About Peter Radford

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Stock Market Illiteracy

Sometimes my total disrespect for the stock market leaps to the fore. It is an extraordinarily skittish place and seems to be full of the most short sighted and most easily swayed folks on earth. Analytically? Don’t even go there. Let’s just say that dunderhead isn’t close to the mark. They can’t read too well either. Take today’s data on incomes from the Bureau of Economic Analysis.

It shows that personal incomes rose in April by a ‘surprising’ 0.5%. I put surprising in quote marks because it appears that the market reacts more to the level of expectation than to the news itself. I too am surprised. Will I be doing back flips? No. Will I declare the recession over and the returns to the glory days upon us no? The stock market will and has. Dumb. Very dumb.

The data also shows that disposable incomes rose even more: by 1.1%. For those of you new to this, disposable incomes gives us an after tax view of how wages and incomes flow through to the point at which they can be spent or saved. The market loves that jump in disposable incomes. Presumably the market view is that we are on the cusp of a good old all-American buying binge. Which will drive consumption up, boost profits and hence drive the stock values higher.

Ummm. I wonder if they read line three of the report: personal consumption expenditures, [‘PCE’]. Had they read that far they might have noticed that PCE fell in April by 0.1% A small fall I admit. Almost insignificant. Except that it continues a trend we all, well I did anyway, noticed last month: the strong upturn in PCE of January and February has been followed by two weak months. That upturn was one of Bernanke’s original ‘green shoots’. It has withered entirely away.

This is not good news.

Look deeper into the data:

Most of the rise in incomes comes from obscure things. Wages fell. Rental incomes and transfer payments went up and produced the rise. Not many average Americans get rental income, so even if that continues I doubt it will lead us to the promised land of consumption growth. And ‘transfer payments’? As its name implies that’s income that is being shuffled around the board, it isn’t new. Think: ‘ American Recovery and Reinvestment Act of 2009’. Sound familiar? How about ‘stimulus package’? That’s right the most important factor pushing up PCE was the stimulus package. Hardly a long term improvement.

And how about the upturn in disposable incomes. Same thing. The stimulus package sucked out taxes. Hence ‘after tax income’ shot up. ‘After tax’ equals ‘disposable’. Duh.

Now keep looking at that data: the personal savings rate rose strongly fro 4.5% to 5.7%. Terrific. That’s the highest rate for fourteen years. We need to become more thrifty. We need to return to the savings rates of the 1960’s when families routinely socked away 10% of their incomes for a rainy day.

But not just yet.

First we need to spend every penny we have to get the engine running smoothly again. Then, once we are all back working we can start to save.

So here’s my, apparently contrarian, view: this data makes me a little queasy. Wages are weak and falling. The stimulus had far too much tax rebate in it, $300 billion of the roughly $800 billion, and what there was is now being saved. Just as I predicted. That means the stimulus will have less effect than it ought to have had. In jargon: its multiplier is too low. Just as Keynes would have argued.

The economy’s problem right now is not savings, nor is it incomes – especially when incomes are temporarily distorted by transfer payments and tax rebates. The problem is spending. In the jargon: final demand is too low compared with the economy’s capacity to produce. We have idle resources: closed factories and unemployed workers. We need to get that capacity back in use. Savings don’t help. Nor do lower taxes.

There is nothing new at all in any of this.

It’s just that the stock market suffers from attention deficit disorder and seems to have forgotten. Don’t worry though: there’ll be a new report soon that will send the market careening off in a negative sense. Probably for the wrong reasons.

And that’s why none of us should pay too much attention to the stock market. They can’t read down there.

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GM: Done For

Saturday night’s agreement between a significant group of GM’s creditors, the company, and the US government has sealed the deal: GM will file for bankruptcy, most likely Monday. Thus ends an iconic chapter in American history. GM once was emblematic of American manufacturing prowess. It generated a full 3% of the country’s GDP back in the 1950’s. It was credited, more than once, with staving off national recession simply by cranking up its own production. And, of course, there was the famous rejoinder from its CEO Charles Wilson [a.k.a.’Engine Charlie’] when he was before a Senate conformation hearing: ‘What’s good for the US is good for GM, and vice versa.’

Now, not so much.

