Liquidity Traps: Refuting the Irrefutable

In a recent article at Cato Unbound, titled Tim Congdon on Liquidity Traps vs. Portfolio Rebalancing, Robert Hetzel says: (emphasis mine)

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

Hetzel is trying to demonstrate that the Federal Reserve can still influence aggregate demand even when the interest rate is against the lower bound (0%). Unfortunately, his irrefutable, logical conclusion is actually quite refutable and illogical. In Hetzel’s theoretical world, individuals willingly part with all of their assets (food, clothes, shelter, etc) in order to receive non-interest-bearing money from the government. Since the central bank owns all of the assets, individuals are then forced to purchase goods back from the central bank. (An aside: How does the central bank choose the price to charge?) While this certainly does stimulate expenditure, since individuals could not otherwise survive, history and logic suggest this moment could never arise. Using the same basic premise, here is a different possible conclusion:

A central bank decides to engage in unlimited open-market purchases. After parting with many/most of their assets, individuals realize that without food (assets) they will be unable to survive. These individuals resist exchanging their remaining sustenance for non-interest-bearing money. Working backward from that endpoint, individuals will begin to hoard physical assets. As other individuals try to purchase goods with money, the money price of assets will rise dramatically (money is devalued). The central bank’s actions will stimulate expenditure until individuals are no longer willing to accept money as a means of exchange.

Although both examples initially result in increasing expenditures, the second example is far from desirable for any economy. Based on this more realistic conclusion, some level of open-market purchases will likely pressure individuals to refrain from participating in the exchanges. An unlimited amount would therefore completely undermine the value of non-interest-bearing money.

To be clear, I am not suggesting that open-market purchases are inherently bad. My example simply makes clear that open-market purchases may have stimulative effects on short term expenditures, but longer-term costs that far exceed those benefits. As the great Frédéric Bastiat noted many years ago: (emphasis mine)

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause--it is seen. The others unfold in succession--they are not seen: it is well for us if they are foreseen. Between a good and a bad economist this constitutes the whole difference--the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil.

Bastiat, Frédéric (2005-05-31). Essays on Political Economy (Kindle Locations 485-491).

Harvard Students Walkout on Modern Economics

From the Harvard Political Review online, An Open Letter to Greg Mankiw:

The following letter was sent to Greg Mankiw by the organizers of today’s Economics 10 walkout. 

Wednesday November 2, 2011 

Dear Professor Mankiw— 

Today, we are walking out of your class, Economics 10, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society. 

As Harvard undergraduates, we enrolled in Economics 10 hoping to gain a broad and introductory foundation of economic theory that would assist us in our various intellectual pursuits and diverse disciplines, which range from Economics, to Government, to Environmental Sciences and Public Policy, and beyond. Instead, we found a course that espouses a specific—and limited—view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today. 

A legitimate academic study of economics must include a critical discussion of both the benefits and flaws of different economic simplifying models. As your class does not include primary sources and rarely features articles from academic journals, we have very little access to alternative approaches to economics. There is no justification for presenting Adam Smith’s economic theories as more fundamental or basic than, for example, Keynesian theory. 

Care in presenting an unbiased perspective on economics is particularly important for an introductory course of 700 students that nominally provides a sound foundation for further study in economics. Many Harvard students do not have the ability to opt out of Economics 10. This class is required for Economics and Environmental Science and Public Policy concentrators, while Social Studies concentrators must take an introductory economics course—and the only other eligible class, Professor Steven Margolin’s class Critical Perspectives on Economics, is only offered every other year (and not this year).  Many other students simply desire an analytic understanding of economics as part of a quality liberal arts education. Furthermore, Economics 10 makes it difficult for subsequent economics courses to teach effectively as it offers only one heavily skewed perspective rather than a solid grounding on which other courses can expand. Students should not be expected to avoid this class—or the whole discipline of economics—as a method of expressing discontent. 

Harvard graduates play major roles in the financial institutions and in shaping public policy around the world. If Harvard fails to equip its students with a broad and critical understanding of economics, their actions are likely to harm the global financial system. The last five years of economic turmoil have been proof enough of this. 

We are walking out today to join a Boston-wide march protesting the corporatization of higher education as part of the global Occupy movement. Since the biased nature of Economics 10 contributes to and symbolizes the increasing economic inequality in America, we are walking out of your class today both to protest your inadequate discussion of basic economic theory and to lend our support to a movement that is changing American discourse on economic injustice. Professor Mankiw, we ask that you take our concerns and our walk-out seriously. 

Sincerely,
Concerned students of Economics 10

Making the Impossible, Possible

Recently I attended a conference discussing the Dodd-Frank financial regulation bill and the problem of "Too Big to Fail" (TBTF) banks. Speaking on one of the panels was Mark Zandi, chief economist at Moody's. Before making his remarks, Zandi prefaced that the potential solutions he would offer for fixing the US housing market were not necessarily ideal but held the greatest potential for actually being adopted. This was certainly not the first time I'd heard a speech prefaced in that fashion, but for whatever reason it struck me differently and led to some perplexing questions.

Most people likely agree that our current economic and political environment is not ideal. Incredible amounts of time and effort is being spent across the country by intelligent people, all trying to find answers to the current problems. Although the options considered in these efforts are surely vast, those recommendations made by politicians and pundits alike, typically focus only on those plans deemed politically feasible. Yet in a democracy, feasibility, to some extent, relies on the public's ability to support a decision. I think it's fair to say that most individuals, myself included, have not spent (and simply don't have) the requisite time necessary to be aware of the ideal options for fixing each sector of the economy. If individuals, broadly, are never made aware of these possibilities, then the odds of public support are clearly diminished. But what if these choices were presented candidly as being ideal along side other options that were deemed more feasible. Would this outlay of options generate more or less support for those policies considered feasible? Would the public occasionally show widespread support for an ideal resolution? Would politicians be praised for providing more information or punished for appearing unwilling to fight for the best outcome?

