1. While conditions have improved, economic recovery is far from complete.  Growth is too slow.  Unemployment is too high.  Implementation of financial reform is still ahead.  Managing fiscal deficits and debt is a daunting challenge for many countries and imbalances in trade remain a persistent problem.  (Other than that, it’s all good…) A couple of times in the speech, Bernanke made comments about “many countries” and it sounded like he simply didn’t want to say “the US.”  It’s sort of like saying to your wife that “some guys would prefer to sit on the couch and drink beer, rather than going to see a play.”  (That doesn’t apply to me Jenny.)
2. Fiscal impetus and the inventory cycle can only drive recovery temporarily.  (Exactly!!!  We can temporarily replace demand with government spending and companies can rebuild inventory, but if final sales numbers are weak, that’s the most telling sign.)
3. In order to have true recovery, consumer spending and business fixed investment must take the lead.
4. For spending to increase, the job market must improve and households must repair their financial positions.  (Households are currently saving 6% of disposable income.)
5. The recovery in growth and jobs has slowed due to weak consumer spending and the demand for housing.  We didn’t expect this weakness. (This really bothers me.)

The Employment Market is Weak and Will Stay Weak

1. The job market has been disappointing.  (You think?)  The slightly lower unemployment rate is mostly due to reduced labor force participation.
2. High unemployment threatens the sustainability of the recovery by hurting incomes and confidence.  (I’m not quite sure what recovery he’s referring to.  Is it the one where the government spent money, the Fed told the banks that they would be huge buyers in the bond market for several months so that the banks could have huge trading gains, we didn’t create any jobs and now we simply have more debt?  That was some recovery.)
3. Slow recovery in the labor market has slowed income growth and increased job insecurity.  In addition, lending standards to households remain tight.
4. Firms don’t want to add permanent workers and are extending hours (for part-time workers) and using temporary workers.
5. Rising sales and confidence will help payrolls.  Of course, this is a big “if.”
6. Even with better growth, we’re going to have high unemployment and resource slack.

Equipment and Software Spending Has Rebounded

1. With respect to business investment, we’ve seen a 20%+ increase in equipment and software in the first half of this year.  Some of this is pent up demand from deferred spending.
2. Business investment in equipment and software should continue to grow due to rising demand, strong corporate balance sheets, replacement cycles and low cost financing.
3. Business investment in structures has contracted (with the exception of drilling and mining).
4. Investment in structures will remain weak.
5. There is a big difference between large and small firms.  Large firms can tap into the public securities markets.  Small firms have to depend on banks.  Large firms are waiting to see consumer demand; small firms are waiting for financing.

Housing Has Weakened Again

1. The housing market has turned down since the tax credit expired.  Lower prices and low mortgage rates should boost demand.  But, there is a glut of homes (foreclosures and vacant houses) – so it will take some time.  (As I’ve described at speaking events for the past year, we’ve relied on housing numbers where the government promised up to $8000 under one condition – you buy a house.  In addition, they subsidized interest rates.  Is it a shock that one of these two factors has ended and the drop in home prices has resumed?)

Government Spending Will Not Support Growth

1. States and local governments will remain under pressure, but tax receipts are showing signs of recovery.  (I haven’t looked into this claim.  Employment has rebounded slightly, so that could explain a small uptick in tax revenue.  But, it defies logic to think that tax receipts are having a strong recovery.)  Federal stimulus will slow, but not so much that it will hurt growth.

Exports Have Improved (But Our Trade Gap is Wide)

1. Improving export markets are an important reason why manufacturing has been a leading sector in the recovery.  We were surprised by the sharp deterioration in the US trade balance in the second quarter.
2. Other times, Bernanke pointed out the trade imbalance which is a huge drag on GDP.

