"Federal Debt and the Risk of a Financial Crisis" - CBO

The likes of Larry Kudlow have been pushing happy talk of late that maybe, just maybe Congress and the Administration will act to extend the Bush tax cuts. This line of thinking is evolving as the evidence is mounting that a new round of economic weakness is in the offing. The official and blue chip economic forecasts are all calling for growth to subside a tad but to average about 3% for the balance of 2010 through 2012. That is most unlikely. Those forecasts will be coming down. And with it will come more talk of stimulus.

While the MSM and some in D.C. are starting the push against the tax increases it was interesting to see the CBO chime in on the topic. They rained all over the rosy thoughts about preserving the Bush tax cuts. They put out a paper yesterday titled, “Federal Debt and the Risk of a Financial Crisis”. Hopefully Mr. Kudlow will read it. I’m sure a number of folks in Washington will. They could choose to ignore this report. But at our collective peril, according to the CBO. The following graph was released a few weeks ago; it was used again in the July 27 report. This is what a doomsday scenario looks like:

The dark blue dotted line is how bad things will be even if we let the Bush tax cuts sunset. But the light blue line is the disaster that will befall us if we don’t let them expire. We will be over 200% debt to GDP in twenty years. This terrible chart still does not tell us how bad things are. This information excludes the intergovernmental debt which is every bit as “Due and Payable” as the debt held by the Chinese. When you add in the extra 4.5T of IG debt we will be north of 150% Debt/GDP before 2020.

We will never make it to 150%. We will blow up in a spectacular fashion before we even get close to that mark. Some snippets from the CBO report: (full report here)

Further increases in federal debt relative to the nation’s GDP almost certainly lie ahead if current policies remain in place.

Unless policymakers restrain the growth of spending/increase revenues as a share of GDP, budget deficits will cause debt to rise to unsupportable levels.

A growing level of federal debt would increase the probability of a sudden fiscal crisis, during which investors would lose confidence and the government would lose its ability to borrow at affordable rates.

Having a small amount of debt outstanding gives policymakers the ability to borrow to address significant unexpected events such as recessions, financial crises, and wars.

The government would need to undertake some combination of three actions:
-restructuring its debt;
-pursuing inflationary monetary policy;
-adopting an austerity program of spending cuts and tax increases.

Governments can attempt to change the terms of their existing debt—investors would demand a large interest premium on subsequent loans for many years.

Foreign investors would face substantial losses.

Higher inflation might appear to benefit the U.S. government. However, higher inflation would also increase the size of future budget deficits.

I am sure that Bernanke reads these reports. I wonder if he was struck by the comment, “higher inflation might appear to benefit the U.S. government”. He should be, that is his only policy at this point. Will he consider the CBO warning? I doubt it. Will Congress? It depends on the November elections.

Two Reports from CBO

The CBO published two reports, The Role of immigrants in the U.S. Labor Market and Social Security Disability Insurance: Participation Trends and Their Fiscal Implications. Nothing really knew in these reports but I found them interesting.

The piece on immigration glosses over the issue of illegal and legal immigration. The data used comes from census and census has a policy:

They (respondents) are not asked about their legal immigration status.

The Department of Homeland Security has a number of 10.8mm illegal immigrants currently. I doubt that that DHS has a real handle on this number. They are just guessing. But absent something better it is a decent number to use. Consider this from CBO


I will go out on a limb and say that the number of people here illegally from the group “Canada/Europe” is statistically small. Therefore the 11 million illegal aliens come from either Mexico/Central America or Asia. Fully 50% of the people in that group. I have no statistical evidence to support it, but it is my belief that the % from south of the border is much larger than the % of Asians. For the purpose of coming up with a number I use 60-40. I think that is understating the percentage. That would imply there are 5mm illegal Mexicans in the US work force.

Before you race off to the comment section to rip me up for that conclusion, read the CBO report. This is the CBO/DHS numbers, not mine. 15.5% of our work force is made up of non-residents. 7% of our workforce is comprised of illegal aliens.

-The CBO marks the report “An Update”. I don’t believe that anything in D.C. is a coincidence. To me it is impossible to look at this report and not conclude, “Something is very wrong, and Mexico is central to the issue”. The President is suing Arizona over its laws. ABC is doing a big special. This topic is coming front and center. And the CBO releases a report that highlights just how big this problem is? Nice timing Mr. Elmendorf. Thank goodness we don’t have to worry about politics getting in the way of analysis at the CBO.

-There was a time in our country when we needed immigration to meet demand for labor and fuel economic growth. Today we have 15 million unemployed and 24 million foreign workers. That ratio jumps out at you. It is easy to conclude that the US is going to move in the policy direction of much more restrictive immigration (legal/illegal). Over a period of years this probably will be beneficial to the employment numbers. But it would absolutely kill growth. Japan has had zero immigration and zero population growth for twenty years. They also have had zero economic growth. Just another of those signs that point our future in Japan’s direction.


The other report on the Social Security DI fund is a historical review of the program and a discussion of the financial status. The DI fund is a well-known shipwreck waiting to happen. The CBO says it crashes in 2018 based on very rosy economic assumptions. I think the actual sinking of the DI will be in 2016. Any shortfalls have to be eaten by the SS retirement fund. So this needs to be fixed or the retirees have to take a hit.

I read the report as a plea for help. DI paid out $120b in 2009. Nearly 1% of GDP. There are 10 million people getting benefits. It is a big deal and a fix must be found. It must be found quickly. It can’t wait until 2018. It will be impossible to fix it then, we have to do something now. Yada, yada.

Here is a graph of expenditures. Note it doubled from $60b in 2000 to $120b in 2009. A 100% increase in just ten years.

What is the cause of this explosive trend in disability payments? According to the CBO the answer is simple. Women are at fault on this one.

The increased number of women who are employed have resulted in more disabled beneficiaries and a rise in outlays for the DI program.

For the heck of it I looked up the 2000 SSTF projections for the DI fund. Their forecast was correct to a fraction. In other words we have know that the DI fund would blowup for at least the last ten years. Nothing was done about it. It has been politically too easy to just push this type of problem off to another decade. Unfortunately we don’t have another decade left to deal with these mega problems. They are all just a few years away.

FHA – “We are Officially Broke”

An interesting item in the Federal Register. This notice: (Link to FHA/FR)

SUMMARY: A recently issued independent actuarial study shows that the Mutual Mortgage Insurance Fund (MMIF) capital ratio has fallen below its statutorily mandated threshold.

We can pretend that that the FHA does not need a bailout, but it does. Unlike its bad siblings, Fan and Fred, there has never been a question whether Uncle Sam is on the hook with FHA. We don’t need a fancy conservatorship this time. Tim Geithner over at Treasury will just write the checks to cover the shortfalls. The good news is that those debts will not show up on the Federal balance sheet. They don’t count because there are “assets” behind these loans.

The Notice would appear to be a requirement of some sort to solicit public opinions on policy changes at FHA. The proposed changes would (supposedly) address the high default rates that the FHA is experiencing. What have they proposed to achieve this? Surprise surprise, they are going to instill some sanity into their lending program.

