a consumption tax?


Update: this discussion is going to move in the direction of the regressive nature of a VAT and income inequality in the U.S. I should note that Canada also has an interesting model. The government transfers benefits in the form of GST tax credits to low- and middle- income households to address the regressive GST. The credits totaled roughly 12% of all GST revenues in the 2008-2009 fiscal year.

Rebecca Wilder

Thursday, April 15, 2010

An auspicious sign: the consumer (for now) is back

I remain very skeptical about the sustainability of the recovery, as the labor market is in shambles and nominal wage growth is unlikely to facilitate “healthy” deleveraging - please see this recent post “Reducing household financial leverage: the easy way and the hard way”. I digress; because you can't fight the data. And for now, the consumer is back.

The latest retail sales figures reveal two bits of information worth noting. First, autos were a big factor in the March 2010 surge. Second, even though the large contribution from motor vehicles and parts compromises my enthusiasm somewhat, the underlying trend has emerged: consumers are less frugal in spite of income constraints.

The March advanced retail sales report was genuinely strong, 7.6% annual pace since March of last year or 1.6% over the month and seasonally adjusted. At first I thought that this heroic sales growth was just a scam. March auto sales were unusually large in response to the competitive pricing during the peak of the Toyota scandal. See’s preview of the March light weight vehicle sales that registered a large 11.75mn gain.

And in reality, the March number was driven largely by auto sales, contributing 1.1% to the 1.6% monthly growth in retail sales. Furthermore, 36% of the total sales bill drove 5.7% of the 7.6% annual gain: nonstore retailers, motor vehicles and parts, and gasoline stations.

One could stop there (which I almost did); but upon further examination, a real trend is breaking out: the growth is broadening across categories with each month that passes. Just look at the evolution since January 2010 (after revisions, of course).

The charts illustrate the sequential contributions to growth from each major category in the advanced retail sales report from left (January 2010) to right (February 2010) to lower left (March 2010). The number next to the date for each chart (title) is the annual total retail sales growth, and you can find the data at the census website here.

You might ask yourself now, what do retail sales look like when conditioning for the robust growth in nonstore retailers, motor vehicles and parts, and gasoline stations? What’s happening to the other 64% of sales? Here’s where the green shoots become even more evident.

The trajectory of retail sales ex nonstore retailers, motor vehicles and parts, and gasoline stations is more of the 60-degree type, an auspicious sign for the near-term recovery.

However, as I have stated time and time again, further deleveraging is imminent. Whether that happens through default or through income growth is all the same in the aggregate - that is, until default causes further macroeconomic instability. Until the economy generates income enough to pay down leverage, the risk of a double dip remains as the inventory cycle is laid to rest. Economic momentum is gaining; let’s just hope that policymakers don’t screw it up.

Here's something of interest: our friend rjs is looking at a sales tax conundrum....

Rebecca Wilder

Tuesday, April 13, 2010

Final destination “rising public deficits” with a stopover in “falling public deficits”

Brad DeLong and Mark Thoma posit that a falling US public deficit is bad news – they are right!

Deficit hysteria is now mainstream thinking, while the more appropriate hysteria should be “jobs hysteria”. How in the world is nominal income growth expected to finance a drop in consumer debt leverage if the government supports a smaller deficit? TARP costs less and tax receipt growth is beating expectations. But that's all it is, beating expectations.

This only proves the endogeneity of the deficit: the sole reason that the private sector is producing stronger-than-expected growth in tax receipts is BECAUSE the government ran large deficits.

Put it this way: as long as the US is running current deficits, then a shrinking government deficit will, by definition, squeeze liquidity from the private sector. During a “balance sheet recession”, the government should be growing its balance sheet not shrinking it.

An excerpt from the Japan's Quarterly Economic Outlook (Summary*) (Summer 1997):
“Thus, recovery in personal consumption is expected to continue after the reaction to the rise in demand ahead of the consumption tax hike subsides in the near future. However, the pace of recovery is likely to be moderate considering the increases in the tax burden, such as the rise in the consumption tax.”
RW: Boy were they wrong – moderate?

