If we were to continue the path of the Great Depression, real economic activity would have still a lot further to fall, and the stock market, though it has fallen a lot this time, would still have another 50% decline to go. Still, if the Great Depression is a guide, the stock market now is well below the level it was at the same relative point in time.

To me, the real question that these charts raise relates to the effectiveness of the fiscal and monetary measures that have been taken this time. Here are some comparison charts:

Clearly, short-term interest rates were lower initially and have since been pushed down to unprecedented levels.

The money supply, which is another indicator of monetary policy, is shown starting 4 years before the downturn (unlike the prior charts):

The authors comment on this chart:

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Fiscal policy, as represented by government surpluses or deficits, is shown again starting 4 years before the downturn.

While monetary policy is wildly different than following 1929, fiscal policy is much less radically different. If we look at year 5 (2009), the fiscal deficit is about 2% of GDP. In 1930, it was zero; but 2% of GDP is not very significant. In 2010, the deficit is projected to be much larger, over 5%, compared to still zero in 1931.

The burning question is whether these differences are enough to push the world economy onto a different, more positive path than occurred in the 1930’s. There are certainly skeptics, especially followers of the Austrian school of economics. The current prevailing view, though, is that these measures, plus more that will be tried if these seem inadequate, will succeed. This seems overly sanguine to me. Rather, I think it is best to view us as in the midst of a grand economic experiment on the largest scale ever tried. Experiments, by their very nature, have uncertain outcomes.

We have already seen one part of the policy armada begin to come apart: the pushing down of long-term interest rates in order to make mortgages cheaper and house purchases more affordable. In the last month, the market has turned sour on US Treasuries. Yields on ten-year Treasuries have risen remarkably this year. The yield on the benchmark 10-year Treasury due May 2019 ended last week at 3.83 percent, up from the low this year of 2.14 percent on Jan. 15 (Bloomberg). Rising long term Treasury yields have pushed up mortgage rates from a low of 4.75% just a little over a month ago to a current 5.45%.

The rise in Treasury yields is being attributed to the massive deficits (the flip side of the economic stimulus). The federal government is going to need to sell $2 trillion of bonds to cover the deficit. There is skepticism in the market that this amount will be saleable at current yields, especially given the concern that all of the monetary measure will lead to inflation. Clearly, not everything is under the control of central government policy makers.

[Long], steady housing price declines seem to defy both common sense and the traditional laws of  economics, which assume that people act rationally and that markets are efficient. Why would a sensible person watch the value of his home fall for years, only to sell for a big loss? Why not sell early in the cycle? If people acted as the efficient-market theory says they should, prices would come down right away, not gradually over years, and these cycles would be much shorter.

But something is definitely different about real estate. Long declines do happen with some regularity. And despite the uptick last week in pending home sales and recent improvement in consumer confidence, we still appear to be in a continuing price decline.

…

Several factors can explain the snail-like behavior of the real estate market. An important one is that sales of existing homes are mainly by people who are planning to buy other homes. So even if sellers think that home prices are in decline, most have no reason to hurry because they are not really leaving the market.

Furthermore, few homeowners consider exiting the housing market for purely speculative reasons. First, many owners don’t have a speculator’s sense of urgency. And they don’t like shifting from being owners to renters, a process entailing lifestyle changes that can take years to effect.

…

In fact, most decisions to exit the market in favor of renting are not market-timing moves. Instead, they reflect the growing pressures of economic necessity. This may involve foreclosure or just difficulty paying bills, or gradual changes in opinion about how to live in an economic downturn.

This dynamic helps to explain why, at a time of high unemployment, declines in home prices may be long-lasting and predictable.

…

Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.

Full Article

It is refreshing to read an economist who thinks about the underlying individual decisions and behaviors that make up a market, rather than merely doing regressions on past economic data.

The article itself is not all that insightful, but what caught my eye was a reference to Robert Shiller, and following that reference did lead me to useful insights. You may recall that Robert Shiller is most widely cited because of the Case-Shiller index of housing prices, an index that captures current housing prices much better than the government index. Shiller is also justly recognized for being an early, persistent alarmist about the housing bubble and the likelihood that when it burst it would do serious economic damage. He did not foresee the magnitude of the calamity, but he shouldn’t be criticized for what no one really foresaw.

To me, what stands out is that Shiller is a full-fledged establishment economist, a full professor at economics and finance at Yale University. As far as I can tell, just about every establishment economist is completely at a loss when it comes to understanding the real economy, that is, the economy that matters to those of us who need jobs, food on the table, the ability to pay for health care, to educate our children, and hopefully, eventually to retire. Establishment economists live in a world of ever expanding production (measured by GDP, which includes all the negatives as positives), where any and all problems are overcome by further increases in production. In this world, stock prices, housing prices, and commodity prices are just not all that important, because they don’t relate to what they consider real, that is real, that is, inflation-adjusted GDP.

Now, of course there is the legion of mathematical economists who migrated wholesale to the big financial firms over the last 20-30 years, but they have had no interest in the real economy either, only in how to use mathematics and statistics to more accurately price assets (ignoring the contradiction between this task and the belief in the theory of efficient markets). There is no doubt that some of this work led to outsize profits for them and their employees, but most of these profits came not from truly better valuations but from using huge amounts of credit to multiply their ability to profit from small imperfections in the market. Hardly any of them saw further than the next bonus check.

