Wednesday, June 30, 2010

Calpers and Risk: Together Forever?

Kit Roane of Fortune reports, Calpers and risk: Together forever? (HT: Bill Tufts, click on link for full article):
Before clocking a $100 billion loss in early 2009, the California Public Employees' Retirement System, known as Calpers, had the swagger of a hedge fund and the certainty of a saint. Other pension funds followed its lead, loading up on leverage, investing in unrated CDOs, shoving money into high-priced private equity deals and barreling into commodities and real estate.

The question now is whether a loss of nearly 40% of its market value -- the worst loss in the system's 77-year history -- has brought Calpers sufficiently back down to earth to avoid another such debacle, and whether other chastened pension systems have followed suit. In truth, not all of the evidence of a rebirth at Calpers is comforting. And in the case of some other underfunded pension funds, their latest financial bets look downright scary.

"Some pension plans are evidently hoping to make up losses by taking more risk," says Olivia Mitchell, executive director of The Pension Research Council at the University of Pennsylvania's Wharton School, whose research has shown many pension funds to be poor asset pickers. But, "pension plans that take a risky position to try to 'earn their way out of underfunding' are quite likely to bear big downside risk when the market tanks."

This is not to say that Calpers, the nation's largest pension fund, hasn't made some strides in the right direction. Facing billions in unfunded liabilities and increasing anger from California taxpayers who are ultimately stuck with the bill, it would be tempting for Calpers to double down. But Clark McKinley, a Calpers spokesman, says the pension system "took some bitter medicine" and has learned important lessons from the recent financial crisis.

Calpers is preparing a new asset allocation strategy after finding that its diversification efforts failed to cushion much of the stock market's fall. Calpers is also reining in its exposure to equity derivatives, moving to reduce leverage in its real estate portfolio, terminating under-performing partnerships, tightening the review process for real estate investments and bringing together its diverse investment groups to poll their knowledge about investment risks and opportunities.

Before, McKinley says, information tended to be stove-piped, meaning the retirement system's fixed income department was selling off mortgages even as the real estate department was shoveling money into the sector.

Years of bad bets catch up

Most of Calpers investment losses came from its largely passive investments in baskets of equities, which still account for about half of the system's assets. But the retirement system also got into trouble by adding leverage, reducing oversight and by chasing other hot markets.

After maintaining a low-risk real estate strategy for decades, studies commissioned by Calpers show that it switched gears in 2002, embracing higher levels of risk even as the real estate market began to top out in 2005. By mid-2009, Calpers had a one-year loss of 48.8% in its real estate portfolio and was reporting among the lowest returns of any large pension fund in the country.

In early 2006, it said it would invest $6 billion in commodities, particularly through index futures, news that caused Grants' Interest Rate Observer to respond: "On the timing of this demarche, we hand Calpers the gold medal for Being Late."

Calpers showed even worse timing in the mortgage market. Just before the market tanked, it invested approximately $140 million in unrated collateralized debt obligations (CDOs) and $1.3 billion in complex buckets of loans and debts called structured investment vehicles (SIV). A Calpers lawsuit puts the SIV losses at "perhaps more than $1 billion."

If the investment losses weren't enough, questions have also been raised about why certain asset managers were chosen by Calpers during this period. The state brought fraud charges against the pension system's former chief executive, Fred Buenrostro, and a former board member named Alfred Villalobos, who later became a money-manager placement agent trying to steer pension system business. Both men have denied the allegations.

Calpers is clearly a better managed pension system these days, and has gained with the market rebound over the last year -- although its $202 billion market capitalization still falls roughly $60 billion short of its 2007 high and the plan remains under-funded by many measures.

But Calpers isn't alone in facing funding difficulties. In one influential study last year, researchers Robert Novy-Marx and Joshua Rauh, of the National Bureau of Economic Research, found that pensions are undercapitalized by $3.12 trillion if one assumes the states have to make good on all of their obligations.

Faced with such possible shortfalls, some pension funds have begun to swing for the fences again. Last year, North Carolina passed legislation allowing its state pension to invest in assets such as junk bonds, commodities and real estate. Wisconsin recently decided to increase its pension's bond exposure by levering the portfolio, with one proposal to add leverage up to 120% within two years (in theory this could reduce the portfolio's stock risk and slightly increase overall returns, but only if interest rates stay low). The San Diego County Employees Retirement Association -- which lost about $150 million when Amaranth Advisors went bust -- is among other public pensions ramping up similar schemes; it plans to borrow up to 35 percent of its assets and invest the money in treasury futures, and sock other funds in emerging market debt.

And a recent review of the Illinois Teachers Retirement System by Alexandra Harris of the Medill Journalism school at Northwestern University found that more than 80% of the system's funds were now seen as risky and that it had added leverage by taking the predominantly risky side of over the counter derivative contracts, such as credit default swaps.

Although Calpers has remained active in many potentially risky markets, so far it has refrained from turning to the sort of concentrated bets undertaken in Illinois or Wisconsin. That said, economists say Calpers could still do more to safeguard its assets.

(Click here for rest of article)
Will Calpers follow Wisconsin and other pension funds leveraging up their portfolios? In a world where pension funds will be lucky to obtain 5% annual return, there is simply no way they will attain that magic 8% investment return without taking on more risk.

But one thing 2008 taught pension fund managers was that asset class correlations are notoriously unstable, especially in a liquidity crisis, and that you have to have safety measures in place to protect against downside risk.

First and foremost, pension funds need to do a better job at managing their liquidity risk. In fact, I think 2008 was a watershed year because people will look back and say that was the year where illiquid, complex, structured strategies died and liquid, easier to understand strategies took off.

But be careful with liquid leveraged strategies. I know the smart folks at Bridgewater know what they're doing, and that a lot of the thought process comes from their work on engineering targeted returns and risk, but I get very nervous when the pension herd moves into replicating a strategy/process without thinking of the consequences of their collective actions, adding more leverage to the entire financial system (bond bubbles can go on longer than you think!).

Large pension funds like Calpers, CalSTRS, the Caisse and CPPIB need to rethink their entire approach to mitigating downside risk. The focus should primarily be on strategic asset allocation, with enough wiggle room to make opportunistic tactical decisions when markets shift abruptly.

These large funds should also be intelligently multiplying their sources of alpha, both internally and externally. My bias remains with liquid strategies. Reuters recently reported that Macro hedge funds best despite May dip - Lombard Odier:

Hedge funds taking directional bets on markets will be among the best performers in 2010 as concerns over the health of major economies continue to dominate markets, said Lombard Odier's head of hedge funds advisory.

Cedric Kohler said on the sidelines of the GAIM hedge funds conference that strong trends in currencies, equities, debt and commodities could help the strategy known as global macro to prosper into 2011 despite a disappointing May.

"The overall environment has been driven by macro events in 2010, and I believe it will continue to be the case because of economic imbalances in the largest markets," said Kohler, whose team at the Geneva-based private bank oversees a fund of hedge funds and advises clients on hedge fund investments.

With markets highly volatile, he said macro managers benefited from their ability to take long or short positions in most markets, trade in very liquid products and change positioning nimbly if their view of the economic outlook changes.

"That's not the same for all asset classes; there has been a significant drop in liquidity in areas like credit, making it difficult to turn around portfolios when the market moves against you," he said.

CS/Tremont data show global macro strategies lost 0.63 percent in May, which Kohler said was disappointing, because such strategies should have performed well in a month when pressure on euro zone economies triggered heavy market declines and sent the euro into tailspin.

"The losses were caused because people were worrying about liquidity and simplifying their trades, with many ending up in the same trade for different reasons," he said.

For example, he said, managers who had been short the euro and long the Australian dollar switched into a euro-dollar trade, which they thought mirrored their original trade and offered better liquidity, while managers playing the Greece theme avoided credit default swaps on worries about a regulatory ban, and used euro-dollar trade as a proxy.

"So people were using same instruments for different reasons, exacerbating volatility in those instruments."

While Kohler said funds of hedge funds should thrive after a difficult two years, he expected their numbers to fall.

