February 25, 2012

G-20 Finance Ministers are presently meeting in Mexico City.  As you will see, perhaps finance ministers from the advanced industrial countries might learn a few lessons from Mexico on how to handle their economies.  It might come as a surprise to many, but Mexico is one of the countries that has fared the best in dealing with the worldwide financial crisis.

V-Shaped Recovery

If we look at real GDP growth, we see that Mexican economic growth was affected by the post-Lehman crisis, but has turned the corner faster than the US, Japan and Western Europe.  In 2008, real GDP growth slowed to 1.2%, followed by a significant downturn in 2009, when GDP contracted by 6.3%.  However, because Mexico’s Federal Government, and the Banco de Mexico, the country’s central bank, undertook appropriate fiscal and monetary policies, the country grew by 5.8% in 2010, with growth estimated at 3.7% in 2011.   Growth is expected to slow modestly in 2012 to 3.4%.  Although growth rates are not China-like, they are still comfortable and indicate a V-shaped recovery.

Fiscal and Monetary Policy

To accomplish this turnaround, monetary policy became accommodative, with fiscal stimulus added to the mix.  Since 2010, the Government has been gradually removing the fiscal stimulus, while monetary policy has remained relatively accommodative.  The country was better able to deal with the worldwide financial crisis than in the past, in part because of its flexible exchange rate regime.

While GDP growth has turned the corner, inflationary pressures also remain under control.  In 2011, the consumer price index rose by 3.3%, and is expected to come in at about 3.0% in 2012.   Although the peso depreciated soon after the financial crisis, it has since recovered significant ground.  This has aided in keeping inflation under control.  

Public Sector Debt

In Mexico, instead of general government debt statistics, analysts usually use the wider public sector figures.  General government debt includes Federal, State and Municipal debt, as well as debt of the Social Security system.  The public sector debt includes not just general government debt, but also the debt of state-owned companies, such as PEMEX, the oil producer.  If we look at the public sector debt/GDP ratio, we find that despite the worldwide financial crisis and the sharp contraction in GDP in 2009, this ratio has changed very little since 2008 when it was 43.1%.  In 2011, it was also estimated at 43.1%, with it projected to rise modestly to 44.2% in 2012.  This is enviable compared to the US, Japan and Europe, where this ratio often exceeds 80%, and continues to climb swiftly in a number of countries. 

Fiscal Deficits

Mexican Government deficits have been modest.  Although there are several ways to measure the deficit, the traditional measure used by the Government showed a 2.5% public sector deficit in 2011, with a projected 2.4% deficit for 2012.  Even if we use other definitions, the deficit remains modest.  One weakness in the Government’s medium-term fiscal balance is the uncertainty regarding oil prices.  In 2011, it is estimated that oil accounted for 34% of Government revenue.  Given the potential for oil price volatility, dependence on this one item is somewhat problematic.  However, when planning each year’s budget, the Government uses conservative estimates for the price of oil.  Nonetheless, unlike Chile, which has built up a sizable financial rainy day fund in case copper prices fall, Mexico has not been nearly as prudent in filling its Oil Stabilization Fund.

The US-Mexico Link

Mexico’s economy is closed intertwined with the US economy, in particular, the US manufacturing sector.  It has taken full advantage of NAFTA (the North American Free Trade Agreement).  As a result, about 80% of all Mexican non-oil exports are destined for the US market.  This is somewhat risky in that the economy is subject to changes in US economic activity.  At the same time, it has benefited during this cycle because US growth, particularly in the manufacturing sector, has stimulated demand for Mexican exports.  Also, since China is a direct competitor to Mexico in the US, the appreciation of the Chinese currency vis-à-vis the peso in recent years, has made Mexican exports more competitive.

The External Sector

In 2012, Mexico is expected to run a modest trade deficit of about US$4 billion (0.3% of GDP) and a current account deficit of US$13.7 billion (1.2% of GDP).  The deficit is easy to finance since net direct foreign investment usually exceeds $20 billion.  The Government has already pre-financed all amortization payments due in 2012.  International reserves have continued to climb and are now in excess of US$145 billion, a comfortable cushion by any means, and well in excess of the country’s gross financing needs, which are estimated at approximately US$80 billion in 2012.  Besides the reserves cushion, Mexico has swap lines with the US Federal Reserve, as well as a precautionary lending facility with the IMF (the Flexible Credit Line totals about $75 billion).

The Banking Sector

According to the IMF, the Mexican banking system is well capitalized and well regulated.  Even when stress tested, the banking system performs well.  There are three reasons for the country’s healthy banking system: 1) it has a large deposit base; 2) the banks didn’t/don’t have significant black box off balance sheet assets; and, 3) there is little cross-border activity.  In addition, household debt is modest, with consumer credit accounting for just about 7% of household disposable income.  Even mortgage debt accounts for only about 15% of disposable income.  One concern has been the large presence of Spanish-owned banks.  However, the Mexican Government has made sure that these subsidiaries are well ring-fenced from potential problems facing their parents.

The Financial Stability Council

In 2010, the Government created the Financial Stability Council, which includes the Minister of Finance, the head of the central bank, as well as the country’s other most important regulators.  It is mandated to identify and address systemic risks in domestic financial markets in a coordinated fashion.

Near-Term Risks

The main near-term risks facing the Mexican economy include: 1) oil price volatility; 2) US economic growth; 3) the European debt crisis; and, 4) domestic security.

Given that the Government depends on oil revenues to fund about one-third of the budget, it is no surprise that oil prices are a potential risk.  As the country’s leaders know so well, oil prices, which are high today, have shown a propensity to fall suddenly over the last 40 years.  There is little the Government can do about this risk, except to try to diversify away from oil revenues as the main source of income and build-up a stronger financial buffer for use if and when oil prices fall.

With 80% of the country’s non-oil exports destined for the US, it is obvious that US economic growth is important to Mexico’s economy.  I doubt that the Government can do much to change that relationship.  In addition, slightly over 10% of its population lives in the US (an estimated 12 million people).  Their family remittances are another important source of income, especially for people in rural areas.  If the US recovery continues, then Mexico’s economy should perform reasonably well.  If US growth slows, that will have a moderately negative effect on Mexican growth.