This kills me. I, and a hundred others, have been writing and screaming that FHA was just a ‘bailout to be’ for a few years now. This was an easy call. FHA was making 96 ½% LTV loans to borrowers with low FICO scores. They did this in a period where RE values fell by 25%. Their business plan was, “How To Take a Bath on the Tax-payer Dime”.

Don’t look for these changes to come anytime soon. I suspect that this will not evolve to a point where actual adjustments are made until after the next election. But these changes are coming. Real equity of 10% will be required for borrowers with low credit scores. There will be restrictions on seller equity, or “concessions”.

My read on the proposals is that the FHA is getting out of what I call “Silly Lending”. If they actually do take these steps it will mitigate future losses. It will also sharply restrict the availability of mortgage credit. Similar steps are being taken by F/F. The implementation will be felt this fall. By spring time mortgage land could look quite different. The D.C. lenders are 95% of the mortgage market today. There are no willing private sector lenders. If Washington steps back RE will get illiquid.

Central to our problems is the fact that for many years a social agenda and lending standards were mixed. The goal was admirable. Make mortgage credit available to all so that everyone could enjoy a leveraged bet on home appreciation. What a terrible bet the feds have financed. There are very few winners in this story. I read the following as a mea culpa. I think FHA accepts that bad lending standards have ended up hurting those they intended to aid. And along the way it hurt all of America’s homeowners.

Given FHA’s mission, allowing the continuation of practices that result in such a high proportion of families losing their homes represents a disservice to American families and communities. It is FHA’s intent to eliminate this portion of its business, and utilize other established methods to reach and support these families.

In the end the mortgage mess will cost us nearly a trillion. A very big price. For that tab we should learn a lesson. Soft lending to achieve broad social goals is a mistake. Tell that to Barney Frank. This was his dream.

Hazy – Hot or Not?

By all accounts the Farnborough Air Show was a smash success. Over $40 billion in total orders. Even BA caught a bid on the news. No doubt the ‘bubbly’ is flowing. Of interest is that this group would be drinking seltzer water were it not for the efforts of one man. Steven Udvar-Hazy bought 25% of those planes.

Hazy has a great story. He took $150k of his own money, borrowed another mil and started ILFC. International Lease Finance is one of the most successful aircraft leasing outfits in history. In 1990 Hazy sold ILFC to AIG. I am sure he cashed out a bundle for his effort. He stayed on as CEO for another twenty years.

In 2006 his net worth was reported at $3.1b. He took a big hit with shares of AIG that he must have owned but in 2009 another estimate comes up at $2.2b. He did fine.

He must have struggled at ILFC the past few years. He was once partnered with a strong AAA, now his parent is a ward of the state. ILFC may be a crown jewel, but it was a tough sale. It’s too big. A transaction at even a remotely fair price would have been difficult to achieve. There simply is not enough private equity and public debt to swing a transaction like that.

Four months ago Hazy left ILFC. He took with him his long time CFO John Plueger. These two must have burned some midnight oil. They started a new company, Air Lease Corp. Funded it with equity. Arranged a $10b lending facility from 9 banks. Bought 136 aircraft and spent all the money. Not a bad first four months.

The people in this industry think that Hazy walks on water. I got a kick out of this lame comment from Norm Liu, president and chief executive of General Electric Co.’s aircraft leasing unit:

“I sure hope he’s right because we’re ordering some too.”

I think Mr. Liu is just hoping (He better be; GE bought 100 planes) No doubt Hazy is too. I, for one, would not want to be going into a capital-intensive business that is elastic to future global GDP. One that is dependent on favorable tax laws, subsidies for half of all deliveries and one that relies on the continued availability of cheap credit.

I wish Mr. Hazy well. He has a good story. But he is going to cost the US taxpayers some serious money. Whatever one might have thought of the value of ILFC (the AIG sub) four months ago, that value is lower today. A lot lower. My guess is that Hazy would like nothing better than to crush the life from his former employer. He’s off to a great start.

Ben Talks to the FT

Tomorrow is a big ‘at bat’ for our boy Ben Bernanke. He is in front of the Senate Banking Committee. I don’t underestimate these Senators. They are well aware of how quickly the economy has slowed in the past sixty days. They know how bad their home state unemployment and budget picture is.

Greenspan said we “Hit an invisible wall” on July 1st. The past three weeks of numbers show that the wall is anything but invisible. A third and fourth quarter slowdown is now baked in the cake. There is a legitimate question, “Do we face a “double dip?" Should that rare event happen, the fiscal picture would become very cloudy. If we don’t grow, we die.

While the Senators will show the Chairman all due respect I expect some fireworks. I don’t know if there is an approval rating for the Fed. If there were it would be at an all time low. Therefore it is in the best interests our legislators to do a bit of Ben bashing. It makes them look like they are doing something important for the folks back home.

The question that I think (hope) we will hear from the Senators is:

“Okay, we have a slowdown staring us in the face. What is the Fed going to do about that?”

It would be easy for Ben to duck the question by saying:

“The timing and choices regarding monetary policy will be made in deliberation with other Fed members and announced publicly at the time a decision is reached”. 

That would be a bullshit answer. Ben has been telling the press for weeks now what his options are and how his thinking is evolving on QE 2. Last week it was the Wall Street Journal. Jon Hilsenrath clearly was speaking to Bernanke and revealing his thinking. Today we have a big leap across the pond for Ben’s “covert” effort to leak the news of his plans. The FT had an article by Robin Harding. Fed Eyes Looser Monetary Policy. To me it was Ben talking and Robin writing. From the article:

The two simplest measures will be to (1) stop paying interest on bank reserves, encouraging banks to lend the money out instead, or to (2) start reinvesting capital repayments from the Fed’s portfolio of mortgage-backed securities.

I think the FT has quoted from Bernanke’s ‘short list’ of policy options. These would be modest initial steps toward a full-blown QE. These measures will not have a significant economic impact. They will be market friendly. Or at least that will be the intention.

As of July 15th the Fed had $1.13 trillion of Agency MBS in portfolio. That is down from the target of $1.25T. Therefore $121 billion of principal has been paid on the Fed holdings. It is a layup for the Fed to announce that it will re-enter the MBS market to top off its portfolio. This would be more a refinement of existing policy. At least that is how it will be framed. The brokers will love the extra 100b+ in business. It will not move mortgage spreads 5 tics.

The Fed is now paying ¼% on reserves. The theory is that moving the rate to zero would stimulate more lending. I guess that if a bank had some reserves and got zero return it would be forced to buy something like GE commercial paper. That would get those short date CP yields close to zero pretty quick. There is a balance sheet consideration to the banks however. I don’t think this change will make any difference at all. Goodbye to all small savers.

The FT also mentioned something that was new to me. The idea is to change the language the Fed uses. The current language is, “ZIRP for the foreseeable future”. This will be changed to read, “ZIRP until X is achieved”. “X” could be a number of things:

X= Unemployment less than 7%
X= Three consecutive quarters of GDP greater than 3%
X= Inflation greater than 3% YoY.
X= Dow 20,000
X= Bernanke re-grows hair

My point is that the X can be set such that no reasonable person would assume that it would happen at anytime over the next two or three years (or longer). So the real language would be, “ZIRP forever.”

Numbers 1&2 are acts of desperation that will accomplish little. And Ben knows that. A change in the language that results in a ZIRP forever policy will be the death of us. It will just take a few more years to figure that out.

