Notes on the Economy – 05/7/10


Cities, states and countries are now facing serious fiscal problems which arise from the simple fact that public managers face no bottom line accountability.   Managers, with horizons driven by election cycles, not the longer term interests of the “company”, too easily cave in to special interests and public pressure.  When the garbage collectors go on strike, the pressure on city politicians to settle is strong indeed.  Over the past few decades, government has grown in size and largess. 

In California, prison guards and highway patrol officers earn up to $100,000 a year (with overtime) and can retire as early as age 50 with a benefit that can reach 90 percent of income.  Even in small cities, pay and retirement packages for government workers far exceed comparable jobs in the private sector.  In Greece, the retirement age is 61 and the retirement benefit is 80 percent or more of last pay earned for public and private workers (and they receive 14 “monthly” paychecks per year).  These stories are replete in city after city, state after state and country after country.  Private companies cannot survive such mismanagement.  General Motors is a classic example.  Over the decades, the UAW, with pressure from government to avoid strikes and promises of protectionism, helped destroy the company.  The bottom line was terrible, but politics trumped rationality, and GM is now a government owned enterprise.  Taxpayers will never recover their (involuntary) “investment” in GM which many feel should have been allowed a structured bankruptcy that would have kept what was good and shed the units and contracts that guaranteed that GM would remain unprofitable in a competitive market.  This administration has made clear its intent to support public and private unions in spite of these growing problems.

Add to this extended periods of cheap and easy credit which further lowers the cost of caving in to pressure and the stage is set for the fiscal disasters we face today.   The larger the role of government in a country, the larger the potential for inefficiency and mismanagement, corruption and graft.  Government entities avoid “bankruptcy” by taking an ever rising share of private sector income, but even this has it limits as we are about to discover (40 percent of tax filers don’t pay any tax).

First, it was passed on a totally partisan basis, paying no attention to the views of the citizens who were overwhelmingly opposed to this “change”.  This “we know best and have the power” attitude smacks of authoritarianism.  Second, it violated a host of important promises ranging from “transparency” to “no tax increases for anyone who earns less than $200,000” (originally $250,000), to the assertion that health care costs are preventing new firms from being formed (a real reach since it is not mandatory, yet, that firms must provide health care insurance).  Add to that promises that we can keep our health care insurance, that we can see any doctor that we want, that premiums will fall and a host of other assertions from the White House and members of Congress.  Assertions that health care is a “right” are simply incorrect, it’s not in the Constitution and it’s not someone’s “right” if I have to work to pay for it.  Finally, the preferences explicitly shown for trial lawyers and union members, “Obama Buddies”, were offensive.  A sad showing indeed.  This was not “government of the people, by the people”, just a few people imposing their values onthe people. 

The compensation that a firm can pay is limited to the revenue that a worker can add to the firm’s operation.  In simple terms, a company cannot stay in business paying workers more than the revenue they generate for the firm.  Compensation can then be divided between cash take home pay and benefits and taxes.  If you are worth $50,000 a year and have benefits and health care costs rise, it is hard to keep paying you the same take home cash.  This is the pressure that employers and employees face.  But this bill does nothing to reduce costs by producing more efficient health care decisions.  Instead, $500 billion in benefits have to be taken from the elderly and those who pay for their own but more expensive insurance who must pay penalties.  This is “rationing”, not “rationalizing” the health care market.

Bottom line, this legislation does nothing to make the health care system operate more efficiently which is the “reform” that people wanted.  Instead, it brings in millions of new “dependents”, those who will look to government for more handouts and vote for them (hang on for immigration reform, 12 million more votes), and raises the health care bill for the country to be paid for by private sector workers (unless you get a union “break”, stay tuned).  To be sure, many will like the “no pre-existing conditions” provisions and keeping “kids” (??) on the family policy until age 26 (guaranteed to raise health care costs).   But these mandates, government definitions of “acceptable coverage” and the penalty structures are likely leading us to a single payer government controlled health care system that will be rife with rationing (how else, for starters, can we cut $500 billion out of Medicare?).  In the meantime, enjoy paying for the 16,000 new IRS “enforcers” out of your income.  There will be more taxes to come.

