recovery

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Weekend Update: GM, Health Care and GDP

After all the chaos of the past few weeks, the ‘green shoots’, bankruptcies, inflation fears, and the onset of the health care reform campaign, this weekend seems rather quiet. That makes it a good time to recap some thoughts relating to the headline events.

GM:

  1. GM’s bankruptcy is a watershed event for the US. Think of the size: GM employs about 210,000 people worldwide and 91,000 here in the US. It has a staggering 463 subsidiaries scattered across 34 countries. Its monthly payroll bill is $476 million. It provides pensions and health care benefits to 493,000 retirees. It has 11,500 vendors and spends $50 billion a year here in the US on parts etc. Its collapse will ripple throughout that entire mess.
  2. I have doubts about its survival even when it emerges from bankruptcy. This is because GM needs more than a financial re-organization, it needs a brand revitalization which is far more difficult to accomplish. When GM entered bankruptcy it had assets of about $82 billion and debts of about $172 billion. That’s a dead company by any stretch of the imagination. More to the point: even though some of its recent cars have attracted critics adulation – the Chevy Malibu for instance – it suffers from a severely depleted brand reputation. Producing good cars now after decades of undifferentiated duds may not help in the face of the competition now ramping up for the kill.
  3. The entire auto industry is a mess. It suffers from chronic over-capacity and needs to reduce itself to a more profitable size quickly. Presumably the emerging markets of China and India will eventually outpace demand from more mature markets and so innovation and scale advantages are likely to shift similarly. GM’s strong presence in China may aid survival if that is the case.
  4. Offsetting that is the likely continued collapse of its brand here in the US. Its appeal to younger Americans is virtually non-existent. Honda, Toyota, Nissan and now Volkswagen have emerged as the suppliers of choice to younger Americans. Volkswagen is building a new factory here to produce 250,000 cars a year as it seeks to double it market share at GM’s expense.
  5. GM remains a very dull company. The word is that Obama’s auto task force were shocked at the poor quality of GM’s management. It is old fashioned, lacks focus, and too attached to the plethora of brands that sank the ‘old GM’. Heads will have to roll before we can expect a vibrant new GM to succeed.
  6. Even with the drastic reduction in costs that bankruptcy will allow – GM expects to shut fourteen factories – it is still not a low cost producer of cars. It is still burdened with huge pension and health care costs that its competitors do not have to carry, the latest estimate is that each car it will make after bankruptcy will still have to earn $300 just to pay for workers who no longer produce anything.

Overall then I see GM as a 60/40 proposition going forward. All that taxpayer money is designed to give the company a window of opportunity. The macro economic conditions it faces remain daunting. I would not be surprised to see GM going through another bankruptcy procedure a few years from now. Let’s hope not.

“The trade-off between wages and health care costs is the key to getting the average voter’s attention: they are already paying a huge price for the system’s failure”

Health Care:

  1. The interesting fact here is that we have no choice but to fix health care. It simply costs too much. The latest estimates I have seen put the total cost of health care at around 18% of GDP this year. That’s an astonishing number. Worse: no one expects it to get cheaper without radical surgery [sorry about the pun]. Indeed as the baby boomers all age and if they consume health care services at the rate their parents did, that 18% is set to become around 40% within a couple of decades. That will bankrupt the country. So something has to be done and quickly.
  2. A key fact to remember: the impact of health care on wages. It has been catastrophic. Because the US system depends on employers giving health care as a benefit its rising cost has squeezed employer’s ability or willingness to give pay raises. Businesses look at wages and benefits as a sum cost. If the cost of health care goes up that leaves less cash available for raises. Looking at the trend over recent years the aggregate of wages and benefits has risen quite steeply. But practically all that increase has gone to pay for health care costs. None has gone to wages. So incomes have stagnated. Without controlling health care we can expect wages to stagnate, and even have to fall to accommodate the expense. That is not tolerable. The trade-off between wages and health care costs is the key to getting the average voter’s attention: they are already paying a huge price for the system’s failure. They need to stop that getting worse.
  3. The fight will come from the insurance companies who do not want a government provided alternative. In order for them to win that argument it looks as if they will have to offer significant compromises. In particular they stand to lose their ability to refuse ‘pre-existing’ conditions. I am deeply skeptical of the insurers: they have no incentive to offer the kind of comprehensive cost cutting the system needs. Nor do doctors. Somehow if we are to avoid a mandated system, incentives have to be introduced to force rationalization, office cost reductions, reduced test frequencies and duplications, and a better focus on prevention rather than cure. How this can be accomplished without government fiat is very unclear.
  4. Paying for the changes will be easier than many people think. First: the system already costs a vast amount, we can accomplish a fair bit of reform by re-allocating what we already spend, rather than by spending more. Second: there is a growing consensus that health care benefits should be taxed. One of the reasons the current system is so bad is that consumers do not bear its costs directly. So they have no incentive to push back against doctors who over prescribe, or against the waste of insurers bureaucracies. By taxing benefits not only do we raise money for reform, but we focus consumers on the cost of the services they are using. Hopefully consumer activism will disturb doctors and insurers enough for them to provide cost effective rather than lavish service.

Solving our health care mess is a high priority for a number of reasons. We need a better return on our investment: right now we have the least efficient system in the world. We need to spend less in absolute terms: we are on a path towards bankruptcy currently. We need to determine whether we want to have our entire population covered: if so, how? If not, why? Even with the difficulties and entrenched opposition there seems to be widespread support for change. I doubt that the resolution will be bipartisan, but this seems to be one area where Obama has the nerve to use the Democrat’s majority. Let’s hope he gets this sorted out this year. We don’t have the money to keep up the current pace of things.

GDP:

  1. There is far too much focus on short term numbers and not enough on the long term trends. My fear is that all the talk of ‘green shoots’ will distract us from digging into the sources of our problems and therefore stop us from eradicating them.
  2. The banking system needs fixing. It is in an awful mess. It is badly managed and runs on business models that are now proven dangerous. One look at the headlines about government ‘interference’ – usually in the Wall Street Journal – and we can see already that the industry has successfully avoided either taking responsibility for the crisis it started or undertaking reform. The breathless criticism of the FDIC’s suggestion that heads should roll at places like Citigroup, as if that wasn’t blindingly obvious, is an example of this. Indeed the banks have so successfully co-opted government that everyone seems scared to suggest doing much by way of fixing them for fear of failure. failure, that is, of one of the banks. From my perspective the collapse of the banks was a failure of their managers, boards and regulators.
  3. On the subject of banks: I urge you all to read John Lanchester’s excellent article in the latest issue of The London Review Of Books. Apart from being an outstanding summary of the crisis it offers up an actual bank balance sheet from The Royal Bank of Scotland. This balance sheet was released to shareholders just two weeks before the bank fell into the abyss where it currently wallows. The lesson I want to highlight is that nowhere in this balance sheet is there a single clue of the impending disaster. None. That the bank’s auditors, managers, and regulators are not all in jail for publishing such an obviously misleading document is beyond me. Without accountability we will not fix the banking system. That means we will not fix the economy.
  4. Employment. The outburst of optimism that greeted Friday’s employment report is testimony more to our depressed mindset than to any rational thought. It was awful. Just not as awful as the last few. That is no triumph. For anyone to trumpet a turnaround based on one month’s data is just plainly irresponsible. It is silly.
  5. All the vexation about rising US bond rates is similarly off center. There are those who are already despondent over inflation: they are arguing that the uptick in US bond rates over that last few weeks is a sure indicator of the bond market’s anxiety over the level of US debt. That anxiety supposedly is so solidly based that we should stop increasing our debt and start reducing it right now. That’s absurd. These are the same folks who sat back and told us that running up debt was not a problem when the cause was tax cutting. Apparently government spending as a cause throws them into a tizzy. Yes: we will need to cut back as soon as the economy is back on track. No: that’s not yet. A steeper yield curve helps the banks. A modest inflation rate helps deal with debt loads. And until we have an economy operating back near capacity all that increase in money supply gets absorbed as demand and not as inflation. Duh.