If Bernanke can whisper to the likes of the WSJ and the FT he should be just as open with the Senators tomorrow. I think the American people should know what he has in store. They should not get that message through an interpreter.

The Dollar This Week

There will be a Hungary story in the papers tomorrow. If you read ZH you know that already. I hope no one was long the Forint.

I don’t know what to make of this story. On one side you could say it looks bleak. It appears that the IMF is playing hardball. This from Christof Rosenberg who runs the IMF mission for Hungary:

“Our talks with the Hungarian government have been interrupted as we have not been able to find enough common ground and there remain too many unresolved issues to take this review to our board”.

"Interrupted" is about as strong a language as the IMF uses. Normal language might be; "Take it or leave it." Bad news there. The other side of this is, “what are the fighting about?” It would appear to be nothing, and therefore resolvable.

Hungary’s government tried to persuade the fund to accept a deficit target of as much as 3.8 percent of GDP for 2011 instead of 2.8 percent. (Bloomberg)

So the flap is about whether Hungary can be at 3% or 4% deficit. That’s interesting. The US is around 10%. Most of Europe is currently double the IMF target as well. If the US were to impose measures that limited our deficits to 2.8% we would implode in less than one year. There would appear to be a fairness issue inside of this. After all, the US has the largest vote at the Fund. And it is also the biggest deficit spender.


The dollar closed Friday at some very interesting levels. I called the long DLREUR trade a “rat trap” six big figures ago. But I am quick to admit I did not see this big a move in the cards. My comments on those closing numbers:


YENDLR at 86.55. This is a toilet bowl price. This is screaming short dollar. It is a terrible trade. It does not matter. This looks lower to me.

DLRCHF at 1.0514. Look at this thing on the charts. Now put the macro story on top. This could easily go to par. It has not held that level before. This time could be different.

DLREUR at 1.2908. What can I say? On paper you could argue 1.10. But the market says no. And the market is still long dollars. To get this market net short of dollars would be another 10 big figures up.

So that gets us back to Hungary and the next day or so. Six weeks ago a bad Hungary story (this is a bad Hungary story) would have resulted in a big pop in the DLREUR. The CDS spreads would have all widened and the MSM would be talking about the demise of the EU.

With that in mind it would not be at all unreasonable to expect a pretty good-sized reversal off of Friday’s numbers tomorrow. Given the complexity of Europe’s problems the Hungary story may refocus the market’s attention and the Euro could move back to the low 1.20’s over the course of a few weeks. If you were a dollar bull those closing prices had to look pretty good to get long. And now there are headlines to support it.

It could also go the other way. Surprise, surprise we may find that there are still plenty of dollars on offer and the bad new on Hungary does not stick. That would be a very significant change in how markets react to news. Call that sentiment. How this can change so quickly is always a surprise to me.

We are at one of those inflection points that is worth noting. Either the dollar will start to reverse back to a stronger trend (this is a pretty good test for that) or it is going a hell of a lot lower than we might have thought possible.

Like I said, the weak dollar is not the logical outcome. Therefore the probability of it happening is high.

CBO Crows

The CBO published a report (pdf) that gives itself a pat on the back. The analysis looks at the success rate of CBO economist's forecasting of key economic metrics over a long period of time. If you can wade through this beast you will see that the CBO thinks pretty highly of itself. One example:

I am going to take issue with the CBO. My first concern is that their measurement stick is a comparison of their forecasts to those of the “Blue Chip” economists. Who cares? Yes they came up with numbers that were highly correlated to others. That proves nothing.The others were off the mark.

My second concern is that the study covered a period up to 2008. That cut off date is convenient. They missed the forecast by a mile in that year and ever since.

Here is a slide of the January 24, 2007 CBO forecast for the budget deficits.

Note that their expectation for the 2008-2011 cumulative deficit was $1.25T. The real number will be $4 Trillion. About a 300% error rate.

I’m razzing on the CBO because they gave me the window with their glowing report. I wonder what it cost to produce. Econometric forecasting is tough stuff. The future is much more unpredictable than what we were used to. It’s not just the VIX, everything is moving faster, including global economic cycles.

In the first slide there is a third column: Administration projections. I think this is a dig at the OMB. Basically they are saying, “We did about the same as the blue chips, but we did better than OMB”. That result makes sense. OMB is the Executive branch and therefore political. Politics always comes in the way of forecasting. This slide is from 2008. It is OMB’s projected deficits. They had us going into surplus. They were off by a tidy $5T.

One lesson might be that the future is not predictable and therefore a range of forecasts must be developed. One of them must be the proverbial “Worst Case”. The view of the dark side is of course produced by the CBO. They just don’t release that set of numbers. They should.

Another lesson would be to get this process apolitical. That of course is impossible.

Bernanke on Equipment Leasing

Our foolish fearless financial leader gave a speech this week titled Restoring the Flow of Credit to Small Businesses. As near as I can tell the Chairman had little to offer those small businesses that were looking for some of that free money the Fed is doling out. One sentence in this did catch my eye. He quoted a participant from Detroit:

"If you thought housing had declined in value, take a look at what equipment is worth."

This hit a personal chord. I have been trying to sell my 55 horse, Ford diesel backhoe/bucket loader for a few months. While my tractor has been gracefully aged (it’s still beautiful to me) it is young in terms of hours worked. No one wants it. Its value is a tad over the scrap value of all that steel.

Some data on the equipment finance segment of the economy from ELFA (Equipment Leasing Financing Association).

-Total financial assets are today $520 billion. At a half trillion this is a fairly large number.

-2009 was a disaster for this group. Some highlights:

Return on assets (ROA) declined by half, falling to 0.6 percent from 1.2 percent during the year-earlier period.

At a ½% return on assets no one is making money. Keep in mind that during most of 2009 we had ZIRP. The lousy net numbers are a result of charge offs.

New business volume among a sample of the ELFA member companies declined 30.3 percent in 2009.

Actually 2009 was not such a bad year, so this drop is a measure of how bad things are in equipment leasing land.

Pre-tax income and net income, in dollar terms, declined by 55.7 percent and 54.4 percent, respectively.

If a public company announced results like this the market would take the stock out back and shoot it for half its value.

These are the results from 2009. We are today more than halfway through 2010. We all know that things have improved somewhat since then. Woody Sutton the ELFA President had this to say:

“Fortunately, it appears the worst is behind us."

Unfortunately for Mr. Sutton his customer base does not agree with him. The results from a survey of its members says something different:

100% of the leadership still evaluates the current U.S. economy as “poor” or “fair.” In June, 67.4% rated the economy as “fair” and 32.6% rated the economy as “poor”.

Think about that for a second. 100% of the responders think the economy stinks. Not even 1% thinks it is good. As the economy slows this fall and winter this industry group is going to suffer. New business will be down, charge-offs will rise. With that in mind do you really want to go out and buy those GE shares? To me it looks like a $10 dollar stock in the making.

Bernanke and the CBO – Bad Numbers

The numbers of late have been horrendous. Today a pile of more bad news. Yesterday we got this from the Fed Minutes:

Participants generally anticipated that it would take some time for the economy to converge fully to its longerrun path; most expected the convergence process to take no more than five to six years.