3.  Jamie Dimon’s defense of “big banks” in his shareholder letter seems to ignore the experience of the past two years.  Big banks are not “inherently risky”, but the larger they are, the larger the share of deposits and capital they put at risk.  A mistake on risk assessment or a failure to diversify can indeed pose systemic risk if the bank is large.  The risk is even higher if the bank’s assets are complex as we have learned.  Mr. Dimon admitted in Congressional testimony that his risk managers (presumably the best in the business) never thought to “stress test” the balance sheet for a decline in house prices in spite of the obviously overdone run-up in prices and supply.  Such a mistake at a smaller bank poses less risk.  The larger the bank, the larger the systemic risk.  Big banks may be better providers of financial services to global institutions as Dimon argues, but enough better for the economy to bear the risk?  Today’s “big banks” are more than large enough to accommodate the largest global institutions and still diversify their assets.  And, syndication is always available, a good way to diversify risk and insure a broader perspective on the risk posed by a “big deal”.  To date, there is little evidence that “scale” of the magnitude of a JPMorgan or Citi provides cost economies, but complexity certainly is increased and complexity is more difficult to manage, raising the likelihood of an oversight of growing risk in some obscure corner of the business.  Mr. Dimon wants to grow the bank and use more leverage in order to increase his share price.  However, the economy should not be put at higher risk to help him out.

4.  Sales of new and existing homes are stalled at low levels, actually falling a bit over the past few months.  There are over 2 million homes for sale across the U.S.  This in spite of historically low interest rates and a government incentive program for buyers.   Housing starts are hovering around 600,000, a normal level would be closer to one and a half million.  Millions of houses are in some stage of foreclosure and could add a million or so to the supply of available homes for sale over the next few years.  An extended tax credit will do little, consumer’s don’t buy a house they don’t want just to get $8,000.  Only buyers who would have purchased absent the program will get the money, a gift from taxpayers.

Mortgage rates are set to rise for the rest of the year.  The Federal Reserve has ended it purchase of 1.4 trillion of Fannie and Freddie debt and mortgage backed securities.  Without this source of funding, mortgage credit will get tighter.

Adding to the upward pressure on rates is the Federal deficit.  Borrowing 1.5 trillion to finance federal spending will push Treasury rates up and this will push up mortgage rates.  The government will be competing with you for credit, and they always win.

With over 10 percent of the housing stock vacant, neither home prices or rents are under much pressure.  There are just too many vacancies and homes for sale.  But the worst is past, March even saw an increase of 15,000 jobs in construction.  But the recovery is going to be a lot weaker without new home construction.  Housing starts are about half of normal levels, they’ll improve some this year, but still be well below normal levels.  Keep up the good work Jay and be well.
5.  The March jobs report was the best we’ve seen in two years.  After losing 750,000 jobs in March last year, we posted a gain of 162,000 net new jobs, a welcome shift.  About 50,000 of those were temporary Census workers, and 45,000 were in education and health care.  Some would view these as government workers as well.   But construction added 15,000, manufacturing 17,000 and retailing 15,000, signs that life is stirring in the private sector.  Another 22,000 were hired in the leisure and hospitality sector, perhaps a sign that the end of severe winter weather is stimulating a little R and R activity.

Of course we need more than that to make a dent in the unemployment rate, which remained constant at 9.7 percent.  There are now 15 million unemployed individuals and a bunch more who have given up finding a job, at least for now.  An improvement in the economy will bring these people back into the labor market, looking for a job and of course adding to the officially unemployed.  We need over 100,000 new jobs each month to just keep up with population growth and new workers and another 200,000 jobs a month for the next three years to re-employ the 8 million who lost their job in the recession.  That’s at least 300,000 a month for the next three years, a tough assignment.

At the peak of the housing boom, almost 8 million workers were employed in construction.   Employment is down more than 2 million, a loss of about 25 percent of the jobs.  Employment losses were probably even larger since many illegal workers found jobs in construction.  Their job losses didn’t show up in the official numbers but in the flow of cash to Mexico.  Most of these jobs were created by making bad loans, mortgages and construction loans made to individuals that couldn’t repay or to builders who were speculating or deceived by flippers who put a deposit down but walked on the deal when they were unable to flip their ownership.   The government is criticizing the banks for not lending more, let’s hope that they don’t force the banks into a repeat of those bad mistakes.