Breaking with tradition is always risky, but I wonder if more transparency might not lead to greater feasibility. My belief is that expanding knowledge will ultimately lead to better decisions and better outcomes. My hope is that politicians will be willing to test these waters more often and be rewarded by voters for taking that risk.

What are different readers' perspectives on this topic and the questions noted above?

Please share your thoughts through comments...

Please Don't Sell Us Your Goods So Cheaply!

As the weak economic recovery continues, a natural response of individuals is to seek out a scapegoat to blame for the problems. One potential scapegoat that has garnered significant attention the past couple years is China. The problem, as stated by many pundits, politicians and economists, is that China has intentionally undervalued its currency. Supposedly this action not only steals jobs from Americans but also impairs our economic growth. Attempting to right these wrongs, Congress is once again proposing to formally label China a currency manipulator and impose import tariffs. Although this proposal has been debated numerous times previously (and failed to pass each time), an unacceptably high unemployment rate heading into a presidential election year has created some urgency for action. Unfortunately the actual effects of currency manipulation have been substantially misrepresented and passing this legislation will almost certainly hurt employment and economic growth.

To better understand the effects of currency manipulation, it’s important to offer a brief comment about currency valuations more generally. Currencies have value for two primary reasons: the ability to purchase goods and to pay taxes. A currency’s value is based on the amount of goods it can purchase. When multiple currencies are involved, an exchange rate provides a measure by which to compare the purchasing power of two different currencies. If exchange rates were left entirely to markets, the values would be primarily affected by changes in the supply of each currency and the supply of goods. In reality, exchange rates are also impacted by interest rates, inflation, and speculation. At a basic level, exchange rates help balance international trade and reduce transaction costs.

Many Americans are currently taking issue with China’s policy of pegging their currency, the renimbi (or yuan), to the US dollar at a below market level. China accomplishes this feat by increasing the supply of their own currency and buying US dollars. Based on these simple actions, it seems obvious that China is manipulating the value of its’ currency. However, if we consider the actions of other governments around the globe, it becomes clear that practically all governments manipulate the supply of their own currency and interest rates. In fact, the US government has been very active in recent years, increasing the supply of dollars and holding interest rates effectively at zero percent. From this standpoint, practically all countries are currency manipulators.

Getting back to China and the policy debate, maintaining an undervalued currency makes one countries’ goods effectively cheaper. The idea behind this policy is to encourage businesses involved in exporting goods and reduce competition from abroad. To date, this policy has been very effective for China in stimulating exports and preventing imports, as displayed by their sizable trade surplus. Delving a bit deeper, a significant portion of China’s exports are manufactured goods. The primary American argument made against China’s currency policy is therefore based on the notion that China is stealing American jobs, specifically within the manufacturing sector.

While I don’t dispute that US manufacturing jobs are most directly hurt by China’s policy, focusing on the lost jobs ignores all other less obvious effects. From the perspective of US consumers, China is intentionally offering products at below market prices. When Americans purchase goods made in China, the cost is therefore less than that expected in a “free” market, hence US consumers are technically saving money. A question not frequently considered is, what happens to the extra dollars Americans save from buying cheap Chinese goods? Apart from a small amount of saving, these funds are largely used in other means of consumption. If some of this demand goes towards American goods or services, than new jobs will be created to counter those lost in manufacturing. Although it is far easier to explain direct job losses in manufacturing, the positive effects on consumption and demand almost certainly outweigh those costs.

A fascinating aspect of tax and trade policy is the ability to achieve similar outcomes through entirely different measures. Using the Senate’s current bill as an example, one of the proposals is to charge an import tax on Chinese goods. This policy increases the price of those goods, reducing the difference between US and Chinese goods. Another way of achieving this result is directly subsidizing American production of those goods currently being imported from China. Under this plan, tax revenue lowers the price of US goods, thereby shrinking the price discrepancy between the two countries. In both cases, most Americans will spend more of their income for the same amount of goods. While these options attack the “problem” from different angles, the economic effects on Americans is basically identical. Despite this fact, my guess is most Americans would oppose a bill explicitly subsidizing a small group of manufacturers using everyone’s tax dollars.

The situations described above reflect a market with only two competing nations, which is certainly not reflective of today’s global economy. In relation to proposed legislation, it’s important to consider how this alters the effects. America remains the global super power in terms of its economic wealth and is still largely unrivaled. Based on wealth and numerous regulations, the cost of living (in dollars) in the US is much higher that most other countries. China, with a much lower cost of living, is primarily competing with other developing nations to sell its exports to Americans. Raising the cost of Chinese imports is therefore much more likely to shift demand to another developing nation than increase domestic demand. Unless import tariffs are applied broadly to all nations (which would be a terrible policy), US manufacturing jobs will remain expensive on the global market.

Another consideration regarding US trade with China concerns the enormous sum of dollars that China receives for all its exports. As mentioned earlier, the value of currency stems from the ability to purchase goods and pay taxes. Clearly China has no use for dollars in paying taxes. Since China pegs their currency to the US dollar, the option of converting dollars into another currency is largely taken off the table. The remaining option, which China uses, involves investing their dollars in US dollar-denominated assets such as Treasuries. Many of the dollars used to purchase Chinese goods actually return to the US in the form of investment and are then spent employing other capital.

Looking beyond the potential impact on US manufacturing jobs, it’s fairly obvious that Americans incur large benefits from China’s currency policy. I think this point becomes even clearer when considering the policy’s effects on the Chinese people. In China, many workers are employed to manufacture goods largely consumed by Americans. The dollars obtained from these exports are then invested in the US. As the US runs large deficits and holds interest rates at zero, China’s dollar-denominated assets are losing value in real terms. Also, due to the currency peg, US monetary policy is effectively imported and currently enhancing inflationary pressures. For many Chinese workers, these policies are effectively suppressing their wages while pushing food and energy prices higher. In effect, China’s currency policy is now causing the real wages of individuals to decline.