The European debt crisis is worrisome, not only for Mexico, but for the world.  If the sovereign debt crisis gets out of control and produces another Lehman-type event, the Mexican economy will be affected but to a lesser extent than other countries simply because of its close ties to the US.

The last risk, or domestic security, is different from the other risks.  In recent years, Mexico has witnessed a violent onslaught by the country’s drug cartels.  It has gotten so bad that, according to polls, over 80% of Mexicans want the military to patrol the streets.  One reason for this is that the police, traditionally underpaid and as a result quite corrupt, are heavily involved in illegal activities.  The problem this poses is not just that it has undermined the quality of life for the average Mexican, but it has also scared away some foreign investors.  This is an important issue in the upcoming Presidential elections scheduled for July 1.

President Calderon has been forceful in dealing with the rising level of violence in the country.  Since Mexican Presidents are allowed only one 6 year term, he will be replaced in December.  Today, it appears that the PRI (Institutional Revolutionary Party) candidate is leading in the polls.  The PRI governed Mexico for decades until Vicente Fox became President in 2000.  This year the PRI candidate is Enrique Peña Nieto.  The PAN (National Action Party) candidate is Josefina Vazquez Mota.  The third candidate is Andres Manuel Lopez Obrador of the PRD (Revolutionary Democratic Party).  He ran an unsuccessful campaign in 2006.

As long as either the PRI or PAN candidate wins, then Mexican economic policy is not likely to change significantly.  If the PRD candidate wins, then Mexico would probably move slightly to the left, because even if the President is from a left-wing party, Congress will remain much more centrist. 

Despite Mexico’s long history of strong Presidents, their strength mainly came from control of patronage.  However, now that the patronage is no longer controlled as well by the President, de jure, the Mexican Congress is more powerful than the US Congress.  As a result, Mexico’s President is constitutionally weaker than the US President.

Medium-to-Long-Term Problems

There are two medium-to-long-term problems that will need to be addressed.  The more immediate problem is the petroleum sector.  According to the Constitution, the petroleum sector must be state-owned.  Private or foreign investment is prohibited.  The problem is that PEMEX would benefit from foreign expertise.  However, most analysts believe that changing the constitution to permit such foreign investments is not likely for the foreseeable future.  Also, according to opinion polls, such a change is not supported by a majority of the public.

The Government is trying to invest more in PEMEX, but it will prove more difficult than if foreign investors or joint ventures were allowed.

Another long-term problem is the aging of the population.  Most people think of Mexico as a country with a young and rapidly growing population.  However, since so many young adults have migrated to the US, the long-term projection is for Mexico to have an older population than the US by 2050.  This is one reason why Mexico has been revamping the pension sector.  Demands for increased health care as the population ages will also be a future burden.

Summary

All in all, Mexico remains well governed economically.  There is clearly a security problem, but if the country has been able to handle the numerous economic problems it has faced in recent decades, I am optimistic that the country will eventually deal with the security issue in an appropriate manner as well.

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February 19, 2012

I am often asked whether the unemployment rate that is widely published is the actual unemployment rate.  Sometimes I find people are suspicious that the Government is misrepresenting the data.  You often hear politicians quote vastly different unemployment rates as though there is a conspiracy to keep the public misinformed about the real economic situation.  The reality is quite different.

Unemployment: Labor Underutilization

The Bureau of Labor Statistics (BLS) is responsible for gathering unemployment data.  As you will soon see, there are actually 6 measures used to calculate unemployment, or more accurately described by the BLS, “alternative measures of labor underutilization.”  This is nothing new.  The Federal Government has been gathering and publishing this data for many years.  Some rates have been calculated for many decades, with the more expansive measures of unemployment, gathered only in more recent years.  However, except for economic analysts, the overall 6 rates are rarely followed and used consistently.

6 Measures of Unemployment

The 6 measures of labor underutilization (unemployment) are specified as follows by the BLS (direct quote):

•  U-1 Persons unemployed 15 weeks or longer as a percent of the civilian labor force.
• U-2 Job losers and persons who completed temporary jobs, as a percent of the labor force.
• U-3 Total unemployed, as a percent of the labor force (official unemployment rate).
• U-4 Total unemployed, plus discouraged workers, as a percent of the civilian labor plus discouraged workers.
• U-5 Total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force.
• U-6 Total unemployed, plus all persons marginally attached to the labor force, plus totally employed part time for economic reasons, as a percent of the labor force plus persons marginally attached to the labor force.

U-3 the Official Unemployment Rate

You now know more than you probably ever thought you would want to about how the BLS calculates unemployment.  As noted above, however, U-3 is considered the official unemployment rate, and is the rate reported by the general media when reporting about unemployment.  Nonetheless, anyone is free to study the other rates.  I should add that the U-3 rate is the one that is most comparable to how other countries report unemployment.

Discouraged Workers

The term discouraged workers is defined by the BLS as, “a subset of the marginally attached, [who] have given a job-market related reason for not currently looking for work.” However, when we look at the trend, although some of these rates are usually higher than U-3, the trend in all of the rates year-over year is now on a downward trajectory, with some variations in the rate of decline.

Seasonally Adjusted Data

Also, when examining unemployment statistics and other data, the usual way to examine them is to use what economists call, seasonally adjusted data.  The reason for that is that employment and many other economic statistics are affected by purely seasonal factors.  Not only the weather, but such things as annual holidays, the start and stop of the school year, plus other regularly recurring events impact monthly changes in data.  To capture the underlying trend, seasonally adjusted data is a better representation of changes in the fundamental environment.

Compare Apples to Apples

Therefore, whenever you hear or read somewhere that the Government is distorting the truth about unemployment, at least it should be clear that no distortion is being made, and all the information is publically available.  In addition, if someone is going to make the argument that the unemployment rates U-4 through U-6 are more appropriate, then at least you should make sure they are comparing past U-4 through U-6 rates, and not comparing those more broadly defined measures against the narrower U-3 definition.

