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5
Aug 11

The Meal Was Great…Part II

Dinner with friends included lots of discussion points that resonated and reminded us of our corporate working lives.   While these points were clear to us as working persons, our perspectives from the outside render these points just as important.  The revealing fact that hits home so closely is:  Americans are being impacted by flawed policies and assumptions whether employed or not, or impoverished or not.

  • Financial Sector Dominance – Government policy encouraged the growth of the financial sector at the expense of the “real economy.”  Glass Stegall, which separated banking operations from trading operations, was repealed by Graham-Dodd.   Devilishly complex financial instruments became Wall Street fee generating devices at the expense of traditional lending.    These firms became employers of choice for talented university graduates.
  • The Short Cut Society – Instead of saving for a house, a vacation or a new appliance we were happy to use credit cards or second mortgage lines for instant gratification.   Instead of a boring career in manufacturing, better a Wall Street trader or hedge fund manager.  CEOs expected huge compensation packages regardless of performance quality.
  • Spin vs. Truth – Shading of the truth became a national obsession.  Instead of honest reporting of inflation statistics, hedonic adjustments lowered the consumer price index, depriving social security recipients and federal pensioners of earned cost of living adjustments.   CEOs spun disappointing earnings results taking write offs, obfuscating the accounting or lowering earnings guidance so that when earnings were finally announced “they beat expectations.”   Congress is no better, promising “smoke and mirrors” debt reduction plans with little, if any, real deficit reduction.
  • Lack of Political Leadership – The debt reduction exercise is one more example of the lack of leadership at the Chief Executive and Congressional levels.  Politicians are more concerned about preening before cameras than serious statesmanship. Bipartisanship seems like a quaint relic of a bygone era.
  • Congress for Sale – Given the enormous cost of congressional races, representatives are in a constant search for dollars from corporations and other large contributors.  Thus, we have Congress captured by special interests.  Congress has long forgotten the middle class voter.  The appearance is that Congress is totally beholden to the corporate sector and that corporations appear entitled to special relief any time they are in need.
  • Complexity – Complexity pervades every part of our political and economic system.  Complexity is used to muddy rather than clarify.  The tax code, Obamacare and financial reform are the latest examples of overly complex legislation and accompanying regulation.  Only an army of lawyers can navigate through these legal minefields.  Conveniently, citizens are kept in the dark and small businesses cannot afford to compete with larger enterprises.
  • Rise of the Nanny State – We recently had New York’s ridiculous attempt to regulate kickball, dodge ball, waffle ball and Red Rover as dangerous activities needing state oversight and a permit.   See Classic Kid Games Like Kickball Deemed Unsafe by State to Increase Summer Camp Regulation.  This is emblematic of a society which demands a legislative or regulatory solution to every problem.   Businesses must be protected against failing (GM, Chrysler, Citicorp, AIG),  employees must be permitted leaves for such mundane diseases as chronic sinus infections (Family and Medical Leave Act), and the public must be protected against carcinogens such as the sun and salt.    Every aggrieved person must have a day in court.  Spill hot coffee on oneself, bring a lawsuit against McDonalds.  Play football and suffer an injury, sue the helmet manufacturer.  Somebody is always to blame and our legislative bodies are all too willing to protect us against life’s vicissitudes.
  • Free Trade– Say it fast and free trade sounds like a great idea.   Cheap foreign goods enrich our lives.   Thus, Ross Perot was ridiculed for saying that NAFTA’s giant sucking sound was American jobs heading for Mexico.   Mr. Perot sold American ingenuity short: American jobs are heading for China, India, Vietnam and a host of other low wage countries. These countries have few, if any, labor, anti- discrimination, family and medical leave, unemployment, child labor, environmental or safety laws.  American workers are being asked to compete against workers who are paid subsistence wages and afforded no protections.   Our politicians are only too willing to serve corporate interests at the expense of the American worker.
  • Immigration – Immigration is probably the purest example of selective enforcement of our laws.  It is difficult for American workers to compete against Chinese or Indian workers.  The problem is even greater as regards undocumented residents in our country.  Further, the cost of medical, education and municipal services is underwritten by the American taxpayer.  In places like Texas, Arizona and California this puts enormous strains on state and local budgets when education and medical services must be extended to undocumented residents.
  • Structural Unemployment – Technology and job outsourcing has added to shockingly high unemployment rates.  It is not clear whether any of these jobs will ever return. As we pointed out, zero interest rates lead to use of more labor saving capital equipment at the expense of hiring workers.  See The New York Times Finally Discovers Structural Unemployment. Hence, our employment problems may not be temporary but a permanent feature of the economic landscape.

 

All of the factors are intertwined.  In fact, they are negatively synergistic.   For example, a Congress that supports failed banks condemns savers and pensioners to miniscule return on savings, further compromising any incipient economic recovery.  A below trend economic recovery only encourages the exile of more jobs overseas so that corporations can retain profitability.

Believe it or not, dinner was pleasant and more.  But our conversational substance and concern for what is happening with our country and what is wrong with America indeed cast a cloud over all our thinking.  Along with other “ways that we were,” optimistic was also one of them, and that is much diminished.

After all this postulating about what is wrong, clearly what should come next are some hypotheses about solutions that can work.  A discussion for another blog.