Robert Shiller is evidently cut from different cloth. He first published Irrational Exuberance in early 2000, before the dot-com bubble burst. He published the second edition in 2006, warning of the unjustified housing bubble.

Not only did he address the general public, but he tried to warn policy makers – although he explains his timidity in doing this in a New York Times article of November 1, 2008, “Challenging the Crowd in Whispers, Not Shouts". In this article, Dr. Shiller gives his view of why everyone, including himself, is reluctant to object too loudly to a widely held consensus view. He cites his experience with the housing bubble.

For example, I clearly remember a taxi driver in Miami explaining to me years ago that the housing bubble there was getting crazy. With all the construction under way, which he pointed out as we drove along, he said that there would surely be a glut in the market and, eventually, a disaster.

But why weren’t the experts at the Fed saying such things? And why didn’t a consensus of economists at universities and other institutions warn that a crisis was on the way?

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group.

…

From my own experience on expert panels, I know firsthand the pressures that people — might I say mavericks? — may feel when questioning the group consensus.

I was connected with the Federal Reserve System as a member the economic advisory panel of the Federal Reserve Bank of New York from 1990 until 2004, when the New York bank’s new president, Timothy F. Geithner, arrived. [Note that this was published on November 1, 2008, before the election and before Geithner became Treasury Secretary. Interesting that Shiller left the panel when Geithner arrived. Roylat] That panel advises the president of the New York bank, who, in turn, is vice chairman of the Federal Open Market Committee, which sets interest rates. In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.

…

I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

…

I based my predictions largely on the recently developed field of behavioral economics, which posits that psychology matters for economic events. Behavioral economists are still regarded as a fringe group by many mainstream economists. Support from fellow behavioral economists was important in my daring to talk about speculative bubbles. [Emphasis added. Roylat]

Two aspects of this article stand out: 1) Incorporating social psychology into an understanding of the failure of the market and its overseers to see what should have been obvious, and 2) the fact that there is a field of “behavioral economics.” It seems well worthwhile to learn more about this field of economics – and I’m starting out by getting a copy of Irrational Exuberance . This could prove to be a basic foundation for understanding the waves of over-optimism (and over-pessimism) that sweep over markets with regularity.

For some reason, a consumption tax has never gotten much political traction. I was interested to see a proposal for a consumption tax at Fivethirtyeight.com, the site made famous by its successful predictions in the 2008 election. It lays out how it would work and some of the benefits. Though it is an elementary discussion, it is a useful starting point for thinking about it. What do you think?

The Ultimate Tax on Harmful Activity?

by Robert Frank @ 10:01 PM, 5/22/2009

When the dollar, US treasury bills, and stock prices slumped yesterday because of growing concerns about the U.S. government’s debt rating, Treasury Secretary Tim Geithner hastily reassured nervous investors that the Obama administration has clear plans to reduce the country’s massive budget deficits going forward. But as I argued in a recent post, accomplishing that will require significant new sources of revenue. And if new taxes are indeed necessary, by far the best ones are those that discourage harmful activities.

But new taxes on congestion and pollution will not be enough. The president has already proposed to allow the Bush tax cuts for top earners to expire as scheduled in 2010. Many economists caution against even further increases in top marginal income tax rates, which would discourage effort and savings.

Fortunately, there is a compellingly attractive alternative: abandon the income tax in favor of a much more steeply progressive consumption tax. Doing so would generate more than enough revenue to balance the federal budget without requiring painful sacrifices from anyone.

Under a progressive consumption tax, each family would report its income to the IRS and also its annual savings, much as many now document their annual contributions to 401(k) and other similar accounts.  A family’s income minus its annual savings is its annual consumption, and that amount minus a large standard deduction—say, $30,000 for a family of four—would be its taxable consumption.  Rates would start low, perhaps 20 percent, then rise gradually with total consumption.  For example, a family that earned $60,000 and saved $10,000 would have annual consumption of $50,000, which, after subtracting the standard deduction, would mean taxable consumption of $20,000.  It would owe about $4,000 in tax, about the same as under the current income tax.

With savings tax-exempt, top marginal tax rates on consumption would have to be significantly higher than current top rates on income. But that’s not problematic, because higher top rates would actually encourage saving.

Consider, for instance, how the tax would affect a specific high-end spending decision. The Smiths, a wealthy couple approaching their 25th wedding anniversary, are trying to decide what kind of party to throw.   Their close friends, the Joneses, recently spent $2 million to stage a gala celebration of their own silver anniversary. The Smith would prefer not to spend that much, but one of their goals is for their family and friends to share a memorable celebration, and they understand a memorable occasion is an inherently relative concept. So they reluctantly decide to stage a $2 million party of their own.

But their decision would have almost surely played out differently under the incentives inherent in a progressive consumption tax. If the top marginal rate on consumption was, say, 100 percent, the after-tax cost of what would have been a $2 party under the current income tax would instead be $4 million.  Facing that extra cost, couples like the Smiths and Joneses would typically scale back, spending perhaps only half as much as they might have.  If the pre-tax cost of the party they chose were $1 million, the after-tax cost would be $2 million.  The government would get $1 million in additional revenue, which could be used to pay down debt.

