European leaders finally accept that Greece is insolvent; it isn’t simply experiencing a liquidity crisis. Debts are reduced to make the payments something Greece can handle. Even better, policy is predictable. Markets don’t like uncertainty. They can handle bad news and adverse events when there is some predictability about the events or the policy response. John Taylor of Stanford makes these and other points in his column in The Wall Street Journal. He delivers the good news, the bad news, and warnings about what could go wrong.
Will the debt write-down, the diminished contagion, and the recognition of the policy problems be enough to make the second bailout work as agreed to, with Greece fulfilling the required conditions? Unfortunately, the answer is probably no.
The IMF forecasts for Greek economic growth are too optimistic, and some Greek politicians, including Antonis Samaras, leader of the major conservative party, have already said they will try to change the conditions of the agreement after the upcoming election. The bailout is front-end loaded, with about €90 billion of the €130 billion paid at the start to recapitalize Greek banks, sweeten the debt deal, and finance the budget.
We know that the Federal Reserve’s QE and zero interest rate policies are hurting savers and conservative investors. But can the policies do long-term damage to the economy? The evidence from Japan is appearing to indicate that it does. Japan’s been following policies for over 20 years that are similar to those the U.S. has been following the last few years. Mired in a depression since 1989 or so, Japan’s economy is looking worse. The FT’s Alphaville has a pretty good summary of the problems facing Japan and how monetary policy hasn’t helped and might have made things worse. Fortune goes further and posits that Japan might soon be following Greece down the road to default. Japan certainly has joined the usual precursor to default, which is devaluation of the currency.
These aren’t academic or interesting musings. Japan is a significant part of the world’s economy, and its problems probably held back global growth the last couple of decades. Because of Japan’s importance to the global economy, a ratcheting down of its economy or a debt default likely would be damaging to everyone else’s economy.
Perhaps more importantly, since the U.S. is closely following Japan’s policies after the bursting of its bubble, whatever happens to Japan eventually is likely to happen to the U.S.
Wall Street is buying protection in the form of credit default swaps to prepare for that day Japan implodes. Trading of swaps on Japanese sovereigns has been highly volatile in the past year — they are currently being sold at around 135 basis points, 100 basis points above Japan’s debt yield, credit traders in New York and London tell Fortune. Credit default swaps provide a way for investors to make money in the event of a default.
While the Japanese debt bomb isn’t expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government’s ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.
Sure, the amount of debt Greece owes to European banks is large. The probability is will pay a significant portion of that debt is small. The damage the eventual default will do to the European banking system and the global economy could be substantial. It’s already disrupted markets and the economy for almost two years. But that’s not the worst of it. The austerity measures being imposed on Greece are damaging its society and probably leading to severe long-term consequences. The recent riots are but a small sample of the damage. There’s a good but disturbing review of the situation in the recent New York Times Magazine.
By many indicators, Greece is devolving into something unprecedented in modern Western experience. A quarter of all Greek companies have gone out of business since 2009, and half of all small businesses in the country say they are unable to meet payroll. The suicide rate increased by 40 percent in the first half of 2011. A barter economy has sprung up, as people try to work around a broken financial system. Nearly half the population under 25 is unemployed. Last September, organizers of a government-sponsored seminar on emigrating to Australia, an event that drew 42 people a year earlier, were overwhelmed when 12,000 people signed up. Greek bankers told me that people had taken about one-third of their money out of their accounts; many, it seems, were keeping what savings they had under their beds or buried in their backyards. One banker, part of whose job these days is persuading people to keep their money in the bank, said to me, “Who would trust a Greek bank?”
The extended period of unemployment by millions of Americans is having some unexpected long-term effects. Of course, the economy is producing less because of the overcapacity. The government budget also is in worse shape because all those people aren’t paying taxes, and they’re likely drawing some kinds of public assistance. Recent data indicates that many of the long-term unemployed are applying for Social Security disability benefits and being granted the benefits. This move has several effects. It takes them out of the work force permanently and reduces government tax revenues long-term. It also means Social Security is paying more in benefits than were assumed before the financial crisis, and it probably is accelerating the time when SS taxes received are less than the benefits paid.
Half of the benefit recipients suffer from “mental disorders” and “musculoskeletal disorders” (such as back pain). “Mood disorders” alone account for over 10% of this group. And once someone starts receiving these benefits, it’s almost impossible to take the off the program. In 2011 only 1% of the recipients lost their benefits because they were no longer deemed disabled. So how much is this program costing the US taxpayer? Apparently quite a bit.
JPMorgan: The cost to the federal budget of these programs has escalated along with the number of claimants, and now runs around $200 billion per year—more than the budgets of the Departments of Commerce, Energy, Homeland Security, Interior, Justice, and State combined.
On Thursday a settlement was announced of the lawsuits against mortgage servicing companies. The suits charged the servicers with fraud in what was known as the robo-signing fraud. The settlement was billed as costing the services (who also are the country’s largest banks) at $26 billion. But this article argues that the banks actually won and their costs are likely to be far less than $26 billion. It gives 12 reasons you should hate the settlement.
2. That $26 billion is actually $5 billion of bank money and the rest is your money. The mortgage principal writedowns are guaranteed to come almost entirely from securitized loans, which means from investors, which in turn means taxpayers via Fannie and Freddie, pension funds, insurers, and 401 (k)s. Refis of performing loans also reduce income to those very same investors.