As noted before, I believe that the official unemployment rate is likely to fall below 8% before the end of the year.

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February 10, 2012

We all know that China is increasingly vital to the world’s economy.  Its economic progress in recent decades has been extraordinary.  A once poverty-stricken country, according the World Bank, it is today an upper-middle income country.  The World Bank estimates 25% of the total population, including 37% of urban residents, are now considered middle class.   I should add that the Government estimated that in January, for the first time in Chinese history, the urban population surpassed the rural population.

Economic Growth Still High But Slowing

Economic growth, although moderating, remains high by any standard.   GDP grew by 10.4% in 2010, with growth of 9.2% in 2011.  However, it should be noted that growth slowed in the second half of last year.  In 4Q11, GDP grew by 8.9%.  Many economists expect that growth could slow to 8-8.5% in 2012.  Last week the IMF forecasted Chinese growth this year would be 8.2%, with an important caveat discussed below.

State Capitalism in Action

The Chinese economy is quite different from most other countries.  The most obvious difference is the extraordinarily high savings rate.  Although estimates vary slightly, it is clear that about 50% of GDP is saved each year.  Although its investment rate is almost as high, since it is below the savings rate, the country regularly runs large current account surpluses.  This is why international reserves are now in excess of $3 trillion, a tidy sum indeed.

Not since Stalin’s Gulag, have we seen such high rates of investment and savings, but with an important difference.  Stalin did this using brute force, while in China it is occurring on its own, albeit with important government incentives.  China today is neither communist nor capitalist in the traditional sense of those terms.  Rather the economic model is probably best described as state capitalism, where individuals make decisions, but where the Government holds and uses its power to move the economy in the direction it wants.

The External Sector

The Chinese economy depends on the external sector for much of its growth.  For instance, in 2011, exports of goods and services accounted for nearly 40% of GDP.  In 2011, exports were about $1.9 trillion, with imports of about $1.75 trillion.  Last year exports grew by 20.3%, with imports growing by 24.9%.  It should be noted that as with GDP overall, the export sector witnessed a slowdown in the second half of 2011.  For instance, in December, exports year-over-year (yoy) grew by only 13.4%, with import growth slowing even more, reaching 11.8%.  The deceleration increased in January 2012 as shown by the trade statistics released today.  Exports fell by 0.5% yoy, while imports fell by 15.3% yoy, causing the trade surplus to rise to over $27 billion.

A major problem faced by the Chinese leadership is how to reduce the country’s dependence on the external sector.  Despite the slight decline in January’s export figures, which was probably affected by the Chinese Lunar New Year, there is a limit to how much the world can continue to absorb increases in exports from China.  The situation is even more urgent today, because now that China’s exports to Europe exceed its exports to the US, the Eurozone crisis is making the transition to more domestic consumption-led growth even more critical.  Last week’s report from the IMF indicated that if the European debt crisis worsened, Chinese growth could fall by as much as 50%.  This would be politically dangerous for the regime, and quite bad for the world economy.

The Property Bubble

One the biggest concerns of many China watchers is the property bubble.  On the surface, the numbers related to construction appear alarming.  However, when you dig deeper, yes, there is a problem, but the structure of the market is so different from in the West, that the property bubble doesn’t imply the same outcomes we saw in many other countries since 2007.

First, let’s look at the scary statistics.  Residential property investment rose by 27.9% in 2011, following an incredible 33.2% increase in 2010.  At the same time, house sales only rose by 5.9% in 2011, declining significantly from an increase in sales of 18.9% in 2010.  China now is said to have over half the world’s skyscrapers (buildings over about 750 feet high).  About half of all household savings goes into the property sector.

Now let’s look at some mitigating factors.  The slowdown in residential sales, and the decline in prices seen in some urban areas, has been engineered by the Government.  Last year, the Government decided it was time to avoid further growth in the housing bubble.  It banned the purchase of second homes in many urban areas.  It raised down-payment requirements.  In addition, it introduced property taxes. 

Also, Chinese investors have a different time horizon regarding the property market, and are less likely to use leverage.   For instance, residential sales totaled about $700 billion in 2010, while in 2011 outstanding mortgages were only about $220 billion.  Many purchases are simply paid for in cash.  It is argued that most home purchases are seen as long-term savings, and are not usually speculative in nature.  This doesn’t mean that some people are not speculating, but the vast majority is probably not.  As a result, even if prices fall 20-30%, for most owners it is irrelevant.  They don’t intend to sell anytime soon, and don’t have to worry about excessive mortgage payments.  People often talk about ghost cities.  The reality is that many empty apartments are already sold, but with low rents, owners usually simply leave them vacant waiting for the eventual upturn.  It doesn’t mean that there isn’t a problem, but the magnitude is different from what we have seen in places like the US or Ireland.

The decrease in residential construction and sales is one reason for slowing GDP growth.  However, in China, the Government intends on coming to the rescue.  It has announced that it intends on building $700 billion in low-income housing, or 36 million units over the next five years.

Local Government Infrastructure Projects

Another concern is that local governments have over-invested in infrastructure and have borrowed too much money from banks.  However, in China, bank solvency is less a problem than in the West.  The worst thing that would happen in China is that accounting forbearance would be used to cover-up the extent of the losses.  Also, the Government is in a position to recapitalize its banks once again if it desired to do so.

Inflation and Monetary Policy

Another issue of concern is the inflation rate.  Last July, inflation peaked at 6.5%, the highest level in 3 years.  In order to slowdown the economy and reduce inflationary pressures, the government raised bank reserve requirements 6 times.  However, as the economy showed signs of slowing and the housing bubble seemed to be contained, the Government reversed itself in November 2011 and lowered reserve requirements.

Most analysts had expected that the Government would continue to lower reserve requirements in 2012.  The Government faces a dilemma for the moment.  Recent inflation numbers have been higher than desired.  In December, the CPI rose by 4.1%, but in January, the CPI rose by 4.5%.  Some argue that January was an aberration because the Chinese Lunar New Year festival occurred January 22^nd through the 28^th.  The Lunar New Year celebration normally causes higher food prices, and a slowdown in production.  For instance, this year food prices in January rose 10.5% yoy, compared to a 9.1% rise in December 2011.  Also, overall prices rose by 1.5% from December to January, the biggest increase in 4 years. 