Inflation is Lower Than We Want

1. Inflation is lower than we want, but inflation expectations are reasonably stable. With growth, inflation will be at an acceptable level.  (Again, all we need is growth…)  We perceive little risk of an undesirable rise in inflation or significant disinflation.
2. The FOMC will strongly fight deflation. This is not a significant risk at this time because the public understands that the Fed will be vigilant in fighting deflation.  If deflation risks increase, the cost-benefit analysis of the four approaches (discussed below) could change (the benefits would increase and the costs would decrease).
3. Regardless of the risk of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery.  The Fed is committed to growing employment and reducing resource slack.  Promoting growth and resource utilization is consistent with fighting deflation.

It’s important to realize that the Fed is counting on growth to save us from deflation.  It’s also important to realize that expectations can change pretty quickly – so relying on stable expectations is questionable.


Quantitative Easing Has Lowered Rates

1. The FOMC’s purchase of agency debt, MBS and long-term Treasuries has both lowered long-term rates and improved market functioning.
2. Bernanke believes that the purchases work through the “portfolio balance channel” – that the purchase of the long-term securities changes the quantity and mix of financial assets held by the public.  Different financial assets are not perfect substitutes – so the reduced supply raises prices (lowering the yields). This pushes investors into other assets (which lowers risk premiums).
3. Bernanke also believes that it is the amount of these securities that are held by the Fed that matters, not the trend. As evidence, he cites the fact that when purchases stopped, there was no significant effect on rates and spreads.
4. The FOMC’s goal is to get back to owning just Treasuries.
5. As the Fed receives payments from Treasuries, they are reinvesting in other Treasuries.  As the Fed receives payments from agencies and MBS, the goal was to simply shrink the balance sheet.  But, the MBS are being repaid quicker than expected (because people are refinancing at low rates) and it seems odd to not supply support to interest rates when the economy is slowing.  As a result, the FOMC decided to reinvest the proceeds from agencies and into long-term Treasuries.

Monetary Policy Can’t Solve All of Our Problems

1. Monetary policy is important, but central bankers alone cannot solve the world’s economic problems. Amen!
2. Monetary policy has been eased aggressively.  Fiscal policy also helped to stabilize the global decline.  This stabilized demand and slowed the rapid liquidation of inventories.
3. Investors are expecting accommodative policy to continue.  This has helped to reduce short-term and intermediate term interest rates (to close to zero).

The Fed Still Has a Loaded Gun…Unfortunately, It’s Loaded With Blanks

1. The FOMC is ready to provide additional monetary accommodation through unconventional measures if the outlook deteriorates significantly.  We have the tools to support economic activity and guard against disinflation. The question is whether the benefit will outweigh the risk.
2. There are four potential tools: (1) additional purchases of longer-term securities; (2) modifying the Committee’s communication; (3) reducing the interest paid on excess reserves; and (4) increasing the FOMC’s inflation goals.
3. TOOL 1: Expanding the Fed’s holdings of long-term securities has been effective in lowering interest rates and bringing down term premiums.  It is likely that this approach would be effective in further easing financial conditions.  But, this would have to be weighed against: (1) the Fed has little experience with this so it is difficult to quantify what the effect will be on financial conditions; (2) it might be that this approach only works when there is large stress on the system and term premiums are high; (3) the uncertainty makes it difficult to calibrate this approach and to communicate this approach; and (4) expanding the Fed’s balance sheet could reduce public confidence in the Fed’s ability to unwind their position and this could lead to higher inflation expectations.
4. TOOL 2: The FOMC could communicate that they will keep interest rates low for even longer than the market has currently priced in.  New expectations should lower longer-term rates.  It is also possible to condition raising rates upon a particular event (like the Bank of Japan has done in the past).  Unfortunately, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality.
5. TOOL 3: The third option is to lower the rate of interest that the Fed pays banks on excess reserves.  Currently, this rate is 25 basis points.  On the margin, this could provide banks with an incentive to (1) increase lending to nonfinancial borrowers; or (2) participate in short-term money markets (reducing short-term rates).  The effect of this would be small because the fed funds rate is currently averaging between 15 and 20 basis points.  It is likely that the fed funds rate would stay above zero (even if excess reserves became loanable in the fed funds market).  The idea is that the fed funds rate would not drop much and would have little impact.  But, a drop in the fed funds rate could make the fed funds market less liquid, as near zero returns might induce participants to exit.  (If this is the case, it’s hard to believe that the fed funds rate would drop at all.)  Most importantly, this might damage the fed funds market…meaning that we would damage the main market that is used to implement Fed policy.
6. TOOL 4: The final proposal is to have the FOMC increase its medium-term inflation goals above levels consistent with price stability.  There is no support for this approach on the FOMC. This might makes sense if prolonged deflation weakened the public’s confidence in the central bank’s ability to achieve price stability (and we needed to change expectations).  But right now, inflation expectations are well-anchored and within a reasonable range.  If we started this policy, inflation would be higher and more volatile, households and businesses would have less confidence in their ability to make long-term plans and the Fed’s credibility would be gone.  In addition, inflation expectations would become less stable and risk premiums (including inflation risk premiums) would rise.