No more than five or six years? Where did that come from? I thought we were doing fine.

The long-term aspect of this problem we are facing probably will take us six years to work through. For the Fed to put this out there was not done without significant consideration. There were quite a few folks who were hoping for the turnaround to take hold later this year. Now they have to wait a half decade. This is not good for confidence. But I give the Fed an “A” for saying it. It is the most probable outcome. The Fed’s words were chosen as a warning of QE 2's arrival later this year. Maybe sooner. What might a six-year slow down look like? We have no clue. All the long-term projections that are being bandied about today are assuming a decade of steady growth

Here is the GDP forecast from the Fed. There is no slowdown in this. The low estimate is 2.8% for far into the future. Bernanke can neither justify or sell QE 2 with these numbers as a backdrop. The long term trend would be about 3%. That is maximum sustainable growth without inflation. Either the Fed's forecast is off the mark, or they have no excuse for a QE party.

We get the same muck from the CBO. Here is their numbers:

Soon we will get the annual report from the SS Trust Fund. Their rosy outlook will also be achieved as result of an economic forecast that has no chance of being realized.

The Fed has put a long-term low/no growth possibility on the table. They have done it in effort to support a launch of the QE 2. I would like to see some economic forecasts from the CBO that reflected the consequences of a six-year GDP that averaged 1%. The numbers that come from that analysis for total debt, debt to GDP, State finances, all private pension funds, Social Security/Medicare and unemployment would be a big eye opener. It looks like an implosion to me.

If the Fed wants to sell the next round of monetary insanity it will have to do it with a budget that shows what happens to us if we don’t grow. Mr. Elmendorf (CBO) and Mr. Goss (SSTF) should do the same. If you want to scare the populace into accepting another QE then at least we should get a look at what we are supposed to be afraid of. The bad news is that if we did see the future under the lens of 1% long-term GDP growth it would scare us to death. And therefore justify Mr. Bernanke’s plans.

On TV

I will be on Dylan Ratigan's show on MSNBC this afternoon at 4:45. With me will be Wendy from Cleveland who I wrote about recently.

Smack Down at the SNB

An important development this morning. The Swiss newspaper Neu Zuricher Zeitung has run an article on the Swiss National Bank and its currency intervention policy. The last paragraph of the article suggests that the head of the SNB, Philipp Hildebrand, could lose his job over the botched intervention.

I reported on June 18th that the second quarter results for the SNB would show a loss of ~$8b as a result of its holdings of Euro’s. Subsequently the FT confirmed my estimate. And now, the leading business paper in Switzerland (and historically a mouthpiece for the SNB) has reconfirmed the magnitude of the second quarter loss.

There are some tealeaves to read here. The CHF is going to move based on market forces and developments outside of Switzerland. In the past few weeks the market for the EUR/CHF has stabilized. But there can be no assurance that this status quo will be sustained. Should conditions in the EU deteriorate from where they are today the CHF will again come under a speculative attack as money leaves the Euro for a safer place.

What is different today is that the SNB is frozen. They can’t intervene any longer. They may have been able to ignore a lowly blogger. They can pretend that the FT does not exist, but they can’t ignore the article today in the NZZ. As far as I am concerned the SNB is out of the market. They are now functionally unable to intervene. It would take a significant crisis and a major move in the EUR/CHF cross to get them back in. Based on these developments I would expect that a move to 1.25 in the cross will come. Should things once again turn negative for the Euro Zone this could happen very quickly.

The Swiss intervention was a colossal error. While the policy was in place it distorted the market. It had the impact of slowing the weakness of the Euro against all currencies. That is how the crosses work. The SNB action had the impact of stabilizing the entire FX market. At least it did for a few months. Now that the Central Bank has had its hands tied the market can run free. No more risk that the SNB is going to muck up a good position. Having won this battle the market will be even bolder the next time an opportunity to lean on the cross occurs. That is just a matter of time. FX volatility is about to increase.

Hildebrand is ex Moore Capital. Louis Bacon runs Moore. Bacon has a long and successful track record of positioning his firm correctly in the FX markets. In May of 2010 Bacon had this to say. Possibly Mr. Hildebrand should have listened to his former boss.

Focusing specifically on Europe, Bacon sees "long-term disastrous consequences for the (European) Union and Europe."

This is an interesting bit of history that is now unfolding. A central Banker is being held up to the world for the mistakes that have been made. Heads may roll. Could this be the beginning of a trend?

On FX

The FX market has gotten boring. The intra day moves are smaller and there is not much real direction that I can see. To get the money flows moving again we need a crisis. There is no crisis in our headlines. So FX traders go to the South of France or the Hamptons. They will be back in a month or so and so will the next crisis.

I try to stay away from FX markets when I don’t have a strong conviction of where the next 5% move will come from. I also try to stay away from FX when the markets have moved 10% in a short period of time.

I’m not sure what the next 5% move for the EUR/DLR will be. We could drift back up over 1.30 or some of the old fire will come back and we could get a move lower to 1.20. For me it’s not a question of who looks better. It is a question of who looks worse. If I had to roll the dice right now I would say that the US could very well win the UGLY competition between now and year end. In spite of the big bounce off of the lows a month ago the market is still overbought dollars. The natural position is short, so we are in an interesting position.

Should a weaker dollar trend emerge the Fed would be delighted. They want inflation so bad they would cheer any source. Charles Engle who works for the Dallas Fed wrote a paper "Exchange Rate Policies" last November that I think represents the broader thinking of the Fed Governors. The full link is here. Some cut and pastes:

A debate has continued over many years on the desirable degree of foreign exchange rate flexibility. One side of the debate has made the case that the exchange rate should be freely determined by market forces. This argument takes the stance that the market can best determine the appropriate level of the exchange rate.

From the standpoint of modern macroeconomics, particularly from the view of New Keynesian economics, that stance is potentially self-contradictory.

Oh boy! First, what exactly is New Keynesian economics? I think this is “Inflate at all cost!” But I am not sure. Essential what is being advocated is a managed exchange rate regime. That’s interesting. Isn’t that what we have been beating the Chinese up over? It must be different.

What is clear is that the proponents of this believe that floating exchange rates will eliminate large current account deficits or surpluses.

However, there is very little empirical support for this notion.

He has a point with this. The US has been wracking up current account deficits for three decades. There is nothing in the current FX market that is going to change this. To achieve a turnaround in the US current account would take years. It would also take an exchange rate that was 50% lower than where it is today.

Macroeconomic theory does not support the claim that a policy that allows a fully flexible exchange rate with complete hands-off by policymakers will deliver an efficient market outcome.

I think this is the New Keynesian thing. It is a strong argument that what we are doing and what we have been doing is not supported by the facts. Interesting that we have been doing “this” since 1971.

An exchange rate or a currency is misaligned when the exchange rate change has led relative prices internationally to deviate from the efficient levels that represent underlying costs. External balance means the currency is not misaligned. This is a notion of external balance that is not arbitrary and simply assumed, but rooted in economic logic.

Read this to mean that the US dollar is overvalued. The imbalances prove that. Important point.

The renminbi cannot be efficiently priced against both the dollar and the euro when the dollar is out of line with the euro. So the amount of trade between the U.S. and Europe is not a sufficient statistic to capture the possible losses from a misaligned dollar/euro exchange rate.