"There's going to be industry consolidation. Those funds of funds which are too small or do not have a clear strategy will either close or be bought," said Kohler.

"But prices won't be high. People won't be buying their strategy or their distribution, just their assets under management," he said.

Kohler is too nice. I think the majority of funds of hedge funds will shut down their operations in the next three years. In a deflationary world, fees matter even more, and they'd better be really good at picking alpha managers if they're going to be charging 1 & 10 on top of the 2 & 20. Even if they are good at picking winners, most investors will balk at paying an extra layer of fees.

Finally, I leave you with some excellent Bloomberg interviews that appeared in the last 24 hours. You will have to click on the links to watch, and trust me, they're all worth watching, especially the first one with Lakshman Achutan, managing director of the Economic Cycle Research Institute (click on links to watch and hit play to load up video):

Achuthan Expects Downturn in Global Economic Growth: Video

Xie Says China's Economy to Slow on Wage Inflation: Video

Crescenzi Says Treasuries Offer Insurance Against Crises: Video

And this last interview with Bill Fleckenstein, which I am able to embed here, is for all you perma-bears who think we're heading into another depression. You'll enjoy it, but I don't subscribe to his gloomy scenario.

To be fair to Bill, I agree with some things he says on how the stock market lost its discounting mechanism. He rightly blames this on speculative momentum type traders and computer powered quant traders who have developed algorithms to exploit market inefficiencies. I call this "algos running amok". It works fine when things are fairly stable, but when volatility spikes, watch out below!

Tuesday, June 29, 2010

Preparing for Next Big One?

Before getting into my latest topic, a follow-up on my last comment. Mike Shedlock wasn't impressed, calling me "another Keynesian clown":
I am sick of Keynesian clowns who do not know the cart from the horse, who think debt is a free lunch, who think spending and debt are the ways to get out of debt problems and most of all never say how this debt is going to get paid back.

What causes depressions is an unsustainable run-up in credit and debt that precedes it, NOT a failure to go deeper in debt.

Anyone who understands 5th grade math should be able to figure that out. Unfortunately, Nobel prize winning economists can't.

"I listen to nonsense from some commentators claiming that if the US is not careful, it will suffer the same fate of Greece. Total rubbish." says Kolivakis.

Three Examples of Total Rubbish
  • People who think crack addicts can smoke crack to cure their addiction
  • Alcoholics who think they can drink their way out of alcoholism
  • Debt junkies (and Keynesian clowns) who think one can spend one's way out of a spending problem
In a sense all of the above ideas will "work".

In the first two cases the result is physical death, nature's way of solving the problem. In the third case, a bond revolt and economic death solves the problem.
Echoing Mish, an astute investor sent me this message:
I'm in the camp that believes its the unsustainable creation of credit during the boom phase that is ultimately responsible for the bust... a la Irving Fisher and Hyman Minsky. We've crossed the event horizon of sustainable debt and no amount of Keynesian economics will save us from the inevitable. We are now up against the simple math and exponential functions.

You are correct, fiscal austerity right now would kill the economy. Absolutely crush it. In the end, Keynesian economic theory and fiscal austerity all lead to the same outcome specifically because it is inevitable. Fiscal austerity just gets us there so much quicker.

For example, Japan. They bought themselves about 20 years to date. They have, despite their best efforts and with a very accommodating global economy failed to grow themselves out of a giant debt bubble that burst in 1989. Now what? A default now is inevitable. It was back in 1989 as well. They just played with the timeframe and in so doing increased the scale of the disaster.
I would like to respond to some of the criticism. First, it amazes me how ignorant people are on Keynes and Keynesian economics. Luckily, Lord Skidelsky, author of the most authoritative biography on Keynes, still writes his excellent columns with a genuine Keynesian twist.

Second, I never agreed with Krugman on the use of the word "Depression" or that we need more stimulus. I just think it's lunacy to start implementing aggressive austerity measures before private sector demand picks up convincingly.

Michael Hiltzik of the Los Angeles Times made this point in his article, Lawmakers are putting economic recovery at risk:
What is the source of the deficit panic that's fueling the pushback on economic stimulus? It's certainly not the public's conviction that government assistance is no longer needed. It's hard to identify a widespread perception that the economy has turned up, although Summers argues that such perception always lags behind reality.

"Recoveries are more like rheostats than light switches," he said. "People are gradually getting the sense of improvement. But it won't feel like everything is better all of a sudden. It will take time."

Is it bond investors fearful that deficit spending will drive up long-term interest rates, harming their portfolios, as the economist Paul Krugman posits? Or is it someone's Machiavellian effort to prove the correctness of Keynesian economics, which supports heavy government stimulus in periods when the private sector withdraws from investment, by imposing anti-Keynesian stimulus cuts while they're still needed?

John Maynard Keynes, it should be noted, was unafraid of government deficits. "At the present time, all governments have large deficits," he wrote in 1931, as his biographer Robert Skidelsky observed recently. "They are nature's remedy for preventing business losses from being ... so great as to bring production altogether to a standstill."

A few years later, Franklin D. Roosevelt bowed to his era's deficit hawks and cut back on federal programs to bring the federal budget more into balance. He got the recession of 1937 for his pains.

The deficit-cutting craze of the modern day threatens another such double dip. Its promoters say they're out to protect long-term economic prospects, but without a short-term recovery there may not be a long term to protect. If they get their way, we may not feel the consequences of their error before it's too late to fix.
One doesn't need to look too far to see how fragile this recovery is. Stocks plunged on Tuesday following a weak consumer confidence report.

And now we have New York Times columnist Andrew Ross Sorkin warning us to prepare for the Next Big One:

The next Great Crash is coming. Guaranteed.

Maybe not today and maybe not tomorrow. But, in all likelihood, sooner than we think.

How can I be so sure? Because the history of modern markets is a story of meltdowns. The stock market crashed in 1987, the bond market in 1994. Mexico tanked in 1994, East Asia in 1997. Long-Term Capital Management blew up in 1998, Russia that same year. Dot-coms dot-bombed in 2000. In 2007 — well, you know the rest.

And that was just the last 20 years or so. The stagflation of the 1970s, the Depression of the 1930s, the panics in the 1900s ... and back and back and back it goes, all the way to the Dutch and their tulip bulbs.

In those giddy years before the Great Recession, it seemed as if we had grown accustomed to the wild ride. Wall Street certainly had. Jamie Dimon, the chairman and chief executive of JPMorgan Chase and Company, likes to say that when his daughter came home from school one day and asked what a financial crisis was, he told her: ‘It’s the kind of thing that happens every five to seven years.’ ”

No one should be surprised, Mr. Dimon insists, that booms go bust. That’s the way markets work. Most Americans probably find that answer unsatisfying, to put it politely. After all, millions have lost their homes, their jobs, their savings.

But now here comes the Dodd-Frank Act, which is supposed to ensure that we never repeat that 2008 finale of Wall Street Gone Wild. The bill, if signed into law, might help us avoid another sorry episode like that. But one thing it won’t do is prevent another crisis — if only because the next one probably won’t be like the last one.

So amid all the back-and-forth over this bill, keep in mind one of the most important aspects of the act: it would give Washington policy makers a powerful tool to mitigate the next too-big-to-fail blowup, however that blowup manifests itself. For the first time, Washington would have what is known as resolution authority, that is, the power to wind down a giant financial institution that runs into trouble. If policy makers had had that power during the tumultuous autumn of 2008, they might have averted the catastrophic failure of Lehman Brothers. They might have placed the teetering American International Group into conservatorship. And they might have taken over Bank of America and Citigroup, and possibly even Goldman Sachs and Morgan Stanley. Senior management would have been tossed out.

“We will have a financial crisis again — it’s just a question of the frequency,” said the economist Kenneth Rogoff, who, with Carmen M. Reinhart, wrote a terrific book titled “This Time Is Different: Eight Centuries of Financial Folly.” The title says it all. We’ve been through this before and will go through it again.