By staging a lavish party, a couple typically has no intention to harm its friends and relatives.  Yet the bar that defines how much one must spend to mark a special occasion is an inescapably social construct.  When some spend more, others must follow suit or be seen as having failed to grasp the magnitude the occasion.  The rub is that when all spend more, the occasions seem no more special than before. As in the familiar stadium metaphor, all stand to get a better view, yet no one sees better than if all had remained seated.

Like a tax on congestion or pollution, a progressive consumption tax is thus a tax on harmful activity. The real attraction of all such taxes is that they essentially create real resources out of thin air.  They cause people to build less expensive mansions, buy cleaner, lighter vehicles, and stage less costly parties, all of which end up being just as satisfying as the more elaborate versions would have been.

Some worry that by discouraging consumption spending, a progressive consumption tax as politically unrealistic. But in a future post, I’ll cite evidence that this tax enjoys support from across the political spectrum.

The focus on US deficits was given a big boost by the news that Moodys downgraded the debt of England. Who would have thought that England, once the financial center of the world and still one of the largest financial centers, would have come to this state? Even more surprising to many is the increasing perception of the possibility that US government debt will be downgraded from the world’s most secure to a lesser status. The news of Britain’s downgrade also caused a sharp fall in the price of US treasuries, because people judged that what happened in England could happen here. Bill Gross of PIMCO (the largest bond company in the world) said that this is not unthinkable (which means it is thinkable).

I recently posted an article on the negative for Britain of the dominance of the financial sector there, arguing that the parallels with the US are all too great. One of the parallels is the massive deficit that both countries are incurring in trying to keep their financial sectors and the economy afloat in a world that imploded as a consequence of financial excesses.

John Mauldin has an insightful, very detailed review of the magnitudes of coming US deficits, their likely consequence for interest rates and bond prices, and of his own gloomy thoughts on the implications for the future non-prosperity in the US. Below are some selected quotes with a link to the full article.

John Mauldin at frontlinethoughts.com, 5/23/2009

A Trillion Dollars as Far as the Eye Can See

As of this week, total US debt is $11.3 trillion and rising rapidly. The Obama Administration projects that to rise another $1.85 trillion in 2009 (13% of GDP) and yet another $1.4 trillion in 2010. The Congressional Budget Office projects almost $10 trillion in additional debt from 2010 through 2019. Just last January the 2009 deficit was estimated at "only" $1.2 trillion. Things have gone downhill fast. …

The Global Recession Gets Worse

Let’s take a quick trip around the world. In the first quarter, the German economy fell by 14%, Japan by 15%, Mexico by 21%, and England was down almost 8%.

Global trade is simply collapsing. The chart below is the ugliest it has ever been. Chinese exports are down 41%, Japanese exports down 38%, Germany’s down by 32%, and so on. (chart courtesy of www.variantperception.com )

…

European banks are in far worse shape than their US counterparts. That is because they utilize far more leverage, on an average about 30 times leverage. How can that be, in what is supposed to be a conservative industry?

"European banks were only restricted on the basis of risk-weighted assets, unlike the US where it is the total leverage ratio that matters, so most European banks bought assets that were rated by Moody’s and S&P, who couldn’t rate their way out of a paper bag, and for anything that wasn’t highly rated, they bought credit default swaps or guarantees from AIG and MBIA. Because of that European banks were able to lever up a lot more than their US counterparties. Given the much higher leverage levels and general worsening of collateral values, we think that all the shoes in Europe have not dropped."

European banks have assets of about 330% of their GDP, compared to US banking assets, which are about 50%. They have over $700 billion in loans to Asian businesses (which are watching their exports collapse) and $1.3 trillion in loans to Eastern Europe, which is in a very serious recession, and so many of those loans are simply not going to be worth anything. Simply put, there is going to be a need for massive amounts of money to bail out European banks, or we’ll watch their economies simply implode. …

Governments around the world are responding to the global recession by running massive deficits. In addition to the US, the UK, Japan, Russia, Spain, and Ireland are all running deficits of over 10%.

And, as in the case of the US, these are not going to be one-time deficits. The IMF predicts that England will shrink again next year and the recovery in the US will be modest at best. The US economy is expected to grow by 0.2% (far from the optimistic projections of various US government agencies), the 16-nation eurozone will eke out a modest gain of 0.1%, and the Group of Seven (G7) leading industrial economies will, as a whole, only grow by 0.2 percent. They project that Japan’s economy will stagnate next year.

Where Will the Money Come From?

And now let’s look at what is bumping in my worry closet. The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion. Maybe. Look at the yield curve on US government debt below (Bloomberg). US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn’t do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

The world is deleveraging. Debt is being drawn down. Securitization of various types of debt has seriously slowed. Banks are cutting back on lending. Home prices are dropping all over the world. Commercial real estate is rolling over, and banks all over the world are exposed. "Recession turns malls into ghost towns" is the headline in today’s Wall Street Journal. Personal savings are rising and retail sales are flat to down. Unemployment is rising.

