Posts Tagged: unintended consequences

American Society / Banking / Business / Political / The Federal Reserve — 0 Comments
13
Dec 10

Exploding Myths, Eroding Confidence

In this country, the American dream is with us from birth.  What is that dream?  Get a good education, work hard, be honest, and one will succeed.  What is success? A good income, one’s own home, a college education for the children, and a comfortable retirement.

There are obvious quantifiable effects from the financial crisis, such as reduced retirement savings, reduced income or job loss.  What about the qualitative effect: loss of confidence?   Every society has its dreams and mythology.  The financial crisis has exploded many of our collective myths and turned the dream into a nightmare.

Exploding Myths

Let’s touch on a few of the exploding myths:

1.      Myth: House prices only go up. Reality: Nationwide, from a peak in July 2006, house prices have declined 28.6 percent (Case-Shiller Index).  Many experts say that house prices will suffer a further decline. See Home Prices Falling at Faster Rate, New Report Shows.

2.      Myth: America is a capitalist society, supporting competition and free enterprise. Reality: We have a form of state capitalism bordering on fascism.  The government now bails out large, private corporations which get into financial trouble: Citibank, GE, GM, Chrysler, AIG and others.

3.      Myth: The Federal Reserve can fine tune the economy to avoid recessions.  Reality: Neither Alan Greenspan nor Ben Bernanke foresaw the internet stock bubble, the subprime crisis or the 2008 stock market crash.  We have suffered two 50% stock market declines in the last decade, and for the last two years we are living in a perpetual recession.

4.      Myth: Keynesian and monetarist economic remedies can pull us out of a recession.  Reality: The Federal Reserve and the Administration have tried every Keynesian and monetarist nostrum from economic stimulus programs, cash for clunker tax credits, home buyer tax credits and the outright printing of money (QE1 and QE2).  None of these programs has reduced unemployment or restored economic growth.

5.      Myth: Buying and holding stocks for the long-term is the road to true wealth.  Reality: In the last ten years the stock market has not appreciated.

6.      Myth: The US financial markets are the most open and transparent in the world.   Reality:  Insider trading scandals (Galleon Group), false accounting (Enron, WorldCom), financial firms secretly trading against their client (Goldman), perfect trading records for quarters at a time (Goldman, Bank of America, Morgan Stanley), high frequency trading and flash crashes all confirm for us the murky and duplicitous nature of our markets.   Our sole clarity is that they are run for the benefit of professionals and insiders to the detriment of the retail investor.

7.      Myth: Congress represents the American people.  Reality: Congress represents major corporations and unions who in turn contribute to selective political campaigns.   Winners in healthcare and financial reform were the major banks, investments firms, health care insurers and pharmaceutical companies, not the American public.

8.      Myth: A good education is the key to getting ahead. Reality: Eighty percent of  last year’s college graduates did not have a job upon graduation.  See A Dismal Outlook: Recent College Graduates and the Job Market.  Unemployment is close to ten percent and underemployment close to 17%.  If you listen to Dr. Bernanke’s advice to get a good education, you have a better chance utilizing that education in Mumbai or Shanghai, not in the United States.

9.      Myth: A combination of savings, home price equity appreciation and social security will support a comfortable retirement.  Reality: The financial crisis has decimated retirement savings and eliminated or diminished any gains from home equity.  Given the massive social security unfunded liabilities and the unwillingness of Congress to consider tax increases, even social security is in no way a sure thing upon one’s retirement.  Many individuals may never retire.

10.   Myth:   Everyone will have affordable health care.  Reality: Health insurance premiums have soared since the passage of Obamacare.  See ObamaCare Raising Health Insurance Premiums.  Moreover, with the cut in Medicare reimbursements and increased paperwork, many doctors refuse to accept Medicare reimbursements.

Myths are for Children

A “harmless” myth told to a child may have little consequence.  But the above myths are not being told to children, they are being foisted on an American population with lives and fortunes at stake.  And these false myths are at the core of our society.

One of the most dangerous myths is that debt does not matter.  Myth perpetuation can exist for a while,  but there are always consequences.

“Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.” [Quote from "This Time is Different: Eight Centuries of Financial Folly"]

Bang is the right word. It is the nature of human beings to assume that the current trend will work out, that things can’t really be that bad. The trend is your friend … until it ends.  See Unintended Consequences

Myths are exploding and confidence is eroding.  Things need to change, before “bang!”

GD Star Rating
loading...
  • Share/Bookmark
Financial — 0 Comments
8
Sep 09

What are the Unintended Consequences of Low Interest Rates?

The Federal Reserve has announced that it intends to pursue a low interest rate policy not only now, but for years to come.  The CNBC cheerleaders mindlessly applaud the Fed for pursuing such a policy.  Let’s play devil’s advocate and examine the heretical position that low interest rates are destroying the US economy.  Let’s look at two classes of investors and examine the unintended consequences of a low interest rate policy.

You retired from a large company sometime in 2005 at age 65 with a final salary of $125k with stay at home spouse.   Your lump sum pension, 401k and personal savings have allowed you to accumulate $2m in investable assets.   With interest rates at 6 percent you plan on $120k in income plus a maximum social security benefit of approximately $27k.  In other words, you can relax and look forward to a financially secure retirement with your assets generating $150 k per year of income.  But after the financial crash, we are in “Bernanke World” where interest rates on 3 month T-bills drop to .1 percent.  Our new retiree shops around and finds 12 month CD rates of .90 percent.  Suddenly, $150k annual income drops to approximately $50k of income including social security payments.  Our retired couple has gone from a life of 3-4 great vacations, visits to the grandchildren and dining out several times a week to barely being able to afford housing, food and supplemental medical insurance.

A couple of observations about the plight of our hypothetical couple: the standard response heard in the media is that our couple can just go back into the workforce.  What workforce would that be? Statistics demonstrate that one of the hardest hit groups in this recession is workers over 50.  What employer is clamoring for our now 69-year old couple to re-enter the workforce?  It seems there are just so many Wal-Mart greeter positions.  They are not particularly high paying positions, at least not enough to make up our hypothetical $100k income shortfall.  Further, my guess is that applicants significantly outpace available jobs.

Where is the political support for our couple?  Where is the vaunted AARP?   Where is the AARP’s famed lobbying machine to make the case that bankers (and quite undeserving ones at that) are being favored over thrifty, hardworking retirees? Where is the Congressional response to the plight of our couple?

Other investor constituencies negatively affected by low interest rates are defined benefit pension funds (the classic pension benefit) and insurance companies.  These groups have a basic goal of matching long term liabilities, e.g. pension payments, annuity payments and life insurance payouts with long term assets that will out earn these liabilities.  This is a pretty simple business model with the insurance company or pension fund keeping the excess earning in the form of a profit or a surplus. In the case of a pension fund this surplus or reduce future funding costs for the sponsor, i.e., a company, university or governmental entity.  Insurance companies and pension funds live in an actuarial world of an assumed return on assets.   Insurance companies were guaranteeing that annuities written in the past several decades would earn in excess of 4, 5 or 6 percent.  Pension funds projected that earning on assets would be between 7 to 9 percent.  These aggressive projections moved ever upwards as the 25-year long bull market gave a false sense of confidence to actuaries and financial executives.  Both the pension and insurance company projected earnings levels are now confronting the reality of a low interest rate world.

In a low interest rate world this patented formula is virtually destroyed.  Bridled by fiduciary concerns limiting risk taking, there is a large potential shortfall between projected and actual earnings.  The ramifications are enormous.  Insurance company earnings will be negatively impacted, corporate sponsors of defined benefit pension plans will be negatively impacted as companies by law will be required to make additional contributions affecting net income and cash flows and states and municipalities will be required to increase taxes to meet funding shortfalls.  The Federal Reserve is forcing fiduciaries to take even greater risk to try to catch up with past underperformance.  The autumn 2008 debacle in the financial markets does not auger well for increased risk taking at this point in the economic cycle.

I do not purport to know what the real rate of interest should be, but neither does the Federal Reserve.  I do know that artificially pegging an interest rate at an artificially low number has numerous unintended consequences, two of which are described above.  Driving investors to greater level of risk taking has never ended well.  Get the Federal Reserve out of the equation and let the free market decide the level of interest rates.

GD Star Rating
loading...
  • Share/Bookmark