Although my economic views favor free trade, I should note that negative consequences stemming from China’s currency policy do exist. By subsidizing their own exports, China has generated an incredibly large trade surplus in total and with the US. This policy increases economic dependence between nations. Partially due to China’s reliance on exports, when global demand falls (especially in the US and Europe), domestic demand is not strong enough to support current production. The result is a surplus of unwanted goods and significant losses on investment. As witnessed during the last recession, a stimulus package, three times the size of that enacted in the US (based on % of GDP), was needed to prevent economic contraction. Systemic risk is certainly increased by China’s trade policy.

In today’s world, policies are frequently established to correct specific problems while ignoring the wide-ranging consequences of those initiatives. Current claims about China stealing American jobs dismisses the massive benefits consumers obtain and overlooks the nature of shifting demand in global trade. During the 1930’s, countries on the gold standard erected tariffs to prevent losing capital to other nations. Global trade fell dramatically, further exacerbating the Great Depression. Creating new barriers to trades, while earning brownie points for some politicians, will only increase our economic struggles and make a sustainable recovery that much more difficult. Hopefully the current debate on China’s currency policy will prove only for show and not be foolishly enacted.

(Note: Don Boudreaux at Cafe Hayek has written a number of great posts on the same theme recently. For anyone interested in further examples of the benefits of China’s currency policy, I strongly suggest reading through his blog posts.)

Slovakia Party Leader Sets Good Example

Sorry posts have been lacking recently as my schedule has become increasingly busier. In terms of the global economy and markets, not much has changed as politicians continue to talk of solutions but no action has been taken. As the Euro-zone heads toward recession and problems escalate, an initial expansion of the EFSF (much more will be necessary) is being held up by two smaller countries within the EU. The following is an interview of Richard Sulik, a party leader in Slovakia, posted by Zero hedge. Although I had previously been unaware of Mr. Sulik, his comments are particularly noteworthy for being honest about the extent of problems within the economic and political realm. Most notably, Sulik recognizes that too much debt cannot be cured with more debt, politicians should not bailout banks that knowingly made risky bets and countries must be constrained by some rules. If only other politicians were willing to be this honest...

Slovakia On Why It Votes "No" To EFSF Expansion: "The Greatest Threat To The Euro Is The Bailout Fund Itself":

Yesterday we reported that tiny Slovakia's refusal to ratify the expansion of the EFSF 2.0 (even though a 4.0 version will be required this week after the "Dexia-event"), may throw the Eurozone into a tailspin as all 17 countries have to agree to agree to kick the can down the road: even one defector kills the entire Swiss Watch plan. Yet an interview conducted between German Spiegel and Slovakia party head Richard Sulik confirms that tiny does not mean irrelevant, and certainly not stupid. In fact, just the opposite: his words are precisely what the heads ot the bigger and far less credible countries should be saying. Alas they are not. Which is precisely why the euro is doomed.

From Spiegel:

Only two countries, Malta and Slovakia, have yet to ratify the expansion of the euro bailout fund. Its fate may be in the hands of a minor Slovak party headed by Richard Sulik. In an interview, the politician explains why he hopes the fund will fail and what he sees as the only way to save the euro.

SPIEGEL ONLINE: Mr. Sulik, do you want to go down in European Union history as the man who destroyed the euro?

Richard Sulik : No. Where did you get that idea?

SPIEGEL ONLINE: Slovakia has yet to approve the expansion of the euro backstop fund, the European Financial Stability Facility (EFSF), because your Freedom and Solidarity (SaS) party is blocking the reform. If a majority of Slovak parliamentarians don't support the EFSF expansion, it could ultimately mean the end of the common currency.

Sulik: The opposite is actually the case. The greatest threat to the euro is the bailout fund itself.

SPIEGEL ONLINE: How so?

Sulik: It's an attempt to use fresh debt to solve the debt crisis. That will never work. But, for me, the main issue is protecting the money of Slovak taxpayers. We're supposed to contribute the largest share of the bailout fund measured in terms of economic strength. That's unacceptable.

SPIEGEL ONLINE: That sounds almost nationalist. But, at the same time, you've had what might be considered an ideal European career. When you were 12, you came to Germany and attended school and university here. After the Cold War ended, you returned home to help build up your homeland. Do you care nothing about European solidarity?

Sulik: If we now choose to follow our own path, the solidarity of the others will also crumble. And that would be for the best. Once that happens, we would finally stop with all this debt nonsense. Continuously taking on more debts hurts the euro. Every country has to help itself. That's very easy; one just has to make it happen.

SPIEGEL ONLINE: Slovakia's parliament is scheduled to vote on the bailout fund expansion on Oct. 11. How do you predict the vote will turn out?

Sulik: It's still open. The ruling coalition is composed of four parties. My party will vote "no"; the other three coalition parties intend to say "yes." What the opposition says is decisive.

SPIEGEL ONLINE: The Social Democrats have offered your coalition partners to support the reform in return for new elections. Do you think the coalition is in danger of collapse?

Sulik: I don't see any reason why it would.

SPIEGEL ONLINE: What will you do should the EFSF reform pass despite your opposition?

Sulik: For Slovakia, it would be best not to join the bailout fund. Our membership in the euro zone, after all, was not conditional on us becoming members of strange associations like the EFSF, which damage the currency.

SPIEGEL ONLINE: If the euro only causes problems, why doesn't Slovakia's government just pull the country out of the euro zone?

Sulik: I don't see the euro as the problem. It's a good project. Everyone involved can benefit from it -- but only if they stick to the ground rules. And that's exactly what we're demanding.

SPIEGEL ONLINE: Which ground rules should we be following?

Sulik: We have to observe three points: First, we have to strictly adhere to the existing rules, such as not being liable for others' debts, just as it's spelled out in Article 125 of the Lisbon Treaty. Second, we have to let Greece go bankrupt and have the banks involved in the debt-restructuring. The creditors will have to relinquish 50 to perhaps 70 percent of their claims. So far, the agreements on that have been a joke. Third, we have to be adamant about cost-cutting and manage budgets in a responsible way.

SPIEGEL ONLINE: Many experts fear that a conflagration would break out across Europe should Greece go bankrupt and that the crisis will spill over into other countries, including Portugal, Spain and Italy.