GDP fell 2.0% in 1998 (from +1.6% growth in 1997) and consumption growth turned negative over the year, -1.1% (from +0.8% in 1997). Please see slide 9 from one of Richard Koo’s presentation in 2008; he highlights the policy-mistake-induced “unnecessary government deficits". The point is: the government deficit is not some exogenous “thing” that the government controls; it’s very much endogenous and a function of private demand.

We’re on this road now: squeezing liquidity out of the private sector; supporting minimal wage growth; and imminent deleveraging is on the horizon(more likely the default route). And Congress is happy that they are squeezing private sector liquidity? I guess so, as reported by the Wall Street Journal yesterday:
"Like a number of Democrats, Mr. Blumenauer said he's "intrigued" with the consumption-tax idea. Tax experts say consumption taxes are regressive, because lower-income people tend to spend more of their income. But a consumption tax could be designed with offsetting breaks for lower-income Americans, to shield them from its impacts."
Rebecca Wilder

Lord Turner at the INET Conference

This alone was worth the trip!

Lord Adair Turner
, Chairman of the FSA

Sunday, April 11, 2010

Macroeconomics: en route

The Institute for New Economic Thinking (INET) hosted its inaugural conference this weekend at King's College Cambridge, an experiment of sorts. I had the pleasure of attending the conference, my first time to Cambridge. John Maynard Keynes wrote his *General Theory* at King's College. And as if that wasn't enough, I dined with blogging legends, Mark Thoma and Yves Smith! The photo was taken at the conference by another attendee, Pierpaolo Barbieri: "Lord Skideslky, easily Keynes’ finest biographer".

The conference was a spectacular fireworks display of economic panels, featuring experts across a broad spectrum of applied macroeconomic theory and policy, including banking and development. (You can see the speaker list, presentations, and video here). Definitely read other conference pieces by Marshall Auerback, Mark Thoma, and Yves Smith.

Through INET, George Soros is funding a vision: that new and innovative macroeconomic theory prevent, rather than fuel, future “Superbubbles”. INET's goal is the following:
“to create an environment nourished by open discourse and critical thinking where the next generation of scholars has the support to go beyond our prevailing economic paradigms and advance our understanding of the economic system as a tool to meet social objectives.”
That's a tall order, and likely not the intended output from the inaugural conference. But what Rob Johnson, Executive Director of INET, probably did have in mind was something of a declaration of war against outdated, disproved, or even deleterious macroeconomic policy and research. And there, I believe that he succeeded.

There was no shortage of criticism at the INET conference.
  • Joseph Stiglitz reiterated the sharp divergence between representative agent models and reality.
  • James Galbraith went the even more aggressive route by suggesting that REH (rational expectations hypothesis), EMH (efficient markets hypothesis), RAM (representative agent models), and DSGE (dynamic stochastic general equilibrium models) be buried beneath a bed of garlic below Keynes' quarters with guards standing atop the burial site. (This was not a direct quote but very close.)
  • Simon Johnson pressed the need for more action to relieve the systemic pressures coming from the still top-heavy US banking system.
  • Dominique Strauss-Kahn charged global policymakers of being complacent with monetary and fiscal policy over the last decade. They were lured in by ostensibly stable growth, when in fact the financial foundation was crumbling below (after, of course, he was disrupted by a globalization protest with the catch phrase “the IMF is the Problem not the solution”).
In my view, the fact that economists were in some sense accepting blame for policy ignorance is a step in the right direction. So what's the next step? What will it take to move macroeconomic theory and policy in a truly innovative and novel direction? I don't know; but I do see two issues that will likely drag the process.

Problem #1: the financial crisis has rendered much empirical and theoretical research obsolete; clearly, this is a solid chunk of what I refer to as the “aggregate Curriculum Vitae”. There's a host of refereed and published literature with now documented spurious results, or entire literature reviews citing papers with theses that tread water at best.

It's going to take time to break through the concrete wall of neo-classical macroeconomic denial (among other types of denials). This is the “old boys club”, where careers and prestige are on the line. It's the true sense of economics as a falsifiable science: some disproved and obsolete macro theory remains ingrained in the profession as some academics, some policymakers, and some politicians cling to their reputations. This “enables” bad economic policy.