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3
Aug 11

The Meal Was Great; Our Outlook, Not As Good

I had dinner the other day with two close friends, both former colleagues.  We are, in parlance, “men of a certain age:”   baby boomers, children of the sixties, sons of World War II veterans.  We all began our work lives in our twenties, worked for giant corporations, and turned jobs into long-term careers.  When first hired by our companies, we planned to stay just a couple of years and then move on to another company.  With the benefit of hindsight now, and the need for false humility ended, we can each gratefully admit that we enjoyed significant professional success, although none of us thought we would rise to the senior executive levels that we did.

We now occasionally get together for dinner and discuss our families, our current pursuits, how our former employer is doing and the general state of things.   Last time, we discussed what went wrong with America generally, why our children will not have long careers with large companies, and why they likely will not be as financially successful as we were.

We spoke about our fathers and the norms of their generation.  They fought in the War, returned and worked hard, and had few expectations about success or wealth.   They kept their noses to the grindstone and rarely complained.

We discussed the landscape of the corporations we went to work for.   When I was hired as a junior attorney, the General Counsel barely made five times my salary.  Bonuses were stingy and a modest number of stock options (in the hundreds of shares) were offered to a handful of our most senior executives.  Interestingly, it was generally a harmonious and engaging work environment. In contrast, by the time I retired, the Chairman and CEO made more than 400 times what an average employee made.  Employees were not nearly as engaged or happy.

The immediate catalyst for our wondering what has gone wrong with America was the current debate over the US debt ceiling.  I started to think back to the blogs I had written and tried to put together some hypotheses.  I caution the reader this is not a rigorous, but rather an impressionistic view of sociological, political and economic trends which shape the current state of affairs.   If it is insightful, I give tribute to good dinner conversation and fine friendship:

  • Loss of Shared Sacrifice – Perhaps it was the “Me Generation” of the 1960’s, but America has lost its sense of shared sacrifice; that is, the notion that we are all in this together and we rise or fall as one nation.   Instead we have an ethic of greed:   I want what I want and I want it now, everyone else be damned.
  • Out of Control Military Spending – Too much of America’s resources are spent in our defense budget.  Compounding this problem is a series of seemingly endless wars.  While we deploy hundreds of thousands of troops to Iraq and Afghanistan, our allies deploy hundreds.  Note that the German, Canadian, and Australian economies boomed, while ours stagnated.
  • The Volunteer Army – A volunteer army allows wars to be fought by other people’s children.  Thus, the popular outcry against wars or military spending is diminished because our own (privileged) sons and daughters are less likely to be involved.
  • Too Many Laws – The Wall Street Journal highlighted the growth in federal criminal law.  We over-criminalize too many areas of society.  One commentator archly noted that someone violates some law each day, often unaware of his lawbreaking conduct. See As Criminal Laws Proliferate, More are Ensnared
  • Unequal Enforcement of the Law – Perhaps since the OJ Simpson trial, our citizens cynically believe that if one hires a good enough lawyer, one literally can get away with murder.  This carries over to the belief if a corporation is big enough, especially a “too big to fail” financial institution, it will never be prosecuted.
  • Socialism for the Rich, Capitalism for the Poor – When the “too big to fail” institutions became insolvent, the Bush Administration, Congress and the Federal Reserve rushed in with a comprehensive program of TARP and zero interest rate lending.  The Obama Administration has continued these policies from the beginning.  Insolvent homeowners have been evicted from their homes, and many unemployed workers have exhausted their unemployment benefits.
  • Reckless Lending and Borrowing – The Federal Reserve was a major culprit in the growth of both public and private credit.  Instead of accepting the economic consequences of the internet bubble crash, Alan Greenspan reduced interest rates to below market levels to encourage real estate lending.   Subprime lending further inflated the housing bubble. Based on an inflated residential and commercial real estate market the economy boomed.  Assuming that this was permanent prosperity, debt was taken on at all levels: states and municipalities, corporations, homeowners and the federal government.  Now we cannot repay that debt.

While my dinner with friends continued all in one evening, Part Two will continue this discussion.

 

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28
Jul 11

It Isn’t That Easy to Avoid a Crisis

David Goldman continues to insist that all is under control.  See my previous discussion in Random Observations.  That is, he insists that current debt and especially sovereign debt problems will not cause another crisis like that of 2008:

More drivel has been written about the probability of financial crisis during the past month than at any time during my lifetime. There’s no crisis–not when all of the problems are transparent, on the table, and subject to negotiation. Instead, there is a change in lifestyle underway for Greek railway conductors, Minnesota firemen, New York City teachers, and a great many other people. Folk who only a few years ago expected to retire at sixty and spend their golden years on cruises will work until seventy and be thankful for a roof over their heads. See Not a Crisis, But a Negotiation

Goldman’s crisis avoidance stands on the following pillars:

  • The problems are known.
  • Because the problems are known they can be negotiated away.
  • Since the financial system has reduced its leverage, a crash cannot occur.  Why?   Because leveraging leads to sales of assets at distressed prices in a crisis.
  • If the US suffers a downgrade, the Federal Reserve and Treasury can easily implement financial maneuvers to work around the downgrade.
  • Finally, we have reduced complex, structured investment vehicles.

