Economy

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Book Review: This Time is Different: Eight Centuries of Financial Folly

I have been reading This Time is Different: Eight Centuries of Financial Folly for the last month. It has been slow going since it reads like a text book and I have read my fair share of text books in my life. I would have given up except that the authors have some collected some important historical data about financial crises. The authors have methodically compiled approximately 800 years historical data base on financial crises and their causes. There are lots of tables, charts, and professorial comments about the causes of the crises.

A few days ago I was surprised when Henry Blodget wrote an article advocating more government spending in the article, Well, It Sure Seems Like Keynes Was Right, and based it partly on Reinhart and Rogoff’s analysis of prior financial crises. I was surprised since the authors did not comment directly about stimulus spending in the chapters I read but here is what Henry wrote:

And I’ve also looked back at history–namely, Reinhart and Rogoff’s analysis of prior financial crises, the Great Depression, Japan, Germany after Weimar, and so forth.

 

So I skipped to the end of the book and read the last two chapters. The closest I came to a comment on Keynesian stimulus spending is:

Debt sustainability exercises must be based on plausible scenarios for economic performance, because the evidence offers little support for the view that countries simply “grow out” of their debts. This observation may limit the options for governments that have inherited high levels of debt. Simply put, they must factor in the possibility of “sudden stops” in capital flow, for these are a recurrent phenomenon for all but the very largest economies in the world.

and

Our extensive coverage of banking crises, however, says little about the much debated issue of the efficacy of stimulus packages as a way of shortening the duration of the crisis and cushioning the downside of the economy as a banking crisis unfolds.

So although the authors are concerned about plausible debt sustainability scenarios since it may lead to “sudden stops” in capital inflow in smaller economies, their data has shown that large economies like the United States have been immune from these “sudden stops”. This leaves open the question of what would happen to capital inflows if the United States undertook another stimulus like Henry Blodgett is recommending.   At what level of debt does the rest of the world decide that the United States debt is not sustainable and they should invest their capital elsewhere. If that scenario occurs we can safely say this time is different.

As a back-handed complement I would like to thank Henry for making the “This Time is Different” book much more interesting than it would be otherwise.

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Was our last economic boom due to consumer debt?

When I read the post, A Deep Look At Revolving Credit, And What It Means For Consumer Spending, the graphs inspired me to try my hand at answering some questions I have been about the importance of consumer debt to our last economic expansion.  So the first thing I did was to create a graph using FRED of the revolving debt versus the S&P 500. To avoid issues with scaling and different units, I told FRED to scale the graph using the latest available data as 100. From the graph I could see that there was a strong relationship between the two lines but I had some other questions. How much of the increased debt was due to the increase in population and inflation? My solution was to create a per capita revolving credit estimate by dividing the revolving credit by the population of wage earners and scaling it to 100 and adding a separate line for the inflation index. Here is the final result.

 

fredgraph_percapita

Now this is an interesting graph. We can see that the S&P 500 and the per capita revolving credit have a close relationship up until the internet boom of 2000. Then things go haywire. We can also see that the per capita rate of revolving debt started to accelerate after 1983. It continued to increase at a rate greater than the inflation rate until 2007 when it started a decline despite a much larger number of wage earners and inflation. This leads me to conclude that the wage earner’s debt was maxed out in 2007.

The next question I had was where does the per capita revolving debt go from here? One way we can make an intelligent guess at the answer is to go from the premise that per capita revolving debt should have grown at the rate of inflation. Using a regressed line of the CPI to provide us with the slope of the line, we would expect that per capita revolving debt still needs to drop another 10% to reach the point that inflation rate would have predicted. Since the wage earner was probably maxed out in 2007 I think the wage earner is unlikely to add more debt any time soon. They are still close to their max debt load. If we assume that wage earner’s tolerance for debt and inflation rates does not change dramatically then it make take another year or two for the wage earner to pay down enough debt and establish enough distance from their max debt level. On the negative side if the wage earner gets panicky about the future of their job and the economy,  there might be some debt repayment overshoot. The logical conclusion is that this new normal for revolving debt will be bad news for the companies whose sales are dependent on revolving debt and make if very difficult for this economy to expand for the next two years.