The good thing, though, is with funding and support from Institutes like INET, this enabling behavior cannot last forever. The aggregate may enable the profession now; but if the foundation starts to crack, i.e., the next wave of graduate students and new tenure track researchers break the mold, the profession will rebuild. I hope.

Problem #2. Talented researchers, early in their tenure careers or currently registered in Ph.D. programs, need incentives and professional support to publish alternative views in top journals. It's so easy to be shunned from the academic community; just take on an unorthodox research agenda, and bang, you're bright and shiny career may be over before you know it. So what's the incentive to rock the boat before establishing tenure? If tenure, by definition, is conditional on top-journal peer-refereed publications?

The new thinking must come from within the Ph.D programs. Building a base of new and sometimes controversial macroeconomic research that is accepted within the top academic community requires funding, but more importantly, a shift in the construct of the labor force. Macro Ph.D. programs across the world need restructuring and innovative teaching that includes an even stronger collaboration between student and adviser than existed before.

They say that lightning never strikes twice. Let's hope that the economics profession avoids the second strike...this time around.

Rebecca Wilder

Monday, April 5, 2010

Reducing household financial leverage: the easy way and the hard way

In case you haven’t noticed, I have become slightly less “optimistic” about the prospects of a sustainable U.S. recovery. I used to think that the household deleveraging story was more of a decade-long project; the economy would cycle throughout. But recent deficit hysteria has me worried; income growth might lapse.

What differentiates this recovery from every other cycle since 1929 is the lingering debt deflationary pressures. There is a very large overhang of U.S. household financial leverage that’s going down one of two ways: the easy way, through nominal income growth, or the hard way, by default. Unfortunately, the hard way is rearing its ugly head.

The chart above illustrates private-sector financial leverage (debt burden). Not a surprise; but, the real leverage problem is in the household sector, and to a much lesser degree, the non-financial business sector. Household debt burden is the ratio of the debt stock (generally mortgages outstanding plus consumer credit) to income flow (personal disposable income), while “de-leveraging” is reducing this debt burden.

Given that the burden has a numerator (debt stock) and a denominator (income), de-leveraging can occur through either variable. As such, I see three (general) de-leveraging scenarios:

1. If there is no income growth, then households must manually pay down debt at the cost of current consumption. The consumption decline drags the economy, and some default results.

2. If income growth is positive, then the degree to which households must pay down debt at the cost of current consumption will depend on the pace of income generation. This is the most macroeconomically-benign scenario.

3. If income growth is negative, i.e., deflation, then real debt burden rises. 30-yr mortgage payments, for example, are fixed in nominal terms and become more difficult to meet as income declines. In this case, widespread default is likely.

Of course, these are just three broad categories, but I believe that my point has been made. McKinsey wrote about this last year. Clearly, choice 2. is optimal. However, evidence is pointing to a de-leveraging process that is more of the 1. and/or 3. type, especially as the federal stimulus effects run dry (although I have noted before that there is room for error in the measurement of the income data).

The chart illustrates annual growth of disposable personal income minus annual growth of disposable personal income less government transfer receipts (DPIDPIexT). The variable DPIexT proxies the personal income growth currently generated by the private sector only. Note: this is a calculated number, based on the BEA’s monthly personal income report (Excel data here). The spread has never been wider, 2.1% Y/Y DPI growth over DPIexT growth in February, spanning every recession since 1980.

The government is propping up income (as it should be). Spanning February 2009 to February 2010, DPI averaged 1.2% Y/Y growth per month, while DPIexT averaged -1.1% Y/Y per month. Further, since the onset of the recession DPIexT fell an average 0.03% M/M (over the previous month), while DPI grew 0.18% M/M.

The economy has crossed the threshold and is expanding – phew! However, without a burst of export income, it’s going to take a lot more than 123,000 private payroll jobs per month to free the economy of its fiscal crutch. (I debated whether or not to use the term “crutch” when applying it to fiscal policy because fiscal policy is not a crutch; but the metaphor works.)

Households WILL drop leverage further; it’s just a matter of how smoothly.