Risks We Knew, and Ignored, in the Last Decade

We knew about the overheating housing market and reckless subprime lending for several years before the crash of 2008.  We knew about the problem of excess leverage in the system. (In fact, the Federal Reserve relaxed leverage requirements, allowing firms like Lehman, Bear Stearns and Goldman Sachs to leverage 30-1 to 40-1).  Ben Bernanke claimed that the subprime crisis was “well contained” and would not affect the overall residential housing market.

None of these known problems could be “negotiated away.”  The financial system indeed seized up and nearly ended in total system breakdown.

What are the Current Risks?

Do we really know the current problems?  Last week, Bank of America wrote off $19.2b in bad loans.   Besieged by lawsuits and an unrecovered housing market, Bank of America can no longer hide behind “extend and pretend” fictional accounting.

…the bank appears to be in denial:

The crucial question today is whether Bank of America needs fresh capital to strengthen its balance sheet. Moynihan emphatically says it doesn’t, pointing to regulatory-capital measures that would have us believe it’s doing fine. The market is screaming otherwise, judging by the mammoth discount to book value. Then again, for all we know, the equity markets might not be receptive to a massive offering of new shares anyway, even if the bank’s executives were inclined to try for one.

Weil correctly depicts BofA as a systemic risk.  See Is Bank America at Risk of a Death Spiral?

And Bank of America is not the only “too big to fail” American bank:

And let us tell you a dirty secret: while Bank of America, thanks to Countrywide, is patient zero of the housing mess, Wells is next in line. Residential real estate is proportionately even bigger relative to the bank’s earnings and balance sheet, its accounting has been somewhere between aggressive and misleading, and despite its pious claims otherwise, it is no better than any of the other big banks. Stay tuned. See Is Bank America at Risk of a Death Spiral?

Both Wells Fargo and Bank of America are large, publicly held corporations subject to scrupulous reporting requirements. Nevertheless, large, unpleasant surprises appear seemingly out of nowhere.  Goldman misses the point, that future financial crises are in plain sight and we seem incapable of dealing with them.  The interconnectedness of credit default swaps makes these banks even riskier.  How can we gauge the effect on these banks of a crisis in Greek, Italian or other sovereign debt?

Being dismissive of the plight of highly paid Minnesota firemen and New York City teachers incorrectly trivializes their key role in any future financial crisis.   The fireman and teacher are both current and future homeowners.   They are also consumers.   The financial world ultimately comes down to discounted future cash flows.  Cut the income of enough highly paid workers and suddenly future corporate, governmental and individual cash flows do not look so rosy.  Moreover, this scenario keeps the housing market under pressure assuring future damage to bank balance sheets.

We need to stop denying our financially interconnected world.  Goldman’s analysis makes two mistakes: it skips over the effect financial austerity will have on housing, banks and tax revenues, and it believes our government and financial leaders can solve crises, even crises that are well understood and “transparent.”   The quagmire of our current debt level discussions only proves my point.

 

 

 

 

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19
Jul 11

Random Observations

What an exceedingly strange period in our economic and financial history!  Amidst a non-recovery economic recovery we have below par growth and high unemployment.  Coupled with economic weakness we have above trend inflation.  Let us consider some of the odder stories from last week:

Ben Bernanke and QE3

The first two exercises in quantitative easing have had mixed to negative consequences.   While the stock market has almost doubled from its low, the “real economy” has languished.   We can further document the relationship between QE and poor economic performance with a look at price hikes in key commodities such as food and energy.

Yet here is Dr. Ben Bernanke before Congress, once again selling us a product repair that simply does not work. On Wednesday, he made it clear that QE3 was part of his thinking. And even he is not altogether sure. On Wednesday, he backed away from an immediate move to start a third round of Fed money printing and bond buying.  See QE3 Guaranteed to Fail

Is there any reason that Dr. Bernanke still holds his job?  While his supporters point to a rise in stocks, the “real economy” has suffered.  Aren’t there better candidates for his job, who will try some new ideas? Are money printing and market manipulation the only ideas that any of our leaders can come up with? And to further the irritation with our Princeton economic guru, note that stocks used to rise and fall on company earnings and the economic outlook, not on which side of the bed the Fed chairman woke up on.

Don’t Worry Be Happy: Just Disregard Europe’s Problems  

David Goldman in Inner Workings points out that the financial crisis in Europe will not be a rerun of Lehman’s 2008 meltdown:

Under the headline “A Fate Worse Than Banking Crisis” my friend John Dizard at the Financial Times points out that any run on Europe’s banks would be instantly countered by swap lines from the Fed and ECB. His point (one I have been making for some time) is that the scope of the European banking problem is well known and that mechanisms have long been in place to deal with the worst-case scenario. Not so with Lehman, where a sort of China syndrome applied: no-one knew the amount of contingent liabilities that might be affected. See Once Again: It’s Not Lehman II

Mr. Goldman continues to calmly assure us that European problems will not create another financial meltdown:

My conclusion: there is no reason to panic over the present kerfluffle, but there is no reason to own any exposure to southern Europe. Ever again.  See Hopeless, But Not Serious: Once Again.

It’s too early to blow the “all clear” whistle on capital markets, but today’s recovery in the major US stock indices reassures me that this is not another financial crisis on the September 2008 scale, just a particularly nasty negotiation after which Italians, Greeks and Spaniards will end up poorer (along with Minnesota teachers, Wisconsin firemen and New Jersey policemen). It was amusing to see the usual suspects among the Street strategists issue dire warnings about increased tail risk just as markets turned around. See Ken Lewis, George Soros and Other Hedgehogs

So Mr. Goldman is assuring us of financial recovery based on one day of a US stock market rally?  His prognostications eerily remind me of 2007 and the assurances from Ben Bernanke, Hank Paulson and other financial luminaries that the subprime crisis was well contained.  Stock markets rallied then too, only to decline disastrously a year later.