In truth the decline and fall of GM is a story worthy of the great Edward Gibbon whose ‘Decline and Fall of the Roman Empire’ is a mammoth read even in an abridged form. The tale is familiar: its cars were criticized as unsafe, it failed to adjust to higher oil prices, it could not compete with more nimble and cheaper foreign manufacturers, and above all else it failed to adapt its fundamental business model to the global market. It became a poster child for the bygone years of American industrial dominance in an era of high technology and service industry growth.

It’s failure is also the failure of middle America to adapt. The 1950’s model of high wage blue collar jobs, good benefits, and job security backed by big union clout served a couple of post-war generations well. It has left their heirs high and dry in run-down industrial towns shorn of income, hope and purpose. All that GM and the people who ran it for the past few decades have left is a shadow of what was once a mighty empire.

Will GM re-emerge?

Most likely. But there are very strong opponents of its bankruptcy plan even after the majority of bondholders have caved in. The main resistance will come from the dealership network where the economic deprivation and political clout converge in a potent way. Many dealers are local leaders in Chambers of Commerce dotted across the country. They spend big money at election time. Now might be a good time to collect on their largesse. The main approach of attack against the company’s plan is to claim that it is illegal. The veracity of this claim rests on the way in which GM is planning to re-emerge. When it moves out of bankruptcy there will be two GM’s: and “old GM” consisting of all the shuttered factories, the old debts, and discarded brands; and a “new GM” consisting of the remaining four brands and the infrastructure needed to make them. The bondholders have accepted a 10% share in the “new GM” while their debt goes with the “old GM”. They have thus contributed nothing to the newer company and may still collect a few cents on the dollar as the bits and pieces of the old company is sold off. This ‘something for nothing’ is what persuaded the bondholders to go along with the plan, but also means that they have been treated preferentially over and above other creditors with an equal claim in liquidation. A court may view this as illegal and render the whole plan improper. This would obviously trigger a round of heated negotiation and slow the entire process to a crawl.

And time is not in GM’s favor.

The company is bleeding cash at a prodigious rate, losing market share, and, most importantly, losing its share of customer loyalty. The longer the slow death lingers on the more difficult it will be to restore even a trimmed down GM to long term profitability.

As it is I am not sure that the “new GM” will have what it takes to survive in a world auto industry that still suffers from a vast over-capacity. The deal made in Germany Friday to sell GM’s European operations to Magna of Canada rather than to Fiat works against GM in the long run: Fiat would have consolidated the industry and shut down capacity. Magna is a new entrant. It is one of the world’s largest auto parts makers and currently assembles cars for other makers – it builds BMW SUV’s as a sub-contractor – but its acquisition of Opel from GM doesn’t help rationalize the auto industry at all. So, while over capacity looms over all the current car makers, it will have a disproportionate effect on the weaker: the “new GM” being on of them.

But that is all for the future.

Right now is time to mourn the passing of GM, and along with it a huge element of the post-war American success story.

These are odd times.

Addendum:

One reason that some bondholders may fight the GM plan in court is that they have insured themselves against loss of value in their bonds by purchasing credit default swaps. They would thus lose nothing. As long as their credit default swap counter-party is solvent and can pay-up. Then I suppose the counter-parties might support the GM plan so as to avoid having to pay out. Oh, what a tangled web this recession has become! Ugh.

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The Economy and Profits

The plummet is now more of a sharp fall.

That’s the best way to describe the way the economy is now behaving. This morning’s release of the revised first quarter 2009 GDP data has it declining at ‘only’ an annual rate of 5.7%. The original estimate, made last month without some of the final data, had the drop at 6.1%. So it seems that the economy is falling less rapidly than either we first thought or the previous quarter which saw a fall of 6.3%.

So have things begun to turn around?

Maybe.

The revision to the first quarter is (a) not very large; (b) less than many people were hoping for; and (c) due mainly to an unexpectedly high level of inventory. This latter point is particularly ambiguous. Inventories can be high because businesses are gearing up for rapid sales. Or they can be high because sales were bad. I think it is the second of these two explanations that underlies the first quarter result and so gives us little to cheer about. Consumption remains mired in the doldrums despite the 1.5% increase in the first quarter, and since that is, ultimately, what will drive us out of recession placing too much hope on the slight upward revision is foolhardy.

Other components of the economy are equally bad: business non-residential investment is awful and much worse that the end of last year; so too is residential investment. Trade has diminished on both the export and import sides and is unlikely to recover any time soon – at least while the entire world struggles to recover from the recession that is now global in nature.