3. That $5 billion divided among the big banks wouldn’t even represent a significant quarterly hit. Freddie and Fannie putbacks to the major banks have been running at that level each quarter.
Corporate profits are another concern. They’ve been at historic levels for several quarters, as have profit margins. We’ve been expecting profit margins and earnings growth to shrink, and that time seems to be arriving. I expect central bank money printing to keep a floor under the economy and the markets, but I also believe we need to be cautious because market prices reflect all the good news. Take a look at this summary of the reasons to be cautious about earnings.
But the increase, 5.8 percent, is less than half the speed at which quarterly profits grew the first nine months of 2011. In the average quarter since the beginning of 2010, earnings have grown five times as fast.
Analysts expect profit growth to accelerate later this year. But so far, almost all the growth comes from two companies, one of them among America’s most favorite, the other among its most hated — Apple and the bailed-out insurance company AIG.
Take away those two companies and profits for the remaining 498 are expected to grow a measly 1.1 percent, according to FactSet, a provider of financial data.
The Fed’s recent announcements make clear to me that it doesn’t care much about the value of the dollar and might even want it to decline. Operation Twist, lending money to the ECB so it can lend it to insolvent banks, and maintaining a zero interest rate policy through late 2014 all indicate other factors are more important than the dollar. Charles Kadlec on Forbes.com says that Fed explicitly plans to devalue the dollar by 33% over 20 years. He figures since the Fed is targeting a 2% inflation rate, that translates to a 33% decline over 20 years.
But, an increase of 2% a year over a period of 20 years will lead to a 50% increase in the price level. It will take 150 (2032) dollars to purchase the same basket of goods 100 (2012) dollars can buy today. What will be called the “dollar” in 2032 will be worth one-third less (100/150) than what we call a dollar today.
The Fed’s zero interest rate policy accentuates the negative consequences of this steady erosion in the dollar’s buying power by imposing a negative return on short-term bonds and bank deposits. In effect, the Fed has announced a course of action that will steal — there is no better word for it — nearly 10 percent of the value of American’s hard earned savings over the next 4 years.
The federal government has been offering mortgage restructuring and relief plans since at least 2008. To date they’ve been small and haven’t had much of an effect on the housing market. The latest plan, offered last week, appears to be bigger and likely to be implemented at least in part. How might it affect you or your loved ones? Take a look at this quick take from Forbes.
There are two important elements of the plan and details of both have been a subject of fierce disagreement. One, which could be worth about $25 billion, relates to how much money would be allocated to benefit homeowners and the specific relief they would receive. The other involves the power states would have to investigate past practices by banks, oversee future ones and monitor compliance with the plan.
U.S. stock indexes are off to their best start since 1987 and are at their lowest valuation since 1989 by at least one measure. Yet, investors remain pessimistic. They continued to withdraw money from U.S. equity funds in 2011 despite strong rallies. Volatility, a long period of poor investment returns, continued weakness in the housing market, and a lack of confidence in the government all are factors in the pessimism. In recent issues of Retirement Watch I’ve been taking a less pessimistic position. The worst of the deleveraging is over for the U.S. and we’re looking to use market volatility in our favor by capturing buying opportunities on market declines. I’m not sounding the all-clear on markets and the economy, but the high level of pessimism plus other factors are long-term positive signs.
Pessimism is taking a toll on the securities industry, where more than 200,000 jobs were lost last year, even as U.S. unemployment declines as the economy accelerates. Sentiment is the worst since the early 1980s, when 17 years of equity market stagnation gave way to the biggest rally in history.
“Investors are scared to death,” Philip Orlando, the New York-based chief equity strategist at Federated Investors Inc., which oversees about $370 billion, said in a telephone interview on Feb. 3. “The fears are justified, but from a valuation standpoint the market has overshot, as it typically does. We’ve been pounding the table to put money into equities.”
How about keeping an eye on Swiss watch sales? JPMorgan thinks the sales are a good indicator of both global and regional economic growth prospects. They point out that the recent data show a rolling over recently on the total sales. But when the data are broken down by region, the U.S. sales are very strong while Asian sales are slowing.
The economy isn’t going to be strong until more people are working and earning incomes similar to those they saw in 2007. Policymakers have been working on the assumption that this is a normal economic downturn, and that the economy would respond to monetary and fiscal stimulus. That hasn’t really worked out, though it did avoid a steep depression. One reason the traditional stimulus hasn’t worked might be that a lot of the current unemployment is structural, not cyclical. The economy has changed a bit since the peak in 2007. There are fewer jobs in financing and housing-related industries.
Two economists, Brad DeLong and Larry Summers, are working on a paper exploring this thesis. You can get a look at some of their key charts and points here. They point out a very important statistic. While the unemployment rate has come down from its recent peak, the employment picture hasn’t changed. We still have about the same number of people working as we did at the economy’s bottom. Many people simply have left the work force in the last few years.
The social discount rate of 4%/year also allows us to do a calculation of the cost of each extra month’s delay in the coming of a recovery proper to the U.S. labor market. Inserting an extra month with the output and employment gap at its current level costs the American economy roughly $100 billion in foregone immediate output. And, at a social real discount rate of 4%, if the reduction in labor-force attachment is indeed permanent, it also costs the American economy $270 billion in the present value of reduced future potential output.
What appears to be the slow transformation of cyclical into structural unemployment in America today is an order of magnitude more damaging to our prosperity than is the simple fact that we are mired in the Lesser Depression.
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