Hmmm. What is suggested is that Purchasing Power Parity with the Euro could result in a mispriced Yuan/Dollar. Yet another good excuse for a weak dollar versus the Euro.

To the extent that policymakers rely on sterilized intervention to control exchange rates, the exchange rate policy contributes less to the credibility of monetary policy.

There is significant discussion of sterilized currency intervention in the paper. I kept looking for the section about Un-sterilized intervention. There was none. The foregoing sentence is vague on this. I read it to be saying that FX intervention must be supportive of monetary policy. Unsterilized FX intervention certainly would do that. The Fed would sell dollars and buy other currencies. The end result will be that the supply of dollars out there will be increased. The fed loves it when they can do that. Especially when all of their other policy options have been exhausted. Which is today.

Unperturbed free markets in foreign exchange cannot be relied upon to arrive at exchange rate levels that deliver terms of trade and real exchange rates that reflect the underlying economic productivity, efficiency, and competitiveness of economies.

Well that is the end of free market economics. We have intervened in every other aspect of our economy. Why not FX?


I think the odds of the Fed actually doing something in the market under the current conditions are close to zero. But current conditions will not be sustained. Something new always comes up. A new crisis will emerge. Should things turn bad for the US I don't think the Fed will hesitate to do whatever it can to avoid a decline in economic growth. That includes some self-serving FX intervention. This wild card has always made me leery trading the dollar from the long side.

Lost in this report was the following sentence. It is presented as an “axiom”. I would disagree. It is most Un-natural for a country to borrow purely to sustain consumption. It is a dead-end policy that will have a very messy final chapter. But don’t doubt for a minute that this is exactly what the Fed believes. We should spend money on our CC because our card has no limit. Nothing could be farther from the truth.

It is natural for some countries to borrow to finance consumption.

Wendy’s Story - Cleveland Jobs Challenge

I wrote an article recently that was critical of Congress’s action to pass a bill extending unemployment benefits. My primary objection was that our lawmakers chose to pass yet another deficit spending bill and used the “emergency” loophole that eliminates the need for Pay Go.

I got lots of feedback from this. Everyone hated my position. Some said that we needed a $500b deficit package (ala Krugman) and that my objection to a lousy $34b was misguided. Others said that there should be no extension of UI at all. A good number suggested that I was a heartless S.O.B. that had no idea what it was like to be unemployed in America today. The later group got to me. I have had an exchange of emails from one person that is facing a wall. She is from Cleveland. Her name is Wendy. Some comments from her:

I was wondering.... Have you ever been scared, really scared?

You speak about H.R. 5618 because it is adding to the debt of the country. My thought is you are so self absorbed that you would stop reading this email right now because "unemployed Americans are not worth it"

Have another martini in your condo in Miami and rest easy knowing you will never be me. Make sure your children and grandchildren know what you are and what you believe, maybe they already know dad is a selfish cruel Bastard who believes money is the most important thing. Thanks to people like you I will continue to go to bed scared of tomorrow. Sleep well

Wendy,

Children: Jessy and Parker

I live in Cleveland, Ohio and am the sole supporter of my children. We can't pay the mortgage, utilities etc. today. The point for those like me there is no future- we have to get through today- eat, clothing- I can't buy detergent today.

I am a Special education teacher with my Masters degree-- with out a job. I did what the President said, "go back to school". I took out loans and studied hard to fulfill the dream of being a Special Education teacher. I don't want a hand out, just a hand up.

I have to admit that this exchange got to me. There have always been people like Wendy who fall through the cracks.  But we have not been through times like the ones we are living through for 80 years. I feel sorry for Wendy, I wish she and all the other Wendy’s did not have to wake up feeling scared. I would like to help her get a job so she could get through this period. I know no one in Cleveland and I doubt that the great state of Ohio is hiring any teachers these days. So she is out of luck.

Possibly someone can help her. I would like to provide some inducement. Here is my proposal:

I will put up $6,000 in cash. $3,000 goes to the employer as an incentive to hire Wendy. No strings attached to that. If a job is offered and accepted they get the money. They can do with it what they wish. The other $3,000 goes to Wendy. She gets the money when she takes the job. This is no freebie.

There is a caveat to this. The job that is offered must provide compensation to Wendy that is equal to or greater than the unemployment benefits she is getting. I would like to see that there were health benefits available at some point. She needs that. The goal here is to get one person back to work and one less person unemployed. The goal is to minimize the fear factor. That is no way to live.

So Cleveland, do you have a job for Wendy? If anyone wants to see the color of my money I would prepay it to one of the Cleveland media to hold pending a job offer. I have nothing to gain here. Just trying to help someone out who clearly needs a little help.

I don't know Wendy. My guess, just from reading her words, is that she would be a good hire for someone. If an employer with a job wants to take advantage of this offer they should contact Wendy at kindnessmatters2010@gmail.com.  Alternatively you could contact me, BGK.Wendy@gmail.com.

There is a flip side to this proposal. What if no one makes her a job offer even with a $3,000 incentive to do so? That much money makes her a free hire for a while. If no jobs are forthcoming it implies that there is no work for anyone looking. Should that be the case we would have to conclude that we are in very serious trouble. It would imply that Wendy, and a few million others, are going fall off a cliff pretty soon.

I’ll let you know the results of this experiment.

Fed to GSEs – Put it on the Balance Sheet!

The June Federal Reserve Quarterly Mortgages Outstanding report contains some interesting information. I’m not quite sure what to make of it.

Consider these two slides from the June report on 1st Q mortgage outstandings.

The Federal Reserve has reclassified $4.4 trillion of IOU’s. They have taken them out of the category “Mortgage Pools and Trusts” and put them on the individual Agency’s balance sheet(s).

Now consider the March 2010 reports from both Fannie and Freddie. They don’t show the shift in assets from “Guaranteed” to “On the books”.

Some thoughts on this.

-This is not a small matter. $4.4 trillion of bookkeeping is involved. This is more than 40% of all individual mortgages. This is a major reclassification.

-In this case I would side with the Fed. All of these dubious assets should be on someone’s balance sheet. But I am stumped as to why the Fed did this without FHFA adjusting its book too.

-The Fed thinks this should be on the Agency’s balance sheets. We all know that Treasury owns the GSEs at this point. That being the case shouldn’t the debts of the Agencies be on the Federal balance sheet? This would put us $3T or so over the debt limit and bankrupt the government on paper. I find it odd that the Fed is pushing this at this time. It works against them.

-This is just an accounting adjustment. But these things do matter. The terms of the Conservatorship require that the GSEs keep their balance sheets below $900 billion. So this accounting adjustment would throw the legal status of the GSEs into question. They would be in material covenant default on the Senior Preferred (Treasury Basura Preff) if this adjustment takes place. Given that all of the other securities of the Agencies are “cross defaulted” this raises the question as to the legal status of all of the publicly traded debt securities of the Agencies. I know Washington did not mean that to happen. But then again, stuff does tend to happen.

-The Fed owns $1.2 Trillion of the former “Trust Securities”. Maybe the Fed feels better knowing that these are direct obligations of the GSE’s. I am not sure that makes them more collectible. But in a bankruptcy a senior claim will have a better chance than a subordinated guaranty. In that sense the reclassification puts the Fed in a better creditor position. But really this is all the same pocket, so why would that matter?