Yesterday was a stark reminder of how unsafe Europe really is:

Greece 2 year interest rate on sovereign date: 34.5%
Portugal 2 year:  21.2%
Ireland 2 year : 23.3%
Italy 2 year : 4.65%
Spain 2 year:  4.55%

America is only marginally safer than Europe.   American research firm Egan-Jones recently also downgraded US Treasury debt.  See Europe is *Not* “Safe”

Are We Better Off Now Than In 2008?

We live in a financially interconnected world, and I am not at all reassured by Mr. Goldman.  I doubt that anyone knows what the effect of a bankruptcy in Portugal or Italy would have on world financial markets.   Could anyone have predicted that the 2008 financial crisis would take down AIG and Lehman and send US banks scurrying to the Treasury for TARP funds?  Do we think the world and the major financial institutions can better weather a storm now than in 2008?  While I may not know, I am more fearful that Bernanke, Goldman, Dimon and Blankfein do not know either, and they are out there making predictions and advocating policy.

Europe, China and the US have spent trillions of dollars trying to bolster their economies.  What if we have used all our money-printing ammunition and the next crisis is even worse?

 

 

 

 

 

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3
Jul 11

All Millionaires are Not Created Equal

In Is Debt Ever Good? we contrasted productive debt and non-productive debt.   There is a duality with millionaires as well.   Some are productive and some are not.

At his Wednesday press conference, President Obama adopted what he figured would be the populist stance, and he vilified millionaires as a group:

Mr. Obama repeatedly mocked tax breaks that he said were for “millionaires and billionaires, oil companies and corporate jet owners,” saying that voters would not look kindly on Republican lawmakers who defended such breaks at the cost of cuts in popular programs like health care, education and food safety….

“If you are a wealthy C.E.O. or hedge fund manager in America right now, your taxes are lower than they have ever been. They are lower than they have been since the 1950s. And they can afford it,” Mr. Obama said. “You can still ride on your corporate jet. You’re just going to have to pay a little more.” See Obama: Republican Leaders Must Bend on Taxes

The financial press immediately declared this as “class warfare.”  See e.g. Obama’s Case Against the Rich Rings Hollow.  I would conjecture that the American public can distinguish between the good millionaire, who creates jobs and real wealth, and the bad millionaire, who becomes wealthy through political maneuvering or illegal activity.

The Productive or “Good” Millionaire

Americans applaud individuals from all backgrounds who have an innovative idea and are able to execute and create real wealth.  Bill Gates (Microsoft); Sergey Brin and Larry Page (Google); Steve Jobs (Apple); Jeff  Bezos (Amazon);  Pierre Omidyar (EBay); Mark Zuckerberg (Facebook) and a host of other entrepreneurs identified a business need, created a new product or service, raised private capital and became wealthy.   Even in the much maligned financial industry there were pioneers such as Charles Schwab who brought discount brokerage and other financial services to the average investor.  These are thriving enterprises, which need no government assistance or special tax breaks to make money and create jobs.

The Non-Productive or “Bad” Millionaire

Unfortunately, we have too many examples of this type of wealthy interloper:

Failed Bankers – Richard Fuld (Lehman), Charles Prince (Citicorp) and Ken Lewis (Bank of America) are examples of bankers who drove their institutions into bankruptcy or made them wards of the state.  Each of these individuals secured great wealth and suffered no compensation “clawbacks” or criminal prosecution.

Failed Corporations – During the financial crisis, companies like General Electric almost went bankrupt.  When they should have diluted shares and jeopardized their own stock-based compensation through equity and debt offerings, crony capitalists such as Jeff Immelt called on their Washington “friends” to extend large, below market rate, irresponsible loans to GE.

Under- performing Corporations – Legions of CEOs collected large compensation packages while their businesses, employees and shareholders suffered.  Instead of amassing their personal largesse at company expense, many an under-performing CEO should have been dismissed.

Criminal Enterprises – Ken Lay and Jeff Skilling of Enron and Scott Sullivan and Bernie Ebbers of Worldcom, among a long and undistinguished list of corporate malefactors, were able to deceive shareholders and bankrupt their businesses.  And worse, each amassed a large personal fortune.

Defense Contractors – A small, tight knit cadre of defense contractors feed at the Defense Department trough.  Many of these contractors have been accused of violating various bidding and other contracting rules, but are never disqualified from bidding on future contracts.  Cost overruns, delays and malfunctioning systems occur far too often.

Why Are Americans Angry?

We are angry at millionaires who game the tax code, misrepresent the financial status of their businesses, and seek government bailouts while continuing to pay themselves outsized compensation packages.  We resent non-performing CEOs who continue to be richly rewarded. We oppose government contractors with cozy Washington relationships.  To the average American, these millionaires win because the game is rigged.

Americans applaud the honest entrepreneur because he or she fills a real societal need. Further, these individuals are the best examples of the American spirit and ethos of creative imagination, perseverance and hard work yielding a valuable result. Americans do not want to destroy these individuals; they want to be these individuals.  Obama is overreaching when he paints all millionaires with the same brush.  What Americans want is an end to the bailouts and special deals that destroy incentives for honest entrepreneurs and both create and protect the undeserving rich.  Americans  want a level playing field so they can compete and become wealthy, too.