We should also note that the last six months of decline have been the worst for fifty-one years. We only averted a total collapse by the skin of our teeth, in large measure due to the extraordinary efforts of the Federal Reserve Board and the administration. Nonetheless we are hardly off life support yet: the banking system remains weak, and rising unemployment casts a long shadow over the near term outlook for consumption. These are the short term dangers. Longer term we have to be concerned about the negative impact of debt reduction. This so-called ‘de-leveraging’ will cramp demand for a long time, possibly several years, so even when the economy is recovering, growth is likely to be slow by historic standards.

Plus all the anecdotal evidence piling up tells us that efforts by businesses to cut costs will come back to haunt them. In particular is the pernicious effect of salary reductions. By eliminating part of income from pay packets around the economy businesses are making harder for consumers to return to old spending habits. This will aggravate the effects of de-leveraging and slow us down even more.

Conversely cost cutting appears to have boosted profits. They rose quite strongly in the first quarter, by 3.4%, after having fallen a whopping 16.5% in the fourth quarter of last year. Only closer inspection much of this recovery in profits seems to be in the banking system where the very steep yield curve – the difference between short and long term rates – is bulking up bank incomes. Don’t forget that banks make most of their money by borrowing short and lending long, so a steep yield curve means they can borrow cheaply and yet lend at much higher rates. This steepness is intentional: part of the administration’s recovery strategy is to engineer a profitable yield curve for the banks so that they can ‘earn their way’ back from insolvency to capital sufficiency. On the face of it this strategy is working so far.

Apart from de-leveraging and cuts in wages there are still very significant dangers lurking out in the weeds. In particular the commercial property market looks very weak. Spreads in the secondary market for commercial real estate based securitized loans are very wide. This is a sign of the growing concern in the market that many developers will not be able to find sufficient funding to roll over their debts and thus will default. The administration is currently trying to extend its TALF loan support program into commercial real estate to help restore confidence, but its efforts have been hampered by Standard and Poor’s announcement that it is reviewing the commercial real estate sector with a view towards reducing most of its ratings from AAA to something a lot less. This could have a profound impact since many secondary investors only invest in AAA rated securities. If the downgrade goes through then the prospect of default by many developers gets much greater. Such defaulting, coupled with the continued uptick in credit card losses could undo all the work to restore bank profits.

So the situation remains delicately poised.

While there are some signs that things are leveling off somewhat all the real variability still lies on the down side. In other words the risks are biased towards worsening that improvement. We need to avoid any of these risks materializing over the next few months in order to emerge from recession.

Will we?

I think the outlook is the same as it was last month: the economy should just about climb out of recession later this year. Possible growth in the fourth quarter of between 0% and 0.5% – that’s a considerable upturn form the first quarter’s decline of 5.7%. Next year looks very weak: growth of between 0.5% and 1.5%.

But this improvement depends on our avoiding the rocks, especially a second round of losses at the big banks. It is not cast in stone.

Keep your fingers crossed.

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The Small Bank Crisis

Lost in all the hubbub about the losses and possible collapse of our largest banks – most of the fuss has been about only the 19 largest banks in the country – is the ongoing crisis that the small, local, banks are facing. So it is worth taking note of what’s going on at the lower levels of our financial system.

And the news is not good.

The latest FDIC report shows some very disturbing trends among our smallest banks. For instance over one fifth are not making any money: the figures for the first quarter include the fact that 22.5% of all banks with less than $100 million in assets are unprofitable. Not all of these will go out of business, but a large percentage will. The FDIC has been very busy so far this year winding up small banks, about 21 through March, and the likelihood is that many more will disappear as we go through the nest wave of loan losses.

Smaller banks are particularly prone to commercial real estate losses because those types of loans make up a much higher percentage of their total loan book. So with the oncoming rush of property developer defaults, which is typical at this time of any recession, the pressure on smaller banks will intensify.

Couple this with the alarming drop in profitability small banks have suffered over the past two to three years – returns on assets have dropped by almost two-thirds for the group of small banks as a whole – and the situation is even worse.

Finally there seems to have been a shift of deposits out of smaller banks towards larger ones. This deprives the smaller banks of their most reliable source of funding and reduces their ability to finance activities in their local communities. Since smaller banks play a pivotal role in many of America’s more rural areas their plight is especially relevant and should not be overlooked.