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Guess How Many Americans Don’t Have Enough Saved To Cover A $1000 Emergency

I was told of the importance of funding an emergency funds for most of my adult life but despite this sound advice, I did not an emergency fund one until about three years ago. It started when after many years, our farm starting to break even. So I started putting away money just in case we had problems again. During the time we had financial problems with the farm, we accumulated a lot of credit card debt. It took the help I got from a relative to get out of the hole and I vowed to my relative and to myself to never let us get in to that debt problem again. I learned my lesson the hard way and hope that others have to follow my path to enlightenment. From my hard learned lessons I find it amazing and disappointing that more people are not embracing emergency funds as a key part of their financial plan. Considering the expected returns in real estate and the stock market the best financial strategy for people with credit card debt is to pay it down and avoid accumulating any more credit card via emergency spending. Like our governments the biggest problem is controlling spending. It is easier said than done but that does not make it any less important.

According to a recent study from The National Foundation for Credit Counseling (NFCC), 33 percent of Americans do not have a savings account of at least $1,000 or more to cover emergency expenses.

The NFCC study surveyed 1,010 Americans to determine how much money they had set aside in the event of a financial emergency that could cost around $1,000.

Of the respondents surveyed, 64 percent claimed to possess emergency funds.

Those individuals without savings said that they would have to turn to an outside source to ask for money if they were faced by an unexpected expense.

In the words of Technorati:

Although the study might have been a bit biased in selecting its sample pool, the fact that such a high number of participants are lacking a relatively modest $1,000 in savings is still alarming. And is clearly something that should be addressed””for example, through better financial education.

This seems to be part of a wider picture of poor financial provision by households in the US. An earlier study by the NFCC found that 30 percent of Americans have zero dollars in non-retirement savings. A separate study by the National Bureau of Economic Research found that 50 percent of Americans would struggle to come up with $2,000 in a pinch.

Savings

And these are just a few of the alarming discoveries made in the NFCC’s annual report. Here are some others:

Today, more than 1 in 5 U.S. adults (22 percent) do not have a good idea of how much they spend on housing, food and entertainment. Although just over 2 in 5 Americans (43 percent) say they have a budget and track their expenses, more than half (56 percent) do not.

More than half do not budget? Well, that certainly explains what is going on in D.C.

Furthermore, more than 1 in 3 adults (36 percent) say they are now saving less than last year. And, in fact, 1 in 3 (33 percent) do not have any non-retirement savings. Although there had been a steady increase in the proportion of adults who have savings between 2008 (63 percent) and 2010 (67 percent), that proportion has now declined somewhat (to 64 percent in 2011).

One of the conclusions that can be drawn from the report is that there seems to be a prevalent attitude in American culture where not enough emphasis is put on self-reliance and personal financial freedom but instead too much has been put on the “gimme-gimme” mentality. That would certainly account for the multitudinous amounts of Americans in debt and the coinciding lack of personal financial responsibility.

View the full report here.

This post originally appeared at The Blaze.

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Guess How Many Americans Don’t Have Enough Saved To Cover A $1000 Emergency
Becket Adams
Tue, 20 Sep 2011 21:00:00 GMT

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If Social Security is a Ponzi scheme, does that make CalPERS a Ponzi scheme, too?

If Social Security is a Ponzi scheme then all of our defined benefit pension plans such as the California Public Employees’ Retirement System (CalPERS) risk falling into the same category. CalPERS is a $226 billion pension fund with an estimated $240 billion unfunded liability according to a Reuters article. So even if you are willing to concede the point that Social Security and CalPERS are primarily "pay-as-you-go" systems as advocated on the Social Security site, you are confronted with three almost insurmountable problems.

  1. How do you scale back the future benefits in an equitable manner?
  2. How do you convince current contributors to contribute more money at the same time you are scaling back benefits?
  3. In the case of defined benefit programs that are partially advance-funded, who is responsible for investment risk?