 

 

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26
Jun 11

Is Debt Ever Good?

All debt is not created equal; some is productive and some is not.  The subtle difference between the two types of debt eludes many economists.

But why is this important?  Why do economic theorists and those who make decisions need to pay attention?  Because the quality of the debt determines whether or not it can be re-paid.  And if we cannot repay our debts in a productive way, we all suffer.

Productive Debt

Productive debt creates wealth.  When we borrow to start a business, expand an existing factory, or purchase needed supplies at advantageous prices we create productive debt for a valid reason.   The borrower is utilizing capital to generate returns in excess of the cost of capital.   Further, prudent borrowing holds out the possibility of “sustainability”:  meaning that the created wealth can be replicated.  Borrowing to expand a semi-conductor factory spurs further production, creating jobs, orders for suppliers and tax payments.  The lender has the security of a productive asset and a stream of income to ensure re-payment of the loan.

Non-Productive Debt

During the credit expansion of the last decade non-productive debt proliferated.  Borrowing took place to buy automobiles, plasma televisions, appliances, single family homes and snowmobiles among other consumer items.  Each of these “assets” depreciates rapidly and has attendant upkeep costs. The debt-laden purchase of any of the above items never led to increased wealth, it merely added another consumer trapped in a debt-ridden life.  In the case of debt-laden purchases of single family homes consumers saddled themselves with mortgage, taxes, insurance and other upkeep costs. Lenders exacerbated non-productive debt through lax lending standards (lending to sub-prime borrowers) and innovative financial products (adjustable rate mortgages, 125% loan to value, second mortgages).  Lenders believed that they would be bailed out of bad loans through ever-rising house prices.  Unfortunately, we learned that this was a faulty assumption.

A second area of non-productive debt is equally pernicious.   Ultra low interest rates have encouraged speculation in stocks and commodities.   Leveraged investments de-stabilize the economic system through inflating asset values, spurring commodity inflation and ultimately creating bubbles and inevitable crashes.

The Shangri-La of Non-Productive Debt

Doug Noland characterizes the United States as the worst offending country in the making of nonproductive debt. In his analysis, he is critical of the loose policies of the Federal Reserve, which encourage unsound lending and have contributed to our bogus boom and inevitable bust:

First of all, booms create a fragile mountain of debt not supported by underlying wealth-creating capacity.  Second, Credit Bubbles inflate various price levels throughout the economy, creating systemic dependencies requiring ongoing debt and speculative excess.  And, third, the boom in non-productive debt will tend to foster consumption and malinvestment at the expense of sound investment in productive capacity.   When the boom eventually falters, market revulsion to unsound debt, the  economy’s addiction to uninterrupted Credit expansion, and the lack of capacity for real wealth creation within the (“Bubble”) real economy ensure a very severe crisis and prolonged adjustment period.  These dynamics become critically important as soon as a government (finally) loses its capacity to perpetuate the Bubble (i.e. Greece, Portugal, Ireland, etc.)

As a crisis unfolds, the markets eventually must come to grips with a very harsh reality:  There will be denial and it will take some time to really sink in – but the markets will come to recognize that too little of the existing debt is backed by real wealth.  Non-productive Credit booms are, after all, essentially “Ponzi Finance” schemes.  See The King of Non-Productive Debt

At this point, the Federal Reserve is faced with severe choices.  It can risk economic implosion, or it can continue to mainline “the debt addict” with greater and greater infusions of new debt.  As we are now witnessing, this money is going into speculation in the commodity and stock markets rather than into productive investment in the “real economy.”  Real economic activity is suffering at all levels as income is diverted to debt re-payment and prices of key commodities soar.

Built on Sand?

A visual metaphor can help us understand how dangerous, unstable and fragile an economy becomes with a mountain of non-productive debt:

What makes sand piles so interesting is the usually seamless transition from stability to collapse. One can add grains to a sand pile for quite some time without disturbing its stability – it simply grows bigger and bigger. Alas, eventually the point is reached when one grain too many is added or is put in the wrong place, and an avalanche and collapse of the sand pile will ensue.

These sand pile dynamics appear to have a lot in common with the modern-day financial system – they serve at the very least as a good metaphor. Of course a crucial difference is that grains of sand do not exhibit purposive behavior, whereas the financial system is populated by thinking and acting human beings. Nevertheless, there are some interesting parallels. Just as a grain of sand near the bottom of the pile has no direct connection to one lying at the top, the various cogs in the financial machinery are likewise not necessarily connected directly with each other, but what happens in one area of the system nonetheless tends to reverberate through the whole system.  See The Edifice of Debt

Collapsing Castles

There are two simple principles to consider in evaluating the ongoing financial crisis.  First, does individual income, or tax collection generally, support our current level of outstanding debt?  Second, is Michael Shedlock’s admonition true:  “what cannot be paid back, won’t be paid back“?  Fantasies of resolving our debt in creative ways, like selling national assets such as road systems or national parks, are just that – fantasies.   Selling physical vestiges of our national heritage is not only soul-destroying and stupid, it just won’t work.