Many argue that inflation will be tamer as the year progresses, but given these recent numbers, the Government would normally want to wait a bit before it lowers reserve requirements further.  However, the latest data from the central bank indicates that bank lending levels are well below expected levels.  Some fear that this is a sign that the economy may be slowing more rapidly than expected.  If so, some are calling for further reserve requirement and money market operations, and possibly even more unorthodox monetary policies.

The Shanghai Stock Exchange

A bright spot in the economy since the beginning of the year has been the Shanghai stock market.  After falling about 33% in 2011, it has risen by about 7% since January 1.  The Shanghai stock market is mainly a retail-oriented market, rather than the institutional market we are used to seeing in the West.  One reason the stock market has risen is that despite signs of an economic slowdown, Government leaders let it be known that they supported the market.  Investors took note and have been buying.

2012 To Be Marked By Major Political Change

Later this year, China will go through one of its regular leadership changes.  The National Party Congress will take place in November.  Although these meetings have been taking place every 5 years since 1977, this one will be somewhat more momentous. 

Over half of China’s top 25 leaders are likely to retire, including 7 of 9 Politburo members (the elite of the elite).  This includes the present Party Secretary Hu Jintao, and Premier Wen Jiabao.  Although on the surface, elections will be by secret ballot, the reality is that behind the scenes maneuvering will choose the new leaders.  Most analysts seem to agree that the next Party Secretary will be Xi Jinping.  Many analysts believe Li Keqiang will become the Premier, although some argue that the premiership is still up for grabs as various party factions jockey for power.  There are factions within the Communist Party which have different views regarding China’s future direction, similar to disagreements seen in the West, but possibly more acute.

This change also represents an important generational change in that it is argued that the new leaders will be the first who were not chosen either by Mao Zedong or Deng Xiaoping.  Although Deng died in 1997, it is speculated that Deng had anointed Hu Jintao to eventually become Party Secretary.

Economic Implications of the Leadership Change 

The implications of this transition for the economy are difficult to predict.  What we do know is that today important policy decisions are arrived at, not by one person, but rather by consensus at the top.  As a result, no matter who the new leaders are, with such large-scale changes set to take place, it is likely that the Chinese leadership will at first be less decisive regarding a whole host of issues, including the economy.   The new leaders will need time to develop a consensus.  Some fear the result may be that the Chinese economy may be allowed to drift for a while until the new leadership settles into place.

The most likely outcome is that the new leaders will not change course dramatically, but we will not know for sure until later this year, or more likely, we will have to wait until 2013 before we can ascertain the desire for change.  The bottom line is that market watchers can no longer avoid following Chinese economic and political events closely to gauge what will happen to the world’s economy.

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February 3, 2012

The latest drop in the unemployment rate to 8.3% is certainly good news for the economy.  As I have discussed in the past, one of the best predictors of consumer confidence are changes in the unemployment rate.  If consumers see that rate go down, they feel more confident about their own job security.  This usually translates into higher consumption.  However, we may not see the consumption number move up every month, because not all consumption is related to retail sales per se, but rather other factors come into play. For instance, warmer weather in the winter may mean less heating oil, natural gas, or electricity consumption.  Nonetheless, over time, falling unemployment rates will boost consumer confidence and spending.

Unemployment Likely to Dip Below 8% By Year-End

Given the sharp fall we have already seen in the unemployment rate, it is now likely that the unemployment rate may dip below 8% before year-end. 

Manufacturing Renaissance

One of the strongest sectors of the economy has been manufacturing, which is witnessing a renaissance.  There are a number of reasons for this. 

First, with the vast discoveries of oil and natural gas in a belt running from North Dakota to Pennsylvania, we are finding that energy security is higher and domestic energy prices are now quite competitive.  This is especially true for users of natural gas.  There is already anecdotal evidence that factories are being built in the Midwest to harness these new power sources.  In addition, although the US dollar has risen against the euro, the dollar has fallen against other countries’ currencies.  All in all, the dollar is not viewed as overvalued by most investors.

Another reason for optimism on unemployment is one I have discussed before, and that is the rising number of Baby Boom retirees.  As pointed out in an earlier blog, 38,000 people were retiring or going on long-term disability in 2001.  By 2010, that monthly number had risen to 138,000.  It will continue to rise for the foreseeable future.

Factory Workers Are Working Longer Hours

A further sign that unemployment will continue to fall, and reinforces the idea that US manufacturing is undergoing a rebirth, is that the nation’s factory workers are working longer hours.  For instance, factory workers worked 41.9 hours in the latest survey, the highest number since January 1998. 

Interest Rate Policy

This leads to the question of what falling unemployment implies for monetary policy.  I would argue that the Federal Reserve should maintain its present interest rate policies until we see inflationary pressures reappear in the economy.  For now, I see none on the horizon.

Also, it is especially important that the Fed maintain loose and unorthodox monetary policies, because the banking system remains dysfunctional.  In some areas banks are increasing their lending, but by no means at a pace to maintain strong economic growth.  Therefore, a combination of muted inflation and banking system dysfunction imply that the Fed should remain the creditor of last resort.

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 January 16, 2012

I was a bit reluctant to write anything more about the Eurozone crisis since all the events seen in recent weeks have been telegraphed months in advance by Granite Springs.  The only thing different now is that we are approaching a critical apex.  What happens over the next several weeks will give us a good idea of how the endgame will play out.

Ratings Management

Although I have often written about how arcane central banking is, there is another area of finance equally arcane, and that is ratings management.  You might say that ratings shouldn’t be managed at all, and that committees should be free to conclude to whatever they might like.  The problem with such a laissez-faire approach is that it would cause chaos in markets.  Slight differences in rating committee makeup might cause significantly different rating results.  It is not the job of the managing director to get to a particular rating, but rather to make sure that rating norms are followed.