Think about this! Under the first approach, we could buy more securities and create concern about the Fed’s balance sheet.  Most importantly, Bernanke already told us that Fed policy alone can’t solve our problems.  The second idea is hilarious…we can tell the market that rates will be zero forever!  I particularly love the idea that Bernanke said that this is what Japan did.  Is this who we’re modeling our policy after?  The Fed admits that lowering interest paid on excess reserves (the third approach) will have minimal impact and the fourth approach (raising inflation goals) is a bad idea.  This is truly amazing.  This is what the media largely described as the Fed considering “bolder moves.”


Regardless of Everything…Don’t Worry, Be Happy

1. The prospects for an increase in growth in 2011 remain in place.  (Jenny, I’m going to quit watching football and start appreciating culture in 2011.)  Monetary policy is very accommodative and Europe has reduced the fear related to sovereign debt.  Banks are becoming healthier and more willing to lend.  Consumers are reducing debt and will return to spending.

Regardless of the Chairman’s optimism, I believe that the economy is going to be ugly for a while.  Consumers can spend their income, their accumulated wealth and what they borrow.  Unfortunately, we have fewer jobs, the majority of people have experienced a drop in wealth (from the stock market and real estate) and it’s tough to borrow (if you want to).  We are in a “dis-virtuous” cycle where depressed spending leads to no job growth and continued low spending.


Have a good week.

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Quick Primer for Beginners (There Are Many New MBA Students Who Are Joining the Email List…)

When you buy a bond, you will receive coupon payments (usually twice per year) and you will get $1,000 back at maturity (assuming there is no default).  When investors buy bonds, prices increase.  When prices increase, that means yields are lower.  In other words, a bond promises to make fixed coupon payments (lets say $20 each six months).  If you only pay $900 for this (and it’s a ten-year bond), your yield (return) is going to be 5.30%.  But, if you pay $1,100, your yield (return) is going to be 2.84%.  In other words, higher bond prices mean lower yields.


My Description of a Bubble

I’m going to define a bubble as a tremendous run-up in the price of a particular asset class or type of security whereby prices move far away from intrinsic value (what something is really worth).  During this run-up, there is widespread optimism that prices can only go higher. 


Some people would also include the idea that a bubble must end with a crash – prices returning to intrinsic value and inflicting significant pain on investors.


Examples of recent bubbles include tech stocks in the late 1990s and the real estate bubble (in many parts of this country) that ended in 2007.


The Arguments That This is a Bubble

1. Treasury yields are reaching historic lows, especially long maturities.


2. The 10-year Treasury yielded 2.6% Wednesday, down from 4% just four months ago.


3. Treasury yields have decreased 31% since the beginning of the year.


4. Treasury returns have significantly beaten the stock market since April.


5. The ten-year yield dropped below the dividend yield of the Dow Jones Industrial Average for the first time since 1962.  (This actually happened before 2008, but then dividends were slashed.)