The administration has begun to shift its bailout attention towards the lower end of the banking market in anticipation of the difficulties that are now emerging there: there are now 305 banks officially listed as being ‘problematic’. The cost to the FDIC of winding up those 21 small banks led its reserves to drop from $17.3 billion to $13 billion in the first quarter alone. As a result it has levied new fees on the banks who benefit from its guarantees in order to raise almost $5.6 billion to create a war chest to deal with the problem banks on its list.

So, while our attention is inevitably focused on the ‘too big to fail’ banks like Citigroup and Bank of America, we should acknowledge the crisis brewing down below. One result of this recession will be a further reduction in the number of small banks scattered across the country. It is not just Wall Street that is being re-cast. Main Street is getting a make over too.

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Health Care, Taxes, and Debt

As we move more into the legislative agenda of the Obama administration, rather than the triage period of economic recovery, several inter-related issues become very prominent. Obama wants to shift the emphasis of health care towards universal coverage, but has to accomplish this against a very strong headwind: the Reagan/Bush legacy of national debt.

The problem is simple: any attempt to provide universal health care coverage, in other words the move from regarding health care as a ‘benefit’ or a ‘consumable product’ towards a basic ‘service’ akin to a utility will cost serious money. Most estimates put the price tag in the range of $150 billion a year. In the context of the Federal Budget this is a very significant addition to the deficit, although it is trivial when set against the cost of bailing out the banks.

The original Obama budget used a variety of methods for financing this cost: mainly the termination of the Bush tax cuts at the high end of incomes, and the implementation of much needed cost reductions in the health care industry.

The problem of cost reduction is of paramount importance. The US system is extremely expensive to run. It absorbs about twice of our national annual income, as measured by its percentage of GDP, than any other health care system in the world. The next most expensive is the French system, which delivers excellent service at half the price. Indeed the French system is arguably superior since it provides more effective basic service to the entire French population, unlike the American system which fails to cover about 45 million people here.

The problem with the US system is is that its fragmentation amongst a vast number of carriers, insurers and other providers dissipates buying power so costs of things like drugs are not forced down. Yet at the same time it is replete with duplicated costs: all those insurance companies carry large administrative overheads and at the front line of care the lack of automation in doctor offices is extraordinary. By any objective standard the system is horribly inefficient.

To those who advocate a totally private system this must be a source of frustration: market forces are supposed to drive out costs because doctors and hospitals should be competing on price as well as service. In fact price should dominate the provision of the basic services since most doctors, within their specialties, have little opportunity to differentiate sufficiently to maintain a higher price service. There will always be niches for very high end services, but those are commonplace the world over even in nationalized systems. The problem here is that the typical market forces that should eliminate waste simply don’t work. Consumers do not look at health care as a ‘consumable item’ except for fringe services like cosmetic plastic surgery. And sick people have very little incentive to search for a ow cost provider: they simply go to their regular doctor or head to the emergency room.

In the American system the true locus of efficiency inducing market forces should be in the cost of purchasing insurance. This is where consumer choice should enter into the equation. But, again, consumers are effectively shielded from the true cost of their choices by the employer provided nature of the service. Because employers provide health care coverage as a ‘benefit’ they find it acceptable to absorb some of the cost. So consumers who get their insurance through the workplace, and that is a large percentage of Americans, do not face the real cost. Thus they have no incentive to demand cost reductions from doctors or insurance companies.

Couple this lack of effective market force with the unique effects of the American litigious process which adds to overhead costs and the end result is a system that is neither market efficient nor universal. It has none of the benefits of being truly ‘privatized’ and none of the benefits of being truly ‘nationalized’. So it exists as a wildly inefficient hybrid absorbing an increasing amount of our wealth while not producing an equivalent level of excellence: the US ranks very low in most of the basic services that the United Nations uses to measure the effectiveness of health care around the world. This is a scandal given the amount of money we collectively spend on it.

So a fix is urgently required before we are swamped by the system’s cost and it squeezes out other more productive and wealth generating activities from the economy.

Hence the need to look at debt loads and taxes.

I have mentioned here many times that the massive expenditure to save the economy was unavoidable. Deficit spending, while distasteful to those of us who are fiscally conservative, is a necessary evil. It is the only method we have for keeping ourselves from plunging full bore into another Depression. And it seems to be working, although there is growing feeling amongst economists of all political stripes that the stimulus may need another round of spending before we are assured of success. Even Martin Feldstein, hardly a left winger, gets in on the act of advocating more spending. Only the hard core ‘New Classicists’ remain berating the Keynesian drift of economic policy, mainly because the current crisis is an indictment of their theory.