Nonetheless we can expect the inflation fear mongers to be out in force over the next few weeks. I imagine this is set to become a regular topic for us to talk about.

So the trilogy of issues to watch for in the next phase of the recession: structural reform of the health care and banking systems; the balance between monetary and fiscal policy; and capacity – which includes the employment outlook.

That’ll keep us busy.

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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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    Mixed News

    This morning brings more data to support the notion that the worst is behind us. But along with it is evidence of the long road ahead. In other words a typical day for this point in a recession.

    1. First the good news: consumer confidence, as measured by the Conference Board,jumped quite strongly last month and is now back roughly where it was in September last year. So the glum despondency of the winter months has been lifted. Maybe it’s the prospect of summer? The rise in the confidence index, from 40.8 in April to 54.9 in May, caught most people by surprise and is the fourth largest one month jump in the index’s thirty-two year history. Notably respondents told the survey compilers that they thought jobs were easier to come by than last month. That seems to be more aspirational than factual, nonetheless sentiment will play a key role in resolving our economic ills, so even this will help if it causes people to spend more freely. Still, we should remember that, at 54.9, the index is still very low by normal standards. Readings in the 70’s are more healthy, so we obviously have a very long way to go in order to find consumers truly breathing easily.
    2. Second: today’s release of the Case-Schiller home price index confirms that house prices are still falling across the country. The index measures home prices throughout the nation and particularly in the top twenty metropolitan districts. All of those twenty districts saw price declines in March, which is the latest available data, with Minneapolis showing a 6.1% drop, the largest ever in any area. The month-to-month price decline was 2.2% nationally, more than anyone expected and shows just how difficult unwinding the housing bubble is proving to be. In fact the year-on-year decline was 19.1%, a record. Sellers are still hoping that the vast inflationary windfall profits the bubble brought them are not going to evaporate entirely, so there remains substantial downward ‘stickiness’ in pricing. It seems difficult for property owners to realize that their gains were on paper and a product of inflation only: selling for ‘less than the home is worth’ is still a common mantra amongst disgruntled sellers. Cities like New York are still experiencing rapid declines – last month’s decline was the largest ever for New York and Detroit – and the backlog of unsold homes will only contribute to the continuance of that trend. Even with mortgage rates at historic lows activity is very poor, with most of that action on distressed properties.

    So the news is very mixed. The consumer confidence data points to a possible uptick in spending later in the year. But the housing data is miserable and will cast a long shadow for a while yet. Couple this with the facts that unemployment is still rising, albeit less rapidly, and that foreclosures are still rising as more and more people experience difficulties after a job loss, and the prognosis is still guarded.

    All the evidence suggests that the recession will end later this year, but the outlook for next is very weak. The optimists look for things to snap back to normal levels of growth – somewhere between 2.5% to 3% for 2010 as a whole. I think that is too high. The combination of stubborn unemployment levels above 9% next year, and the continued need by most families to reduce their debt levels, doesn’t leave much room for a strong recovery in spending. Add in the weak outlook for business investment and exports and a more likely prospect is for to grow only a little over 1.5%. Given that the population will grow more than that, the implication is that wealth per person will actually fall next year.

    That’s not a strong recovery by any means.

    We will have to wait until 2011 for strength to re-appear across the board.

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    Social Security and Deficits: Bad Analysis

    Sometimes you come across really silly commentary and allow it to slip by because it doesn’t seem worth the time to say anything. I must admit that has been a very frequent occurrence during the past few months. Especially so with respect to two favorite topics of the conservative politicians: Social Security and Federal Deficits.

    I’ll keep this brief, so let’s take them one at a time.