And yet we continue to accumulate non-productive debt at an alarming rate.  Was the collapse of the sub-prime market the “grain of sand” that caused near systemic collapse? What will be the next grain of sand?  What will be the consequences?

 

 

 

 

 

 

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14
Jun 11

Financially Malled

An inside page item in last week’s Wall Street Journal caught my attention:  Faded Malls Leave Cities in the Lurch. The article focuses on the recession’s effect on retailers and the decline of sales tax revenues affecting municipal budgets.   What we have is another cautionary tale about overly optimistic spending on urban malls.  Apparently, retailers have been willing to build even in the face of a glut in retail space, and now they are suffering the consequences.

A Litany of Woe

Sales tax receipts account for 23% of all state and local tax collection.  Unfortunately, in 6 of the last 10 years municipalities have witnessed worsening declines in this revenue source, with a decline of 6.6% in 2009 and 5% in 2010.    Much as experts would love to blame this sad state of retail affairs on the bad current economy, the facts of the decline may go much deeper and last longer:

…it is problem that will persist after a recovery, as demand for retail complexes is whittled by online shopping and the waning popularity of the big-box store selling everything from groceries to electronics.

“I am not sure cities can go back to playing the retail game the way they have over the past 25 years,” said William Fulton, mayor of Ventura, Calif., and editor of the California Planning and Development Report newsletter.  See Faded Malls Leave Cities in the Lurch

Neighboring cities have engaged in dysfunctional escalating competitions to build ever bigger malls.  To entice owners, cities have offered sales tax revenue sharing agreements, real estate tax abatements, development bonds with municipal guarantees and infrastructure improvement such as roads, and exit ramps from highways.

This largesse is now catching up with cities faced with worsening budget shortfalls.  In one example, Independence, Missouri, has used public funds to make a $3.5m debt payment for a local mall. It expects to make another $4m payment this year.  Plus, the city was forced to lay off and furlough employees to fund these payments.  In another case, Tracy, California, is paying Macy’s $2.7m to move into a local mall, this to prevent the mall from closing altogether for lack of an anchor store.

Goldilocks and the Wolves

Financial media trumpeted the 2000’s as the decade of the “goldilocks economy”: a virtuous cycle where low interest rates spurred the growth in the housing market, and then, derivatively, gains in other industries as well: mortgage bankers, investment bankers, second mortgage lenders, attorneys, appraisers, appliance dealers, builders etc.  Sales tax revenues increased, municipal budgets expanded, municipal workers hired and generous wage, pension and other benefit increases flowed.   The Federal Reserve not only spurred this cycle with low interest rates but kept them too low for too long.  This party continued unabated until the economy hit the wall in 2008.

The Wall Street Journal article failed to complete the story of the malls and municipal finance.  Not only are malls in trouble, but the homeowners who shop in them are in trouble. The two failing markets are symbiotically intertwined.  Foreclosures and falling prices only cut real estate taxes and collections.  The municipalities who extrapolated out endless prosperity now suffer the aftermath: insufficient revenues to make bond payments, obligations under union contracts for wage increases, and underfunded pensions, and active and retired health care liabilities.  The “virtuous cycle” of the “goldilocks economy” is now pernicious with a downward spiral of increased fees, reduced services and threatened defaults.

Finally, the article begs the question of what should be the proper role for government.  We can argue about whether it is to secure individual freedoms and rights, or to ensure the safety of the citizenry. Philosophy aside,  I would argue that government has no legitimate role in incenting shopping mall construction or wooing mall tenants.  Revenue sharing deals, tax rebates, infrastructure improvements and other incentives seem to transcend the proper role of government. Private entrepreneurship is just that, private.

The Wall Street Journal item is just one microeconomic issue in our post financial crash economy. Unfortunately, there are many more stories to tell like the follies of the mall.

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7
Jun 11

Unemployment and the Fall of Labor

U.S. Government and private statistics, reported last week, reinforced our dismal unemployment trend:

  • The unemployment rate rose to 9.1%.
  • Only 54,000 jobs were added in May with numbers revised downward for April as well.  This number especially alarms when compared to the projections of 150,000 to 175,000 new hires.
  • Employment in states, counties, and municipalities fell to their lowest levels since 2006, as governments were forced to reduce their workforces to meet budget targets.
  • New unemployment claims continue to average more than 400,000 per week.
  • 13.9 million individuals are unemployed. 8.5 million people work only part time.
  • 4 million individuals have given up looking for a job.
  • 6.2 million have been unemployed for more than six months. See Dismal Payroll Data

Economic experts, an oxymoronic term and group if ever there was one, offer a number of explanations: over regulation, the costs of complying with Obamacare, illegal immigration, free trade, an anti-business administration and other excuses.   Prophet without Profit has consistently argued that structural change has happened in the American work force.  This economy, recession and “recovery” is neither your father’s nor grandfather’s, and we are kidding ourselves to think we can treat it as such.  See, e.g., Why this May be Worse than the Great Depression and The New Reality: Permanent Job Loss.