This is not done to get to a certain rating result, but rather to make sure that all of the stakeholders in ratings, especially investors, are being given the information required to make an appropriate decision regarding what the rating agencies conclude regarding credit risk.  I warned you this was arcane.  Frankly, some analysts never get it.  They get so focused on an issue that they lose sight of what the ratings are supposed to do – reduce arbitrage in markets.

Can a Rating Ever Be “Wrong”?

Surprisingly, the answer is, no.  The rating scale is a probabilistic assessment of default and in some cases, severity of loss.  Therefore, by definition, there is always a small risk that even a AAA could default.

However, practices grew up to make sure the ratings were reasonable representations of credit risk, including detailed default studies.  However, reading the default studies will make you go cross-eyed, given all the permutations and different ways of looking at rating histories.  There is one simple rule that was followed when I was at Moody’s and I think, given recent rating actions, is probably followed today.  That is, a mistake has been made if a rating is above investment grade one year before a bond defaults.  At S&P and Fitch, investment grade is BBB-, while at Moody’s Baa3 marks the investment grade frontier.

Who Cares and Why Now?

Most people have concentrated on the French downgrade.  Frankly, a one-notch downgrade from AAA to AA+ is a minor event.  What is more significant, and less noticed, have been the multiple notch downgrades of other Eurozone countries, in addition to having negative outlooks attached to the new ratings.  Already many of the Eurozone members have gone below the investment grade frontier.  For me, it is especially significant that Spain and Italy both received two notch downgrades with a negative outlook.  With Italy now a BBB+ with a negative outlook, it doesn’t take long for the agency to move the rating to below the investment grade line.  This is significant for many reasons, including disallowing many types of investors from holding the securities.  In addition, such bonds have to be pulled out of many indices of investment grade bonds.  As usual, the fine print is important.

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January 2, 2012

As this New Year begins, it’s time to think about what we might expect on several fronts.  The predictions here are what I see as the most likely outcomes.  Black swan events, or events quite out of the ordinary, can always lead the economy astray.  I will talk about those at the end.

The Great Decoupling

The US real economy is slowly decoupling from the European debt crisis.

I have argued for a while that an important reason for the huge cash pile held by US transnational corporations was that they wanted to avoid the funding problems caused by the banking crisis of 2008.  Any CFO worth his or her salt has known that a European banking system crisis was likely over the near-to-medium term.  Keeping cash insulates them from the European bank retrenchment presently underway.

As long as oil prices don’t go through the roof again, and since a longer term cut in the payroll tax is likely to be passed, I expect consumer spending to hold up relatively well.  Although housing remains a burden, it is a known commodity, and doesn’t appear to be getting worse.  If anything, it is nearing bottom.

Fiscal austerity will remain the watchword at the Federal, State and Local levels.  However, I don’t expect any great movement to austerity just yet at the Federal level.

Investment rates may be somewhat weaker unless certain corporate tax incentives are renewed, something not even remotely likely until after the November election, no matter who wins.

Consumer Confidence

What really drives consumer confidence are changes in the rate of unemployment.  When unemployment is rising quickly, as it was for quite some time, or when it remains stubbornly high, consumers become more concerned about their own job security.  After all, we have to remember that today about 91% of the US labor force is still working.  The recent declines in the unemployment rate have been good news to consumers and to retailers. 

I should add that the rapid rise in the number of retirees changes the traditional dynamics of the unemployment rate, as pointed out to me by some economist colleagues recently. 

The Baby Boom and Unemployment

If you look at the number of people who received Social Security or Disability payments from the Federal Government, the monthly average in 2010 was about 126,000.  It is likely that the vast bulk of these people left the labor force.  The monthly average was a mere 38,000 in 2001.  That means this rate more than tripled in 10 years.  We are clearly seeing the retirement of the Baby Boom generation affect employment.  This is likely to accelerate for many years to come.  The implication is that the generally accepted rule of thumb, that we need about 200,000 new jobs created each month to begin to lower the unemployment rate, is probably no longer true.  We probably need significantly less, something we have been witnessing in recent months.

US GDP Growth

As a result of declining unemployment boosting consumption in 2012, given the need to replace an aging auto fleet, increasing domestic production of energy, and modest Federal Government austerity, at best, I believe that despite ongoing problems in Europe, the US economy is likely to grow by 2.5-3.0%.  If I am wrong, I believe we might beat it to the upside.

Europe, the Euro and Recession

Europe is a different matter.  With few exceptions, the outlandish austerity being demanded of most Eurozone members will likely push the overall Eurozone into a modest recession of a decline of about 0.5-1.0%.  It will be more severe in the periphery countries, but since Germany doesn’t need the depth of austerity required of others, German growth will push up the average.  The key problem that Italy and other peripheral countries will face will be growing political discontent as austerity bites.  Italy will be living through its fifth recession in 10 years.  Ireland recently reported a dramatic one quarter decline in GDP, despite decent external performance.  Greece will be living through its fifth year of negative growth.

How long will this torture last?  The Europeans have enough tools to keep kicking the can for quite some time.  What might derail them is if political unrest begins to spread to Italy on a level so far only witnessed in Greece.

Eurozone Shrinkage Might Put Shorts at Risk

One interesting risk is that one or more countries leave the Eurozone in 2012.   If that happens, a one-way bet on a declining euro may prove to be a big loser.  Without Greece, never mind Italy or Spain, the euro might soar against the dollar, despite problems the European banks will face.  Some US financial institutions might also be affected in this scenario, but since this is such old news, contingency plans are clearly in place for US banks, which means Europe is unlikely to derail US growth, except at the margin.

What Can Go Wrong?

What could happen to make US and European growth much worse than forecast?  Bickering in Congress over the budget is a risk.  However, given the fiasco surrounding the payroll tax cut extension, I believe that since a number of Republican senators are running in what will be tight races, tensions will not be allowed to reach the fever pitch witnessed in July and August of 2011 over the budget ceiling, especially since the polls indicate that the Republicans received the larger part of the blame for the payroll tax cut fight, with the President’s popularity rising.

