Wednesday, September 14, 2011

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.

Tuesday, September 13, 2011

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 Capitalismby 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.

Sunday, September 11, 2011

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.

Thursday, September 8, 2011

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.

Wednesday, September 7, 2011

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.

Tuesday, September 6, 2011

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.

Monday, September 5, 2011

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.


Reminiscent of headlines in 2008, Friday witnessed new troubles stemming from apparently plagued mortgage-backed securities. From the FHFA website (

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 
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 (

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.

Thursday, September 1, 2011

Roberts: The Microeconomics of the Broken Window Fallacy

As a DC resident, last week I experienced both an earthquake and a hurricane. Thankfully neither resulted in significant injuries within the impacted areas and property damage was also less than some might have expected. These experiences have provided opportunity for several economists to once again discuss the economic effects of natural disasters. Earlier this year, when Japan was hit by a terrible earthquake and tsunami, numerous economists and market "experts" noted that the destruction would be positive for economic growth due to rebuilding efforts. Similar comments sprung up following Hurricane Irene's treacherous path across the eastern seaboard.

These discussions are precisely when better definitions of economic growth are needed apart from GDP. Based on my understanding, if someone's car was destroyed and they choose to replace the vehicle by purchasing another, that purchase adds to GDP, while the lost vehicle subtracts nothing. From a real world perspective, the person whose car was demolished is now worse off, since they still own only one car but are now out a significant sum of money. Meanwhile, the car salesman is only better off by the amount the other individual spent. On the whole the economy is not better off since the amount of goods remains the same. GDP therefore fails to account for the depreciation or destruction of asset value, which plays a significant role in establishing wealth and economic well-being.

Russ Roberts of Cafe Hayek, who helped create the "Fight of the Century" videos (linked below), provides a wonderful example of what's known as the broken window fallacy. His counterpart on the website, Don Boudreaux, also had a humorous retort to Peter Morici (Professor at University of Maryland) regarding this fallacy and his willingness to destroy property for payment in order to benefit others ( I urge those not familiar with the argument to read the articles and determine which theory is more compelling.

The Microeconomics of the Broken Window Fallacy:
The Keynesian defense of breaking windows or the economic virtues of hurricanes would go something like this:
Yes, breaking windows is destructive. Yes, it reduces wealth. But when there are large amounts of unemployed resources, say in the glass business, then breaking windows is close to a free lunch. In a world of unemployed glaziers, breaking windows can jump-start the economy by putting the unemployed back to work. They will spend the money they receive for repairing the broken windows.
When confronted with the claim by those of us who like Bastiat, that the money to repair the windows will now be unavailable to spend on something else, the Keynesian responds like this:
But people are sitting on money that is doing nothing. The insurance company that will now pay back the homeowner whose house was damaged by the hurricane was sitting on piles of cash. That cash was sitting in the bank where the bank has excess reserves not being lent out, not being invested. So yes, breaking windows can improve the incomes of glaziers and start a process of recovery.
What do we respond, those of us who are enamored with Bastiat and who think he’s right?
I would re-state the Bastiat story and tell it a little differently than it is usually told. The usual point is that the money has to come from somewhere–we see the repaired window but ignore the things that don’t get built or bought. But I think a better way to tell the story is to point out that the RESOURCES have to come from somewhere. The hurricane increases the demand for glaziers and that is good for glaziers. But that is good for all glaziers, employed and unemployed. It pushes up the price of glass repair. That discourages some folks from having glass work done who otherwise would have done it. So there is some offset of the hurricane’s impact on glazier employment. And as the Hayek character says in “Fight of the Century“:
You see slack in some sectors as a “general glut”
But some sectors are healthy, only some in a rut
So spending’s not free – that’s the heart of the matter
Too much is wasted as cronies get fatter.
So while glaziers (and carpenters) may be unemployed, other sectors (such as the wood market) may not be having such problems. The hurricane has a big impact on the price of wood, discouraging a bunch of would-be demanders of wood from buying as much as they did before. Again, there’s an offset. The point is that “aggregate demand” doesn’t tell the whole story.
But the real problem with breaking windows is that it’s not productive. I know. That’s obvious. But think about what the words mean. Right now, there are a lot of unemployed construction workers. What does a hurricane do? A hurricane IS good for carpenters and glaziers and roofers. But it’s unproductive work. It gets the home owner back to the status quo. It doesn’t create anything new or valuable. I’m not saying the production is wasted. I’m saying it’s a repair. Why is that important?
Imagine a world where there hasn’t been a hurricane and I want to help the unemployed carpenter. Here are two ways to do so. One is to burn my house down and then call the carpenter and give him $100,000 to rebuild my house. Here is the second way. I call the carpenter and say, I feel bad that politicians artificially increased the demand for housing at the end of the 20th century, pulling you into an industry that cannot be sustained at its current leve. I feel bad that you’ve been unemployed for three years. So I’m going to give you $100,000.
Which of those two policies would have the bigger stimulative effect? The charity should have a bigger effect. No offsets from pushing up the price of lumber and so on. But giving people money doesn’t change the underlying problem that there are more carpenters than work available for them. Creating temporary work either by burning down houses deliberatively or accidentally through a hurricane doesn’t change the fact that there are too many carpenters and glaziers relative to demand.
So the hurricane will put carpenters back to work. But it would be even better if there had been no hurricane and people had just given them a check. Charity is more productive than destroying stuff and paying people to get back to square one.
But the charity approach is what we’ve been doing for the last few years. It’s called unemployment insurance. I know, it’s supposed to be stimulative but there’s no sign that it is. Why would it be? It doesn’t solve the problem that there are too many carpenters.
This is related what Arnold Kling calls “Patterns of Sustainable Specialization and Trade.” Repairing houses damaged by a hurricane isn’t sustainable. And if I just give carpenters money because I feel sorry for them, that isn’t trade. That’s charity. Both have the same stimulative effect–very little, because they don’t get at the underlying problem. Prosperity is the way we specialize and serve each other, creating products and services that we each value. Destruction cannot be the source of prosperity.