    Social security is not about to go belly up. It will survive. Many generations of Americans can look forward to receiving their payments.

    There I said it.

    Every time an opportunity presents itself to cry doom and the end of the world, right wing politicians and their economist allies kick up a huge cloud of dust full of foreboding and angst. They tell us in very studious and serious tones of the impending bankruptcy of the Social Security system, and how we might just as well ditch it since it is about to cave in under its own weight. The recent report by the system’s trustees analyzing the recession’s impact was just another such opportunity.

    Gasp!

    Wow. The recession actually made the finances of the Social Security system worse. Who’d have thought? You mean when the economy tanks financial stuff like Social Security receives a negative impact? No! Well than we might as well shut the thing down. After all its as good as bankrupt.

    Rubbish.

    The trustees report shows that the surplus runs out in about three decades from now. Three decades. The surplus runs out. Surplus. That’s not going bankrupt. It means that we revert to a pay-as-you-go system. The right wingers have been crying wolf on this one for years. Decades actually. Ronald Reagan called the system bankrupt over forty years ago. He called a team of ‘experts’ in to tinker with it, which they did, and now it still runs an annual surplus. That would be surplus as in more money comes in than goes out.

    Reagan is famous for calling the system ‘socialist’ and for thinking it undermined the moral fiber of the American public. he wanted us all to rely on our savings for retirement. There’s probably plenty of folks who had their pensions eliminated by the likes of IBM who thank their lucky stars they ignored Reagan. And what about all those people unlucky enough to retire last year when the market had hammered their 401k’s? Think they look at Social Security and thank their lucky stars the doomsayers didn’t win the argument? I do.

    Yes there are issues with the system. The problem is that we live far too long after retirement. Most pension plans, including Social Security, didn’t take into account our increasing life expectancy. They are all underfunded as a result. The days of retiring at fifty-five are long gone. Society can’t afford it anymore. The fix is to make up some of the under-funding, in Social Security we can do that by lifting the ceiling on contributions, and to raise the retirement age in line with life expectancy. When Social Security was introduced the average person collected for only a few years, typically between five and ten. Nowadays some people collect for over twenty years. These two actions solve any funding issues we might have. Both are completely politically feasible.

    End of Social Security problem.

    We should have learned long ago to ignore the doomsayers. Like Reagan their agenda is political, not economic.

    Which connects nicely with my other bete noir. Federal deficits.

    It was Ronald Reagan who plunged us into the huge deficits we now see as commonplace. He sought to cover up his profligacy, and his debasement of conservative ‘values’, by combining the Social Security budget and the government’s Operational Budget [defense spending etc]. This combined budget, what he called the ‘Unified Budget’, has a deficit much lower than the operational budget by itself. Why? Because Social Security runs a huge surplus. So here we have Reagan decrying the imminent collapse of Social Security while at the same time using its surplus to hide his own ruinous fiscal policies.

    It is hard to find a better example of cynical and hypocritical politicking than Reagan’s attitude towards the ‘unified budget’.

    The funny thing is that we have not learned much about deficits.

    In general I would decry deficit spending. That’s why I spent so much time criticizing Reagan and then Bush. They both perverted the word ‘conservative’ and ended up running the largest peacetime deficits the country has seen. Neither cut government spending, yet both ran as fiscal conservatives. Their respective legacies are the deplorable shape they left the country’s finances in. They both enacted unaffordable tax cuts that were touted to stimulate the economy. Neither did.

    Which brings us to the debate about today’s crisis.

    There are many who are tearing their hair out over the massive run-up in the national debt that all the various bail-outs and stimulus policies are causing. By the time the crisis abates we are likely to have a debt to GDP ration of well over 80% maybe much more. The last time we approached those levels was 1945, and the debt was war-time induced. These naysayers presumably want us to let the ‘markets’ take care of themselves and to keep government frugal.

    I most recently came across this lunacy during the excellent debate sponsored by the New York Review of Books. It was Niall Ferguson defending the Hooverites in that discussion, during which he faced off famously with Paul Krugman.