If tensions in Europe reach a level where civil unrest erupts in Italy and elsewhere, then exiting the euro becomes more likely, and the near-term recessions in the periphery could become much more pronounced.  This is difficult to predict. 

Iran Remains a Risk

The single most difficult event to predict would be if Iran continues on a course to threaten closure of the Strait of Hormuz, the world’s single most vital oil shipping route.  Normally, I would dismiss this out of hand, but since things are not going well in Iran already, the regime might try something stupid to divert the population’s attention from the country’s homemade problems.  This could cause not just oil prices to soar, but could cause significant military action in the region.  Since Iran is testing medium-range missiles that could reach many targets in the Middle East and Europe, such a threat will not be tolerated by NATO.

At present the Iranian Government is denying it intends to close the Strait, but the Europeans are debating joining the US in boycotting Iranian oil.  That might prove the trigger.  In such an event, US Treasuries will likely soar, as will gold.

North Korea: Comic Opera?

Kim Jong Un might prove a problem, but for today, following North Korea is more like watching comic opera, rather than anything to take too seriously.  Let’s hope I am proven right about that.

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December 21, 2011

Once again, politicians in Washington are doing a disservice to the nation. You would have thought that last July’s debt ceiling fiasco would have been enough. No, it’s dejà vu all over again. The Administration and Congress have been working on this for months.  Since it was increasingly apparent that a complete compromise was not going to be arrived at by the end of the year when the payroll tax would rise by nearly 48% for about 160 million Americans, the Administration and the Senate came up with a short-term compromise.

The Senate Deal

The payroll tax would be extended for two months. Since Democrats didn’t want to touch entitlements, and Republicans wanted this to be partially funded, the Senate bill included a hiking of fees on Fannie and Freddie mortgage purchases. The Republicans, who have been demanding that the President approve the Trans-Canada pipeline from Canada to the US Gulf, included a requirement that the President must make a final decision within 60 days, something he had earlier opposed. Everyone got something, and everyone lost something.

There are other important parts of the bill, including maintenance of long-term unemployment benefits.  In addition, the planned 27% cut in payments to doctors who take Medicare patients, which is scheduled to begin in January, would be rescinded.

House Republicans Reject the Senate Bill

As we all know, it looked like a done deal. However, House Republicans rejected the Senate bill by using a parliamentary technicality. However, when you study the Republican House’s version of the bill, it has some very unusual requirements. Yes, it extends the payroll tax cut for one year, but it also requires that long-term unemployment benefits be gradually reduced from 99 weeks to 59 weeks. It also requires that all younger people be required to get a GED if they hadn’t already graduated high school.  Also, the government will require drug testing of the unemployed.

The cut in Medicare reimbursements would be rescinded for 2012-2013, and in fact, would be raised by 1% in 2012.

The costs of the plan would be paid for mainly by freezing Federal Government employee pay through 2013, plus increasing Federal employee co-pays on their benefits.  Their program also includes higher Fannie and Freddie fees.

What Does This Mean?

If Congress doesn’t pass the payroll tax cut, the extension of unemployment benefits and change the Medicare reimbursement program, the economy will certainly suffer in 2012. If there is no agreement for a full year, the average family making $50,000, would pay about $1,000 more in taxes.  That may not sound like a lot to many, but that means about $83 a month less in spending money for such families. For the average working class family, $83 is significant.  Clearly for those workers who will lose their unemployment benefits, which will occur in February, a paycheck is simply gone. For the medical industry, significantly lower Medicare reimbursements may cause more doctors to pull out of the system. With lower fees paid, many may be forced to reduce employment in the medical sector, one of the strongest employment sectors to date.

I have seen various estimates for the full impact on GDP next year, ranging from 0.5% to 1.5% less growth in 2012.  In an economy that has still not fully recovered from the Great Recession, and with economic storm clouds still hanging over Europe, it is irresponsible not to pass the payroll tax cut and the extension of long-term unemployment benefits. Also, I find it somewhat discriminatory to require GED or equivalent training for the long-term unemployed.  Given our country’s demographics and social history, I would guess that this burden would fall more heavily upon African-Americans and Hispanics.

A Compromise Early Next Year?

Some suggest that if a bill is not passed by the end of the year, Congress still might pass something in the early part of the year.  First, that will create havoc with payrolls across the country.  Second, if something can be passed early next year, why can’t something be passed now?  It makes no sense, and it puts the economy at risk.

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December 15, 2011

I, and others, have talked about the need for countries to exit the Eurozone.  Indeed, I, and others, have also written briefly on how to do it.  Given developments over the last several months, especially developments in recent weeks, preparing such plans becomes all the more urgent.

Options Facing Eurozone Governments

As we all know there are three options facing Eurozone leaders: 1) Fiscal Union; 2) Shrink the Eurozone to its core members which meet many optimum currency area criteria, including such countries as Germany, France and the Benelux; or 3) Dismantle the Eurozone completely and have all countries return to their original currencies.

Fiscal Union Means Different Things to Different People

I have sincere doubts that a true fiscal union is possible among the 17 Eurozone members.  Not only are there different interpretations about the meaning of fiscal union, but the actual implementation and maintenance of such a union during periods of economic stress are highly suspect.  In addition, even if fiscal union does happen, whatever that may turn out to mean in practice, it will take years to implement.  The Eurozone simply doesn’t have the time it will to take to implement another grand experiment that is likely, in any event, to fail.

Complete Disintegration Possible But Not Necessary

A complete disintegration of the Eurozone is certainly possible, but is unnecessary.  The core Eurozone members have enough attributes of an optimum currency area, at least under second best conditions, to be able to hold together if they really wished to do so.

Shrinkage of the Eurozone is Most Likely Outcome

Therefore, from my point of view, the most likely scenario is #2; shrinkage of the Eurozone to core members, with most, if not all peripheral members departing, either individually or en masse.  Frankly, it doesn’t matter which of the last two options happens, because if an individual country leaves, the other peripherals will be forced by market and political conditions to leave the Eurozone in short order, or the plan could include a clean exit of most.  Therefore, I will aim my thoughts at what each individual country needs to do to exit the Eurozone.  If more than one leaves at the same time, the same actions are still going to be required. 