GM is running TV ads claiming that they have repaid their government TARP loan of $8 billion and change early.  Eight billion?  The taxpayer invested 80 billion of TARP money into GM and Chrysler, most of that to GM.  How does $8 billion pay that off?  It doesn’t.  What it bought us is 61% ownership in the new GM and a block of stock for the UAW.  Previous shareholders and bondholders got virtually nothing.

So what is that stock worth?  General Motors recently reported a LOSS of over $4 billion dollars, not a great return on the tens of billions taxpayers “invested” in the car companies (not voluntarily, no sane private investor would have invested which is why government had to).  With profits like this, the share price will surely fail to rise to the historically high levels needed to insure a return of taxpayer money. 

The problem could get even worse long term.  The GAO has reported that the pension funds (for 900,000 workers) are underfunded by $17 billion.   Payments of about $15 billion have to be made in the next few years to the pension funds.  Hard to make these payments with no earnings.  The company continues to liquidate itself, this time losing taxpayer money.  The government’s clear preference for unions in all these dealings suggests that more taxpayer money will ride to the rescue in the years to come.  

If the company was doing something of value (to us) and doing it well (making money), we might be happy to see the debts being repaid out of earnings.  But that’s not happening and may never happen.

7.  Congress has undertaken a series of attempts to stimulate consumer spending by providing tax breaks for actions taken before a date certain.  First came the $8,000 tax credit for buying a new home.  This was followed by “cash for clunkers”.  And now Congress is contemplating a tax credit for hiring new workers.  And there may be more ill-conceived plans to entice the consumer to spend more.  It was, after all, a sharp decline in consumer spending that led us into a deep recession.

There are several important facts of life to recognize in evaluating these schemes.  First, none of these plans will get someone to buy a house, buy a new car or hire an employee that wasn’t going to do so anyway in the time period close to the passage of the program.  No one spends $200000 on a house just to collect 8000, a small percentage of the house price.  The same was true for cash for clunkers.  It is very likely that all consumers who participated in the program would have purchased a vehicle in the proximate time period without the program.  All these programs did was to pull future demand into the current period, reducing future demand, a fact revealed by the precipitous decline in home purchases once the credit ended.  Bottom line, the two programs were just gifts from taxpayers to consumers who would have purchased anyway.

A proposed $5,000 tax credit for hiring a new employee will have the same result.  No business will spend a salary of $30,000 or $40,000 or whatever to get a $5,000 credit which lasts only a short period of time, leaving the firm to pay the full cost in the future.  Once again, such a program would just be a gift from taxpayers to firms that would have hired anyway.  It will rearrange the pattern of hiring, but not increase it.

The most recent report on housing starts indicated that little was happening there.  In a normal year, we would build over one and a half million new housing units.  Current starts are under 600,000, because over 10 percent of all housing units are still vacant.  Housing will come back, but slowly, and this is one reason why the recovery from the recession will be slower than hoped for.

8.  The National Federation of Independent Business released its March survey of its 400,000 member firms this week and the news was not good.  The Small Business Optimism Index fell from February and remained below 90 where the Index has been stalled for almost 2 years.  For comparison, during the 1980-82 recession, the Index fell below 90 in only one quarter.  At the bottom of that recession, 47 percent of the owners expected improved business conditions in the 6 months following the survey, net of the pessimists.  In March of this year, a negative 8 percent expected improvement, meaning more owners expect the economy to weaken this year than improve, even though we have already logged three quarters of real output growth.  That good news has not invigorated small business owners as more of them plan to cut employment than to expand jobs, and plans for capital spending are at 35 year low levels.

Consumer sentiment also faded according to the University of Michigan, which has monitored consumer sentiment for over 50 years.  Optimism fell in the first few weeks of April, with a reading about as bad as a year go April when the real economy was plunging.  Since the economy is growing reasonably well now, something else must be bothering consumers.  45 percent rated government economic policies as poor and 38 percent were distressed by the health care bill.  Consumers see little prospect of income gains and worry about possible tax hikes in the future.  Although consumers recognize that houses are a great buy, they aren’t buying.  A record high number cite low prices as a reason why it is a good time to buy a house, but few plan to take advantage of the low prices and mortgage rates.  Poor job and income prospects stand in the way.  
So, after a quick recovery from strong negative growth a year go to strong positive growth (a “V”?), it appears that the economy may slow down.  Small businesses and their customers, consumers, are distressed about the job situation and uncertainty about income growth which is threatened by Congress’s myriad of proposed regulations and taxes.  There isn’t any good news coming from Washington or the state capitals and this uncertainty produces a logical response from consumers and business owners, don’t spend unless you have to.  That is slowing the recovery.