Sulik: Politicians can't allow themselves to be pressured by the financial markets. Just because equity prices fall and the euro loses value against the dollar is no reason for giving in to panic.

SPIEGEL ONLINE: But do you really believe that politicians can calm the financial markets by stubbornly sticking to their principles?

Sulik: Let's just ignore the markets. It's ridiculous how politicians orient themselves based on whether stock prices rise or fall a few percentage points.

SPIEGEL ONLINE: You're not afraid that a Greek insolvency could mark the beginning of the crisis instead of the end?

Sulik: No. There's not going to be a domino effect along the lines of "first Greece, then Portugal and finally Italy." Just because one country goes broke doesn't mean the other ones automatically will.

SPIEGEL ONLINE: Nevertheless, banks could run into significant problems should they be forced to write down billions in sovereign bond holdings.

Sulik: So what? They took on too much risk. That one might go broke as a consequence of bad decisions is just part of the market economy. Of course, states have to protect the savings of their populations. But that's much cheaper than bailing banks out. And that, in turn, is much cheaper than bailing entire states out.

SPIEGEL ONLINE: Does one of your reasons for not wanting to help Greece have to do with the fact that Slovakia itself is one of the poorest countries in the EU?

Sulík: A few years back, we survived an economic crisis. With great effort and tough reforms, we put it behind us. Today, Slovakia has the lowest average salaries in the euro zone. How am I supposed to explain to people that they are going to have to pay a higher value-added tax (VAT) so that Greeks can get pensions three times as high as the ones in Slovakia?

SPIEGEL ONLINE: What can the Greeks learn from the reforms carried out in Slovakia?

Sulik: They have to make cuts in the state apparatus. The Slovaks could also give them a few good ideas about the tax system. We have a flat tax when it comes to income taxes. Our tax system is simple and clear.

SPIEGEL ONLINE: One last time: Do you honestly believe the euro has any future at all?

Sulík: I believe the euro has a future. But only if the rules are followed.

Interview conducted by Maria Marquart

Social Security is a Ponzi Scheme?

Monday night’s Tea Party debate featured discussion about Social Security as a Ponzi scheme. Over the past several days this conversation has garnered an increasing amount of blog space. Given the extensive attention currently being paid to this topic and potential that it continues through next year's election, I decided to offer my own thoughts.

Before outlining my view, I think it’s important to clarify the criteria being considered to determine a Ponzi scheme. The following is directly from the SEC’s website:

“A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.”

While I believe this definition should be used as the basis for discussion, recent commentary suggests various other definitions are being considered. If that is the case, I’d urge politicians and others offering opinions to clarify their definition. Without knowing the basis for comparison, it is difficult to judge the merit of their views. However, since alternative definitions have not been provided, the one noted above will serve as the standard for my argument.


Although I disagree with the opinion that Social Security is a Ponzi scheme, acknowledging why some may make that argument will aid in debunking the theory. The basic design of Social Security provides benefit payments to older, retired individuals that are largely funded from payroll tax revenues paid by younger, income earning individuals. When the baby-boom generation entered the work force, yearly payroll tax revenues greatly exceeded Social Security benefit expenses and a trust fund was created to “hold” the surplus funds while accruing interest. Now, as the baby-boom generation retires and starts collecting benefits, payments have begun exceeding revenues. Based on demographics, these yearly deficits will continue to widen, ultimately exhausting the trust fund. Since payroll taxes will no longer cover all benefit payments, the expectation is that Social Security cannot fulfill its current promises. Whether or not one deems this outcome to be fraud, I believe this scenario leads many to believe Social Security is a Ponzi scheme.


Having established a basic premise for calling Social Security a Ponzi scheme, the deficiencies of that argument can be set forth. In the above scenario, an assumption is made that when the trust fund is exhausted, Social Security will be unable to pay promised benefits in full. A critical error within this assumption is the apparent view that Social Security is a stand alone program, not incorporated within the federal government’s budget. To some this may seem an inconsequential difference, however this small fact is crucial to determining the eventual solvency of the program.


The US government is a currency issuer, which means that under the current monetary system, the government can never run out of dollars. Ponzi schemes ultimately fail when a sufficient amount of new funds can not be obtained to repay all investment "returns" and withdrawals. With Social Security, when payroll taxes are no longer sufficient to provide the entirety of earned benefits, the government is required to supply the difference. Since the government never has to borrow funds in order to spend, regardless of tax revenue, Social Security benefits can always be paid in full.


As long as the US government remains a currency issuer, claims that Social Security is a Ponzi scheme are as foolish as comparing the solvency of the US government to either Greece or households. Apart from self-imposed constraints, the US federal government can always repay debt denominated in dollars, including future Social Security benefits. The one crux of this argument is that excessive money printing (deficit spending) can create inflation during periods of near full-employment. Stemming from this issue, the true question regarding Social Security and all government expenditures is whether tax levels are appropriate for the chosen size of government.


Social Security benefits can be provided indefinitely and therefore suggestions that the system is a Ponzi scheme are misunderstandings, at best, or at worst, intentional misrepresentations. Too much recent time and effort has been directed at worrying about deficits, both current and future. Our nation would be better served to focus on current problems of excessive private debt and longer-term concerns about the desired size of government. Hopefully our leaders will direct their attention and the nation’s to these problems in the days ahead.

Europe Bests US in Stock Opportunities

Following the global recession a couple years ago, I thought discussion about different sections of the global economy decoupling from one another would have ceased. Surprisingly, as Europe seemingly begins another economic downturn (several countries are already in a recession or depression), many investors and analysts remain of the opinion that Europe's problems will be largely contained. Will Europe's economic troubles be contained in the same manner as the US housing bubble (which was decidedly not)?