While Dodd-Frank might avert another crisis in the short term, Mr. Rogoff says the legislation itself is less important than how regulators act on it — and keep acting on it over the years.

Before World War II, “banking crises were epidemic,” Mr. Rogoff said. Then things settled down because “regulation had become pretty draconian” and laws were actually enforced.

But memories fade. “Having a deep financial crisis is the best vaccination for another right away,” Mr. Rogoff said. Down the road, a lot will depend on the regulators. Ten or 15 years after a crisis, and sometimes a lot less, the watchdogs start to doze. Political winds change. Regulators loosen up.

Many on Capitol Hill insist Dodd-Frank means the end of the “too big to fail” culture, period. Many on Wall Street insist it means the end of American finance. Bankers and their lobbyists argue that American businesses and consumers will ultimately suffer, since all these rules will end up throttling the vital flow of credit through the economy.

Neither side is entirely correct. Businesses in general, and Wall Street in particular, often overreach in search of profits. And regulators, however stringent the laws, often struggle to keep up. We haven’t found a way to legislate around that sober reality.

Consider the 2002 Sarbanes-Oxley law, which sought to reform corporate America after the Enron and WorldCom scandals. The Supreme Court upheld the constitutionality of Sarbanes-Oxley on Monday. It is a strong law that sought to hold executives accountable for accounting shenanigans. Many business people screamed that the law was too strict. Few experts ever argued that the law was too lax.

Have companies engaged in financial fraud since? You bet.

After the Exxon Valdez oil spill in 1989, the government enacted the Oil Pollution Act. Did that legislate away oil spills? Of course not.

Strong regulation is important. And Dodd-Frank goes a long way toward cracking down on some of the worst practices that led to this financial crisis. But my bet is that next time, the culprit won’t be C.D.O.’s or swaps, or shady subprime mortgages. No, the culprit will be some other financial instruments — something someone somewhere is probably dreaming up right now.

In his memoir, Henry M. Paulson Jr., the former Treasury secretary, recalled telling President George W. Bush in 2006 that it was impossible to spot a coming financial blowup.

“We can’t predict when the next crisis will come,” Mr. Paulson told the president. “But we need to be prepared.”

Dodd-Frank, whatever its pros and cons, helps prepare us for the next Big One — whatever that might be. But it won’t stop it.

No legislation will ever stop another financial crisis. Moreover, the financial reforms were just fluff — cosmetic changes that did not address deep structural issues, especially in the OTC derivatives market which remains totally non-transparent.

Finally, stocks moved down violently on Tuesday, but there is no fundamental reason for such a thrashing. Instead of preparing for the "Next Big One", market participants should prepare for a long period of wild market gyrations. What we've witnessed in the last few months may be a taste of things to come.

Monday, June 28, 2010

The Third Depression?

Jim Randle reports, G20 Leaders Pledge to Cut Government Deficits:
Leaders from the world's 20 most important economies set targets to slash government deficits, haggled over tougher financial regulations and compromised on a proposal to tax banks. The G20 meeting wrapped up Sunday in Toronto.

G20 leaders say the global economic recovery is fragile and faces serious challenges, including growing government deficits.

The Greek crisis showed how large deficits can make lenders worry that they will not be repaid, and keep them from making the new loans, stalling the economy.

Canadian Prime Minister Stephen Harper urged his colleagues in advanced nations to cut their deficits in half in three years, but also urged them to make cuts with caution.

"Here is the tight rope that we must walk," he said. "To sustain recovery it is imperative that we follow through on existing stimulus plans those to which we committed ourselves last year but at the same time advanced countries must send a clear message that as our stimulus plans expire we will focus on getting our fiscal houses in order."

Mr. Harper's point is that cutting deficits too little or too slowly hurts investor confidence. But if nations make the cuts too deeply or too quickly, they risk losing the potential economic stimulus generated by government spending, something that critics say could push the global economy back into recession.

The G20's final communiqué, hammered out by leaders behind closed doors, also offers a compromise on a proposal for a new tax on banks.
Some economists are worried about the push to slash deficits too early. In his op-ed piece in the NYT, Paul Krugman goes as far as calling for The Third Depression:

Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.

Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.

But future historians will tell us that this wasn’t the end of the third depression, just as the business upturn that began in 1933 wasn’t the end of the Great Depression. After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.

In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.

As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy, by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.

Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners’ medicine.

It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.

And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.

I also fear that policymakers are making a major mistake by moving so aggressively to cut deficits at a time when the global economy remains fragile. If you go back in history and look at all the major recessions, they were preceded by major policy mistakes. Either the Fed started raising rates too aggressively, or governments slashed spending too aggressively, or both.

I listen to nonsense from some commentators claiming that if the US is not careful, it will suffer the same fate of Greece. Total rubbish. The US economy has as much in common with Greece's economy as Canada's economy has with Romania's economy. All those who claim "it's time to face reality" and cut spending "or face the grim reality that Greece is facing" should be careful for what they wish for. Their myopic focus on austerity could choke off any consumer demand perking up at this critical juncture.

And while some commentators fear a double-dip recession or that the "Great Recession" never ended, I see hopeful signs of recovery. Stéfane Marion, Chief Economist at the National Bank of Canada had this to say about today's US consumer spending figures:
A large amount of economic data will be published this week to help validate/invalidate the robust earnings growth expectations for Q2 – the bottom-up consensus is currently calling for a rise of 27% on a year-over-year basis. In our opinion, we need nominal GDP growth of at least 4% for current profit assumptions to be realized.

After last week’s dismal housing data, it is clear that residential investment will not be a vector of growth this quarter. Fortunately, business investment and inventory rebuilding will more than offset this weakness. However, to get 4% nominal GDP, the consumer sector cannot retrench. Data released on Monday morning are constructive. Consumer spending grew 0.2% in nominal terms in May.

This outcome was all the more impressive in that it occurred despite a 1.6% decline in spending on energy goods. In fact, if we exclude spending on all the non-discretionary items (housing, gasoline, groceries and health), personal consumption expenditures were up a robust 0.4% on the month. As today’s Hot Chart shows (see chart above), spending on discretionary goods and services is actually set to accelerate to a 6% annual clip in Q2. This performance, the best in three years, is not suggestive of disarray in consumer spending patterns.

While I see signs of recovery, I also worry that policy blunders and this myopic focus on austerity to assuage bond vigilantes will kill any recovery going on right now. Below, please watch Chris Haye's interview with Dean Baker, one of the few economists who correctly predicted the US housing meltdown. Listen carefully to Mr. Baker's comments because he's absolutely right on so many of the key points he raises.

Sunday, June 27, 2010

Gauging the Risks of Recession

Advisor Perspectives published John Mauldin's latest weekly comment, Risk of Recession. It's an absolute must read, and I highly suggest you read it all, but I will focus in on the following:
Jonathan Tepper (coauthor of the next book I am working on) sent me this piece from a group called EMphase Finance, based in Montreal. They wrote this back in April, as the Weekly LEI was beginning to turn over. They have found a bit of data that seems very good at predicting the economy of the US 12 months out. Let's take part of their work:

"Many market participants are debating whether or not a double-dip recession will occur within the next quarters. As we are writing our report, ECRI Weekly LEI fell quickly to 122.5 points from 134.7 in April. This indicator did a good job leading U.S. Real GDP Y/Y by 6 months over the last two decades. However, ECRI Weekly LEI recently became quite unreliable as it increased up to 25% Y/Y in April, a level consistent with an unrealistic 8% U.S. Real GDP Y/Y! You can notice the problem on the left chart below.

"We discovered a new leading indicator to forecast U.S. Real GDP Y/Y, and it is simply the U.S. Terms of Trade (TOT). It is defined as the export price / import price ratio. We are pleased to be the first to document this, at least publicly. On the right chart above, TOT leads U.S. Real GDP Y/Y by 12 months. The only drawback: underlying time series are monthly instead of weekly, but this is not really an issue with that much lead. Also, the relationship still holds well if we extend to the maximum data (1985)."

Their conclusion?