All this should be massively deflationary. Interest rates should be falling or at least not rising. But a funny thing is happening. In the past two months, the yield on the ten-year bond has risen by 1%. It has moved 0.38% or almost "4 big handles" in just two weeks. Look at the chart below. What is happening?

According to Merrill Lynch, the size of the world bond market is estimated to be approximately $67 trillion, with the shares of US, Euroland, and Japanese securities each representing less than 50 percent of this total. (PIMCO)

England has been put on negative watch for its debt rating. Bill Gross said yesterday that it is not unthinkable that the US could lose its AAA rating. I think the bond market is looking at the mountain of debt that will have to be somehow sold and wondering where such a colossal sum will come from. Where do you find $10 trillion in the next ten years for US debt?

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let’s be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

…

Long before we get to 2015, let alone 2019, I think the bond markets will have called a halt to $1 trillion deficits. There will be a real crisis. The deficits will not be funded at anywhere close to an interest rate that will not break the budget. Taxes will get raised beyond what they were in the Clinton years. And Obama’s budget makes some very optimistic judgments about how much will be saved in medical costs, as if no one has tried to rein in medical costs before. The crisis may come much sooner if his universal health-care bill is passed as proposed without offsetting cuts somewhere else.

Watch the bond market. Rates should be going down, not up. The bond market is telling us the deficit simply can’t be financed down the road. Now, maybe a few cool heads in the Democratic Party will prevail in the US Senate and the deficits will be brought under control. (The Republicans have so far seemed as clueless as they are impotent.) We could (theoretically) run $400 billion deficits for a very long time, as GDP would be growing somewhat faster.

It would be best to run budget surpluses, but the game does not end if there are reasonable deficits. It ends with deficits that cannot be funded except by monetization. And that will tank the dollar, except against all the other countries that are monetizing their debt.

I am increasingly inclined to think that as the world comes out of its current malaise – and it will – US investors should think more globally with their investment portfolios. That is something we will explore over the coming year. But that’s enough for today.

Full Article

Mr. Silver conjectures:

Could it be that there’s been some sort of paradigm shift in Americans’ attitudes toward their cars? Perhaps, given the exorbitant gas prices of last summer, Americans realized that they weren’t quite as dependent on their vehicles as they once thought they were.

He is cautious about asserting this as the case, but he ends the article with a similar thought:

The exceptionally sluggish pace of new-vehicle sales, moreover, in the face of extremely attractive incentives being offered by the automakers might imply that Americans are considering making more-permanent adjustments to their lifestyles.

I would be happy to believe that Mr. Silver is right, but unfortunately, I don’t think his analysis is compelling.

Several years ago, I did a similar analysis of miles driven using income and gasoline prices as explanatory variables. It successfully predicted fairly accurately changes in gasoline consumption for the period analyzed. I decided to see what my model would predict for January, 2009. It predicted an increase in gasoline consumption of about 2.4% for January 2009. This was lower than Mr. Silver’s prediction of about a 4% increase, but it still is supportive of Nate’s contention that behavior has shifted in the last year.

Many of us would be happy if Americans were shifting their attitude toward cars for the better (and lesser), but I think there is a more likely explanation that doesn’t involve any shift in attitudes.

In my analysis, I used per capita income and Mr. Silver used employment/unemployment to reflect changes in the economy that impact driving. What neither of these capture are changes in wealth and borrowing, and these are what most likely explains the much lower level of driving — as well as lower purchases of automobiles and many other products.

Wealth has been estimated to have fallen by about $11 trillion dollars in 2008. This is about equal but opposite to total earned disposable income in 2008 and about equal to 10% of all savings and other net assets.

Further, in years prior to 2008, people were borrowing against their rising home equity and using the proceeds to support their consumption. Again, in the latter part of 2008, people shifted from being big net borrowers to being net savers. The change was substantial and significant, people shifted from net annual borrowings of about $1 trillion in 2006-2007 to net repayments in the 4th quarter of 2008 at an annual rate of about $400 billion. 

The increase in wealth in earlier years not only made people feel richer, it allowed people to borrow to consume more. Both wealth and borrowing reversed themselves substantially in 2008.  This was a shift that was not reflected at all in Mr. Silver’s (or my) prediction model.

There is no doubt that the loss of wealth made people feel much poorer and caused them to become much more frugal in many ways. I know I feel poorer, even though my measured income didn’t change much, and I certainly am driving less because of it.

Because wealth accumulation hasn’t varied greatly over time, It may be hard statistically to tease the wealth effects on consumption of gasoline out of the data, but common sense says that it wouldn’t take much of a wealth effect to explain the drop in gasoline consumption in January, 2009.

Mr. Silver’s oversight reflects a broad problem with economic models in general: they are good at “predicting” the past periods from which their parameter values were derived, but they fail at crucial times. These crucial times are when times are not “normal” and the relations of the past no longer hold.

This “failure at crucial times” was most certainly true of the statistical models and estimations that gave all of the financial firms such confidence that they had virtually eliminated risks through use of esoteric derivative instruments. We all know now that this sense of assurance was misguided in the extreme. The latest estimate is that over $4 trillion of supposedly low-risk debt will have to be written off, with worldwide ramifications with which we are all now all too well aware.