But, given the mess that three decades of Reagan/Bush profligacy have created, notwithstanding the entirely accidental Clinton surpluses, we are facing almost historic debt levels as a result of the current ‘triage’ approach. And already that is causing nerves to crack in the bond market. The prices of US treasury bonds are dropping at the moment for a variety of reasons:

  • faster economic growth will engender inflation. Bonds will fall in anticipation of inflation: interest rates will climb to compensate for inflation. Higher interest rates means fixed rate US treasury bonds are worth less, hence the decline in price of bonds.
  • the enormous amount, some would say ‘glut’, of bonds being flooded onto the market by the US as it tries to bail itself out needs to be maintained in the market. This is a simple matter of supply and demand. Greater supply of bonds will reduce their price. The result: lower bond prices and higher interest rates.
  • now add in the expectation of funding needed for the Obama agenda, and the supply of bonds seems to grow even more. The result: lower bond prices and higher interest rates.
  • lastly, foreign investors will start to unwind their holding of US bonds, as their respective domestic markets recover and offer higher yielding opportunities for investment. The result: lower bond prices, and higher interest rates in the US in order to maintain foreign investor involvement in the market.

There seems to be a theme here.

Even with the Federal Reserve Board’s efforts to reduce the supply of bonds through purchases most estimates put the Treasury’s bond issuance requirements at around $2 trillion this year alone – it has already issued about $900 billion this year.

In other words fiscal policy is a mess and we need to start to plan to tighten it back up in order to prevent a massive bond market revolt against the US. The jitters last week when Standard and Poor’s threatened to downgrade the UK debt from its AAA status was a strong shot across the bows here as well.

So what to do?

Raise taxes.

There seems to be little appetite for expenditure cutting in Washington. And in truth there is little that can be done in any case. The largest chunks of the budget are each sacrosanct: I doubt, for instance, that defense spending will be reduced substantially any time soon even though it is egregiously high when compared to other nations. The US spends as much on defense [or more properly ‘offense’] than the next ten countries in the world combined, and it is wedded to defense systems that have no place in the post-Cold war era. Yet cutting defense spending seems politically infeasible. Likewise reducing or eliminating entitlement spending: even the supposedly anti-government ideologues like Reagan and Bush balked at that. In fact they added to the spending. The American middle class likes its perks, but doesn’t want to pay for them.

So in the absence of cost cutting we will have to raise revenues. This means taxes. I have already alluded to the elimination of the upper end Bush tax cuts, but that alone won’t be enough. US corporate taxes are already among the highest in the industrial world and probably need cutting rather than raising – but only if the loopholes are also done away with. This leaves other taxes such as excise and sales taxes. I would wager that the US will end up with a European style Value Added Tax [‘VAT’] in the not too distant future. Given our need to shift our priorities more towards savings, a larger emphasis on consumption taxes surely has to be in the offing.

But. Lingering in the background of the health care debate is a massive tax opportunity. One that Obama has now begun to turn to, even though he hammered McCain during the election for raising it. Resolving the employer tax exclusion could free up more than enough money to pay for the entire edifice of universal health care – some estimates put the extra revenue that abolishing this loophole would provide at $300 billion a year. Serious money . Huh? I can hear you all asking. What is that? It seems that way back during World War II the government put a lid on wages in order to control costs and it simultaneously introduced a ferocious tax on ‘excess profits’. After the war businesses that started to make good money again were faced with rising profits and no ability to raise wages. So they turned to giving away health benefits in lieu of wages. Why? Because the wartime legislation also excluded the cost of employer health care coverage from taxes. So providing health care was subsidized by the tax exclusion. And, as usual, the continuance of a tax subsidy distorts the market: decades later we have a mangled health care system because businesses can reduce their tax bill by offering health care as a ‘benefit’.

So there you have it: our fiscal constraints will dictate in large part the next phase of the Obama agenda. The costs of unwinding the Reagan/Bush binge are enormous and threaten to undermine any attempt to rationalize our health care system. With some imagination and a little political courage we can accomplish both at the same time. Indeed I see them as firmly intertwined. We spend too much on health care, and we ned that money to get our house back in order.

Welcome to the era of change: cost cutting and fiscal responsibility. That’s very conservative. And it’s a huge change from the past three decades of waste and illusion.

Change we can believe in? Or simply change we need?

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