"As you probably noticed earlier, TOT is suggesting a decline of U.S. Real GDP Y/Y to nearly 0% within the next 12 months. Q2 2010 Real GDP Q/Q Annualized to be released on the 30th July may match expectations as it reflects data of the last three months, which were positive in general. However, we are most likely going to see weaker numbers in the next quarters. Will this lead to a double-dip recession? We believe the odds of a double-dip recession within the next 9-12 months are minimal, but odds may increase to 50-50 in 2011, depending on the evolution of variables we follow in the upcoming months."

And while we are on leading indicators, let's end with this note from good friend and data maven David Rosenberg of Gluskin Sheff (based in Toronto).

"For the week ending June 11th, the ECRI leading index (growth rate) slipped for the sixth week in a row, to -5.7% from -3.7%. Only once in the past – in 1987, but the Fed could cut rates then – did this fail to signal a recession. But a -5.7% print accurately signaled a recession in the lead-up to all of the past seven downturns.

"The consensus is looking at 3% real GDP growth for the second half of the year, but as Chart 2 (above) suggests, the two quarters following a move in the ECRI to a -5% to -10% range is +0.8% at an annual rate on average. So right now the choice is really either a 2002-style growth relapse or an outright double-dip recession – pick your poison."

I suggest you all read Emphase Finance's June 2010 letter. Francois Soto writes well, reviewing many leading economic indicators. I am glad John mentioned his firm in his weekly letter giving me chance to discover and promote new talent in Montreal's finance circle.

Another Montreal firm John mentioned was Bank Credit Analyst (BCA Research). BCA is where I got my hands dirty and really learned about markets and macroeconomics. I miss those Friday afternoon meetings where someone presented market research and each Managing Editor talked about the risks they saw in the areas they covered.

Eric Lam of the Financial Post reports that Chen Zhao of BCA Research thinks a double-dip recession is unlikely and European worries are overblown:

U.S. economic data has recently taken a turn for the worse, while the sovereign debt contagion continues to spread in Europe, leading many to mouth the two words nobody wants to hear: Double Dip.

Chen Zhao with independent research firm BCA Research, said while there are continuing concerns weighing on global markets, the world will bend but not break.

“The odds of a double-dip recession are low and as long as there is no renewed economic contraction, equity prices should grind higher over time,” he said in a report.

Efforts by central banks, especially in the United States and Sweden, to expand their balance sheet by taking on equity have worked to stabilize banking sector problems and deflationary tendencies.

“Therefore, the ECB’s recent move to beef up quantitative easing and its reassurance that it will buy sovereign debt and even private credit should be viewed very positively,” Mr. Chen said. “This action has greatly reduced the risk of a major policy blunder and therefore lends support to risky assets over time.”

Of course, there is still a real risk of double-dipping in Europe, but Mr. Chen said the eurozone economy has been “rather moribund for years” and is so marginalized its contribution to global growth has become minimal.

For example, when the Japanese economy collapsed in the early 1990s, many expected a chain reaction sending the rest of the world into a death spiral.

Instead, the rest of the world went into a sustained boom.

“What the experience suggests is that the cross influences of various economic forces are always intertwined and that they are difficult to disentangle and assess at the time,” Mr. Chen said. “Netting it all out, it seems maintaining a positive bias is a reasonable posture as far as investment strategy is concerned.”

Besides, people start talking about a double dip at some point after every recession, and there is no reason why this recession is any different, he said.

I agree with Chen. My contacts at pension funds, economics departments, and at hedge funds all tell me the likelihood of a double-dip recession is low. In fact, some see the US economy picking up again in 2011 after growth rates come down in the second half of this year/ early next year.

It's too early to tell but one thing is for sure, E.S Browning of the WSJ is right when he reported that rapid declines in stocks have rattled even optimists:

A look at history confirms something many investors had felt about the market's recent turmoil: It is the speed of the declines, even more than the size, that has been most shocking.

The Dow Jones Industrial Average fell 12.4% in just 42 days from the peak on April 26 through June 7. The Standard & Poor's 500-stock index fell 13.7% in 45 days from its peak.

The only other time in 80 years that the Dow has fallen that far, that fast so early in an economic rebound was in 1950, when North Korea invaded South Korea to start the Korean War. Then, the Dow fell 13.6% in 31 days from peak to trough, according to a study done for The Wall Street Journal by Ned Davis Research. Stocks recovered in 1950 and remained in a bull market for another decade.


This spring, the stock decline has been blamed on things like fears of spreading debt woes in Europe and the Gulf of Mexico oil spill, severe problems but somehow less bone-chilling than a Communist invasion. The fact that the market has proved so fragile has made even some optimistic analysts wonder whether the troubles might be deeper than people had believed.

"This correction has had more legs than we thought," says Tim Hayes, Ned Davis's chief investment strategist.

At the end of last week, stocks did rally. Mr. Hayes says the many indicators he tracks tell him the recent downdraft is probably a nasty interlude to be followed by more gains. Still, the market's vulnerability has left him with doubts.

"We could actually be in a bear market now," he acknowledges. If so, stocks would resume their declines and, by the most common definition, the Dow would continue down to at least 20% from the April high.

Before the April swoon, the Dow had been up 71% from its low on March 9, 2009, one of the fastest rallies of that size in market history.

To see how the recent declines stack up with past ones, Ned Davis Research looked at all pullbacks of 10% or more during periods when the economy was in the first 18 months of recovery from recession, as it is now. Normally, that is a strong period for stocks: The study found that rapid declines are rare in such a period and tend to be associated with unsettling world events.

In 1955, the Dow fell 10% in 18 days—a smaller decline than today's, but a sharp one. It came at the time of President Dwight Eisenhower's heart attack, which shocked the country. To find a similarly large decline in a short period, one has to go back to 1928, when the inflated stock market wavered less than a year before the 1929 crash.

It isn't common for stocks to go into a bear market so soon after an economic recovery has begun, but it isn't unprecedented. It happened in 1962, at the end of the long 1950s bull market. In 2002, stocks fell more than 31%, during the Enron and WorldCom scandals. That was another period when stocks rallied after a long bear market and then hit trouble, a double dip that shattered investors' confidence. In 2002, the rally ran out of steam and the bear market resumed, although the rally in 2001-2002 wasn't nearly as long or as large as the one the market has just experienced. Much like 2002, the recent decline has also alarmed many individual investors who had only just begun to regain their appetite for stocks.

Stocks also went into bear markets in the early phases of economic recoveries in the 1930s and 1940s, a period of economic and international unrest.

Some analysts compare the current pullback with a 15.6% correction that began late in 1983. That one came at the beginning of a long period of stock strength that ran from 1982 through 2000, and turned out to be no more than a painful blip. The difference is that the 1983-1984 correction happened slowly, over eight months.

Some say that electronic trading may be playing a part this time by contributing to exceptional volatility, because hundreds of millions of shares can change hands in minutes. Once, it was highly unusual for 90% of stocks to be up or down on any single day. In recent years, as computers have come to dominate trading, it has become much more common.

Bespoke Investment Group did a study looking at all declines of 10% or more in the S&P 500 since 1927. Those include 40 cases in which the S&P 500 fell as much as, or more than, its recent 13.7% decline.

In 25 cases, the majority, stocks continued down and wound up in a bear market, meaning a decline of 20% or more. But there was still a significant minority of cases, 15, in which the declines stopped short of a bear market.

"This correction has happened very fast compared to most corrections," says Justin Walters, Bespoke's co-founder.

The deeper a decline gets, the higher the odds it will become a bear market. Like Mr. Hayes, Mr. Walters says he expects stocks to avoid a bear market this time. But if stocks turn down again and "we hit a new low, the odds are really high that we will go into a bear market, based on the historical numbers," he says.

One reason that analysts such as Mr. Walters and Mr. Hayes expect stocks to recover is that they were looking particularly strong shortly before the April declines.

Almost 30% of stocks on the New York Stock Exchange hit new highs in March, the most since 2003, Mr. Hayes says. The market turned down just one week after the percentage of new highs peaked in mid-April.