This is not a new problem. For many years companies had difficulties managing the funding and benefits of their pension plans. An additional problem was what to do with defined benefit plans for companies that no longer existed. This problem became very apparent when the steel companies disappeared in the 1970’s. In 1974 the government created the The Pension Benefit Guaranty Corporation(PBGC) to take over the defined benefits for pensions for bankrupt companies. The funding for the PBGC came from fees charged on the remaining existing corporate defined benefit plans. This policy seems to have worked. In the following years most private companies converted their pension plans into defined contribution plans and problems with the remaining defined benefit plans diminished considerably. On the other hand public sector fully embraced the defined benefit plans. Part of the allure was that the promise of future benefits was a major issue in collective bargaining agreements. Instead of pay raises they were promised future health and pension benefits.  The long history of problems that the private sector had with funding and managing defined benefit pension plans seems to have been ignored by the public sector. Since the management of defined benefit plans were not being managed differently than the way the private sector managed their plans it is inevitable that they would duplicate the same mistakes. Considering the size and extent of the public sector unfunded pension and health care liabilities, most of these agreements were done in bad faith and led to deliberate mismanagement of pension funding and benefits. It will probably take some form of the PBGC for state and local governments that is funded by the public sector pension funds and has strict funding and benefit rules to clean up the public sector pension mess.

Social Security is different from the public pension plans but it shares many of the same mismanagement of funding and benefits problems and a more puzzling style of investing. Considering the size of unfunded liability for Social Security, the funding and benefits have been negotiated in bad faith, too. So although comparing Social Security to a Ponzi scheme may seem too severe, it shares the same bad faith negotiations and plan mismanagement as public sector pension plans. A pension plan relying solely on "pay-as-you-go" financing and funky investing may have been a viable option for my father’s generation but not my son’s generation. The pact between one generation and the next is about to be broken. The future of defined benefit plans in general is in doubt. Defined contribution plans are the preferred option in the private sector but suffer from inadequate savings rate. This problem can be fixed by a relatively simple solution, policies to encourage a higher savings rate. It remains to be seen whether defined benefit plans can overcome their predisposition to bad faith negotiations and mismanagement and create a better pension outcome than those offered by defined contribution plans.

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Why Those Keynesian Stimuli Are Not Working

For a stimulus to be economically helpful it needs to be “timely, targeted, and temporary.” This stronger version of the Lawrence Summers quote is an important economic policy issue to ponder. So let’s start out the discussion with a look at how the Swiss manage federal stimulus. The Swiss made it through the last recession relatively unscathed. Despite the benefits of being the reserve currency status, the United States economy did a lot worse than the Swiss economy. The Swiss secret to a resilient economy appears to be something written into their constitution called the debt brake rule.

Effectively, the rule aims to maintain a structural budget balance every year. The rule allows deficits to be run in a recession, but requires surpluses in better economic times so that over the cycle the budget is in balance.

Putting the Brakes on U.S. Debt | Committee for a Responsible Federal Budget

 

This sure looks like a working example of the proverbial “Keynesian stimulus”. In the United States our policy makers have embraced  “Keynesian stimulus”  plans since the Great Depression but we have much different results. Here is a post from Mercatus that demonstrates that temporary increased federal spending always seems to lead to higher permanent federal spending.

The chart shows how expenditures as a share of GDP spiked during World War II but were reduced rapidly and significantly. However, spending never returned to the pre-war level and has followed a general upward trend ever since.

Today federal, state, and local expenditures as a share of GDP are back at the highs reached during World War II. This time, however, we are unlikely to see a swift decrease. Wartime expenditures on items like weaponry and salaries for conscripted soldiers were relatively easy to wind down. The bulk of current and future government spending is on entitlement programs like Social Security and Medicare. This variety of spending is nearly impossible to reduce in the near term.