A post today on Pragmatic Capitalism, by Surly Trader titled UNITED STATES VERSUS EUROPE, highlights the divergence between the Eurostoxx 50 and S&P 500. The graph below compares the performance of these two stock indexes since the March 2009 lows. As you'll notice, the indexes initially moved significantly higher together, with Europe even outperforming to a small degree. Correlation remained pretty tight throughout the first portion of the sovereign debt crisis until May of this year. Since then, the S&P 500 is down nearly 15%, but the Eurostoxx 50 has lost more than 40%. Although a significant portion of the difference may stem from European banks (which currently face much larger funding issues), numerous other companies have been dragged down with the broader index.

Anyone reading or watching financial news over the past several weeks has surely heard a vast number of individuals argue that US stocks are extremely cheap based on forward looking earnings estimates. Ignoring for a moment that these estimates are almost always too optimistic, if one believes US stocks are cheap based on those metrics, than Europe is screaming "buy." As the article notes,

"The Eurozone is facing massive political headwinds, but at a dividend yield of 5.98% and P/E of 8.35, it looks relatively attractive versus the S&P 500′s 2.23% dividend yield and 12.71 P/E."

Based on these stock indexes, it certainly seems that Europe is pricing in a far worse economic outlook than the US. Holding the belief that if Europe experiences a significant economic downturn, the US will also be dragged into recession, European stocks, broadly, appear to offer a better risk/return profile.

Recent strength in US markets seems partially related to hope that the EU crisis will be kicked further down the road and that some version of QE3 will be announced next week. I've previously stated why the latter will be ineffective, apart from a short-term boost to stocks, and believe time is running out on the former. My personal view is to remain defensive, focusing on companies with strong balance sheets and large dividend yields. Two names within the Eurostoxx 50 that seem particularly enticing (and I currently own) are Sanofi (SNY) and Total (Tot). Both stocks trade at or below book value, sport P/E's below 7 and offer dividend yields above 5%. Maintaining a 3-5 year investment horizon, I believe these companies will offer significant relative value.

Inflation is NOT the Answer

A couple weeks ago I argued against the numerous economists calling for the Fed to establish higher inflation targets as a remedy for excessive debt. My concerns were centered around the notion that inflation does not create wealth, but rather transfers it from creditors to debtors. Since that post, several FOMC members, including Chairman Bernanke, have spoken about the current state of the economy and potential stimulative actions the Fed could take at its next meeting. Much of the commentary has been typical Fed speak, which involves saying very little in a manner that is difficult to decipher. However, parsing through words and actions has led a majority to expect some form of new quantitative easing to be announced on September 21st.

Recently, on Project Syndicate, Raghuram Rajan (finance professor at the Univ. of Chicago) penned an article titled, Is Inflation the Answer?. Rajan is effectively arguing against the same calls for much higher, short-term, inflation. Although the piece makes a brief note about the distribution effects of such a policy, the focus is on the effectiveness of creating higher inflation.

One critical factor that could hinder effectiveness is the Fed’s credibility. Having maintained a specific target for a long time, the unintended consequences of suddenly changing policy are unknown. If the target can be changed once, why not again, and again? A moving inflation target would also be difficult to explain within the realm of price stability. Were the Fed to raise the target temporarily, given its prior track record, why should the market expect inflation to remain under control? Within this realm of possibility, its fairly easy to foresee an outcome where inflation rises well beyond new targets and ultimately needs to be reigned in Volcker-style. For anyone who lived through that experience, recollections of the early 1980’s recession and double-digit unemployment are probably not pleasant.  

The other significant deterrent Rajan notes relates to the maturity length of current debt. A policy of high inflation is primarily beneficial if nominal income growth outpaces interest on debt. However, if debt needs to be rolled over in the near future (due to maturity), the new debt will require much higher interest rate payments. In that scenario, higher inflation’s impact on reducing debt burdens is minimal. As Rajan notes, this largely reduces the positive influence on government debt, bank liabilities and households with floating rate mortgages.

While I agree with nearly all of Rajan’s points in this article, one point I must argue against is the notion that “[foreign] investors might be needed to finance future deficits.” As I’ve shown numerous times before through MMT, the US government never needs to finance deficits. Aside from that opposition, I think Rajan makes a wonderful case against higher inflation. In conclusion, he adds suggestions for outright debt relief through write-downs. I remain convinced that this method of reducing debt burdens should be the primary focus of current federal policy.

Equity Analysts' Forgotten Word: Sell

Each day, various Wall Street equity analysts update stock recommendations and issue new opinions on previously uncovered securities. Depending on the mood of the market and prestige of the analyst, these recommendations can move a stock by several percent in a day. Numerous investors and money managers pay significant sums for these opinions, which subsequently aid in determining whether to buy, sell or hold specific stocks. Considering the amount of money spent on employing these analysts and the profit derived from their reports, one is persuaded to assume significant predictive value lies within Wall Street's research. Is this a fair assumption, or is Wall Street selling snake oil?

Well, according to recent data "published by Sam Stovall, the chief investment strategist of Standard & Poor’s Equity Research," the answer is almost certainly the latter. An article on MarketWatch yesterday by Robert Powell titled, Things are bad, but analysts can’t say ‘sell’, highlights Stovall's analysis. The numbers speak for themselves:

“Consider, at a place and time such as this, with the economy teetering on the verge of another recession, none of the 1,485 stocks that make up the S&P 1,500 has a consensus “Sell” rating. And just five, or 0.3%, are ranked as being a “Weak Hold.””

"There were (don’t laugh) just 167 (0.08%) “Sell” recommendations and 697 (4.2%) “Weak Hold” recommendations out of a total of the 19,868 Wall Street research reports reviewed in Stovall’s analysis."

Although Stovall's research screams of bias, he attempts to conceive of valid reasons the numbers are so skewed. One explanation offered is that “if stocks for the long run are on an upward trajectory, then everything is a hold.” At first glance this statement appears plausible enough to gloss over, but upon further examination it is extremely flawed.