It is rare for stocks to go from such broad strength directly into a bear market. It usually takes indexes weeks to begin a decline after individual stocks begin fading. The only time a bear-market decline began a week after a peak in new highs was in March 2002, and many analysts consider that downturn the continuation of an old bear marketrather than the start of a new one.

Bearish analysts worry that the market's recent weakness is a sign that the world's debt and unemployment problems may be too severe to keep the stock market moving higher. But Richard Sylla, professor of economics and financial history at New York University's Stern School of Business, says he feels optimistic about the market.

His research shows that horrible decades like the past one tend to be followed by better periods for stocks. It is normal for stocks to rally when unemployment is high, before the economy is fully back on its feet, he says. He says corporations have cut their debt and improved cash positions and profits.

Prof. Sylla says he put some of his personal savings back into stocks early this month. He didn't put all his cash to work, however, and says he would consider buying more stocks if prices fall more. Although it could take more time, he says, he thinks better days are ahead for stocks."After 10 bad years, I think the next 10 years will look pretty good," he says.

When it comes to understanding stock market swings, I love reading Tim Hayes of Ned Davis Research, one of the best strategists in the industry. Just like BCA, the whole team at NDR is excellent and they provide top-notch research to their institutional clients.

My personal feeling is that the dominance of high frequency trading (HFT) platforms at prop trading desks of large banks and large hedge funds are behind the rapid declines in stocks we have witnessed.

Finally, take the time to read Ciovacco Capital Management's latest essay, Market Corrections and Economic Cycles. Mr. Ciovacco concludes

  • The markets are currently weak and need to be monitored closely.
  • Even in the context of an ongoing bull market, further weakness in stocks is possible, especially over the next two-to-twelve weeks.
  • History says patience remains important since the odds continue to favor gains in risk assets over the next three-to-twelve months

Decisions in the next two-to-twelve weeks will most likely be very important relative to full year 2010 performance. As long as the odds favor positive outcomes over the longer-term, we will make an effort ride out any future volatility. If the odds shift in a bearish manner, we will make principal protection a higher priority.

I still think that we are likely going to experience a low volume summer melt-up in stocks. I am looking for oil prices to head higher, mainly because of geopolitical risks, but I also think algorithmic trading will pick-up and you're going to see some very jerky markets this summer.

I am more confident that the US economic recovery will proceed unabated, albeit at a slower pace than the last ten months. Keep watching those employment reports at the beginning of the month because any sign of a recovery there will bolster confidence in stocks and the real economy.

Saturday, June 26, 2010

"New Austerity" Threatening Global Recovery?

Earlier this week, George Soros said German fiscal policy endangers the European currency union:

“The German policy is a danger for Europe, it could destroy the European project,” Soros was quoted as saying. “If the Germans do not change their policy, their exit from the currency union would be helpful for the rest of Europe,” he added, according to the report.

Soros also said that one “can’t rule out a collapse of the euro,” Die Zeit said.

Collapse of the euro? Obviously Soros is short euros, but he's not the only one concerned about Europe's fiscal policies. In counterpunch's weekend edition, Michael Hudson writes, Europe's Fiscal Dystopia: the "New Austerity" Road:

Europe is committing fiscal suicide – and will have little trouble finding allies at this weekend’s G-20 meetings in Toronto. Despite the deepening Great Recession threatening to bring on outright depression, European Central Bank (ECB) president Jean-Claude Trichet and prime ministers from Britain’s David Cameron to Greece’s George Papandreou (president of the Socialist International) and Canada’s host, Conservative Premier Stephen Harper, are calling for cutbacks in public spending.

The United States is playing an ambiguous role. The Obama Administration is all for slashing Social Security and pensions, euphemized as “balancing the budget.” Wall Street is demanding “realistic” write-downs of state and local pensions in keeping with the “ability to pay” (that is, to pay without taxing real estate, finance or the upper income brackets). These local pensions have been left unfunded so that communities can cut real estate taxes, enabling site-rental values to be pledged to the banks of interest. Without a debt write-down (by mortgage bankers or bondholders), there is no way that any mathematical model can come up with a means of paying these pensions. To enable workers to live “freely” after their working days are over would require either (1) that bondholders not be paid (“unthinkable”) or (2) that property taxes be raised, forcing even more homes into negative equity and leading to even more walkaways and bank losses on their junk mortgages. Given the fact that the banks are writing national economic policy these days, it doesn’t look good for people expecting a leisure society to materialize any time soon.

The problem for U.S. officials is that Europe’s sudden passion for slashing public pensions and other social spending will shrink European economies, slowing U.S. export growth. U.S. officials are urging Europe not to wage its fiscal war against labor quite yet. Best to coordinate with the United States after a modicum of recovery.

Saturday and Sunday will see the six-month mark in a carefully orchestrated financial war against the “real” economy. The buildup began here in the United States. On February 18, President Obama stacked his White House Deficit Commission (formally the National Commission on Fiscal Responsibility and Reform) with the same brand of neoliberal ideologues who comprised the notorious 1982 Greenspan Commission on Social Security “reform.”

The pro-financial, anti-labor and anti-government restructurings since 1980 have given the word “reform” a bad name. The commission is headed by former Republican Wyoming Senator Alan Simpson (who explained derisively that Social Security is for the “lesser people”) and Clinton neoliberal Erskine Bowles, who led the fight for the Balanced Budget Act of 1997. Also on the committee are bluedog Democrat Max Baucus of Montana (the pro-Wall Street Finance Committee chairman). The result is an Obama anti-change dream: bipartisan advocacy for balanced budgets, which means in practice to stop running budget deficits – the deficits that Keynes explained were necessary to fuel economic recovery by providing liquidity and purchasing power.

A balanced budget in an economic downturn means shrinkage for the private sector. Coming as the Western economies move into a debt deflation, the policy means shrinking markets for goods and services – all to support banking claims on the “real” economy.

The exercise in managing public perceptions to imagine that all this is a good thing was escalated in April with the manufactured Greek crisis. Newspapers throughout the world breathlessly discovered that Greece was not taxing the wealthy classes. They joined in a chorus to demand that workers be taxed more to make up for the tax shift off wealth. It was their version of the Obama Plan (that is, old-time Rubinomics).

On June 3, the World Bank reiterated the New Austerity doctrine, as if it were a new discovery: The way to prosperity is via austerity. “Rich counties can help developing economies grow faster by rapidly cutting government spending or raising taxes.” The New Fiscal Conservatism aims to corral all countries to scale back social spending in order to “stabilize” economies by a balanced budget. This is to be achieved by impoverishing labor, slashing wages, reducing social spending and rolling back the clock to the good old class war as it flourished before the Progressive Era.

The rationale is the discredited “crowding out” theory:

Budget deficits mean more borrowing, which bids up interest rates. Lower interest rates are supposed to help countries – or would, if borrowing was for productive capital formation. But this is not how financial markets operate in today’s world. Lower interest rates simply make it cheaper and easier for corporate raiders or speculators to capitalize a given flow of earnings at a higher multiple, loading the economy down with even more debt!

Alan Greenspan parroted the World Bank announcement almost word for word in a June 18 Wall Street Journal op-ed. Running deficits is supposed to increase interest rates. It looks like the stage is being set for a big interest-rate jump – and corresponding stock and bond market crash as the “suckers’ rally” comes to an abrupt end in months to come.

The idea is to create an artificial financial crisis, to come in and “save” it by imposing on Europe and North America a “Greek-style” cutbacks in social security and pensions. For the United States, state and local pensions in particular are to be cut back by “emergency” measures to “free” government budgets.

All this is an inversion of the social philosophy that most voters hold. This is the political problem inherent in the neoliberal worldview. It is diametrically opposed to the original liberalism of Adam Smith and his successors. The idea of a free market in the 19th century was one free from predatory rentier financial and property claims. Today, an Ayn-Rand-style “free market” is a market free for predators. The world is being treated to a travesty of liberalism and free markets.