    It was Brad DeLong who quipped recently that there are two rules to follow in economics right now:

    1. Paul Krugman is correct; and
    2. If you disagree with Paul Krugman, please refer to Rule # 1.

    Ferguson’s defense of a purely monetarist approach to our problems places him at odds with Krugman. And it makes him wrong.

    It is lamentable that we have collectively forgotten the salutary lessons of the Great Depression, and in particular the analysis of Keynes. Markets sometimes need help getting back on their feet. In fact markets are highly dysfunctional under the circumstances we now find ourselves in. This is not new thinking. It harkens back to the 1930’s. The Depression was made worse by the very policies that those afraid of deficits and debt now advocate. It is senseless to inflict ruin on ourselves purely because certain ideologically motivated analysts cry foul at rising debt levels. My own belief, as you know, is that we have not gone far enough: we should have spent even more.

    This is not to say that fiscal policy should always be loose and woolly the way that Reagan and Bush seemed to think was OK. Not at all. We will need to deal with the debt quickly if we are to avoid damaging side effects such as lowered debt ratings and high interest rates.

    But that does not mean we should not pull out all the stops to right the ship now. We can worry about the debt later. We have the capacity to raise debt, so we should use it to save ourselves.

    Arguing, as Ferguson does, that the stagflation of the 1970’s is an inevitable result of Keynsian policy is nonsense. The circumstances of the two eras are entirely different. Plus the success of the Freidmanite monetarist revolution that many believe ‘solved’ the stagflation of the Carter years now appears to have been more a happy coincidence and perhaps an illusion: other factors played a key role too.

    Bad analysis is rife. In more normal times we can laugh it off or engage in polite rebuttal. These are not normal times and so bad analysis should be called to task more aggressively.

    People’s livelihood’s depend upon it.

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    The Outlook: Part 2

    Following up on my short post yesterday about the Federal Reserve Board’s outlook for the economy, today I received the Congressional Budget Office [‘CBO’] forecast which takes the form of a briefing to Congress. The story is pretty much the same. But there are small differences we ought to be aware of.

    The CBO takes a dimmer view of the outlook for unemployment. The Fed predicts the unemployment rate topping out at between 9.5% and 9.75%. The CBO expects it to go beyond 10.0%. The news this morning that jobless claims moderated very slightly seems to indicate that the job situation is settling down a little. The key statistic to watch is not the week to week data because that can easily be distorted by a single and unrepresentative event: last week’s figures was much higher because it included a rash of Chrysler lay-offs. Instead we should pay attention to a moving average stretching back a month or two. This allows us to remove distortions like the one caused by Chrysler and thus get a better reading on trends. When we do this the ‘bottoming out’ effect is more noticeable. It is clear that job losses are still very high, but that there is no discernible worsening. There’s a hint of stabilization. And I mean only a hint.

    Nevertheless given the continued high level of job losses, and the very high degree of difficulty workers are encountering as they try to find new jobs – which is also embedded in this morning’s data release because continuing, as opposed to new, claims for unemployment benefits are still at record highs – I expect the CBO prediction to be more accurate. Plus I have a feeling the Fed deliberately erred on the optimistic side when talking about the job outlook because it wanted to use unemployment in its bank stress tests, and as you know, I think they wanted to soften those test for political reasons.

    So unemployment will be a very significant drag on the economy right through the next year or two.

    Having said that the CBO still predicts that the recession will end later this year and that we will see very slow growth during the third and fourth quarters of 2009 followed by a slightly better outlook in 2010. Currently the CBO is predicting GDP to grow by about 2.9%, adjusted for inflation, next year. There are two ways of looking at that. One is that it is quite low given that ‘normal’ recoveries usually get off to a flying start and then settle down later. The second is that it is quite good given the huge hole we are climbing out of and the ongoing risks we still have to overcome. I am in the second school.