The lesson is: When you are basing decisions on some model based on the past, don’t rely on it to predict the future accurately. Experience, intuition, and common sense need to be brought to bear as well.

To be more accurate, there should be several lifeboats in the scene, in front of “Free Market”, labeled “Taxpayers” and “Retirees.” Probably others can think of more endangered lifeboats.

NOT OUT OF THE WOODS YET

Experts Warn that Banking Euphoria Is Premature

By Stefan Schultz

04/23/2009

Good news from six US banks has raised hopes that an end to the financial crisis might be in sight. But German experts think the euphoria is wishful thinking. As they see it, things are going to get worse soon — and banks will be forced to make billions more in write-downs.

The news spreads like wildfire and hope starts to bloom. One after the other, six US banks — including the largest, Bank of America — have submitted performance figures for the first quarter of 2009 that are far better than experts had predicted.

Share traders in New York: Hopes of an upturn may be premature, analysts warn.

Banks like Wells Fargo and JPMorgan Chase have posted profits reaching into the billions. Goldman Sachs has even announced that it plans to pay back the billions in emergency bailout funds it received from the US government. And analysts are also expecting to see positive first-quarter earnings from German banks.

The results have fuelled hope that the financial sector has started its climb out of the economic abyss, and the first batch of optimists are already announcing that the financial crisis, which has already lasted almost two years, will soon come to an end. "We expect that the banks’ reporting season will bring more positive results like the ones JPMorgan has submitted," says Robert Halver, for example, an expert on capital markets at Baader Bank.

But some experts think such conclusions are dangerously misguided. "We’re far from being out of the woods," says Dirk Schiereck, a professor of banking at Darmstadt Technical University. "The banks are still extremely vulnerable." And Hans-Peter Burghof, an expert on finance at Hohenheim University, even goes so far as to speak of an "expansion of the crisis, which might soon even get new banks into serious trouble."

Just a Brief Burst

Analysts are also looking at the rest of the year with extreme skepticism. "To a very significant degree, the bank profits from the first quarter can be attributed to a very special constellation of fortunate factors that are very atypical for banks," says Guido Hoymann, an analyst at Bankhaus Metzler. In fact, in the first three months of the year, major corporations like Siemens and Porsche have taken advantage of rock-bottom prices in the banking sector to refinance expiring bonds.

Hoymann estimates that in the first quarter alone, the volume of debt refinancing amounted to 45 percent of the usual annual volume. As he sees it, this boom has boosted commission income and investment banking profits for many US banks. German banks are likely to have enjoyed a similar interim boost in the first quarter, he adds.

"But it’s not going to last," Hoymann says. "Current forecasts already indicate that the lending business will normalize." And when that happens, the banks will once again lose a major source of profits.

An additional factor is that many US-based financial institutions are taking full advantage of relaxed accounting rules. Such rules make it possible, for example, for companies to postpone write-downs. Goldman Sachs has also benefited from the fact that the government pressured it into transforming itself from an investment bank into a completely normal bank. As such, it has become subject to different accounting rules, which has meant that the company did not have to report results for the month of December.

Bleaker Prospects

The prospects for the coming months are worrying. "It might be that the recession doesn’t get any worse," Burghof says. "But there is no doubt that it will expand — and affect the banks once again."

In fact, the economic situation is anything but secure. Experts argue over whether the economy in 2009 will decline by 4, 5 or 6 percent [in Germany] and whether the turnaround will take place in the summer, fall or winter. But there is one point on which the majority of experts agree. "The economy is unlikely to grow as quickly as it shrank," says Jörg Hinze, an economic analyst at the Hamburg Institute of International Economics (HWWI). "It might stagnate for a long time at a very low level or only gradually start climbing again."

But a slow rebound will not stop the crisis. If the economy improves too slowly, the pressure on companies will mount, and hundreds of thousands of workers in Germany currently on short time might find themselves out of a job in the fall.

And that would present the banks with even more risks. Many banking establishments anticipate an explosion of loan defaults from private and business clients. Bank of America and JPMorgan, for example, have built up reserves reaching into the tens of billions to respond to possible new write-downs.

The New Risks of Market Deregulation

At present, the banks are hardly feeling the recession yet. "Currently, the attitude among politicians is that you should bail out anything that could cause any pain," says Hoymann. But doing so does not correct the structural problems of markets and businesses. As Hoymann puts it, it’s "like avoiding going to the dentist" — in the short term, you save yourself some pain, but in the long term everything gets rotten.

"The government can’t keep following its current line forever," Hoymann adds. As soon as politicians start leaving the market to its own devices again, the restructuring that had been deferred will hit companies and people all the harder. And that would mean new strains on the banks as well.

Burghof fears that lingering weakness in the economy will soon pull even more financial institutions into the crisis. "The longer the recession lasts, the more job losses and serious financial difficulties there will be for small- and mid-sized companies," he says. "A number of savings banks are currently worried that they will have to make some major write-downs soon as well."

It does seem to be the case that the risk of financial collapse is much smaller now than a few months ago. Every major government has made clear its intention to do whatever is necessary to bail out whatever is necessary to prevent cascading losses. This is certainly a huge positive for stock market valuations.