6. There has been $559 billion inflow into bond mutual funds and $233 outflow from equity funds from January 2008 to June 2010.  Treasury bonds returned 13% over that span while stocks lost 21%.


7. There is little evidence of deflation (which would justify really low rates).


8. We’re eventually going to have to print dollars (because of our unfunded liabilities) and that will be inflationary (so prices must not be reflecting intrinsic value).


9. China is reducing their holdings and PIMCO recently lowered their holdings…yet prices are increasing.


10. Tobias M. Levkovich (US equity strategist at Citi) said that he found a “startling” correlation between equity returns in the period from 1990 to 2005 and Treasury bonds since 2000.  In other words, this will end like the tech bubble.


11. Levkovich also pointed out that the money flow into bond funds is similar to the money flow into equity funds in the 1990s. Investors put $480.2 billion into mutual funds that focus on debt in the two years ending June, compared with the $496.9 billion received by equity funds from 1999 to 2000, according to data compiled by Bloomberg and the Washington-based Investment Company Institute.


12. Investors are buying Treasuries, but rates can really only go higher from here.


13. The chase for yield always ends badly.


14. Investors are simply buying Treasuries because they are fearful and if this fear subsides, bond prices will fall.


15. In “The Great American Bond Bubble” by Jeremy Siegel (Wharton professor) and Jeremy Schwartz (director of research at WisdomTree), they argue that the four year US Treasury is yielding 1%, and they analogize this to buying tech stocks with a P/E ratio of 100.  (They also make the same analogy to TIPS with a 1% yield.)  These are TERRIBLE analogies.  Bond investors will get their face value ($1000) back.  Even if we have inflation, the purchaser of a four year UST will not get crushed.  While this is a terrible argument that Siegel and Shwartz made (in my opinion), I still want to include it in the arguments being made.


The Arguments That This is NOT a Bubble

1. Low yields are not simply a UST phenomenon.  Bond yields have dropped around the world.  The 10-year UST hit 2.53%, the German 10-year bund fell to a record low 2.27%, the U.K. gilt hit 2.98%.  In Japan, the 10-year yield is .94%.


2. David Rosenberg pointed out that Federal Reserve policy has a 90% correlation with the direction of bond yields.  The Fed is not going to increase rates for a long time.


3. The Fed is committed to rebuilding the banking system.  They’re not going to let yields rise.


4. The average spread between the fed-funds rate and the 30-year bond has historically been 200 basis points.  With the long bond at 3.60%, the 30-year yield could still fall a long way (meaning long bond prices could continue to increase).


5. If we have deflation, the real returns will look large.


6. The Treasury market is simply forecasting a slow economy.


7. We are seeing a slowing economy and a government that is determined to prop up a weak recovery.  This has caused rates to fall.


8. We see little sign of economic strength, inflation or the Fed raising rates.


9. The inventory adjustment (which had a huge impact on GDP in recent quarters) is mostly done.  In addition, the stimulus is largely done.  There is little reason to expect high GDP growth.


10. We have 9.5% unemployment, capacity utilization under 75%, low home prices and stocks that are in a trading range.  Treasuries may be a wise choice for investors.


11. We are seeing risk aversion – and this is rational.  There is great uncertainty about the economy, taxes, spending and politics.


12. We’re seeing a shift from speculation to saving and it’s reflected in the purchase of Treasuries.  Older investors are really trying to save (without taking risk) and this is impacting the price of Treasuries.


13. Banks aren’t lending money, so they’re buying Treasuries.  This demand is increasing prices.


14. It’s hard to have a bubble in bonds because we know what the cash flows will be.  It’s different than the speculative nature of tech stocks or Las Vegas housing.


15. Selling is not going to lead to more selling (if bond prices start to fall).  We’re unlikely to have the type of crash that we saw with tech stocks.  Again, we have an idea of what the cash flows will be.  You know that the government is going to give you your $1000 back at maturity.  While you risk not keeping up with inflation, you don’t risk seeing your investment go to zero.


