Saturday, July 3, 2010

Bond Market Worried About 1930s Echo?

David Leonhardt of the NYT wrote an excellent article this week, Governments Move to Cut Spending, in 1930s Echo:
The world’s rich countries are now conducting a dangerous experiment. They are repeating an economic policy out of the 1930s — starting to cut spending and raise taxes before a recovery is assured — and hoping today’s situation is different enough to assure a different outcome.

In effect, policy makers are betting that the private sector can make up for the withdrawal of stimulus over the next couple of years. If they’re right, they will have made a head start on closing their enormous budget deficits. If they’re wrong, they may set off a vicious new cycle, in which public spending cuts weaken the world economy and beget new private spending cuts.

On Tuesday, pessimism seemed the better bet. Stocks fell around the world, over worries about economic growth.

Longer term, though, it’s still impossible to know which prediction will turn out to be right. You can find good evidence to support either one.

The private sector in many rich countries has continued to grow at a fairly good clip in recent months. In the United States, wages, total hours worked, industrial production and corporate profits have all risen significantly. And unlike in the 1930s, developing countries are now big enough that their growth can lift other countries’ economies.

On the other hand, the most recent economic numbers have offered some reason for worry, and the coming fiscal tightening in this country won’t be much smaller than the 1930s version. From 1936 to 1938, when the Roosevelt administration believed that the Great Depression was largely over, tax increases and spending declines combined to equal 5 percent of gross domestic product.

Back then, however, European governments were raising their spending in the run-up to World War II. This time, almost the entire world will be withdrawing its stimulus at once. From 2009 to 2011, the tightening in the United States will equal 4.6 percent of G.D.P., according to the International Monetary Fund. In Britain, even before taking into account the recently announced budget cuts, it was set to equal 2.5 percent. Worldwide, it will equal a little more than 2 percent of total output.

Today, no wealthy country is an obvious candidate to be the world’s growth engine, and the simultaneous moves have the potential to unnerve consumers, businesses and investors, says Adam Posen, an American expert on financial crises now working for the Bank of England. “The world may be making a mistake, and it may turn out to make things worse rather than better,” Mr. Posen said.

But he added — after mentioning China, India and the relative health of the financial system, today versus the 1930s — that, “The chances we’re going to come out of this O.K. are still larger than the chances that we aren’t.”

The policy mistakes of the 1930s stemmed mostly from ignorance. John Maynard Keynes was still a practicing economist in those days, and his central insight about depressions — that governments need to spend when the private sector isn’t — was not widely understood. In the 1932 presidential campaign, Franklin D. Roosevelt vowed to outdo Herbert Hoover by balancing the budget. Much of Europe was also tightening at the time.

If anything, the initial stages of our own recent crisis were more severe than the Great Depression. Global trade, industrial production and stocks all dropped more in 2008-9 than in 1929-30, as a study by Barry Eichengreen and Kevin H. O’Rourke found.

In 2008, though, policy makers in most countries knew to act aggressively. The Federal Reserve and other central banks flooded the world with cheap money. The United States, China, Japan and, to a lesser extent, Europe, increased spending and cut taxes.

It worked. By early last year, within six months of the collapse of Lehman Brothers, economies were starting to recover.

The recovery has continued this year, and it has the potential to create a virtuous cycle. Higher profits and incomes can lead to more spending — and yet higher profits and incomes. Government stimulus, in that case, would no longer be necessary.

An internal memo from White House economists to other senior aides last week noted that policy makers “necessarily tend to focus on the impediments to recovery.” But, the memo argued, the economy’s strengths, like exports and manufacturing, “more than make up for continued areas of weakness, like housing and commercial real estate.”

That optimistic take, however, is more debatable today than it would have been a month or two ago.

As is often the case after a financial crisis, this recovery is turning out to be a choppy one. Companies kept increasing pay and hours last month, for example, but did little new hiring. On Tuesday, the Conference Board reported that consumer confidence fell sharply this month.

And just as households and businesses are becoming skittish, governments are getting ready to let stimulus programs expire, the equivalent of cutting spending and raising taxes. The Senate has so far refused to pass a bill that would extend unemployment insurance or send aid to ailing state governments. Goldman Sachs economists this week described the Senate’s inaction as “an increasingly important risk to growth.”