    There are huge imbalances still to be reduced. Consumer debt reduction will cramp consumption and business investment still looks very weak. And exports simply will not be a factor. The collapse in world trade has hammered economies that rely on exports: Japan’s economy dropped like a stone in the first quarter this year – it fell at an annualized rate of 15.2% from January through March which is astonishing by any standard – so it is extraordinarily unlikely that the US economy will be lifted by trade. That leaves government spending as the lynchpin of growth for a while to come. The Federal Deficit is the essential fuel we need until consumption adjusts to the new less indebted world of the future.

    The problem with that is the glut of US government bonds that are now out on the world markets. There are signs that our ability to fund the debt will run into difficulty if the rate of deficit spending is not curtailed soon. Already recent bond auctions – the Treasury sells its debt through an auction process – have been less than enthusiastically received and there are even rumblings that the US may lose its AAA bond rating later this year. For those who doubt this I point to the UK as exhibit ‘A’: their bond rating was lowered by Standard and Poor’s just today. Rumors of a US downgrade are picking up steam. While not a catastrophe a downgrade would signify a historic moment for the US economy and would not just raise the interest rates the government has to pay, but, because so much domestic US debt is priced at spreads from Treasuries, it would cause the entire nation’s interest rate structure to shift upwards also. Plus, historians may well look back on such a downgrade as the defining moment in America’s transition from world economic dominance to mere parity with China or the European Union.

    Who would benefit from higher rates?

    The banks.

    The CBO report documents that the credit markets have climbed back from the edge of doom: the apocalyptic spreads we saw in the immediate aftermath of the Lehmann debacle have fallen away to being merely high. Confidence is evidently flowing back into the world’s financial system -as it should given all the taxpayer money that we have thrown at it. Nonetheless as banks start to look forwards at earnings trends over the next few years their ability to grow profits will depend heavily on the nature of the yield curve – the difference between short and long term rates. Without a resurgence of inflation I expect the Fed to keep short term rates quite low for years ahead in order to help growth. The potential of higher US bond rates will tend to drive longer term rates upward and thus widen the yield curve. Why will this help banks? Because the essence of banking is to borrow short and lend long: their cost of funds lies at the lower end of the curve and the prices they charge on loans lies at the higher end. So the steeper the yield curve, the more profitable banking becomes.

    This will make Tim Geithner smile since he is relying on the banks to ‘earn they way’ back out of their capital malaise. But it will tend to press down on borrowers, both consumers and businesses, and will thus slow the recovery.

    Finally the CBO highlights an essential conundrum we should all be aware of: there is a massive conflict between the near term requirements of fiscal policy and the longer term requirements.

    Near term we need to run huge deficits. That is the only way we know to stop the economy falling into a depression. It is testimony to the efforts that have been necessary so far to avoid total collapse that the US budget outlook over the near term is, frankly, terrible. The Federal Deficit has shot up as a result of things like TARP and the stimulus package. This is as it should be and follows the prescription of Keynesian economics perfectly. But: fiscal policy cannot remain that loose. At some point we will have to start work on reducing all this debt we are now issuing.

    I have said before that our task has been made much worse by the Reagan/Bush legacy. We ran horribly lax fiscal policies through both the 1980’s and the 2000’s. The result is the world is awash with our bonds just as we need to flood the market even more. Hence the glut I mentioned above. Instead of running fiscally conservative policies both Reagan and Bush ran incredibly irresponsible ones. It was Cheney who famously said that ‘deficits don’t matter’. Well they always did. And they matter very much right now.

    There is no doubt that fiscal policy will have to revert to very tight standards in a couple of years. That implies both higher taxes and less spending.

    Once again this will put a lid on consumption.

    So for all these reasons: debt reduction, the collapse of trade; higher cost of debt; and the need for higher taxes, I just cannot see a return to strong GDP growth for a while.

    In fact that 2.9% GDP forecast by the CBO looks ambitious to me.

    Let’s hope they’re right.

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