Conclusion

The point of this article is simply to identify the arguments on both sides.  I think that many of the arguments (but not all) on both sides are compelling!  I think that the economy is horrible and we’re unlikely to see any inflation for a while.  As a result, I think that it will only feel like a bubble to investors who buy really long-term Treasuries with the thought that they will hold them until maturity.

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1. In normal times, economic policy tries to maximize growth over the long run by encouraging saving and investment.  Fiscal stimulus, on the other hand, tries to increase spending in the short-term to provide a jolt to the economy.  The hope is that the economy will recover and we can handle the debt from the excess spending.




2. Stimulus can help maintain spending when banks aren’t lending.




3. Outlays from financial stimulus can be divided into three categories: direct spending, discretionary spending and tax cuts.  Direct spending was largely comprised of Medicaid and unemployment insurance payments.  Discretionary spending went to federal agencies to fund projects such as roads and schools.  Tax cuts were used for the Making Work Pay credit ($800 for some couples) and a one-year patch to stop people from being subject to the AMT (alternative minimum tax). 
    




4. The best way to boost consumption in the short-term is to put money in the hands of those who are least likely to save it. This means giving money to the poor and unemployed.




5. Research on the multiplier effect indicates that we get the highest multiplier effect from unemployment insurance extensions, then tax breaks and budgetary aid to states.  Far behind are more generous depreciation provisions and the extension of the AMT patch.
   




6. In order to be successful, stimulus must also be timely. Approximately 1/3 was spent in 2009, 40% in 2010 and 25% in 2011 – 2019.  In other words, some was timely and some will not be.




7. It is impossible to know with certainty how many jobs were saved or how much growth was created by the stimulus because we don’t know what would have happened if we didn’t do this.




8. The only thing we can be certain of is that the stimulus has caused a huge increase in our budget deficit.  The fear is that private-sector borrowing may be crowded out in the future and the tax burden is likely to grow.

For a different view, you can read “How the Great Recession Was Brought to an End” by Alan S. Blinder (Princeton professor and former Fed governor) and Mark Zandi (Chief Economist, Moody’s).  Here’s the link. They take a broader perspective, looking at fiscal policy, monetary policy and other actions by the Fed.


Blinder and Zandi point out that the government had two goals: (1) to stabilize the financial system; and (2) to mitigate the recession.  They conclude that the government helped to avert a depression.  Without the government’s response, they believe that GDP would have been 11.5% lower, we would have lost 8.5 million more jobs and we would be experiencing deflation.


They conclude that financial market policies (TARP, bank stress tests, quantitative easing, etc.) had a much larger impact than the stimulus.  With that said, they still believe that the stimulus had a substantial impact – raising 2010 real GDP by 3.4% and adding 2.7 million jobs.  The authors state that “the stimulus has done what it was supposed to do: end the Great Recession and spur recovery.”


They also make clear that there are plenty of things we could argue about:


It is also not difficult to find fault with isolated aspects of the policy response. Were the bank and auto industry bailouts really necessary? Do extra UI ben­efits encourage the unemployed not to seek work? Should not bloated state and local governments be forced to cut wasteful bud­gets? Was the housing tax credit a giveaway to buyers who would have bought homes anyway? Are the foreclosure mitigation ef­forts the best that could have been done? The questions go on and on.


While all of these questions deserve care­ful consideration, it is clear that laissez faire was not an option; policymakers had to act. Not responding would have left both the economy and the government’s fiscal situ­ation in far graver condition. We conclude that Ben Bernanke was probably right when he said that “We came very close in October [2008] to Depression 2.0.”


While we can all disagree with the various policies (and I certainly disagree with some), I would recommend this paper to you because it has a great summary of many of the programs that were implemented.


Here are my conclusions from my reading of these papers:

1. The extent of the government’s actions was incredible.  Blinder and Zandi’s first exhibit (see below) really makes this point.
   