When people discuss stocks having risen throughout history, they are generally referring to an index such as the S&P 500 or Dow. An important factor often overlooked in this comment is that those indexes are weighted based on market capitalization and price, respectively. This means that stocks which perform better over long periods exert far greater influence on the direction of the entire index than stocks that perform poorly. It should also be remembered that the worst stocks are frequently swapped out of these indexes for stronger ones, creating a survivor bias. Consider these stocks from 1980:

Allied Chemical, American Can, American Tobacco B, Bethlehem Steel, General Foods, Inco, International Harvester, Johns-Manville, Minnesota Mining & Manufacturing, Standard Oil, Texaco, Union Carbide, Westinghouse Electric, and Woolworth.

Those companies were all included in the Dow at the start of the 1980’s, yet many of the names are likely foreign to investors today because the stocks (and companies) no longer exist. The point that Stovall’s reasoning misses is one of basic capitalism. In the long run, most companies fail as new technologies and forms of production eliminate economic profits. The only way to avoid this outcome is through monopolies, either natural or government created. So unless analysts believe capitalism no longer exists in the US, it makes little sense to assume all stocks are at least a hold.

In our everyday lives, if a friend always gave the same advice, most of us would likely stop seeking advice from that friend. Regardless of the economic or market outlook, Wall Street recommendations consistently and uniformly provide the same guidance. Despite this knowledge, markets and investors continue to hand over money for Wall Street’s opinions. Stovall’s analysis is a helpful step towards unveiling the truth about Wall Street recommendations. Hopefully further research will expose the currently subjective process and ensure that stock recommendations are more objective in the future.

Inflationary Outlook Resembles Depression Era

Yesterday I remarked that current economic troubles are reminiscent of the depression era that Keynes and Hayek lived through. At that time, Keynes believed that deflation would continue indefinitely and sought actions that might prevent a deflationary spiral. Despite Keynes' brilliance, there were many factors influencing the post-World War II global economy that he failed to foresee. An influx of cheap natural resources from abroad, expanding global trade, the baby boom generation and government deficits all helped reverse the deflationary trend and create nearly constant inflation in the US ever since.

Although the US appears on the verge of recession, Americans are more concerned with hyperinflation than outright deflation. Randall Wray, an economics professor at the University of Missouri-Kansas City (and fellow Wash U alum), explains why The prospects for inflation have not been smaller since 1930. Wray is one of the top economists today promoting Modern Monetary Theory (MMT), hence his views on inflation versus deflation deserve significant attention. As Wray points out (and I have detailed previously), a primary reason Americans fear inflation relates to a misunderstanding of recent monetary policy conducted by the Federal Reserve. One cannot accurately assess the impact of quantitative easing without understanding how bank reserves function in a modern monetary system. The linked piece offers a wonderful, yet simple explanation for the casual reader.

Ultimately, inflation or deflation is about the quantity of money chasing a certain number of goods. As Wray notes, significant unemployment, declining real income and large household debt imply the direct opposite of hyper, or even high, inflation. If Wray's outlook proves true, investors currently rushing into gold and other commodities will find themselves on the wrong end of the trade. For most individuals, this prognosis should not be taken as negatively as typical news commentary would have one believe. Over the past decade, Japan's real GDP growth averaged .8% per year, despite averaging .3% deflation. During the same period, U.S. real GDP growth averaged only 1.6%, with average inflation of 1.9%. Many other factors certainly impacted economic growth, however a majority likely favor the US, rendering the minor disparity even less noteworthy.

I urge those readers concerned about inflation or considering investing in gold to read through Wray's entire piece for a different perspective. Given the struggles presently facing the global economy, hyperinflation should be the least of our concerns. Once we stop fighting the problems we don't have, policy making can return to focusing on the problems we do.



Interesting note: During the decade discussed above spanning 2001 to 2010, the Fed almost perfectly achieved its long-run inflation target of 2% (based on core PCE inflation). Even though the Fed was successful, real GDP growth over that span was the weakest experienced since the depression. The period mentioned also witnessed violent swings in prices. One personal suggestion for the future, is that our society rethinks the goals of the Federal Reserve and monetary policy.

The Next Keynes

“One thing is certain: if there is another Keynes out there, he or she will be someone who shares Keynes’s most important qualities. Keynes was a consummate intellectual insider, who understood the prevailing economic ideas of his day as well as anyone. Without that base of knowledge, and the skill in argumentation that went with it, he wouldn’t have been able to mount such a devastating critique of economic orthodoxy. Yet he was at the same time a daring radical, willing to consider the possibility that some of the fundamental assumptions of the economics he had been taught were wrong.”

-Introduction by Paul Krugman to The General Theory of Employment, Interest, and Money, by John Maynard Keynes

Nearly 80 years ago, the Great Depression and World Wars inspired a debate between two of the greatest economists of the 20th century, John Maynard Keynes and F. A. Hayek. The global economic paralysis and social upheaval of their time could not be explained or remedied by then current economic theories.  Both men relied heavily on knowledge of past research and experience to forge recommendations for a new path forward. Since then, their alternative perspectives have largely shaped political discussion of macroeconomics. Although Keynes’ ideas garnered significant weight first, Hayek’s warnings have proved extremely prescient regarding the outcome of government intervention.

Today’s global economy appears more reminiscent of that period than any time since. Industrialized nations are teetering on the edge of another recession, struggling to find solutions in the face of impotent monetary policy. Meanwhile, within the developing world, radical changes are being brought about by revolts against enshrined leadership. Numerous lessons learned during the early 20th century have been forgotten and must be re-learned. However, much has also changed about the global economy throughout the decades. While the old lessons remain important, modern theories are warranted to address today’s political and economic issues.  

So far, the Great Recession has failed to spur any radical changes from previous conceptions of macroeconomics or political theory. Witnessing mass unemployment and increasing levels of poverty around the globe, one can only hope that new theories and practices will be developed that inspire a brighter future. While I certainly don’t expect to become the next Keynes (or Hayek), I believe the qualities noted above that made Keynes special are worth striving towards. Moving forward it’s incredibly important that theorists fully understand the strengths and weaknesses of historical theories, yet are willing to step beyond the boundaries and approach today’s questions from a fresh perspective.