Increasingly, though, the pervasive view has become that the worst of the downturn is behind us and that we shall soon see the beginnings of recovery. This spreading belief seems to be what underlies the persistence of the rally. The continuation of the rally, or even the maintenance of the current level of the stock market is dependent on the validation of this rosy view by actual performance in the coming months. If output continues to decline, or profits erode more seriously than now expected, the market seems likely to head downward again.

Thus, forecasting the stock market now seems more tied to forecasting the economy than it has been since the collapse of the market last Fall, a collapse driven by the dawning realization of the extent and the impact of the toxic assets spread around the world. My own view is that there are more negatives than are being taken seriously by the optimists. We are in waters that haven’t been visited since the depression of the 1930′s, and with the added uncertainties created by the extent of interconnectedness of the world economies and financial institutions. It seems too good to be true that the economies of the world can simply shrug off all of the major dislocations that have occurred in the last six months. In my experience, most things that seem too good to be true are…

Here are the views of two people that accurately warned of last year’s debacle, Nouriel Roubini and Gary Shilling, both of whom I’ve cited before. Roubini’s views are what I would call now almost mainstream, since the mainstream has joined him – although he continues to be more pessimistic. Shilling’s views are more iconoclastic, especially with respect to inflation versus deflation. Recognize, though that Federal Reserve Chairman Bernanke has repeatedly voiced his concern about deflation and his determination not to let it happen.

RGE Monitor’s Newsletter

Greetings from RGE Monitor!
Today we present some of the main conclusions of the recently released update to the RGE 2009 Global Economic Outlook.

The global economy is in the middle of a synchronized contraction that will push global growth into negative territory in 2009 for the first time in decades. . This will be the worst financial crisis since the Great Depression and the worst global economic downturn in decades. Global trade volumes face their sharpest contractions of the postwar era – trade is expected to contract 12% in 2009 due to the severe and prolonged global demand slump, excess capacity across supply chains and the continued crunch in trade finance.
Many analysts and commentators are pointing out that the second derivative of economic activity is turning positive (i.e. economies are still contracting but a slower rather than accelerated rate) and that green shoots of an economic recovery are blossoming. RGE Monitor’s analysis of the data suggests that the global economic contraction is still in full swing with a very severe, a deep and protracted U-shaped recession. Last year’s economic consensus forecast of a V-shaped short and shallow recession has vanished. While the rate of economic contraction is slowing compared to the free fall rates of Q4 of 2008 and Q1 of 2009, we are still a long way away from the economic bottom and from a sustained recovery of growth. In particular, in Europe and Japan there is little evidence of a positive second derivative of economic activity.
However by the end of Q1 2009, there were some signs that the pace of contraction had slowed in many economies especially in the U.S. and China, where policy responses have been more significant and leading indicators in the manufacturing sector may have bottomed before they did in Europe and Japan. However, major economies including all of the G7 will continue to contract throughout 2009, albeit at a slower pace than at the beginning of the year.
Moreover the global recovery might be sluggish at best in 2010 given the overhang of credit losses of financial institutions, lingering credit crunch, need for retrenchment by overstretched and over-indebted households in current account deficit countries and a slow resumption of demand prompted by extensive government stimulus.

Some key elements of RGE Monitor’s outlook include:

• Global economic activity is expected to contract by 1.9% in 2009. Advanced economies are expected to contract 4% in 2009. Japan and the eurozone will suffer the sharpest downturns. U.S. GDP will continue to contract, albeit at a slower pace throughout 2009, with negative growth in every quarter.

• Emerging markets will slow down sharply from the stellar growth rates of the past few years, with the BRIC economies growing at half their 2008 pace.

• Deteriorated terms of trade, slower capital flows and tighter credit will push Latin America into recession from the 4.1% growth of 2008. Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela will all shift to negative territory on a year-over-year basis while smaller countries, like Peru, will experience a significant slowdown.

• Countries in Eastern Europe and the CIS will experience some of the sharpest contractions given the withdrawal of foreign credit and the risk of a severe financial crisis. The reduction in oil revenues and financial stress will contribute to a 5% yoy contraction in Russia and some countries – especially in the Baltics – are at risk of double-digit contractions.

• Export-dependent Asia’s growth will slow significantly to less than 3% in 2009. China will have a hard landing with GDP growth falling to 5.5% while India will slow sharply to 4.3%. All four Asian Tigers (Singapore, Taiwan, South Korea and Hong Kong) as well as Malaysia and Thailand will experience recessions.

• The Middle East and Africa will mark much slower growth, half of their 2008 pace, given the reduction in capital inflows, reduced demand from the U.S. and EU and decline in commodity prices and output. Israel and South Africa will suffer slight contractions.

• The unprecedented fiscal and monetary stimulus may help alleviate the substantial contraction in private demand and reduce the risk of a global L-shaped near-depression. Debt financing may be a challenge for many countries though, especially emerging markets or the most vulnerable Western European economies.

• Job losses during the current global recession might exceed those in recent recession, contributing to increases in defaults and posing additional risks to banks. The unemployment rate in developed countries will reach double-digits by 2010 (as early as mid-2009 in the U.S.) and push more people in developing countries into poverty. Moreover, despite new funding from multilateral institutions, severe contractions will raise the risk of social and political unrest.