Guest Post: One Death is a Tragedy, One Million is a Statistic

At this point, most readers are likely aware of my skepticism towards broad headlines and general government statistics. For those seeking greater insight into the ways GDP misrepresents economic well-being or other similar issues, I suggest reading the free book, Mismeasuring Our Lives: Why GDP Doesn't Add Up by Joseph Stiglitz, Amartya Sen and several others. In the meantime, Peter Tchir of TF Market Advisors, details a few of the recent headlines and dives into the actual calculations that should provoke such skepticism. Although I don't have a specific tally, weekly initial jobless claims have been revised higher nearly every week for the past year (if not more). An interesting side note on the topic, during the past two weeks these claims were supposedly higher than normal due to a significant number of Verizon employees filing for unemployment insurance. While the report only counts claims filed, I'm curious whether any employees that willingly went on strike received unemployment benefits.

Tchir, whose posts I look forward to daily, also offers pertinent information about channel stuffing, inventory builds and the statistical significance of non-farm payroll reports. In my opinion, these topics only scratch the surface or questionable data mining and reporting. Here are a few other topics that deserve further consideration:

1) GDP is calculated in two different formats by the BEA. Why do the measures deviate from one another?
2) The BEA also uses a GDP deflator to represent inflation and convert nominal GDP to real GDP. The BLS calculates inflation as CPI. The Fed prefers to use PCE (personal consumption expenditures) when measuring inflation. All three tend to deviate from one another and at least recently the GDP deflator has been the lowest (CPI or PCE measures would likely have shown negative real GDP growth in Q1 and Q2). Why are there several different measures, used for different purposes?
3) On average, S&P 500 companies tend to report quarterly earnings that exceed analyst estimates 60 to 75% of the time regardless of the macroeconomic environment. Why are these estimates consistently wrong in the same direction?
4) Analysts and investors frequently highlight cash on the balance sheet as a sign of strength in corporate America. However, a company that borrows $1 million in cash certainly does not have a stronger balance sheet than another company with no cash or debt. Why is the size of debt never considered when discussing the amount of cash?

There are certainly countless other statistics that could be included in this list and are deserving of further research and transparency. Too frequently these statistically insignificant data points are directing policy and allocation of capital to the detriment of the larger economy. Continuing the discussion Stiglitz and others hoped to incite will ideally lead to policies that better address the economic and personal well-being of society.

Guest Post: One Death is a Tragedy, One Million is a Statistic:
Submitted by Peter Tchir of TF Market Advisors

One Death is a Tragedy, One Million is a Statistic

Another day of statistics, where the headlines are widely published, some details are somewhat explored, and in-depth analysis is next to nil.