The tendency for spending to ratchet up during a crisis is important because it suggests why fiscal stimulus is unlikely to be economically helpful. In an oft-repeated quote, economist and stimulus advocate Lawrence Summers has argued that stimulus ought to be “timely, targeted, and temporary.” Otherwise, it is unlikely to be economically helpful. The fact that spending rarely returns to pre-crisis levels suggests that governments may find it impossible to implement stimulus in the way Keynesians such as Summers would like to see.

Federal, State, and Local Expenditures as a Share of GDP at WWII Levels | Mercatus

Finally here is an analysis why the United States stimulus efforts are not working.

ONE REASON WHY THOSE KEYNESIAN STIMULI AREN’T WORKING: They’re Not Keynesian. “Whalen isn’t simply dumping on Keynesianism, he’s bent on pointing out that even its latter-day adherents are straying far from their master’s theory. And in this, he’s surely correct. As Allen Meltzer has argued, Keynes was against the very sort of large structural deficits that characterize contemporary federal budgets and policy, believing instead that deficits should be ”˜temporary and self-liquidating.’ And Keynes believed that any sort of counter-cyclical spending by government should be directed toward increasing private investment, not simply spending current and future tax dollars on public works projects. Or, to put it another way: If the federal government had a strong track record of responsible spending, it would mean one thing if it went into hock for a short period of time to goose the economy (again, whether this would work is open to question). It means something totally different when a government that spent all of the 21st century piling on debt and new, long-term entitlement programs responds to an economic downturn first by creating yet another gargantuan entitlement (Obamacare) and taking on even more debt in the here-and-now.”

 

ONE REASON WHY THOSE KEYNESIAN STIMULI AREN’T WORKING: They’re Not Keynesian. “Whalen isn’t simply…

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Death Cross Now In Play

The “death cross,” is where the 50 Day Moving Average crosses below the 200 Day Moving Average. When it happens the technical analyst folks say things like:

The “death cross” confirmed at the end of last week’s dramatic action, and this significant event points to the growing possibility of a new bear market.

Death Cross Now In Play

This is what it looks like courtesy of Yahoo Finance. Here is the link, http://finance.yahoo.com/echarts?s=%5EGSPC+Interactive#chart2:symbol=^gspc;range=1y;indicator=sma(50,200)+volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined.

DeathCross

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Daily Treasury Real Yield Curve Rates

Although I personally loathe buying any treasury debt at this time, negative real interest rates on ten year bonds is a pretty unique situation. For the people who are buying treasury bonds is more important than the interest rate risk. The idea of the ten year bond closing the week at ”“0.02 tells me that the financial system has more money than good ideas so they settled for a secure, small loss idea.  For the Treasury that this is a great time to extend the average maturity of our total debt and reduce the amount of debt that need to be re-financed when the interest rate goes up.

Daily Treasury Real Yield Curve Rates

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Financial Events That Caught My Attention Last Week

Unlike most of the media the debt ceiling debate I thought the debate went as expected. After watching the budget debates in California, Illinois, New Jersey, and Wisconsin I was expecting the debt ceiling debate to be ugly and to satisfy no one. However the most interesting financial result from the debt ceiling agreement was the movement on the 10 year Treasury bond. So while the media pundits were still talking about rising interest rates for consumers, the 10 year bond continued to go in the opposite direction. That left me to conclude that the big financial issue driving the dollar higher and the treasury bond rates lower was the combination of the Eurozone blowing up and the United States economy stalling. It is got to be hard on the Chinese. Their best export market was tanking and their plan of using a basket of currencies to replace the dollar as the reserve currency was going down along with the Italian and Spanish economies. If the world economy is slowing down, the domestic issues confronting the Chinese are likely to heat up. It is likely that the average Chinese worker will think that they got the raw end of the economic boom.