Rebecca Wilder

Friday, April 2, 2010

The U.S. economy: on the surface and under the hood

The GDP recovery is underway. But below the GDP hood, the picture is not as bright. The labor market is weak, and income-generating prospects remain muted. The latter portends a back-up of consumer spending down the road without substantial policy support.

Please see Spencer's post at Angry Bear blog for a very nice interpretation of today's employment report, but he sums it up quite nicely:
Yes, the employment situation has quit deteriorating, and there are encouraging details within the report. But the overall rebound in the economy and the employment situation is one of being stuck in the doldrums.
But why is the U.S. economy stuck in the doldrums? Isn't GDP recovering smartly? (Read on.)

The chart illustrates the GDP contraction for each recession since 1971, except that for 2001 because in sum GDP did was rather flat. Point "0" represents the quarter where GDP bottoms out. I circumvent the official date of the recession's end as point 0 - the NBER is the agency that "dates" business cycles in the U.S. - because I want to focus on GDP, which is a composite of spending motives (including the government).

On the surface, the economy appears to be improving smartly; GDP bounced back 1.9% since its cyclical low in Q2 2009. But what we've really got here is a inventory-led recovery, with a Q3 boost from auto sales, and depreciated capital and software that must be replaced. Top that off with a small boost from non-defense federal government consumption, where in Q4 that was more than offset by the decline in the contribution to growth coming from state and local governments, and the recovery looks a little less stable.

I work in fixed income. Companies that wish to rollover debt or finance an expansion of capacity may do so through a public bond issuance. As an anecdote, companies will travel to our offices in order to "tell their story" and garner support for the issuance. Guess how many companies have told me that the proceeds of the bond issuance (essentially borrowing funds from the institutional investor at usually a fixed coupon rate) will finance expansion and new production capacity - none this year! Nada. (Actually, that's not totally true: earlier this year an Indonesian power company wanted to rollover debt financed new capacity from last year.)

There's plenty of spare capacity, so that existing resources can supply new demand. However, this portends (in my very small sample) a slowdown in fixed investment growth, and further crimps hopes for a strong recovery.

Jobs growth needs to pick up, or else income and earnings growth will continue down (or at best move sideways).

It is NOT the time for government support to let up. Don't worry about what markets think, worry about what people think. They can't move; and they can't find a job (well at least officially 9.7% of the labor force, or the 9.1m part-time for economic reasons workers). As such, the hope for sizable private-sector income growth is looking negligible.

Rebecca Wilder

Thursday, April 1, 2010

Stratfor video on the Eurozone

Click on picture to play (takes a bit to load)!

Rebecca Wilder

The saving rate paradox

Edward Harrison at Credit Writedowns is theorizing why the saving rate is falling when it should be rising, as households scram to deleverage their balance sheets. My reaction to this is twofold: first this is a meaningless exercise; but second, and worse yet, there's likely something very "unhealthy" going on here.

Meaningless: The BEA conducts a comprehensive revision of the NIPA tables every five years. The saving rate is usually revised upward, and by a fair amount, as was the case for most of the 2000s.

So in "roughly" 5 years from 2009 (it's not uniformly 5 years between each revision), you will see a higher saving rate than you do today. As I said in July, the
"BEA has "found" that households have been in fact saving roughly 1% more of their disposable income per quarter since 1995, 0.9% per quarter in 2008."
They will "find" it again.

Unhealthy: But even if they don't "find" much more than an average +1% a year, there's probably something a bit more sinister and non-economic (i.e., in addition to the wealth, income, or substitution effects - see Edward Harrison's post on this point) going on here: non-market activity is rising. I haven't seen a study to this point - if you have, please send me the link; I am very interested - but I wouldn't be surprised if non-market income has crept up lately, i.e., through the informal labor force.

With an employment-to-population ratio a shocking 58.5% in February (it was 63.4% as recently as March 2007), there's got to be a growing supply of labor that is "working under the table" just to get by. This non-market income would flow through the spending accounts but not the income accounts. Therefore, you have official consumption going up with official income (doesn't include non-market income) stalling, which reduces the saving rate.

Now go back and read Marshall Auerback's push for government as ELR (appropriate credit is given in this report)!

Rebecca Wilder