-I don’t think that the Fed makes $4 trillion changes in accounting without substantial internal discussion as to the implications. Therefore this is quite deliberate and we should not ignore the significance of it. I’m still wondering what the significance is. I’ll ask the Fed and the FHFA. If they respond, I'll let you know.

Red Money - (Conspiracy Theory #11)

A muse on a hot day.

I was having a drink at a swell bar in the city the other night. The place was packed. My friend and I had a laugh about an old story that crossed our lives many years ago. The story of Red Money. Some time later, as we were leaving, a well-healed guy comes to me and says a bit conspiratorially, “ I believe in Red Money too”.

I am not sure where this story originated. It has been around forever. The reason it has stood the rumor mill test of time is that it is so fundamentally believable.

It goes like this. One morning we wake up and the Treasury has made an announcement that it is going to convert all US currency from green to red. The process will commence immediately and continue for a period not to exceed four months. Very few would be impacted. If you had money in a bank, money fund or brokerage account it would make no difference. If you had some green cash you would either spend it or deposit it into your account. It would not influence the value of the holdings of foreign reserves. That is all “electronic” money. Red money would only impact cash money.

The Federal Reserve reports that there is approximately $1 trillion of US coinage outstanding currently. That number is up from $570b in 2000 and $260b in 1990. As a percentage of economic activity it has risen from 4.5% of GDP in 1990 to 7% today.

For as long as I can remember the Federal Reserve has always had this disclaimer on the Coinage Outstanding line in the reported balance sheet:

16. Estimated.

In this case “estimated” could mean anything. It might be something reasonable like +/- 10%. But if you are inclined to believe in Red Money you might also be inclined to believe that this estimate could be off by 100%.

What might happen if we woke up to a red money world?

-Again, for all electric money and most of the actual cash holders this would mean nothing. The next time you went to an ATM it would come out red. The new and old would be equally acceptable. As old is spent it would work its way through retailers and Banks with no problem. After the four months money could still be changed. But it would require disclosure.

-US money is in every corner of the world. When the word gets out that it can’t be used after a given period of time it too will be exchanged back through the banks. The moneychangers around the world would have a field day for a while.

-There are many groups out there that are holding onto cash money for reasons that go in color from grey to black. You have the husband who tries to hide money from his wife. You have a million small retailers who skim cash every week to hide from the IRS. Illegal aliens in the US all have cash money. There is a ton of gambling money. On the completely illegal side we go from bad to worse. Drug dealers, drug cartels, organized crime, bank robbers and all manner of burglars. Throw in the pirates, gunrunners, crooked politicians and very bad boys that I put in the Jihadists camp.

How much of the money outstanding is in these hands? More than we want to believe. $300-500 billion would be my guess.

-You can’t deposit more than $10k into a bank and not have a “flag item” requiring disclosure and identification. While some black money will get back into the banking system the bulk of it will be stuck. This will be a global phenomenon.

-If you had a million or so in hundred dollar bills that were going to be toilet paper in a few months and the “teller window” was closed, what would you do? Spend it as fast as you could. What might you buy? Anything, including: Jewelry, uncut diamonds, gold and silver, big boats, as many cars as you could find, houses, raw land, cases of wine, art works. Anything that had a chance to hold value. Fur coats and expensive clothes would be flying off the shelf. Restaurants would be full and travel/leisure would explode.

-Red Money would have to be done with a wink and a nod. It would be understood in advance that a consequence would be that Bergdorf Goodman, Saks and Macy’s would quadrupled their cash sales overnight. That would be the intended consequence. So long as the money was going into consumption they would look the other way. But at the same time some very big (and smart) eyes and ears would be looking at the money flow. This would be a good way to flush some of those bad boys into the open.

-Counterfeit money would be burned.

-The Fed sends billions of new money out every day. This would be a massive ramp up. If you believe in this concept it is no stretch to assume that the contingency plans for how this would get done are already in a book. It would be expensive. But the jolt to the economy and the associated increase in tax receipts would offset it. How much would we pay to get a “follow the money” lead to Bin Laden? How much have we already spent?

-The most desperate characters would face the biggest risks of disclosure. They might just let the money they are sitting on turn to dust. That would not be a bad outcome either.

-This could backfire on the Fed. What would be the consequence of this if we went into it assuming there was a trillion out there and after a few months we find it is actually 2 or 3 trillion? A very big credibility problem. Economists would have to burn the mid-night oil trying to re-figure the connections between monetary grown and GDP. The old ratios would be worthless. If the number were much bigger than we are guessing at then it would be a big slap in the face of the Keynesians. Money does not multiply as fast as we thought.

-On the flip side we could get an unanticipated result. Only $500b could show up. The rest would be smoke and off the balance sheet. It would be quickly replaced by the Fed. They would love that opportunity.

-I have seen several reports of big ticket missing cash in both Iraq and Afghanistan. How much of this has not been reported? Who has this money? What are they doing with it?

-If one wanted to give the global economy a ~$300 billion of “instant demand stimulus” this would be on the list. It would be a micro burst of activity that would support another (longer) inventory cycle. Yes, a lot of this money would be re-channeled into useless things like a packet of diamonds, a Corvette or a condo in Miami. But that is what we have been doing for the past twenty years. This just picks up the pace a few notches. There is next to no cost to this. We might just catch a bad guy.

-For some this would destroy the dollar bill as a store of wealth and a medium of exchange. Roubles, Yuan, Euro’s, Yen, Aussies, Loonies and Kiwis would fill the void. That would not be a bad result either. Who doesn’t want a weaker dollar?

Cleveland Fed on GDP - Dreary Outlook

The Cleveland Fed issued a report that looked at the historical relationship between lagged GDP growth and the steepness of the yield curve. They compared the ten-year with the three-month bill yield. They used this information to make a probability estimate for a double did recession. Not surprisingly, they concluded that the probability is only 10%. I would take that bet. If anyone in Cleveland is interested, let me know.

I don’t question the Cleveland Fed’s (“CF”) analysis. If you rely on history to predict the future then the probability of a slowdown is low. This argument has been made by a number of pundits of late. While historically correct, I think this is dangerous logic.

It’s not clear to me that the CF believes in the predictive capability of steepness of the yield curve. Their caveat:

Other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades.

When they say this they really mean, “We don’t trust these results. There is too much “noise” in the current data. We are publishing this to try to blunt the ton of negative media about another recession. We want consumer sentiment to be as high as possible!”

Some reasons why the predictive powers of the yield curve may not hold up this time around.

-Sure the yield curve is steep. That is because we have ZIRP. With 3-month bills at an 1/8th everything looks steep. The bill yields since 1960:

We have never had a period like this. We are living in a dirty float. These are not true market rates. Nor are they sustainable without substantial consequence. We are on steroids. The results we achieve while on these powerful drugs should be discounted.

-The NY Fed’s 1.75T QE operations are having a continued impact. The result is extraordinary excess liquidity. Don’t trust current bill yields. This will change at some point.

-The yield curve that the CF relies on has collapsed of late.

-The global macro story has benefited short-term liquidity in the US for the past six months.  This too is temporary. It may be unwinding as I write.