Sovereign Nations are Above the Law

Many will argue that there is no legal way to exit the monetary union.  If there is one thing I have learned after doing country risk analysis over many decades, is that sovereign nations do not allow legalities to get in the way of their national interests.  The world will simply adjust to the new circumstances, not the country to foreign law, the only exception being genocide, which is not under consideration here.

The Plan

These are the steps needed to exit the monetary bloc: 

1. The Government needs to coordinate its actions with only the most senior officials in the ECB, Germany, France, and the US (including the Federal Reserve).  These officials must be sworn to secrecy, not because if the secret gets out the plan will halt, but rather, the plan will simply become disorderly.  If Stalin, Churchill, Roosevelt and then Truman could keep significant war plans secret, I think senior European and US leaders today can accomplish something similar.  The stakes are high — the stability of the world economic system.
2. The Government needs to issue a decree, which redenominates all contracts, public and private, made under domestic law from euros to the new national currency.  Contracts subject to foreign law would not be affected.  This is important because most government debt is sold under local law.  As a result, all legal arguments regarding redenomination of local contracts will be adjudicated in local courts.
3. All domestic assets and liabilities of banks domiciled in the country will be immediately redenominated into the new currency.  Any foreign currency deposits held at foreign branches of domestic banks will remain unaffected.  This will provide some foreign currency for the country to continue to carry out financial transactions.  However, capital controls on financial transactions handled through the financial system will be imposed, requiring government approval for any foreign currency withdrawals by residents from foreign branches.
4. The Government will need the cooperation of the ECB and the US Federal Reserve to provide temporary swap lines to the central bank of the exiting country.  Rates charged should not be punitive.  If the Government doesn’t get such cooperation, or is too fearful that the plan will leak before its announcement, then it can still go through with the redenomination, but the process will be more chaotic.  If swap lines are in place, then the newly independent central bank will have access to adequate foreign exchange to help keep the domestic banking system’s foreign transactions working in an orderly manner during the transition period.
5. The Government should have prepared new local currency notes in advance.  Although many countries can accomplish this domestically, for security reasons, it is probably better to ask the US Government to do it under the strictest of secrecy.  The new notes should include denominations as low as one currency unit of the new currency, unlike today, where one euro coins exist.  The reason is that it is easier to produce bank notes than coins quickly.
6. The Government should preferably do this during a long national holiday period.  The period between Christmas and New Year would be ideal, but if no holiday period is near to the desired date, then the Government should simply declare a multiday bank holiday.
7. Euro notes should be allowed to circulate freely.  Until enough local currency is available, the euro may act as a unit of exchange.  Since in the beginning, local residents will probably believe the euro to be a superior currency, euro notes will probably soon disappear naturally from circulation as Gresham’s Law plays out.
8. The military should be put on alert in case of civil disturbances.
9. All stores and/or merchants should post dual prices until the public becomes used to using the new currency, with such new dual prices posted by end of the bank holiday.
10. The initial exchange rate of the currency should be set at one euro to one unit of national currency.  The resurrected national currency should be allowed to float freely.  The most likely initial outcome will be a sharp depreciation of the new currency.  Also, with no need to defend a particular exchange rate, the government has less need for sizable international reserves.  Since local bank balance sheets will have both sides of the ledger redenominated, this redenomination should not affect their solvency in local currency.  If necessary, however, depending upon their international branch balance sheets, temporary accounting forbearance may be required.
11. Residents should be free to leave the country with their euro notes if they wish.  They should also be free to take high priced assets such as jewelry with them.  Knowing that there will be no interference with such asset transfers, will make the transition less psychologically traumatic.
12. Since this is simply a redenomination back to the original currency, this should not be considered a default by the rating agencies, since they did not consider it a default when the euro was created and all local currency obligations were redenominated into euros.  Ratings do not speak to price or to exchange rates.  Since the original redenomination did not trigger credit default swaps in the past, it becomes hard to argue that such a redenomination would trigger them under the redenomination, but I leave that to others.
13. Part of the incentive to the ECB, Germany and France to cooperate in this matter, is that it will give them some advanced warning helping them deal with the fallout such a departure might have on their own financial systems.  If they do not cooperate, then they will not know it’s timing in detail.
14. The Government should immediately approach the IMF following the redenomination and ask for assistance.

Although this plan may sound radical at first, and will cause major near-term disruption, after the initial adjustment is made, the countries exiting the euro should be able to once again begin to grow and resume their historical growth paths.  This is not ideal, but in the long-run, will improve real incomes for local residents.

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December 12, 2011

Last week, the Europeans had another of their seemingly endless summits dealing with the sovereign debt crisis.  In certain respects, this particular meeting was hyped a bit more than others because it was supposed to result in a European Union-wide treaty to more closely align individual national government budgets, or as it has been dubbed, a Fiscal Compact. More on that below.

A decision was made to provide an additional  €200 million to the IMF to help European sovereigns.  But that will not make a big difference.  €200 is simply not enough money in the great scheme of things.

There was also agreement to create the European Stability Mechanism (ESM) in July 2012 instead of in July 2013, but there didn’t seem any agreement on whether to keep the EFSF in place once the ESM is created.  That decision will be delayed until March 2012.  All in all, the summit achieved some things, but nowhere near enough to give investors a sense that the Eurozone sovereign debt crisis has moved closer to resolution. 

Britain’s Veto

On the Fiscal Compact side, things didn’t turn out quite as planned.  The most important outcome was that the UK refused to be a participant in any EU treaty, which didn’t provide certain safeguards to the City of London, and its vital financial markets.  This forced the other EU members to come up with a convoluted mechanism to get around Britain’s basic veto.  They will attempt some sort of system of bilateral treaties, which will then be approved on a country-by-country basis. Good Luck!

Enforcement

What I find interesting is that since the individual bilateral treaties will not be EU treaties, any enforcement of violators looks problematic at best since I doubt EU institutions can enforce non-EU related disputes; but I leave that to international lawyers.  However, even the treaty/treaties doesn’t/don’t seem that different to me from the earlier Stability and Growth Pact, which was soon violated by both France and Germany early in the last decade. Some of you may remember that the Stability and Growth Pact was supposed to avoid exactly the problems the Eurozone is facing today.