This shows the usual ignorance of how interest rates are really set – a blind spot which is a precondition for being approved for the post of central banker these days. Ignored is the fact that central banks determine interest rates by creating credit. Under the ECB rules, central banks cannot do this. Yet that is precisely what central banks were created to do. European governments are obliged to borrow from commercial banks.

This financial stranglehold threatens either to break up Europe or to plunge it into the same kind of poverty that the EU is imposing on the Baltics. Latvia is the prime example. Despite a plunge of over 20 per cent in its GDP, its central bankers are running a budget surplus, in the hope of lowering wage rates. Public-sector wages have been driven down by over 30 per cent, and the government expresses the hope for yet further cuts – spreading to the private sector. Spending on hospitals, ambulance care and schooling has been drastically cut back.

What is missing from this argument? The cost of labor can be lowered by a classical restoration of progressive taxes and a tax shift back onto property – land and rentier income. Instead, the cost of living is to be raised, by shifting the tax burden further onto labor and off real estate and finance. The idea is for the economic surplus to be pledged for debt service.

In England, Ambrose Evans-Pritchard has described a “euro mutiny” against regressive fiscal policy. But it is more than that. Beyond merely shrinking the economy, the neoliberal aim is to change the shape of the trajectory along which Western civilization has been moving for the past two centuries. It is nothing less than to roll back Social Security and pensions for labor, health care, education and other public spending, to dismantle the social welfare state, the Progressive Era and even classical liberalism.

So we are witnessing a policy long in the planning, now being unleashed in a full-court press. The rentier interests, the vested interests that a century of Progressive Era, New Deal and kindred reforms sought to subordinate to the economy at large, are fighting back. And they are in control, with their own representatives in power – ironically, as Social Democrats and Labor party leaders, from President Obama here to President Papandreou in Greece and President Jose Luis Rodriguez Zapatero in Spain.

Having bided their time for the past few years the global predatory class is now making its move to “free” economies from the social philosophy long thought to have been irreversibly built into the economic system: Social Security and old-age pensions so that labor didn’t have to be paid higher wages to save for its own retirement; public education and health care to raise labor productivity; basic infrastructure spending to lower the costs of doing business; anti-monopoly price regulation to prevent prices from rising above the necessary costs of production; and central banking to stabilize economies by monetizing government deficits rather than forcing the economy to rely on commercial bank credit under conditions where property and income are collateralized to pay the interest-bearing debts, culminating in forfeitures as the logical culmination of the Miracle of Compound Interest.

This is the Junk Economics that financial lobbyists are trying to sell to voters: “Prosperity requires austerity.” “An independent central bank is the hallmark of democracy.” “Governments are just like families: they have to balance the budget.” “It is all the result of aging populations, not debt overload.” These are the oxymorons to which the world will be treated during the coming week in Toronto.

It is the rhetoric of fiscal and financial class war. The problem is that there is not enough economic surplus available to pay the financial sector on its bad loans while also paying pensions and social security. Something has to give. The commission is to provide a cover story for a revived Rubinomics, this time aimed not at the former Soviet Union but here at home. Its aim is to scale back Social Security while reviving George Bush’s aborted privatization plan to send FICA paycheck withholding into the stock market – that is, into the hands of money managers to stick into an array of junk financial packages designed to skim off labor’s savings.

So Obama is hypocritical in warning Europe not to go too far too fast to shrink its economy and squeeze out a rising army of the unemployed. His idea at home is to do the same thing. The strategy is to panic voters about the federal debt – panic them enough to oppose spending on the social programs designed to help them. The fiscal crisis is being blamed on demographic mathematics of an aging population – not on the exponentially soaring debt overhead, junk loans and massive financial fraud that the government is bailing out.

What really is causing the financial and fiscal squeeze, of course, is the fact that that government funding is now needed to compensate the financial sector for what promises to be year after year of losses as loans go bad in economies that are all loaned up and sinking into negative equity.

When politicians let the financial sector run the show, their natural preference is to turn the economy into a grab bag. And they usually come out ahead. That’s what the words “foreclosure,” “forfeiture” and “liquidate” mean – along with “sound money,” “business confidence” and the usual consequences, “debt deflation” and “debt peonage.”

Somebody must take a loss on the economy’s bad loans – and bankers want the economy to take the loss, to “save the financial system.” From the financial sector’s vantage point, the economy is to be managed to preserve bank liquidity, rather than the financial system run to serve the economy. Government social spending (on everything apart from bank bailouts and financial subsidies), disposable personal income are to be cut back to keep the debt overhead from being written down. Corporate cash flow is to be used to pay creditors, not employ more labor and make long-term capital investment.

The economy is to be sacrificed to subsidize the fantasy that debts can be paid, if only banks can be “made whole” to begin lending again – that is, to resume loading the economy down with even more debt, causing yet more intrusive debt deflation.

This is not the familiar old 19th-century class war of industrial employers against labor, although that is part of what is happening. It is above all a war of the financial sector against the “real” economy: industry as well as labor.

The underlying reality is indeed that pensions cannot be paid – at least, not paid out of financial gains. For the past fifty years the Western economies have indulged the fantasy of paying retirees out of purely financial gains (M-M’ as Marxists would put it), not out of an expanding economy (M-C-M’, employing labor to produce more output). The myth was that finance would take the form of productive loans to increase capital formation and hiring. The reality is that finance takes the form of debt – and gambling. Its gains were therefore made from the economy at large. They were extractive, not productive. Wealth at the rentier top of the economic pyramid shrank the base below. So something has to give. The question is, what form will the “give” take? And who will do the giving – and be the recipients?

The Greek government has been unwilling to tax the rich. So labor must make up the fiscal gap, by permitting its socialist government to cut back pensions, health care, education and other social spending – all to bail out the financial sector from an exponential growth that is impossible to realize in practice. The economy is being sacrificed to an impossible dream. Yet instead of blaming the problem on the exponential growth in bank claims that cannot be paid, bank lobbyists – and the G-20 politicians dependent on their campaign funding – are promoting the myth that the problem is demographic: an aging population expecting Social Security and employer pensions. Instead of paying these, governments are being told to use their taxing and credit-creating power to bail out the financial sector’s claims for payment.

Latvia has been held out as the poster child for what the EU is recommending for Greece and the other southern EU countries in trouble: Slashing public spending on education and health has reduced public-sector wages by 30 per cent, and they are still falling. Property prices have fallen by 70 percent – and homeowners and their extended family of co-signers are liable for the negative equity, plunging them into a life of debt peonage if they do not take the hint and emigrate.

The bizarre pretense for government budget cutbacks in the face of a post-bubble economic downturn is that the supposed aim is to rebuild “confidence.” It is as if fiscal self-destruction can instill confidence rather than prompting investors to flee the euro. The logic seems to be the familiar old class war, rolling back the clock to the hard-line tax philosophy of a bygone era – rolling back Social Security and public pensions, rolling back public spending on education and other basic needs, and above all, increasing unemployment to drive down wage levels. This was made explicit by Latvia’s central bank – which EU central bankers hold up as a “model” of economic shrinkage for other countries to follow.

It is a self-destructive logic. Exacerbating the economic downturn will reduce tax revenues, making budget deficits even worse in a declining spiral. Latvia’s experience shows that the response to economic shrinkage is emigration of skilled labor and capital flight. Europe’s policy of planned economic shrinkage in fact controverts the prime assumption of political and economic textbooks: the axiom that voters act in their self-interest, and that economies choose to grow, not to destroy themselves. Today, European democracies – and even the Social Democratic, Socialist and labour Parties – are running for office on a fiscal and financial policy platform that opposes the interests of most voters, and even industry.

The explanation, of course, is that today’s economic planning is not being done by elected representatives. Planning authority has been relinquished to the hands of “independent” central banks, which in turn act as the lobbyists for commercial banks selling their product – debt. From the central bank’s vantage point, the “economic problem” is how to keep commercial banks and other financial institutions solvent in a post-bubble economy. How can they get paid for debts that are beyond the ability of many people to pay, in an environment of rising defaults?

