Tag Archives: TARP

The Federal Government Races to the Cliff

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In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken.  Both intend to jump out at the last moment.  But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling.  The chance is at least 1/4 that the result will be similarly disastrous.    

It is amazing that the financial markets continue to view the standoff with equanimity.   Interest rates on US treasury bonds remain very low, 3% at the ten-year maturity.   Evidently it is still considered a sign of sophistication to say “This is just politics as usual.  They will come to an agreement in the end.”  Probably they will.  But maybe not.   (I’d put a ½ probability on an agreement that raises the debt limit, but just muddles through in terms of the genuine long term fiscal problem.  That leaves at most a ¼ probability of a genuine long-term solution of the sort that President Obama apparently proposed last week – described as worth $4 trillion over ten years.)

My advice to investors is to shift immediately out of US treasuries and into high-rated corporate bonds.  If the worst happens, you will probably save yourself from a big capital loss within the next month.  If not, there is no harm done.

The game is not symmetric.  The Republicans are the ones who are miscalculating.   Evidently they are confident of prevailing:  they rejected the President’s offer, even though he was willing to cut entitlement programs.

The situation is complicated because there are a number of different people crammed into the Republican car.    There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills.  But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.).  This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees.   It doesn’t matter: the car would still go crashing into the ocean far below.   The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis. 

There are other guys (and gals) in the car who are even more delusional.   They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending.  This is literally impossible, arithmetically.  But they honestly don’t know this.   It is as if they were insisting that the car can fly.   Sometimes it can be a good bargaining position to adopt a very extreme position.  But if you are demanding that the car flies, you are not going to get your way no matter how determined you are. 

It seems likely that the man in the driver’s seat – House Speaker John Boehner – does realize that his fellow passengers don’t have the facts quite right.   But there is also a game of chicken going on within the Republican car.  The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues.   (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.)   The guy who is riding shot-gun in the car – the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.   

It seems to me that Boehner, too, is miscalculating.  Given that the car can’t fly, the crazy guy is probably going to oppose him in the primaries no matter what he does.   So I don’t see what his plan is.   But whatever it is, he has made it clear that he doesn’t plan to agree to any increase in tax revenues.   

As a result the Republican leadership is in the remarkable situation of refusing to agree to Obama’s offer to solve the problem so long as the solution includes raising tax revenue, even if it is via such measures as ending distortionary subsidies for ethanol, oil companies, and corporate jets.

If I had to guess:   The financial markets will wake up just before August 3.   US bond prices will finally fall.  The market reaction will shock the Republican leadership into action.  (Precedents include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.)   They will finally make the small but necessary concessions on tax revenues.   But by then it might be too late.

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A Review of Predictions of the Last Decade

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         December 31 is technically the end of the first decade of the 21st century.  It is perhaps an appropriate time to review one’s predictions.    It seems to me that I got some things right over the last decade.  Indulge me while I review the predictions that came true, before turning to those that did not work out as well.

Stock market peak     At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market”  (Nov. 20, 1999).   This was four months before the bubble burst in 2000.  So far so good.

The Euro        Also at the start of the decade, I thought the european currency was undervalued.   My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000).  Over the next eight years the euro in fact rose 60% in value.    (But, incidentally, “I don’t mean to express an optimistic forecast regarding European economics or governance…. Europeans have made many mistakes, the leaders and public alike.” 2006.)

The Yen       In January 2008, I wrote about “…the carry from the yen to the euro:  it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”  (“Getting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements in International Financial Markets,”  Milken Institute Review 10, no.1, pp.38-45)   By November 2008 the yen had sharply reversed, precisely in the way predicted.

TIPS           I recommended Treasury Inflation-Protected Securities to my blog readers, early in what turned out to be a period of steep rise in their value.  (Feb. 2009.)

            The big economic story  of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it.    A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right).   I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini.  A 2009 paper identifies 12 commentators as having warned that the US housing market would end in a serious recession.

What parts of the crisis did I get right?

Severity of 2008-09 recession             After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:

 “Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…”  (Oct. 30, 2003.  Also Dec.2003 and Nov.2004).    

I said it again as the downturn began:”… if the economy does go into a recession, Mr. Frankel says, “it is likely to be worse than the last one” (WSJ, 1/21/2008).

That seems to me precisely what happened.

Budget deficits   At the start of the decade:  “We need to think about using our budget surplus to provide for the retirement of the baby boom generation, not to blow it on a big tax cut” (May 16, 2001).  But of course the Administration chose the latter policy.   Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible.  The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.”  (May 24, 2006.)   Indeed.

Market underestimation of risk        I was dubious of the “Great Moderation.”   By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high.  (May 24, 2006.)  The markets were underestimating this risk:
 “How can the implied volatility in options prices be so low?  Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.”  (Nov. 2006.)    “The implicit volatilities in options prices are substantially too low, and will rise.  … market estimates of risk are lower than they should be.  … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies.    Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.”   (Jan.12, 2007. And again, May 14, 2007.)     
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written.  It was to go as high as 80 when the full financial crisis hit in 2008.

The carry trade “should be reversing.” (Jan.12, 2007.)    Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)   

International crises    When asked Have financial developments made the International Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.”    (March 1, 2007)   I identified Hungary and other Eastern European countries as particularly vulnerable.  (Jan. 2008.)

The coming financial crash       The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look good now:

 “The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…”     (In Responding to Crises, Cato Journal, Spring 2007.)

Housing          Of the various asset markets, housing was the area where policy had most clearly gone awry.    I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.”   (March 26, 2007.)    “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.”  (April 28, 2007.)     

The start of the recession     “[A]t the time of writing [Jan. 2008], the United States appeared to be poised on the brink of recession….A coming recession may be more severe and long-lasting than the last one in 2001….”   By May 2008 I had figured out that a recession was indeed probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.   

Banking crisis resolution       When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work.  (March 23, 2009.)  I felt pretty isolated.  Others attacked the plan, from both left and right.  They expected Tim Geithner’s stress tests to be phony.  The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks.  They wanted either to nationalize the banks or leave everything to the free market.  As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.   

The trough      Financial markets stabilized in the first half of 2009.  Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then.   This turns out in fact to have been the case: The record shows that the recession ended that June.

Predictions gone wrong          Needless to say, I got plenty wrong in the decade as well.   For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came.   For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar in international currency use by 2015 or 2022.    It now seems unlikely.   I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar.  Yet flows into the U.S. showed that the dollar is still a safe haven.  For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.

My most spectacularly wrong predictions were all in the area of politics.  I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College.   (This did not happen after January 2001.)   I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise.  (Not!)   In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president.   (Wrong again.)  

In the coming decade, I resolve to eschew political forecasts, and stick to economics.

[Comments can be posted on the Belfer site.]

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Needed in Treasury Plan: Price-discovery, write-down, & taxpayer protection

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Some observations on the plan announced by Treasury Secretary Tim Geithner yesterday:

 

Clearly we need to hear more details.   sympathize with Geithner, who has only been in office a couple of weeks.    He has had to take over in the middle of the worst financial crisis in 77 years, at the same time that he must personally fill out the reams of forms that it takes to get confirmed by the Senate (like all such new appointees)  and to fill lots of positions throughout the upper levels of the Treasury.    But the American public will demand further elaboration  on his plan soon.

 

For now, one must guess what is going to be the precise shape of the new Private Public Investment Fund (PPIF).    Continue reading

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