What If?

Given that Britain looks right in not having joined the euro to begin with, maybe this latest British veto should be a wake-up call to other EU countries that these treaties will lead to another dead end.

Think of Europe today if they had never had adopted the euro. In the past, Germany prospered even as the deutschemark appreciated over time.  The German Government would be spending its time on making the domestic economy more efficient and not worrying about bailing out other countries.

The French would probably be spending almost all their time on their up-coming Presidential election. 

Italy would have maintained business as usual.  There would be a crisis every few years, a depreciation of the lira, soaring exports, and domestic growth. All along Italians would have continued to become wealthier as they had been doing until the euro was introduced.

Ireland and Spain would have probably avoided the housing and banking crises they face, or at least they would have been much less severe, because in the past their interest rates would have risen as inflation rose, choking off some of the housing speculation.  

Just think of all the time and effort expended on trying to save Greece from itself.  As I have mentioned before, the Greek Government has been notorious for years at misrepresenting its statistics. No one outside of Greece would have noticed or cared.

The Ratings Agencies

To make matters more complicated, Moody’s this morning reiterated once again that it would be examining all EU sovereign ratings in the first quarter on 2012, which in scope is even wider than the S&P announcement last week, which said it would be reviewing 15 of the Eurozone sovereign ratings.  These announcements only confirm our warning that volatility will be with us for some time to come. Compared to Europe, the US is clearly a safe haven.

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December 2, 2011

We are reaching a point where perhaps it’s time for the Delphic Oracle to reappear.  The mixed signals we are getting from the economic data both in the US and abroad, plus the already Delphic-like statements from politicians are mindboggling.

Unemployment Falls to 8.6%

First the good news:  US unemployment fell from 9% to 8.6%, the lowest it has been since March 2009.  We all should be cheering.  At the same time we got some moderately good news regarding non-farm payrolls.  In November, the initial estimate is that jobs increased by 120,000, with over 140,000 in the private sector.  The public sector keeps chopping away at employment.

Payroll Revision Are the Real Story

Since this was the first payroll estimate for November, as I have written before, don’t put too much store in its value because small firms usually only report with a lag.  The same seems to have happened these last few months.  October payrolls were revised upward from 80,000 to 100,000, not great, but better than originally published.  September’s jobs figure was revised up from 158,000 to 210,000.  Anything above 200,000 makes me feel more secure.  However, we have to keep in mind that although both the payroll numbers and the unemployment rate seem to be moving in the same direction, they are based on very different surveys.

People Keep Leaving the Labor Force

Believe it or not, as we have seen before, much of the dramatic improvement in unemployment didn’t result because of the surge in new jobs.  Rather, once again, people continue to leave the labor force.  The latest estimate is that 315,000 fewer people were actively looking for work.

On-Going Malaise

Maybe this dichotomy helps explain the on-going malaise Americans feel.  Yes, more jobs are being created, but clearly not at a fast enough rate.  Also, there seems to be a serious skills-mismatch.  When you look at the latest payroll data, you find that many of the new jobs created were in the retail and restaurant businesses.  I don’t want to knock either industry.  They are key to our economy, and people who are working there are usually quite happy to be employed.  However, they are not the traditional high-paying jobs we saw in construction, an industry that remains completely on its back, and is not likely to recover for years.

Consumption Explained

Nonetheless, a falling unemployment rate helps explain on-going strength in consumption.  We have to remember that consumers don’t react to actual levels of unemployment, but rather to changes in the rate of unemployment.  With unemployment no longer on the rise, consumers may be feeling slightly more bullish about their own job security.  Let’s hope the politicians in Washington don’t screw this up by not extending the payroll tax cut, which they need to do by the end of the month.

Central Bank Intervention

I am sure you have heard about the famous large-scale coordinated central bank intervention earlier this week, which contributed to one of the strongest stock market rallies we have seen in quite some time.

Well, it was more a news event than anything substantive.  These swap lines have been in place for some time.  In fact, when they were first instituted on a grand scale following the 2008 financial crisis, they played a role in containing the financial fallout.  Since these lines are not really new, why did markets make such a big deal?

Market Reaction and Market Misunderstanding

First, anything that even gives the appearance of coordinated action calms investors.  Second, for those who understand central banking, by far the most arcane area of finance, realize that this was done for two reasons: 1) European banks are now so weak, that even paying about 1-1.1% down to about 0.5-0.6% was considered a significant savings: and, 2) Fear of financial contagion emanating from the European Sovereign debt crisis prompted the Fed to forfeit about 0.5% of its profits on such swaps (most of which normally go to the US Treasury) not to lend to US banks but to make available to foreign central banks to prop up their own banks.  For the Fed this isn’t an enormous amount of money, but at least we should all understand the nature of this aid.

Discount Rate Cut Now Possible

It also creates an odd situation where, depending on how foreign central banks charge their banks to use these funds, technically the US discount rate charged to US banks is now higher at 0.75%.  This tells me that we are likely soon to see a cut in the US discount rate.  Keeping it at 0.75% is just inconsistent.

How’s Europe Doing?

It depends on where you live.  If you are living in Germany, then you are probably going to have a very Merry Christmas.  If you are living on the Eurozone’s periphery, you are probably going to feel like Bob Crotchet’s family did during Scrooge’s pre-reformed days.

December Euro Meeting

Everyone is pinning their hopes on an up-coming meeting of European leaders on Dec. 8-9.  Maybe Christmas miracles do occur, and a real solution to the debt crisis will be found.  My best guess is that Mario Draghi, a highly competent official, and now Head of the ECB will come up with something to keep things quiet for a while.  In the end, it remains a political drama centered around the need for painful structural reform meaning either a full fiscal union of Eurozone countries, a shrinking of the Eurozone or a collapse of the Eurozone.  Unfortunately, any of these prospects are a threat not just to Europe but to world growth in 2012.

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