The answer is that creditors can get paid only at the economy’s expense. The remaining economic surplus must go to them, not to capital investment, employment or social spending.

This is the problem with the financial view. It is short-term – and predatory. Given a choice between operating the banks to promote the economy, or running the economy to benefit the banks, bankers always will choose the latter alternative. And so will the politicians they support.

Governments need huge sums to bail out the banks from their bad loans. But they cannot borrow more, because of the debt squeeze. So the bad-debt loss must be passed onto labor and industry. The cover story is that government bailouts will permit the banks to start lending again, to reflate the Bubble Economy’s Ponzi-borrowing. But there is already too much negative equity and there is no leeway left to restart the bubble. Economies are all “loaned up.” Real estate rents, corporate cash flow and public taxing power cannot support further borrowing – no matter how wealth the government gives to banks. Asset prices have plunged into negative equity territory. Debt deflation is shrinking markets, corporate profits and cash flow. The Miracle of Compound Interest dynamic has culminated in defaults, reflecting the inability of debtors to sustain the exponential rise in carrying charges that “financial solvency” requires.

If the financial sector can be rescued only by cutting back social spending on Social Security, health care and education, bolstered by more privatization sell-offs, is it worth the price? To sacrifice the economy in this way would violate most peoples’ social values of equity and fairness rooted deep in Enlightenment philosophy.

That is the political problem: How can bankers persuade voters to approve this under a democratic system? It is necessary to orchestrate and manage their perceptions. Their poverty must be portrayed as desirable – as a step toward future prosperity.

A half-century of failed IMF austerity plans imposed on hapless Third World debtors should have dispelled forever the idea that the way to prosperity is via austerity. The ground has been paved for this attitude by a generation of purging the academic curriculum of knowledge that there ever was an alternative economic philosophy to that sponsored by the rentier Counter-Enlightenment. Classical value and price theory reflected John Locke’s labor theory of property: A person’s wealth should be what he or she creates with their own labor and enterprise, not by insider dealing or special privilege.

This is why I say that Europe is dying. If its trajectory is not changed, the EU must succumb to a financial coup d’êtat rolling back the past three centuries of Enlightenment social philosophy. The question is whether a break-up is now the only way to recover its social democratic ideals from the banks that have taken over its central planning organs.

I am more optimistic than Michael on Europe. There will be short-term pain, workers will be squeezed, but longer-term, if Europe survives this crisis, these reforms will put it back on solid footing for many years to come. This doesn't mean the Euro can't go lower (I think it will), but I feel that doomsayers are premature pronouncing Europe's death.

Of course, if the G20 only focuses on austerity measures and ignores growth and how to tackle long-term structural problems like high unemployment, then the world economy will slip into a protracted deflationary death spiral.

Finally, take the time to watch Bloomberg's interview with Rod Smyth, chief investment strategist at Riverfront Investment Group and Richard Regan of (click here to watch). Below, RT's Anissa Naouai interviews Ella Kokotsis to get her take on what we can expect from this weekend's meeting.

Friday, June 25, 2010

Close But No Cigar!

Angela Charlton of the Boston Globe reports, French prime minister urges big cost-cutting:
France's Prime Minister Francois Fillon on Friday rebuffed unions angry over plans to raise the retirement age by two years, urging the French to show "courage" and make an unprecedented effort to cut the enormous national debt.

The government said Friday it's considering freezing public sector salaries for the next three years -- a prospect that prompted unions to slam the door on salary talks with the labor minister in protest.

Unions are energized after nationwide strikes and protests Thursday that brought nearly a million people to the streets to protest President Nicolas Sarkozy's bid to reform a money-losing pension system. The reform includes raising the retirement age from 60 to 62 -- which would still be among the lowest in Europe.

Fillon defended the pension reform at a news conference hastily arranged after Thursday's protests.

Fillon said he "understands the worries" of workers, but added, "We must break the spiral of indebtedness. ... We need a bit of courage."

He carefully avoided using the word "austerity," saying it was too soon to impose cutbacks like the more sweeping ones introduced in Germany or some other European countries.

He spoke as Sarkozy and Finance Minister Christine Lagarde were heading to Canada for meetings of the G-8, or Group of Eight, and later the G-20, or Group of 20 leading world economies.

A key subject at the discussions will be how to revive the world economy after global financial meltdown, and how much and how fast to cut government spending.

Lagarde said on France-Inter radio Friday that France's pension reform is the government's way of "trying to send a message of security to the markets" about France's commitment to cutting its debt.

The French budget deficit was at 7.5 percent of gross domestic product last year. The conservative government has vowed to bring it under 3 percent -- the threshold set by the European Union -- by 2013. The Greek crisis has given added urgency to France's plans to cut back.

Fillon insisted that the pension reform and other cost-cutting would not threaten to slow the economic recovery, and reiterated forecasts that the French economy will grow 1.4 percent this year after contracting 2.5 percent last year.

Fillon said the retirement reform will save nearly euro19 billion ($29.3 billion) in 2018 and should bring the pension system back into the black that year.

Unions say money for the pension system should come from higher taxes or charges on those who are still working, and see cost-cutting in the pension system as an attack on a hard-fought way of life. The government says that given rising life expectancy, workers must retire later.

Unions have long feared that public sector salaries could be targeted in cost-cutting measures, and the government confirmed Friday that a 3-year salary freeze is on the table, according to Jean-Marc Canon, head of the CGT-Fonction Publique union.

He was part of salary talks with Labor Minister Eric Woerth on Friday that ended in a union walkout.

Feeling the heat, French president Nicolas Sarkozy said cigars are out and perks will be cut ahead of austerity measures:

Parliamentary pensions, a lavish Bastille Day garden party and ministers’ Cuban cigars are to be sacrificed in the name of economic recovery as the French government seeks to show that ministers are sharing the pain of their austerity drive.

With his government attempting to raise the retirement age and bracing people for cuts of €45 billion in public spending, president Nicolas Sarkozy has said ministers must lead by example and reduce their own budgets. France has not yet set out a detailed austerity package, but the national auditing office recently called for urgent moves to trim the deficit.

It is widely believed that Mr Sarkozy will cancel the traditional July 14th garden party at the Elysée Palace, an annual event that was attended by 7,000 people last year and cost more than €700,000.

Ministers are also to be ordered to cut the number of people employed in their cabinets (private offices), while a reduction in the number of ministers is expected in the next reshuffle.

The government’s belt-tightening follows a series of damaging revelations about ministers’ extravagant lifestyles and waste of public money.

It was reported this week that prime minister François Fillon had asked junior minister Christian Blanc to reimburse the state €12,000 of taxpayers’ money which was used to buy expensive cigars.

Le Canard Enchaîné, which has specialised in publishing details of ministers’ expenses, had published receipts from a Paris cigar shop for high-end Cuban brands that were billed to the government.

Mr Blanc, a former head of Air France who is now junior minister for the greater Paris area, blamed a staff member for the purchases and has already reimbursed €3,500 for those he had smoked.

Further embarrassment followed when it was revealed that Christine Boutin, a minister sacked last year by Mr Sarkozy, was still earning €18,000 a month from the state thanks to a parliamentary pension and a special “mission” from the president to write a report on globalisation.

Ms Boutin said she would keep the pension and give up the € 9,000 a month for the report.

The Boutin controversy then led to five ministers who were drawing a parliamentary pension being ordered to forego them as long as they served in the cabinet.

Until recently, the generous perks and privileges given to France’s ruling class had attracted relatively little scrutiny, but the economic crisis, public disquiet and regular leaks have shone a harsh light on the system.

Two months ago, Mr Fillon ordered ministers to take only commercial flights after his state secretary for overseas development, Alain Joyandet, spent €116,500 chartering a private jet to attend a conference in Martinique.

Another perk in peril is the free Paris flat that goes automatically with cabinet rank, whether needed or not.

That one hit the headlines when industry minister Christian Estrosi was revealed to be occupying rooms at the Economics Ministry in eastern Paris while lending a relative his official apartment overlooking the Eiffel Tower on the other side of the city.