• Commodities as a class are likely to come under renewed pressure in 2009 despite some support from production cuts. RGE expects the WTI oil price to average about $40 a barrel in 2009 as demand destruction continues to outweigh crude supply destruction.

Long-Term Outlook: Slow Growth And Deflation

(excerpted from the March 2009 edition of A. Gary Shilling’s INSIGHT)

From 1982 until 2000, the U.S. economy enjoyed rapid growth with real GDP rising at a 3.6% average annual rate. Furthermore, this 18-year expansion, which cumulated to an 89% rise in inflation-adjusted economic activity, was interrupted by only one recession, the relatively mild 1990-1991 downturn, which depressed real GDP by only 1.3% from peak to trough.

Extended Expansion

From a fundamental standpoint, the growth spurt ended in 2000 as shown by basic measures of the economy’s health. The stock market, that most fundamental measure of business fitness and sentiment, essentially reached its peak with the dot com blow-off in 2000 and has been trending down ever since (Chart 1). The same is true of employment, goods production and household net worth in relation to disposable (after-tax) income.

Nevertheless, the gigantic policy ease in Washington in response to the stock market collapse and 9/11 gave the illusion that all was well and that the growth trend had resumed. The Fed rapidly cut its target rate from 6.5% to 1% and held it there for 12 months to provide more-than ample monetary stimulus. Meanwhile, federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus.

As a result, the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to housing (Chart 2), commodities, foreign currencies, emerging market equities and debt, hedge funds and private equity. Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would. Thus persisted what we earlier dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Not Sustainable

Even before these final speculative binges, the forces driving the economy in its long expansion were unsustainable, as we’ve been stressing for years in Insight. These forces included the decline in the consumer saving rate and jump in consumer debt, the vast leveraging of the financial sector, increasingly freer trade and loose financial regulation, all of which are now being reversed.

In the 1980s and 1990s, American consumers were more than willing to cut their saving rate because they believed stock portfolios would continue to grow rapidly and take care of all their financial needs. Then, when stocks collapsed in 2000-2002, house appreciation (Chart 3) seamlessly took over to continue the push down the household saving rate from 12% in the early 1980s to zero. Americans saw their houses as continually-filling piggybanks because, they believed, home price appreciation would continue indefinitely. They tapped that equity freely with home equity loans and cash-out refinancing.

The flip side of saving less is borrowing more, as evidenced by the leap in all consumer debt and debt service, both in relation to disposable (after-tax) income and relative to assets. In relation to GDP, the cumulative outside financing of the household as well as the financial sector leaped for three decades, measuring the immense leveraging in these two areas. Not surprising, amidst this consumer borrowing and spending binge, consumer spending’s share of GDP leaped from 62% in the early 1980s to 71% at its peak in the second quarter of 2008 (Chart 4).

The Tide Turns

Now, however, consumers have run out of borrowing power. As of the third quarter 2008, homeowners with mortgages had on average 25% equity in their abodes after all mortgage debt was removed and that number will probably drop to the 10%-15% range with the further decline in house prices we are forecasting (Chart 3). At that bottom, after a 37% peak-to-trough collapse, almost 25 million homeowners, or nearly half the 51 million with mortgages, will be under water, with their mortgages bigger than their house values. In total, the gap will be about $1 trillion.

The nosedive in stocks has also discouraged consumer spending as have mounting layoffs (Chart 5), maxed out credit cards and tighter lending standards and weak consumer confidence. Rising medical costs are also a drag on consumers as their co-pays and deductibles mount. For decades, credit card issuers and other lenders encouraged consumers to indulge in instant gratification. Buy now, pay later. But now, habits are changing. Debit cards are becoming popular since they deduct charges directly from the user’s checking account and, therefore, don’t increase indebtedness. Layaway plans are back in style after nearly disappearing.

[The article continues with much, much more analysis and insight]

As one commentator, whose name I can’t recall, said recently, “There is no rush to get back in the market. There will continue to be plenty of opportunities for highly profitable investments well after the future is much clearer than it is now.”

He offered a goal for his actions that I applaud:

…I want every American to know that each action we take and each policy we pursue is driven by a larger vision of America’s future – a future where sustained economic growth creates good jobs and rising incomes; a future where prosperity is fueled not by excessive debt, reckless speculation, and fleeing profit, but is instead built by skilled, productive workers; by sound investments that will spread opportunity at home and allow this nation to lead the world in the technologies, innovations, and discoveries that will shape the 21st century.  That is the America I see.  That is the future I know we can have.

He built on a parable in the Sermon on the Mount to lay out a five-point program for building an enduring prosperity:

There is a parable at the end of the Sermon on the Mount that tells the story of two men.  The first built his house on a pile of sand, and it was destroyed as soon as the storm hit.  But the second is known as the wise man, for when “…the rain descended, and the floods came, and the winds blew, and beat upon that house…it fell not:  for it was founded upon a rock.”

We cannot rebuild this economy on the same pile of sand.  We must build our house upon a rock.  We must lay a new foundation for growth and prosperity – a foundation that will move us from an era of borrow and spend to one where we save and invest; where we consume less at home and send more exports abroad. 