The Fall of Labor

In Game Over, Mark Lapolla, managing director of Knight Capital Americas rationally explains our high unemployment:

  • We have created a worldwide economic system where we swap American intellectual property for cheap foreign labor from countries like China or Vietnam.
  • Enterprises based on intellectual property need less capital, commodities and most importantly, less labor.
  • The amount of human labor to produce an economic value has become “de minimis.”
  • Productivity for each newly added worker added has soared, approximately $80,000 per worker compared to a national average of $14,000.
  • Technology has supplanted labor in our enterprises.
  • Evidence of the problem is in high unemployment, duration of unemployment, and little or no wage growth.
  • The housing boom was a temporary salve to workers to permit extraction of wealth from homes.  That band aid policy is now over.
  • The few new highly skilled jobs that appear are being filled by over qualified employees.  They earn much less than they earned in their last jobs.  They do not contribute to a healthy level of economic consumption.

Implications

The implications are quite stark.   A society built on consumption must become a society of savers.  Unemployment will remain high for much longer than may be politically palatable.  Good jobs in the work force are going to require a high level of scientific, computer and mathematical skills.   Finance, retailing and other service jobs will be in a long decline.  Similarly, high unemployment will equal slow growth.  The housing market will continue to stagnate.

In the same vein Charles Hugh Smith recognizes these structural labor force problems.  America has focused too long on the quick fix of creating instant wealth through financial schemes or social media like Facebook and Twitter. We are now paying for our long term neglect of manufacturing job creation, and our failure to pursue a rationale industrial policy:

The U.S. has a distinct industrial policy: benign neglect, ignorance, favoritism towards real estate development and financialization, and a fanatic devotion to short-term profits and cost-cutting. Productive vs. Unproductive: Manufacturing vs. Financialization

To bring America back we are going to need to de-emphasize getting an MBA, and to focus on technical skills:

The U.S. culture denigrates skilled labor and glorifies the C.E.O. and innovator as god-like heroes. Other nations, notably Germany, maintain a value and education system which recognizes and nurtures technical skills. In the U.S., we fawn over social media companies that generate billions in new wealth for Wall Street and a handful of founders and venture capitalists, and drill into every student’s head the value not of tradecraft skills but of a four-year business degree. Productive vs. Unproductive: Manufacturing vs. Financialization

Smith concludes that in the winner take all, extraction economy, we get a small number of wealthy winners and the remaining 90% are relegated to living in a corporate-colonial economy ruled by financial oligarchs.

Our Next Steps

The first step is to recognize that our industrial and employment policies are deeply and structurally flawed.  We are applying outmoded policies to a vastly changed economic situation.  The second step is to stop wasteful and ultimately fruitless government efforts like boosting the stock market or housing market through quantitative easing or zero interest rates.   The third step is to reorient economic policy to encourage a return to manufacturing, to re-train the labor force in technical areas, and to create incentives to save and invest.  Otherwise, last week’s headlines will become even scarier.

 

 

 

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4
Jun 11

“Justice” for the Poor and a Pass for the Rich?

An embarrassing feature of the financial crisis has been the lack of criminal prosecutions.  Despite the extraordinary level of talent in the Justice Department, the Attorney General cannot muster a serious case.  Promises of investigations and action have proven hollow.

Hitting Bottom?

This week we reached a new low in this dearth of prosecutions.  A Wall Street analyst temporarily cheered the financial markets in his analysis of Goldman’s Sachs’ legal predicament:

Goldman Sachs Group Inc. (GS) won’t face criminal prosecution related to sales of mortgage-linked securities because such a move could threaten the U.S. financial system, according to Brad Hintz, an analyst at Sanford C. Bernstein & Co.

The U.S. Department of Justice, which is reviewing a Senate subcommittee report that alleged Goldman Sachs misled clients before the financial crisis, will avoid jeopardizing the fifth- largest U.S. bank by assets because it’s viewed as “too big to fail,” Hintz wrote in a note to clients today.

“If an alleged violation is identified during a Goldman investigation, we expect a reasoned response from the Justice Department,” Hintz wrote. “In a worst case environment, we would expect a ‘too big to fail’ bank such as Goldman to be offered a deferred-prosecution agreement, pay a significant fine and submit to a federal monitor in lieu of a criminal charge.” Goldman ‘Too Big’ to Face Prosecution Over Mortgage Securities, Hintz Says

Institutionalized Cynicism

Mr. Hintz’s analysis oozes Wall Street smugness.  Too big to fail institutions can break the law with impunity with little threat of meaningful retribution?  I would insist that “meaningful retribution” does not mean large fines; it means jail time for convicted executives and sanctions for criminal enterprises.

Let’s examine Mr. Hintz’ moral bankruptcy:

  • We are three years into this financial crisis.  Even though it is patently absurd, Bernanke and Geithner have proclaimed themselves system saviors. To the contrary, we have spent $5.1 trillion dollars in deficit spending.  We have rewarded reckless bank investments, and kept interest rates at zero.  And yet an analyst has the temerity to assert that the indictment and conviction of Goldman Sachs would jeopardize the financial system?  If this is true, then Geithner and Bernanke should be indicted as well.
  • Goldman Sachs has already entered into a $550m civil settlement with the SEC for misleading investors in mortgage-backed securities.  It also agreed to reform its business practices.  Clearly, Goldman does not fear the worst retribution, as it has misled or committed perjury in testifying before Sen. Levin’s subcommittee. Truthful testimony before a Congressional committee is fundamental to our democracy.  Panels investigating Watergate, Washington corruption and organized crime elicited truthful testimony under the threat of perjury and jail time. How is the public served in letting a Wall Street firm and its executives expect but a wrist slap?
  • Equal justice under the law is fundamental to our democracy, and it is being undermined. Anger and cynicism is on the rise.  Why not rob a bank if the worst penalty is that you will have to pay back only a fraction of the proceeds?   Why continue to voluntarily pay your taxes? Underpay or refuse to pay and then negotiate.  We cannot incarcerate enough juveniles from the ghetto nor throw enough drug dealers in prison.  While these individuals may have committed reprehensible crimes, fraud and perjury are equally reprehensible.