Fadela Amara, state secretary for urban affairs, admitted this month that family members sometimes used her official apartment in the same upmarket district while she stayed in her own more humble flat in a working-class part of the city.

The revelations about ministers’ royal-style perks have been especially damaging because they coincide with the government’s attempts to prepare the public for severe spending cuts.

Didier Migaud, the head of the national auditing office, said savings of €45 billion would be needed and that the government would be required to take a “very sharp turn” on public finances.

France, alone among the biggest European economies, has yet to set out details of a savings plan, but a spokesman for Mr Sarkozy said measures would be outlined in the coming weeks.

What are those French ministers smoking? Meanwhile, Reuters reports that the Greek government agreed on Friday the most radical shake-up of its pension system in decades to avert bankruptcy and satisfy foreign lenders despite fierce opposition at home:

The reform cuts benefits, curbs widespread early retirement, increases the number of contribution years from 35-37 to 40 and raises women's retirement age from 60 to match men on 65.

"We inherited a pension system which had collapsed and we are fixing it," Labour Minister Andreas Loverdos told a news conference after the cabinet approved the cuts. "It is our responsibility to save the country from bankruptcy."

The ruling socialists face a battle over the reforms, agreed as part of a 110 billion euro ($147.6 billion) emergency loan package from the EU and IMF. Most voters oppose the reforms and a strike on June 29 will gauge the strength of public discontent as lawmakers start debating the bill.

"The draft pension bill ... is slaughtering fundamental pension rights," public sector union ADEDY said in a statement.

By contrast, the EU Commision in Brussels praised the overhaul as respecting the loan deal.

"We welcome it as a major step towards improving the sustainability of public finances," spokesman Amadeu Altafaj Tardio said.

The socialist party has 157 of 300 seats in parliament and the reform is likely to pass despite some criticism from its ranks.

Analysts see the Greek pension reform as a test case. It goes beyond tax increases and public wage cuts to tackle a sector which epitomises many of the woes that have caused the country's downfall, including tax evasion, red tape, selective privileges and delayed reforms.

And if you think things are bad in Greece and France, here comes Romania where protests are taking place over pension, wage cuts:

Hundreds of people were protesting Friday in the Romanian capital over cuts to public wages and pensions, the spokesman for the country's president said.

Unions said there were 600 people outside the presidential palace, but the spokesman said there were about 400.

Anti-riot police had to stop about 25 or 30 people who went past the barricades, spokesman Valaureu Turan told CNN.

Prime Minister Emil Boc recently announced a 25 percent cut in public sector wages and a 15 percent cut in pensions. The Constitutional Court of Romania ruled Friday that part of the laws are not constitutional, so the government will have to decide on the next step, Turan said.

As you can see, the global pension war is spreading fast. Change is brutal and workers are angry. Who can blame them? They're seeing banksters get away with billions in bonuses and bailouts, and now that the pension Ponzi is running out of money, they're stuck having to work longer to make up for the shortfall.

As for the capitalist ruling class pushing these reforms, they're all saying 'close but no cigar'. If Marx were alive today, he'd be pouring over pension legislation and pension documents, trying to understand how the financial capitalists have stolen trillions from common workers, engineering the greatest transfer of wealth in the history of mankind, and saddling them with massive debts in the form of pension IOUs.

Thursday, June 24, 2010

A New Plan for Valuing Pensions?

Mary Williams Walsh of the NYT reports, A New Plan for Valuing Pensions:

The board that writes accounting rules for states and cities has proposed a new approach for pension disclosures that falls far short of what some financial experts hoped, but which would still force many governments to highlight pension shortfalls they have played down.

The current standard has come under heavy fire from mainstream economists, who say it makes virtually all government pension benefits look less costly than they really are.

Government officials have granted pensions to teachers, police, judges and other public workers for years, without reflecting the true cost, analysts say. Now the bills are coming due, and in many cases there is not enough money set aside, adding to the fiscal distress across the country.

Pensions are a third-rail issue for the Governmental Accounting Standards Board, and it has been working with great deliberation. Its pension project began early in 2006 but is nowhere near completion. Earlier this month, the board issued a “Preliminary Views” statement, summarizing its conclusions so far and requesting public feedback. A new standard is unlikely to take effect until at least 2013.

Fiscal hawks have been urging the accounting board to require states to measure their pension obligations at fair value. Corporations already do this when they report their pension numbers to the Securities and Exchange Commission.

But state and local officials have resisted, and the Governmental Accounting Standards Board seems to have taken their objections to heart. Its new proposal would let them keep measuring their pension obligations the same way as before, with one big exception.

The rule makers want to shine a bright light on the states and local governments that routinely fail to put enough money into their pensions — places like Illinois, New Jersey and Pennsylvania — that year after year contribute less than their actuaries tell them they have to contribute to their pension funds. The accounting board wants those places to show the missing amounts on their balance sheets, not hide them in footnotes.

Further, instead of minimizing the shortfalls, those governments would have to calculate the shortfalls in a way that magnifies them.

“I think they hope this will be the disciplinary tool that will get everybody funding at the actuarial rate,” said Jeremy Gold, an actuary and economist who served on the accounting board’s pension advisory task force but who does not like the proposed new method. “They hope they will be punishing the real laggards.”

He said the board’s stated purpose was to foster correct financial reporting, not mete out punishment.

Many states and cities will be relieved at least that more far-reaching types of changes have been sidelined. They had feared a shift to fair value accounting in general and especially now, after big investment losses in 2008.

Some economists have been trying to strip down pension numbers to present something like fair value anyway. The most recent such study, by Eileen Norcross of the Mercatus Center at George Mason University and Andrew Biggs of the American Enterprise Institute, determined that if New Jersey’s state pension system disclosed its pension numbers at fair value, it would have a shortfall of $170 billion, instead of its reported $46 billion.

“This path is not sustainable,” Ms. Norcross said.

Governments and their actuaries argue that it is unfair and misleading to show them at their worst — or at any particular point in time. States and cities, after all, are fundamentally different from corporations — they do not do things like acquire each other or file for Chapter 11 bankruptcy protection.

In addition, while companies need to bring their pension funds to a standing stop and measure them during such events, governments never engage in such transactions, so they say there is no reason to disclose their financial status at a single time.

“I doubt anybody’s imagination is vivid enough to imagine the merger of states such as Kansas and Missouri, or Ohio and Michigan,” said Rick Roeder, an actuary and consultant in San Diego, in testimony submitted to the accounting board. “For a plan sponsor with a 50-plus-year time horizon, today’s market value can be anything but fair.”

At the heart of the dispute is the way governments gauge the value of the pensions they owe future retirees in today’s dollars — a commonplace financial calculation known as discounting. It is used to calculate things as diverse as bond prices and mortgages.

Discounting is based on an interest rate, which is supposed to reflect the riskiness and other attributes of the underlying asset. Current accounting rules tell governments to use the investment return they expect over the long term. In practice, this means most public pension funds now use about 8 percent.

Many economists criticize this practice, arguing that 8 percent reflects a fairly high degree of risk, though state pensions are guaranteed by law and are therefore virtually risk free.

Standard economic theory says they should be measured with a very low discount rate — something much closer to the rate on Treasury bonds than to the higher risk securities in most pension investment portfolios. These days, many economists think the states should be using a rate of about 4.5 percent to measure their pension obligations.

The difference — three or four percentage points — translates into hundreds of billions of dollars when applied to pension obligations.

The 50 states together reported pension obligations of $3.3 trillion as of mid-2008, and secured with assets of $2.3 trillion, according to the Pew Center on the States. But Ms. Norcross said that if the states had to report their pension obligations on a fair value basis, the number would have been $5.2 trillion.

What this means is that current liabilities of US public pension plans are heavily understated because they're not calculated using the proper discount rate, the yield on Treasury bonds. Perhaps reporting pension obligations on a fair value basis is too onerous, but the alternative of using a higher discount rate based on an unrealistic long-term investment return is too generous and will ultimately leave taxpayers on the hook. When it comes to pension obligations, better to be safe than sorry.