Stemming from the current economic malaise and general dissatisfaction with government is a willingness to accept novel ideas. The directions taken will likely determine the length of the current crisis, as well as size and forms of governance for years to come. The time is ripe for another Keynes. Hopefully our generation will find and listen to him or her.

Poor Premise Supports Corporate Tax Holidays

In Foreign Income Rising, I discussed the potential for another corporate tax holiday to allow repatriation of foreign income. This evening, Andrew Ross Sorkin discusses the matter along with a recent proposal to reduce the employer portion of Social Security taxes (link below). Sorkin reaches a similar conclusion that temporary tax breaks are unlikely to result in significant job growth but will increase the federal deficit. While the source of the proposals (Chamber of Commerce) should make clear which group's priorities are being considered, it's important that politicians recognize the source of our current economic weakness. Business are not hiring because demand for their goods is not significant or stable enough to warrant new employees for increasing production. Demand stems primarily from individuals, who are currently overburdened with debt and choosing to pay down debt rather than increase spending. If temporary tax cuts are desired, the focus needs to be on individuals.

The Fallacy Behind Tax Holidays: Corporate America and Wall Street are engaging in a form of horse trading - tax cuts for jobs. There is one small problem: temporary tax cuts rarely result in new jobs and always result in less tax revenue.

A September to Remember

Three years ago, on September 7th, 2008, the federal government nationalized Fannie Mae and Freddie Mac. The following week, Bank of America bought a Merrill Lynch, Lehman Brothers filed for bankruptcy and AIG was bailed out by the Federal Reserve. During the next couple weeks, Washington Mutual also went belly-up, Wachovia was acquired and the remaining investment banks converted into bank holding companies. In markets, credit spreads widened drastically and equity market volatility heightened substantially, including the S&P 500’s largest loss in history of over 100 points (nearly 9%).  

This year, following a weak August, credit and equity markets have gotten off to a miserable start in September. During the first two days of trading, the S&P lost nearly 4% and at the moment is down close to 3% in the futures market. Losses in Europe are even more staggering, with several major indices already losing nearly 10% this month, following grater than 15% drops last month. Sovereign and bank credit markets, especially in Europe, are also freezing up as the crisis worsens. These are ominous early signs of another September to rival its historic predecessor.

Although only three short years have passed, the global economy appears to be following a similar pattern. After trying to kick the can down the road for more than year, numerous underlying problems are unraveling around the world in concert with one another. Each successive attempt at papering over issues has a shorter shelf-life and the time for politicians to get ahead of the troubles is rapidly decreasing. A quick tour around the world’s major economies will shed light on the ensuing global crisis.

US-

Reminiscent of headlines in 2008, Friday witnessed new troubles stemming from apparently plagued mortgage-backed securities. From the FHFA website (http://www.fhfa.gov/webfiles/22599/PLSLitigation_final_090211.pdf):

Washington, DC -- The Federal Housing Finance Agency (FHFA), as conservator for Fannie Mae and Freddie Mac (the Enterprises), today filed lawsuits against 17 financial institutions, certain of their officers and various unaffiliated lead underwriters.  The suits allege violations of federal securities laws and common law in the sale of residential private-label mortgage-backed securities (PLS) to the Enterprises.  

Complaints have been filed against the following lead defendants, in alphabetical 

order:

1. Ally Financial Inc. f/k/a GMAC, LLC

2. Bank of America Corporation

3. Barclays Bank PLC

4. Citigroup, Inc.

5. Countrywide Financial Corporation

6. Credit Suisse Holdings (USA), Inc.

7. Deutsche Bank AG

8. First Horizon National Corporation

9. General Electric Company

10. Goldman Sachs & Co.

11. HSBC North America Holdings, Inc.  

12. JPMorgan Chase & Co.

13. Merrill Lynch & Co. / First Franklin Financial Corp.  

14. Morgan Stanley

15. Nomura Holding America Inc.

16. The Royal Bank of Scotland Group PLC

17. Société Générale  

These complaints were filed in federal or state court in New York or the federal court in Connecticut.  The complaints seek damages and civil penalties under the Securities Act of 1933, similar in content to the complaint FHFA filed against UBS Americas, Inc. on July 27, 2011.  In addition, each complaint seeks compensatory damages for negligent misrepresentation.  Certain complaints also allege state securities law violations or common law fraud.

Although the full repercussions cannot be known at this time, the fall out may prove very large. While the Obama Administration has been working hard to undermine an investigation by New York’s AG into similar matters, another part of the administration has seemingly subverted those goals. This lawsuit almost certainly dampens the Administration’s hope that the largest banks could avoid serious litigation in return for a small fee ($8.5 billion). Of the institutions listed above, several pose interesting related questions, yet the biggest questions are tied to Bank of America’s solvency.

Witnessing its stock fall more than 50% this year (shown below), Bank of America has continually denied claims about needing to raise capital. Despite these apparently false claims, the bank raised capital by selling warrants and preferred stock, along with a significant stake in the China Construction Bank, at steep discounts. Even with these actions, confidence remains fragile, as shares tumbled again on Friday.

Due to its purchases of Countrywide and Merrill Lynch, Bank of America was effectively sued in three separate claims noted above. Combining these claims generates total claims against in excess of $50 billion. However, these claims only represent a small portion of potential liabilities outstanding related to the sale of MBS and foreclosure fraud. Whether the bank ultimately settles these claims or attempts to fight in court, losses will almost certainly be significant and uncertainty regarding the outcome will weigh on the firm for some time.

Apart from unknown losses discussed above, the bank is also currently sitting on untold losses related to its own mortgage holdings, as well as European bank and sovereign debt. Thanks to the ongoing suspension of mark-to-market accounting, the actual market value of current assets is highly unpredictable. Regardless, markets are suggesting current assets should be marked down by billions of dollars and those numbers can only increase as markets weaken.