9.  “CROWDING OUT” – Coming Soon to a Lender Near You
In a “closed economy”, savings is the source of all capital (textbook: “a country can invest no more than it saves”).  With open economies, there is the possibility to tap the savings of other countries.  It is the ability of the U.S. to borrow from the rest of the world that has permitted us to have solid growth in consumption as well as in investment (new homes construction and plant and equipment etc.) which has amounted to around 15% of GDP while our savings had amounted to substantially less.

The economy imploded in the fourth quarter of 2008 when consumers decided to move their saving rate (out of disposable income) from near zero levels to around 5% (nothing to brag about!  In the late 1970s, the saving rate was over 10%).   This meant that retail sales declined by hundreds of billions of dollars, starving the bloated number of strip malls, retailer outlets and restaurants built to feed our partying during the 2003-07 period.

So, now instead of building the 1.6 million new housing units thought to be needed on a trend basis, we are building 600,000 (down from 2.2 million late in 2006).  That means that credit demands to support the construction of 1 million or more housing units is gone.  New car purchases are running 5 million below “norm”, no credit demand to finance those.  Capital spending (plans and actual outlays) among small firms (NFIB Small Business Economic Trends) is at 35 year lows.  More firms still plan to reduce inventories than to increase them.  Consumers are paying down their credit card debt nearly every month.   Loans are down because demand is down, not because banks are refusing to make good loans (of course credit is harder to get than in 2007, credit standards have returned!  And there is a recession, cash flow is down).

With private credit demand so low, it is not so surprising that we financed last year’s $1.4 trillion federal deficit without much pressure on interest rates.  But, going forward, as private credit demands revive, they will begin to collide with the need to finance $1.5 trillion dollar federal deficits.  This can only produce higher interest rates, especially if providers of foreign savings become less willing to lend to the U.S.  While private parties are sensitive to interest rates (like mortgage rates), the government is not and will always win this contest, paying its interest expense from tax revenues.  This “crowding out headwind” is likely to slow the economic recovery going forward.  Raising taxes to reduce the size of the Federal deficit will certainly not stimulate the economy either, even if it reduces government credit demands and “pay go” doesn’t seem to be slowing spending since everything is an “emergency” and exempt from the restriction.  It’s going to be painful.

Assuming that regulators decide that banks are indeed too large, how might a reduction in size be accomplished?  There is already in place a limit on the share of domestic deposits a bank may have (although recent “resolutions” of troubled banks have resulted in these limits being exceeded).  But banks were able to grow using foreign deposits (not insured by the FDIC) and by issuing bonds (guaranteed by the FDIC until recently).  To be more effective, setting a minimum level for the ratio of core deposits to assets would limit growth funded by bank debt or foreign deposits and reduce leverage.  For community banks, this ratio is very high since few issue bonds or have foreign deposits.  

Capital requirements should also be increased with asset size.  This will discourage growth since it lowers the return on capital unlessincreased size reallyproduces the cost economies or extra revenues that supporters of big banks argue are present.  Federal Reserve research suggests cost economies disappear at around $10 million in assets, but there is disagreement.  This way, banks wont grow unless it really pays.

FDIC insurance charges should be applied to assets (less capital) instead of core domestic deposits.  It is the assets that put the deposits at risk, so the insurance tax should be applied there, and be higher the more complex and opaque the assets carried on the balance sheet of the bank.
Off balance sheet and “repo” activities should be more transparent and better monitored, making them more difficult.  These can’t be ways for banks to avoid compliance (by temporarily offloading those “troubling assets” that might violate regulations in a repo in exchange for wonderful cash or Treasury securities for example).

These regulatory changes would raise the cost of getting large, force the capital increases needed as risk rises, and force banks to actually realize the cost savings or benefits allegedly produced by “bigness” so that the return on investment will not be compromised.  Regulators would not need to arbitrarily set limits on bank size since the regulations would compel banks to raise capital as needed and to realize alleged scale economies to maintain a competitive return on investment.  That, or shrink, reduce leverage and opacity to earn a competitive return for shareholders.  This is just what the “regulator doctor” ordered.