-Almost all other economic indicators are telling us a different story.

-Unless Paul Krugman gets his way and we get another $500b of useless spending the fiscal side of the equation is heading into a wall. This is the most compelling side of the recession story.


A true double dip recession is a very rare occurrence. Once in the last 60 years. I am not forecasting one because of that. I think it is much more likely that we are entering a period of prolonged sub par growth. I see us bumping back and forth around zero for several more years. The NBER will not call that a recession. It sure will feel like one.

The analysis by the CF should be tempered given the “materially different” conditions that exist today. The probability of recession is significantly higher than they have suggested. Similarly, any forecast of future GDP growth should be discounted. With that in mind consider this graph from the same report:

“Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.00 percent rate over the next year.”

How much should we discount the CF forecast of 1%? I would suggest about 1%. We will have very little net growth over the next eight quarters.

The CBO and the SS Trust Fund look at the longer term using growth rates of 3%. We are going to be lucky to get a third of that. Without growth at or near 3% our deficits will explode. Our social obligations will overwhelm us.

A second recession will kill us. A few years of slow growth will scare us to death.

H.R. 5618 - Extending Unemployment – A Bad Bill

The House passed H.R. 5618 on Friday along party lines. This bill would extend unemployment benefits to November 2010. To see if your congressperson voted for this bad legislation see this list.

I have two major objections to the bill. First is that this is not “pay go” and second this is all about politics and an election.

The House bill was structured as an “emergency” spending bill. This designation allows for it to be exempt from the pay go rules. I am one of those who think that the biggest emergency the country faces is the size of the budget deficit. This bill would add $34 billion to our debt load. Here is how the CBO scored it.

If the Senate passes this bill it would extend benefits to the end of November. Gee, that is a convenient time. Just a few weeks past the critical bi-elections. This bill has little to do with structural unemployment. It is about buying votes and trying to sustain political control of Congress. Those that support/vote for it will say that they are doing so to help the unemployed. Actually it is just more bad legislation. This is about politics, not economics.

The Senate has gone on a ten-day holiday and will pick up the proposed legislation when they return. The vote will be on party lines. As of this weekend that means the White House has 57 of the 60 votes needed to pass. Olympia Snowe (R. Ma.) has indicated she will support it. Therefore they are two votes shy. If this deal clears the Senate and becomes law it would mean that two Republican Senators had their arms twisted, that or they had their political palms greased with some form of side deal. Washington at its worst.

Does it matter that we are adding another $34b to our debt load when the debt is already $14 trillion? Not really. This only increases our debt by a ¼%. It is equivalent to about 20 days of interest. We are in so deep at this point that $34b is a very small number. How is that possible?

I think the outcome of this legislation is important in a number of respects. It will influence markets and the economy.

-If passed, it will be a weight on the dollar. Outside of the US every country is singing fiscal conservatism. We stand out in the opposite camp. Passage of this bill will be reflected in the capitol markets.

-If enacted it will have some short-term beneficial impacts. It will keep consumption going for a bit longer. More I-phones will be bought, the number of defaults will be a bit less, there will be some monthly data released that will hide some of the weakness.

-The President’s fiscal commission will release its results on December 1st. The day after the extension of benefits will expire and three weeks after the election. There is no way this temporary extension will be extended at that point. Either we hit a wall then or we hit a wall now. The President and the legislative side of D.C. will not be able to avoid the recommendations of the fiscal commission.

-If this bill is not passed it will accelerate the slowdown that now seems to be coming at a frightening speed. Consider these two graphs of the number of people who will be impacted. By the end of July the number grows to 3.2mm. These are big numbers. This will show up on Wal-Mart’s sales. It will show up everywhere. Consumption will drop. Landlords will not get paid. Confidence will drop. Markets will drop. Federal and State revenues will drop. Deficits will rise. Debt will rise. These things will happen sooner versus later. H.R. 5618 just buys a few months.

-

NFP - A View From the Street

A pal who trades bonds for a living sent me his thoughts on the NFP numbers. An interesting take. His thinking on the birth/death adjustment in July is an early warning of what will come. I also like his comments re: QE2 and a short term back up in rates. Just another view; this guy has been good.

Quick Take: the numbers are not great. Some will want you to believe that we are 10-12mos into a recovery – we should not be losing 125k jobs at this stage.

Worse, Weekly Hours Worked edged down 0.1%. (This is a leading indicator to employment, though we cannot read all too much into one month’s data. Though if we see a tick down again next month, look out.)

The Unemployment Rate went down – great news, right? Not when it retreats by way of Labor Force Participation loss:

“The civilian labor force participation rate fell by 0.3 percentage point in June to 64.7 percent. The employment-population ratio, at 58.5 percent, edged down over the month.”

We actually have 301,000 less people working this month than last month (139,420 May vs 139,119 June), but since the labor force decreased by 652,000, less were actually counted as unemployed, and that helped the headline number:

May calculation: [14,973 Unemployed] / [154,393 Labor Force] = 9.7%

June calculation: [14,623 Unemployed] / [153,741 Labor Force] = 9.5%

That’s not improvement. It’s a faulty data point to consider: the UE Rate is not capturing what’s going on. We should not be looking at it.

Consider that the Labor Force has flat lined over the last 3+ years. This is due to discouraged workers, not because the population stopped growing:

Had the Labor Force Participation rate not dropped so severely over the last 3 years, we’d have a Labor Force around 157,500. This would equate to a UE around 11.6%. So we have nearly 2% of UE shaved off by Labor Force Participation alone.

The alternative measures of UE:

U-6 to 16.5% from 16.6% seasonally adjusted.

U-6 to 16.1% from 16.7% NOT seasonally adjusted.

Private Payrolls were up 83,000 though, so that’s improvement, right? We’ll see – without the birth/death “guess” of how many new small business were started this month, we’d have been at -64,000. Birth/death is added every month, and then adjusted in Jan and July, with hindsight, for ‘wrong’ guesses. Birth/death has added 728,000 jobs since February. Next month comes the adjustment – the last adjustment was in January, when they took away 427,000 of the previously added jobs. We’ll find out next month if the BLS found they were too optimistic in 1H2010.

With a Zero interest Rate Policy, Census hiring, QE and Stimulus mostly behind us, we’re heading the wrong way. While I have been, and still firmly am, in the deflation/lower rates camp, watch out for another head-fake and a period of higher rates like we saw in the fall and winter. In my opinion, should be very concerned about Bernanke/Obama feeling backed into a corner and going “all in” with another massive round of QE (and I mean massive). In fact, considering the election cycle, I’d be very surprised if this does not happen. We need to take our medicine, but what we’ll get is another dose of methadone, dragging this out for years more….

Ford, Tesla and Solyndra - Good News or Bunk?

Some are touting Ford’s improved financial position. They actually paid down some debt and threw some crumbs to Preferred shareholders.

Some are looking to the IPO of Tesla as an indication that the capital markets are open and doing what they are supposed to do. Raising equity for new companies.

Some are pointing to marginal gains in employment. The manufacturing sector is generating jobs. Especially in the areas of alternative energy.