Another weird economic report was the Federal Reserve report on consumer debt, http://www.federalreserve.gov/releases/g19/.  As a fan of Dave Ramsey, http://www.daveramsey.com/home/, I believe that the economic health and wealth of the United States depends on more Americans becoming debt free. It obvious to many people that Americans have too much consumer debt and it is time for the debt pendulum to start swinging back the other direction. Getting our fiscal house in order starts in our own home first. The G19 report by the Federal Reserve was showing that Americans were making some progress in 2009, 2010, and 2011. In 2009 and 2010 the debt went down at rate of ”“4.4% and -1.7% respectively. In 2011 the rate rose at rate that was comparable to our inflation rate, 2.1%. In June our accumulation of debt accelerated to about 7.7 percent from 2.5 percent in May. This drove up the preliminary rate for the second quarter to 4.4% and well above the inflation rate. Both cars and credit card purchases contributed almost equally.

Maybe we will get lucky. The price of crude oil continues to dive as the world economy slows down. It appears that once again we are looking at a mixed bag of inflationary and deflationary indicators. Inflation and deflation continues to be my biggest fears for the United States economy.

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The government is not a household, and shouldn’t be run like one – Ezra Klein – The Washington Post

 

When economic times are good, households should spend and invest more, while government should spend and invest less. When they’re bad, households need to cut back, and the government needs to step in.

There are several things wrong with his complaints about comparing households to governments. When we look at a longer time scale we see the government continues to spend more in good and bad times. Historically the last time the government cut back in good times was after World War II. Over the last 100 years government spending chases revenues because it is a politically easy thing to do because it maintains a sense of status quo between tax revenues and expenses. When we have a recession this status quo is disrupted. There are several options available to us. The Keynesian strategy is to strike a bargain with the devil and step up special, short term spending to stimulate the economy. The hope is that it will result in sustainable, long term growth which can pay for the debt. It is hard to find times in history that this strategy actually worked but history has shown that it is politically suicide to do nothing. The good news is that our economy has been blessed with continuous growth and prosperity regardless of our economic strategy.

For most people there is nothing special or unique about special, short term spending plans whether it is used by the government or an individual. There is no “free lunch” for government spending. The household analogy to stimulus spending in a recession is an unemployed person using their credit card or a personal loan from a relative to pay for job search expenses. In some cases this strategy results in a job that the person can use to not only maintain their style of living but also to repay the loan. This strategy probably works best with people whose career opportunities are expanding. For people later in their career or in declining businesses this strategy probably does not work. These people will have to adjust to a life with lower income, lower expenses, and possible loan defaults. If we follow the household analogy to its logical conclusion we are confronted with the same core questions for both governments and households, “Have we peaked and what can we do about it?” Most people understand these questions and their consequences. In this case the household analogy is a particularly appropriate tool for explaining the difficulties and consequences of spending decisions.

The government is not a household, and shouldn’t be run like one – Ezra Klein – The Washington Post

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oftwominds: The Devolution of the Consumer Economy, Part II: Rising Costs, Declining Wages

I have been thinking along these same lines for several months now although I worded a little bit differently. I agree that the average American worker is increasing living as a debt serf. Increasingly they live from one paycheck to the next. This makes job changes and increased wage demands a risky career choice. It follows that the average American worker must rebalance both their spending habits and the debt portion of their assets. This implies that the consumer driven economy must decline and a manufacturing or export driven economy must pick up the slack. It also implies that there is a bubble in financial market driven by the derivative/insurance instruments. Unlike the stock and bond markets the securitization market appears to be very inefficient market as demonstrated by the collapse of the mortgage securitization market. Until these “derivative” markets are recognized as risky and containing many poor performing investments, investing in businesses that make “stuff that people want” will be a low priority.
The key feature of financialization is that the outsized profits and opportunities come not from producing goods and services but from leveraging, borrowing, obscuring risk and gaming widely ignored regulations. Banks made money not from prudent loans but from taking $1 in deposits and originating $50 of risk-laden loans from that paltry capital. Wall Street reaped billions by packaging high-risk mortgages as “low-risk” investments.

The housing bubble offered the ambitious debt serf a rare opportunity to lie and leverage just like Wall Street. Anyone with sufficient chutzpah could buy a number of houses with no-document “liar loans” with option-adjustable rate loans at super-low rates of interest, hold the homes for a few months and then flip them for profits.