It’s a foundation built upon five pillars that will grow our economy and make this new century another American century:  new rules for Wall Street that will reward drive and innovation; new investments in education that will make our workforce more skilled and competitive; new investments in renewable energy and technology that will create new jobs and industries; new investments in health care that will cut costs for families and businesses; and new savings in our federal budget that will bring down the debt for future generations.  That is the new foundation we must build.  That must be our future – and my Administration’s policies are designed to achieve that future.

Again, these are goals that are admirable and upon which most can agree.

Where I continue to part company with the Obama Administration is in its handling of the financial crisis. Obama explained and defended the bailouts of the banking system, but I found the defense disingenuous and unconvincing [my comments interspersed]:

The heart of this financial crisis is that too many banks and other financial institutions simply stopped lending money.  In a climate of fear, banks were unable to replace their losses by raising new capital on their own, and they were unwilling to lend the money they did have because they were afraid that no one would pay it back.  It is for this reason that the last administration used the Troubled Asset Relief Program, or TARP, to provide these banks with temporary financial assistance in order to get them lending again. 

Now, I don’t agree with some of the ways the TARP program was managed, but I do agree with the broader rationale that we must provide banks with the capital and the confidence necessary to start lending again.  That is the purpose of the stress tests that will soon tell us how much additional capital will be needed to support lending at our largest banks.  Ideally, these needs will be met by private investors.  But where this is not possible, and banks require substantial additional resources from the government, we will hold accountable those responsible, force the necessary adjustments, provide the support to clean up their balance sheets, and assure the continuity of a strong, viable institution that can serve our people and our economy.

Of course, there are some who argue that the government should stand back and simply let these banks fail – especially since in many cases it was their bad decisions that helped create the crisis in the first place.  But whether we like it or not, history has repeatedly shown that when nations do not take early and aggressive action to get credit flowing again, they have crises that last years and years instead of months and months – years of low growth, low job creation, and low investment that cost those nations far more than a course of bold, upfront action. 

Those who argue for an alternative to taxpayer-financed bailouts are, for the most part, not opposed to “early and aggressive action to get credit flowing again.” To the contrary, they argue that propping up “zombie” banks is counter to the goal of getting robust bank lending established. Even after the bailouts, the banks with impaired assets are going to be reluctant to lend. In any event, the second sentence is not logically implied by the first, i.e., it is a non sequitur.

And although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – “where’s our bailout?,” they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.

Again, while it is true that bank capital can support multiple dollars of lending, if there is sufficient demand for the loans, bailouts are not the only way to improve the balance sheets of banks so that they have the capital required to support loans. Obama continues:

On the other hand, there have been some who don’t dispute that we need to shore up the banking system, but suggest that we have been too timid in how we go about it.  They say that the federal government should have already preemptively stepped in and taken over major financial institutions the way that the FDIC currently intervenes in smaller banks, and that our failure to do so is yet another example of Washington coddling Wall Street. So let me be clear – the reason we have not taken this step has nothing to do with any ideological or political judgment we’ve made about government involvement in banks, and it’s certainly not because of any concern we have for the management and shareholders whose actions have helped cause this mess.   

Rather, it is because we believe that preemptive government takeovers are likely to end up costing taxpayers even more in the end, and because it is more likely to undermine than to create confidence. Governments should practice the same principle as doctors: first do no harm.

I believe that Obama is sincere here, but I also believe that he has listened to and sided with advisors who have sold him one side of the argument, a failing in judgment that I attribute to his years at Harvard, where he gained an undeserved belief in the intellectual superiority of the the Eastern Scholarly Establishment, led by Harvard.  Notice that he says, “we believe that preemptive government takeovers …” He does not provide reasons and evidence, only belief to support his policies. Further, he mischaracterizes the situation when he says “preemptive government takeovers.” There would have been nothing “preemptive” in the takeover of Citigroup, Bank of America, and others that were realistically insolvent and only prevented from failure by the infusion of tens of billions of government funds and hundreds of billions of government guarantees.

Obama fails to provide answers to the thoughtful critics of his policies. Rather he mischaracterizes their arguments and rebuts the mischaracterizations. This is neither compelling nor honest. He continues:

So rest assured – we will do whatever is necessary to get credit flowing again, but we will do so in ways that minimize risks to taxpayers and to the broader economy.  To that end, in addition to the program to provide capital to the banks, we have launched a plan that will pair government resources with private investment in order to clear away the old loans and securities – the so-called toxic assets – that are also preventing our banks from lending money.

Obama doesn’t even attempt to answer the critics of his Private Public Investment Partnership (PPIP, or more accurately termed GASP – “Geithner And Summers Plan”), a sweetheart deal for investment banks and hedge funds that acts as a fig leaf for another trillion dollars of taxpayer bailout money.

Although I give Obama A’s and A-pluses on most of his actions and programs to date (including the stimulus package and budget), I give him between a C and D on his bank bailouts. My only hope is that Obama has said many times that he expects to make mistakes, implying that he is open to recognizing and learning from his mistakes. Let’s hope he recognizes this mistake sooner rather than later.