The parallels to 1937 are not reassuring. From 1933 to 1937, the United States economy expanded more than 40 percent, even surpassing its 1929 high. But the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.

Given this history, why would policy makers want to put on another fiscal hair shirt today?

The reasons vary by country. Greece has no choice. It is out of money, and the markets will not lend to it at a reasonable rate. Several other countries are worried — not ludicrously — that financial markets may turn on them, too, if they delay deficit reduction. Spain falls into this category, and even Britain may.

Then there are the countries that still have the cash or borrowing ability to push for more growth, like the United States, Germany and China, which happen to be three of the world’s biggest economies. Yet they are also reluctant.

China, until recently at least, has been worried about its housing market overheating. Germany has long been afraid of stimulus, because of inflation’s role in the Nazis’ political rise. In responding to the recent financial crisis, Europe, led by Germany, was much more timid than the United States, which is one reason the European economy is in worse shape today.

The reasons for the new American austerity are subtler, but not shocking. Our economy remains in rough shape, by any measure. So it’s easy to confuse its condition (bad) with its direction (better) and to lose sight of how much worse it could be. The unyielding criticism from those who opposed stimulus from the get-go — laissez-faire economists, Congressional Republicans, German leaders — plays a role, too. They’re able to shout louder than the data.

Finally, the idea that the world’s rich countries need to cut spending and raise taxes has a lot of truth to it. The United States, Europe and Japan have all made promises they cannot afford. Eventually, something needs to change.

In an ideal world, countries would pair more short-term spending and tax cuts with long-term spending cuts and tax increases. But not a single big country has figured out, politically, how to do that.

Instead, we are left to hope that we have absorbed just enough of the 1930s lesson.

Not everyone agrees that government spending shouldn't be reigned in. An editorial in the Calgary Herald comments, A new long depression?: World should follow Canada's lead:

The violence that occurred during the recent G20 summit in Toronto and the focus on the $1-billion cost of the affair overshadowed what was surely the most critical element of the meeting of world leaders: how to prevent, or at least best deal with, the continuing grave economic problems that beset almost all of the G20 countries save Canada.

Many Canadians, most of whom kept their jobs in the short, sharp recession that ended one year ago, may understandably be blissfully unaware of the pressing economic problems many other countries yet face as they struggle to reemerge from their recessions, or worse, to avoid a slip back into another recession.

They should be more aware and governments should also be careful whose advice they take. This past week, in a piece entitled The Third Depression, Nobel Prize-winning economist Paul Krugman even wrote of the possibility of a third Great Depression, noting that while recessions occur regularly, he feared that much of the world was entering a Long Depression akin to the one that occurred following the 1873 panic in stock markets, which was followed by years of instability and deflation.

Krugman's remedy -- governments should spend, spend, spend to prevent deflation -- is not one with which we agree. Krugman's Nobel Prize is admirable, but other Nobel economists also exist and they disagree with Krugman. Canada's Robert Mundell, a Nobel Prize winner himself, recently advised the American government to lower business tax rates to spur reinvestment and recapitalize American banks.

U.S. room to move on tax rates, or much of anything else, is severely limited by how much Washington has already spent.

The U.S. public and Congress seem to have soured as of late on any new "stimulus" measures, this perhaps because the last round of deficit-increasing trillion-dollar stimulus packages, from the last administration and the new one, did not, as current U.S. President Barack Obama hoped, lower U.S. unemployment.

Instead, much of the money spent on bailouts, temporary tax rebates, cash-for-clunkers for automobile purchases and $8,000 tax credits for home purchases, merely stole purchases from the future and into the past 12 to 18 months. The result has been weakened consumer spending as of late. So the United States is back to where it started with an even bigger debt.

That, along with similar problems in Europe, is why the Krugmans of the world are incorrect to urge governments to spend more. Moreover, just this week, the Genevabased Bank of International Settlements stated that, "The first and most immediate challenge is to make a convincing start on reducing budget deficits in the advanced economies."

Private-sector confidence has steadily eroded as governments have borrowed more. Governments that excessively borrow crowd out the private sector and the private sector knows it, which is why companies are reluctant to spend on capital investment and new employees.