The initial jobless claims number has become a farce. It is virtually statistically impossible for this many upward revisions unless the data is purposely under reported. I can understand the desire to smooth data, or make it seem better, but at some point the line of credibility is crossed. Not only do they screw with the main statistic, but they seem to use continuing claims as a secondary diversion. Last week’s 3641k continuing claims seemed statistically implausible, yet it was cheered. The doom and gloom crowd argued that it must be from people using up eligibility, in the end, it was just wrong by over 100k, according to today’s release. How is that possible?

Next we move to auto sales. It is hard to avoid hearing about auto sales today, probably, because the headline numbers seem good. I can almost ignore the fact that the first thing mentioned is the percentage change from a horrible period last year, but I am shocked the focus is still on total sales. Since at least 2005, the problem with car companies has been selling cars at a profit, not just selling cars. Nothing from the data indicates how profitable the sales are. So we can cheer this headline, but to a large degree it is meaningless. Then, making it more meaningless, is the fact that it includes fleet sales and is really based on sales to dealers. It doesn’t give a clear picture of how many cars were driven off the lot by bona fide, actual, human owners. If anything, the hype surrounding these figures rewards channel stuffing. There seems to be a degree of confusion by those spouting the numbers about the lack of follow through in the stocks. Maybe stocks have finally learned the lessons from these numbers, but it would be great if the masses were presented with details and useful statistics rather than just what the auto companies want to hype.

Then there was the ISM Manufacturing data. The sighs of relief from trading floors shook the buildings almost as much as last week’s earthquake. Where to begin with this data? It is a “diffusion” index. So it treats each respondent’s answer the same. It doesn’t matter if a company has 5 employees, or 5,000, their answer counts the same in the survey. If the often unreliable ADP report is correct that most of the hiring is occurring at small and medium companies, does that impact ISM?

If 2 small companies report better conditions, and 1 large company reports worse conditions, then the diffusion index would be 66, but the real world impact might be a lot different. Size does matter. Maybe that is part of the reason we see a discrepancy between regional surveys and the national survey? Does ISM report diffusion indices based on size? It would be interesting, at the very least, to see if there is a dramatic difference between big and small companies.

The next thing about the ISM methodology that I find interesting, is that the positive responses include positive responses and ½ of unchanged responses. I guess that is necessary to make a diffusion index, but I would like to see if it is realistic. Do “unchanged” responses have a tendency to follow the trend the following month? I could easily see someone who reported improving conditions one month being inclined to report unchanged the next month, even if conditions were actually worse. These are surveys done by people like you and me, well actually by people with “survey filler outer” included in their job description.

I’m not saying that having the data broken down more precisely would change the market reaction, but I don’t see why it isn’t available, and I don’t see why more analysts aren’t demanding that data. We can all look at a headline, but the value comes from those who can figure out what is going on behind the scenes. If there have been structural changes in the economy (and I believe there have been), then knowing more details would be helpful. The old rules of thumb may be deceiving us.

Of the 5 components, I am most confused by inventories. Inventory growth strikes me as highly suspect. I can see times where it is indicative of future economic growth as companies prepare for increased demand, but equally, it strikes me that it could represent a sudden slow down in final demand resulting in an unexpected inventory build. Had inventories remained unchanged, we would have seen a sub 50 print. You can’t convince me easily that inventory build last month was a positive indicator, yet that is what the headline would have you believe.

This is all in advance of tomorrow’s NFP report. NFP holds a special place in the dubious statistic category. First we have the fact that there are two separate surveys. We have the establishment and the household. The establishment survey is statistically significant for changes of 100,000; whereas the number is 400,000 for the household survey. In this day and age where virtually everything is done on the internet, I bet Google or Facebook could probably produce a more accurate report within a few months if either one bothered. Until that time, we are stuck with 2 sources of data, both of which have wide margins for error. Then we have the fact that for many months, the birth/death model generates more jobs than the headline itself. That wouldn’t be bad if it didn’t seem to require annual revisions lower. Once again the consistency of the annual revisions indicates that the reports are designed to produce numbers more positive than the reality in the hopes that by the time it is adjusted down, the market has moved on. Having said all of that, the market, or at least the analysts will try and distinguish between 40,000 and 80,000 when the difference is not actually significant or verifiable. They will latch on to whatever survey provides the most positive spin. Those who said the household survey matters more than the establishment survey, will find equally compelling reasons why it is now the establishment report that matters, or vice versa. Obama will be talking about jobs next week, so no matter what number comes up, expect it to be cited often over the next week.

I just realized, the president will be speaking about jobs and more handouts right before the start of the NFL season. Even Stalin might blush at trying to use bread and circuses so obviously.