How long will the confidence last? With Bear Stearns, Merrill Lynch and Lehman Brothers, the final straw seemed to be when institutional investors began pulling funds in mass. Considering recent votes in the US House, another TARP seems unlikely at this juncture. If Friday’s lawsuits spur another significant sell off in the bank’s stock, institutional investors may decide to seek safety elsewhere. Were a run on Bank of America to occur, it’s hard to envision several other weak banks not being targeted as well. The Dodd

Europe -

On a timeline basis, the sovereign debt crisis in Europe feels most similar to the US housing crisis. Nearly 18 months ago, problems began showing up in EU periphery countries, notably Greece. As yields widened, the country’s solvency was questioned and after ECB intervention, a bailout was concocted. Despite a couple more bailouts, Greece’s economy continues to deteriorate under the weight of austerity and a strong Euro. Over the past few days, short-term yields have exploded upwards, with the 2 year exceeding 50% (shown below). Not only are markets pricing in 100% chance of default, but far more significant losses than the most recent proposals by the EU/ECB. Apparently recognizing Greece represents a solvency issue, not liquidity problem, the IMF and several EU nations are reconsidering any further aid. 

After Greece, Portugal and Ireland also fell victim to economic deterioration and questions regarding their own solvency. These countries have been locked out of credit markets for more than a year now. Having also received bailouts for austerity measures, economic performance has not turned around and debt levels have worsened. Resolutions involving some form of default still appear almost certain.

While most market participants expected Spain to become the next casualty of bond vigilantes, markets surprisingly leap frogged Spain, instead attacking Italy. Starting in July, 10 year yields quickly spiked from under 5% to early 6.5% (shown below). Fearful of the consequences, the ECB once again stepped in to purchase Italian and Spanish debt to stem the rising yields. After successfully pushing yields back below 5%, the markets have once again responded, sending Italian yields back above 5.5% today. 

The recent rise comes after Italy’s government attempted to roll back various austerity measures. As Kiron Sarkar notes in a post on The Big Picture (http://www.ritholtz.com/blog/2011/09/people-who-play-with-fire/):

“The Italians better reconsider their recent attempts to backslide from their commitments – they have a large debt maturity this week – some E14.6bn and E62bn by the end of September (the highest ever in a single month). In total, Italy must roll over E170bn by end December – Whoops.”  

Trying to sell that amount of debt may generate a further sell off in Italian debt, for which the ECB and EU appear unprepared.

Sovereign debt problems are on the verge of spiraling out of control, which is especially scary considering the lack of political unity in Europe. Time is running out on a grand solution and if politicians are forced into a reactive resolution, markets and economies will likely pay the price. As sovereign debt continues to be repriced lower, the resulting market losses are weighing heavily on European banks.

Stock prices of European banks have been falling precipitously over the past couple months. After a brief reprieve due to several countries banning short-selling on the securities, prices are once again falling. As I detailed in Europe Revives Failed Policies of 2008, these measures have been proven to fail and may even worsen the situation. Currently, credit spreads for interbank lending are showing significant strain and approaching levels last witnessed during the crisis of 2008 (shown below, top). Credit default swaps (CDS) on many banks are also reaching new records, potentially stemming from banks trying to hedge counter party risk (shown below, bottom).

Given the global nature of banking, credit problems in Europe may leak into US markets.  Once again, the ECB and Fed (primarily) will be forced to provide liquidity to the financial system. Similarly to the US, if one major bank faces a run, several others are likely to follow. With most of Europe already either in recession or experiencing sub-1% growth, the entire EU risks falling into another recession by year end. Risks are now increasing at a rapid pace, hence the next few weeks promise to be very interesting.

Asia -

After suffering a horrendous earthquake and tsunami, the Japanese economy fell back into recession. While trying to rebuild, global economic fear has sent cash flocking to the safe-haven Yen. Recently hitting all-time highs against the dollar (shown below), a strong Yen has caused exports to falter and hindered the economic recovery. Attempts by the BOJ to intervene in exchange markets have proved woefully unsuccessful. Further hurting the potential for recovery has been an unwillingness to increase deficit spending, which could generate internal demand and weaken the currency. 

As for China, the country has been fighting inflation by raising reserve requirements. History shows that this measure is not particularly successful in reigning in inflation. Recent moves to let the Yuan float higher are more encouraging. China also faces trouble relating to a fixed investment rate near 50%, potential housing bubble and rapidly increasing bad bank debt. Regardless of specific measures taken to thwart these issues, history suggests the most likely outcome is a “hard landing,” which could represent GDP growth below 5%.

For both of these export driven countries, weakening demand from US and Europe will pose significant problems on top of those already established. As the financial crises of 2008 displayed, global economies are very intertwined in today’s world and the troubles of one large nation will exert pressure upon the others. With equity markets in both these counties having already joined Europe in bear market territory, the immediate future is not looking promising (shown below: Hang Seng, Nikkei, Shanghai).

Over the past two years, markets have responded positively to a stimulus led economic recovery across developed nations. Weakening within credit markets has been largely written off as excessive caution. As credit markets weaken further and economic recoveries falter, it appears this time is not different. Equities have been moving quickly to catch up with credit markets on the way down, however the remaining spread still seems quite wide. Unfortunately the global financial system is practically no more transparent than several years ago, which means questions of solvency, plaguing the market, will be hard to defend against. Measures taken in 2008 to provide liquidity and capital will also be significantly harder to pass in a world concerned with sovereign debt and monetary devaluation.

US and German 10 year yields have now joined Japan in the sub-2% club (shown below), which suggests a lengthy period of minimal economic growth and inflation. As equity markets price in a similar outcome, I expect much further declines. A focus on individual companies with strong balance sheets and high dividends should offer great relative value. As for the dollar, equity weakness, global risk and ultimately an interest rate cut by the ECB will likely provide strength. There are times to seek a return on capital and times to seek the return of capital, I believe now is the latter.

Only three years ago, the global economy witnessed the worst recession since the Great Depression. Few people imagined so short a time could pass before the world was once again faced with such enormous challenges. Back then, September marked the period where issues started to really unravel. Could September once again witness the unfolding of historical events? Only time will tell, but based on the first few days, it certainly appears this will be another September to remember.