This is all bunk. The money for all this is coming from Uncle Sam. This is the US Treasury doing the lending. Not private sector banks that we functionally own. This from the Federal Financing Bank:

$400 Billion 'Pay Go' Stimulus? It’s Possible.

UPDATE December 2,2010:

Hello. I wrote this piece on July 1,2010. It has had more views than any of my other missives. I can only hope that this interest comes in part from “deciders”.

I meander quite a bit. I apologize. The intro is dated, but my expectations for a soft economy are proving out. Follows is a summary of the proposal for a $400b PayGo stimulus. After that is the original article, warts and all:

Tks for the interest. BK

Amount of Stimulus……………$400 billion

Source………………………………..A one year reduction of Social Security payroll taxes from 12.4% to 5.4%. Employees save $240B. Employers save $160b.

Repayment…………………….A “Bill Gates” means test. Social security benefits will be eliminated for those who have taxable income of $150K (200K joint) or higher. The suspension will continue until the $400b has been repaid (plus interest) to SSA. The estimated time frame for the savings to offset the cost of the $400b stimulus is 4-5 years.


Compensation for Lost Benefits……………….Assume that a person forgoes $20k per year for five years (100k). Upon their death the estate of this person will be subject to Federal death taxes. The estate would get a full credit of $100k against any federal estate taxes that may be due. This passes a benefit to future generations. It is the opposite of all other measures that pass a cost to future generations.

$400 Billion 'Pay Go' Stimulus? It’s Possible

The whiff of deflation that the bloggers have been crying about has turned into a very noticeable global stench. The numbers from the US today on housing starts (record 30% drop) and the ISM manufacturing index are just the latest in a long and growing list of indicators that are headed in one direction. South.

The stock market knows this with a 10%+ drop of late, but the real signs are in the bond market. Sub 3% ten-year should be considered an omen. Nothing good will come from these lower interest rates.

Our political leaders must be crapping in their pants. Obama, Geithner, Summers etc. are not blind. They may be publicly ignoring the signs, but privately they are sweating big time. Their hands are tied. The Administration tried to get Congress to pass an emergency-spending bill to support the States and extend unemployment benefits. As of last night that effort failed. It would appear that we are about to fall off of a cliff.

I am pleased that Congress failed. More federal debt and spending is not a solution. I am also happy to see that the reason this effort failed is that our Congressional representatives have come to the conclusion that if they vote to spend our money they simply will not get re-elected.

I am not sure that any stimulus would really turn the tide of what appears to becoming at us. I am certain that more deficit spending will not solve the problem. There is today a “confidence factor” that is part of the equation that has not existed in the past. If Washington voted another deficit spending package of $300-400 billion the markets would not rejoice, they would tank. A step like that would lead S&P to downgrade our paper and we would be looking at a very long slide into a very deep hole.

I will stick my neck out and say that if we do not have some form of renewed stimulus ASAP we are going to be headed into negative growth territory by the end of the year. I don’t see a depression in our future (12 months – 10% GDP drop), but it is getting easier to forecast near zero growth for the next 24 months. We don’t need a depression for there to be a crisis. Negligible growth for an extended period of time will do it just as well. Should something like that happen we would end up in a hole we simply cannot dig ourselves out of. Unemployment would be north of 15%. Social problems/crime would be exploding. States would be either desperate or bankrupt. If we have no growth the federal deficit will balloon even if spending is not increased from current anticipated levels.

With this in mind I want to reintroduce an idea that I believe should be considered. We need a $400b stimulus. We need it fast. And it has to be “pay-go”. The pieces for this stimulus are right in front of us. For the life of me I can’t imagine why the “deciders” have not considered it.

I want to put $240b in the hands of workers and another $160b in the hands of corporations and small businesses over a twelve month period. I want the private sector to do the heavy lifting of fighting the slowdown. I do not want the federal government to spend more money. The Feds have done a terrible job. It is time for the private sector to have a chance.

Currently workers pay 6.2% of their wages on social security contributions, employers pay an additional 6.2%. Small businesses pay the same total percentage. If these percentages are lowered workers will have bigger paychecks and employers will have extra cash to either hire more workers or invest in productive capacity.

A reasonable estimate of SS revenues for fiscal 2011 is $700 billion. I want to drop that to $300 billion. This would imply that the combined SS tax rate would fall to approximately 5.5% from the 12.4% or a ~58% drop in total payroll taxes. I would skew this reduction in favor of the workers on a 60/40 basis. The end result would put the $240b in the hands of workers, the $160b in the hands of employers.

If something like this were accomplished, it would certainly revive economic growth. It would be (in my non PhD mind) the smartest way to stimulate consumption. The private sector would be spending this money. Far better than the federal government building bridges to nowhere.

Something along these lines would spin SS out of control. I doubt that they would recover. Therefore reducing SS revenues for a year is just another way of deficit spending and it will not work unless SS achieves spending cuts that are equal to the $400b in lost income. I believe there is a way to accomplish this.

The CBO produced a report on tax rates that I thought was interesting. The full report is here. The data provided is from 2007 and therefore stale but I believe the numbers today are not too far from those of 2007. The following information is contained in the report:

The number of households that have no children but are 65 and older and that have income(s) greater that $384,000 was equal to 4.4 mm in 2007.

Some of these households are two individuals others one. I estimate that this represents approximately 6mm people. They are all receiving an average of $18,000 from Social Security on an annual basis. That comes to $80-100b per year.

If the SS benefits of the >$350k set were eliminated for 4-5 years the SS Trust Fund would be net revenue/expenses neutral. Therefore the pay-go status is achieved.

Some thoughts:

-We need to raise taxes. But if we do, that will hurt the economy. This plan is a form of tax increase, but consumption from the >$350k, +65 set is not going to be influenced.

-There are those that scream, “Do not touch SS!!” I say the hell with them. This does not change benefits for the vast majority of beneficiaries. Nor does it alter the long-term financial status of SS.

-This is a tax on the rich. Yes it is. Who else are we going to tax?

-This is confiscation. Yes it is. In return I would give those that lose benefits a dollar for dollar tax credit on any federal estate taxes that may come due on their death. This, in theory, benefits future generations. Keep in mind we have no estate taxes at the moment, therefore this is a tax credit of questionable value and no impact on the current budget.

-Let the private economy work. This is not government spending. If we put $400b back into the proper hands it will work to stimulate the economy. I will let the PhD’s quantify the results. I will tell you that this will have a far greater and lasting impact then a similar sized government-spending package.

-Unlike any of the other plans that have been put forward this is politically “saleable”. It negatively impacts about 2% of the population. The other 98% may benefit, but there is no social cost or increased debt.

-This is, “Screw old rich people”. Yes it is. But ask Bill Gates or Warren Buffett. This is in their best interests. They have big stakes in our economy. Much larger than a few years of SS checks. My guess is they would be big supporters. There are 300,000 SS beneficiaries that had incomes >$1.7mm. These same folks are getting $5b of benefits that they don’t need.

A plan like this only buys time. It does not address the long-term issues. I hate the “kick the can down the road” approach. This is no different. It may not work. At the end of 12-18 months we may find ourselves exactly where we are today. Staring at a void. But on a federal level this will not add to our debt. I can’t think of any other approach that gives us a chance and does not include more debt.

Disclosure: This plan would take money out of my pocket. I believe it is the right thing to do.