Europe is awash in red ink; the U.S. is mired in federal and state debt and a massive housing over-supply four years after prices first began to decline, and China's overheated property market may also soon burst causing more economic problems for the world. The situation worldwide calls for governments to be careful in their spending, not to assume they can finance another stimulus with questionable results.

Japan has been in what amounts to a "long recession "since the early 1990s -- and it followed Krugman's advice. At present, we think it more sensible for other nations to follow Canada's lead, our own Nobel-winning economist, and finally allow the private sector ultimately and finally to pull the world out of its economic malaise.

Of course, Paul Krugman isn't one to back down from debates on the economy. He was interviewed on Charlie Rose on Friday night (click here to watch) and he has taken on his critics in his blog, even openly threatening to punch them in the kisser.

On Saturday, Mr. Krugman wrote in his blog, The Hawks Who Cried Wolf:

I’ve been taking a bit of a trip down memory lane, looking at older blog posts in aid of a possible future project. And I was struck by something I sort of knew, but hadn’t focused on: the latest round of oh-my-God-the-bond-vigilantes-are-attacking-gotta-cut is the third such round since Obama took office.

First, there was a runup in interest rates in the spring of 2009 — mainly a reaction to receding fears of a second Great Depression, but widely interpreted as a sign of impending fiscal doom. Then rates went back down.

Second, there was a big scare in the fall of 2009, based on, well, nothing — which is what led me to write my original post on invisible bond vigilantes. And fear of this phantom menace helped scare the Obama administration away from a second stimulus.

Finally, there was the bond scare of March, in which we were turning into Greece because of a blip in rates barely visible on the charts. Since then, rates have plunged.

It kind of makes you wonder: why do such claims carry any credibility? Bear in mind, too, that anyone who actually acted on these deficit scares — who, for example, believed Morgan Stanley’s prediction of soaring rates in 2010 — has lost a lot of money.

But I have a sinking feeling that the next time long rates rise even a bit — say, back to where they were a year ago — we’ll be told that the bond vigilantes have arrived. Really. And Washington will believe it.

And rates can rise from these levels, especially if economic data comes in stronger than expected. Consider this, Bloomberg reports that Treasury Two-Year Yield Drops to Record Low on Slowdown Concern:

Treasuries rallied, pushing the two- year note yield to an all-time low, as U.S. companies added fewer jobs in June than economists forecast and China’s manufacturing growth slowed.

The extra yield investors demand to hold 10-year notes over 2-year debt dropped the most in six weeks on heightened deflation concern. The U.S. government will sell $12 billion in 10-year Treasury Inflation Protected Securities on July 8.

“Whoever is calling for a double dip is emboldened by this week,” said Suvrat Prakash, an interest-rate strategist in New York at BNP Paribas SA, one of the 18 primary dealers obligated to participate in Treasury auctions. “We have to be a little more cautious about what we expect in the future.”

The yield on the 10-year note dropped this week by 13 basis points, or 0.13 percentage point, to 2.98 percent, according to BGCantor Market Data. The price of the 3.5 percent security maturing in May 2020 increased 1 1/8, or $11.25 per $1,000 face amount, to 104 13/32.

The benchmark note’s yield fell the most since the five days ended May 21, when it dropped 22 basis points. It touched 2.88 percent on July 1, the lowest level since April 28, 2009. The two-year note yield slid 3 basis points to 0.62 percent after reaching the all-time low of 0.5856 percent on June 30.

The difference between 10- and 2-year note debt, known as the yield curve, dropped this week to 2.36 percentage points after touching 2.28 percentage points on July 1, the lowest level since Oct. 2.

The narrowed spread indicates investor preference for longer-term bonds, which tend to rise on slowing inflation. Two- year rates tend to track the outlook for the Fed’s target rate for overnight lending.

“Bonds are saying this economy is getting bad,” said Michael Franzese, managing director and head of Treasury trading at Wunderlich Securities Inc. in New York. “People are going across the curve. They are buying for yield and capital preservation.”

My feeling is that the curve flattener trade is getting overcrowded, and yields can easily snap back from these levels, especially if economic data comes in stronger than expected.

But maybe the bond market is worried that austerity measures will effectively kill the fragile economic recovery, pitching the world into a protracted period of deflation. With 10- and 30-year yields plummeting to their lowest level since April 2009, there sure seems to be an ominous 1930s echo in the air.

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