A Glimmer of Hope?

Today the tide appears to be turning:

Goldman Sachs has received a subpoena from the office of the Manhattan District Attorney, which is investigating the investment bank’s role in the financial crisis, according to people with knowledge of the matter. Goldman Said to Get Subpoena Over Its Role in Crisis

The good news is that Cyrus Vance Jr. stepped into the prosecutorial vacuum and issued subpoenas.  The bad news is the thunderous silence from the Justice Department and the New York state attorney general.

I attended a recent talk by Rabbi Adin Steinsaltz, a renowned biblical scholar.  He noted that the genius of the Torah as a legal instrument is that judges were admonished to favor neither the rich nor the poor.  America outside of Wall Street and Washington believes that the rich, “too big to fail” banks have been given a permanent get out of jail card.  We could restore belief in equal justice under the law if we vigorously prosecuted and convicted rich wrongdoers the way we currently pursue poor ones.

 

 

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30
May 11

Wildfires and the Economy

Sometimes very wise things are also very simple: like a story for children.  I am a mentor volunteer for local disadvantaged fourth graders. This week’s reading assignment was to read and discuss Wildfires, a short children’s book written by Seymour Simon.

The author’s theme seemed contradictory:  wildfires are not always harmful.  Rather, they are part of the natural cycle of forest life.   They occurred well before man populated North America.  Extended droughts provided the necessary environment so that when lightning storms arose, wildfires ensued.   No firefighters or park rangers impeded the natural order of things.   Eventually, enough rain fell to extinguish a fire, or a fire would run out of fuel.

In elegant language understandable to fourth graders, Mr. Simon advocates a controversial and grown up point. The US Forest Service actually did a disservice to the long term health of our forests.   Our ecosystem needs fires to allow light to reach the forest floor, to remove kindling which could cause even larger conflagrations, to permit certain animal species to reproduce, and to allow tree seeds to travel and reproduce.  New and natural growth cannot occur without the cleansing effect of a wildfire.   We now understand that aggressive firefighting was poor governmental policy that actually damaged the environment.

An Economy Managed Like a Wildfire?

The economic analogy is obvious.  When the 2008 great financial crisis occurred the Treasury and the government overreacted.   Treasury pleaded with Congress to create bailouts: TARP, TALF and an alphabet soup of other programs.  The Federal Reserve aggressively lowered interest rates to zero and made bank purchases of distressed mortgage-backed securities and other poorly-rated assets.   Finally, the Administration went on a policy and public relations campaign to save GM, Chrysler, GE, AIG and other large private companies.   Government chose to aggressively fight the financial wildfire.

Policy makers forgot that, like a healthy forest, capitalism requires “creative destruction.”   Coined by Joseph Schumpeter in his work entitled “Capitalism, Socialism and Democracy” (1942), this term denotes a “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

In a properly functioning capitalist economy, old or dysfunctional businesses must be discarded and  replaced by more dynamic enterprises.    If not, we would still be powering computers with vacuum tubes instead of advanced generations of semiconductors.

Killing the Business Cycle

On Friday, David Goldman’s blog Inner Workings pointed out the fallacy of aggressive governmental steps to arrest the financial crisis.  His prediction:  we will be mired in a little or no growth mode for years.

I’ve been on Larry Kudlow’s CNBC show arguing that the US will have 2% growth indefinitely–no real recovery, no double dip, no banking crisis, but no bank stock rally. Today’s depressing numbers are in line with my depressing expectations. We’ve got a creative-destruction economy, without the creation: the startups, the venture capital, the entrepreneurship. MySpace and LinkedIn don’t count: they are a faddish extension of old technology, a means by which Americans who bowl alone can pretend to have lots of friends.  The People’s Republic of America Reports 1.8% GDP Growth (or: Why this is NOT a Business Cycle)

Lending to create new businesses has evaporated.  In fact, credit creation is moribund.  Banks are happy to borrow at low interest rates and reinvest at higher interest rate government securities without undertaking the riskier business of lending.  New business formation is harmed.  Multinational corporations are satisfied with earning profits outside the United States, which means we have anemic job growth.  We are mired in a non-recovery recovery.

Let the Light In

In our wildfire analogy, the largest trees are the ones that most need to be eliminated.  These are the ones that block growth on the forest floor.   Government may have temporarily arrested financial decline, but at what cost?   I grant you that it will be painful to permit the creative destruction of our “tallest trees”: poor performing banks and industrial companies.   The pain would be sharp but not prolonged.  Using another analogy, we needed to rip the economic band aid off quickly to minimize prolonged pain.http://www.prophetwithoutprofit.com/wp-admin/post-new.php

Mr. Simon in Wildfires pointed out another flaw in aggressive fire fighting:  putting out smaller fires too early.  Dangerous residual undergrowth became tinder for more destructive, larger, out of control wildfires.   Similarly, our government did not fix the financial problems of 2008; they only postponed our date with a larger financial conflagration.

 

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