2. While we could argue about whether the government was to blame for many of the problems that they were solving, I would agree that the “non-fiscal stimulus” policies prevented a financial collapse.  While many of the programs are unappealing (TARP, AIG, Fannie and Freddie, etc.), the situation would have been much worse (and probably would have cost us much more) if the government had not acted.




3. I have mixed feelings on the stimulus program.  Our nation wanted a stimulus bill and the bill helped to alleviate panic.  Of course, we made a lot of decisions really quickly with respect to spending.  I am particularly opposed to programs that helped particular industries (such as Cash for Clunkers).




4. Much of what we did was simply a wealth transfer to bank shareholders.  I’m really tired of hearing that we’re not going to lose much money in TARP.  In my opinion, the Fed’s purchase of MBS and Treasuries (and their announcement that they would be buying them) ensured the profitability of many banks.  It’s interesting to see the trading profits of the banks during this time period – it would seem to lead to the conclusion that profitability increased with low interest rates and with knowledge of what the Fed would be buying.




5. I disagree with Blinder and Zandi’s conclusion that the stimulus program helped to end the recession and spur recovery.  My fundamental disagreement is that I don’t like to say that we’re out of recession.  If we have positive economic growth that results from government stimulus but can’t create jobs and growth isn’t sustainable on its own, can the recession really be over?  Why are we talking about the possibility of a double-dip recession – it seems to me that this is simply one long recession (and it’s not done)?




6. The debt that resulted from this recession will be just one small piece of the debt crisis which will eventually emerge in the long-term.

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Since this is a long email, I want to give you the short version (and then you can read on if you’re interested).  I start with the following assumption: the Democrats and Republicans both agree that most all of the tax cuts should be extended.  Therefore, that must be the politically easy (wrong) thing to do.  I think that the tax cuts should be allowed to lapse in their entirety and here’s why:

1. Allowing tax rates to return to prior levels sends an important signal to our citizens and our creditors: we’re serious about getting our financial house in order.  It lets people know that we are willing to suffer in order to avoid a situation in which our debt spirals.




2. Even if rates return to their “pre-Bush” levels, they are not historically high.




3. We are in the middle innings of a long-term financial crisis.  We need to take action now.




4. We averaged GDP growth of 2.3% from the time the tax cuts were enacted until the recession started.  During that time, we still ran a deficit and our debt increased. There’s no evidence that low tax rates helped us.  (You are free to argue that things would be even worse with high tax rates, but one thing I know is that when something doesn’t work, continuing on won’t improve the situation.)




5. I am distrustful of many of the arguments that people are making about continuing the tax cuts.  See article below on the five tax cut myths.




6. Some of the people who have really studied this situation favor allowing the tax cuts to lapse.  Greenspan thinks we should do this.  Barry Bosworth (Brookings Institute) also thinks we should let them lapse.  Even Glen Hubbard (who helped design the tax cuts) thinks that we have made mistakes in cutting taxes while increasing spending (although he wants to keep the cuts until the next President takes office).

Below, I have summarized two interesting articles and I’ve also provided the link for Stephen Colbert’s take on the issue (see Part 3).


Part 1: Deficits Make Bush Tax Cut Fans Say There’s No Free Lunch

First, I’ve summarized a great article by Peter Coy (Bloomberg).  Here’s the link.  My quick opinion is that the issue of the tax cuts shows how difficult it is going to be to solve our long-term problems.  We don’t know what impact the sunset of these cuts will have on growth (there are too many variables for anyone to know for sure), so we just argue what we believe.  But, in my opinion, the time has arrived for us to show that we are serious about addressing our problems.  Whether we slow our growth now or later, it’s going to happen.  But, I’m not a fan of kicking the can down the road.  We need to start our painful process today.


Background Info

1. The Bush tax cuts seemed to make sense when they were enacted.  We were reducing our deficit during the Clinton years.  In addition, in late 2001, our economy was slowing.  But, it turns out that the deficit reduction during the Clinton years was misleading.  Much of this reduction came from the internet boom (and executives paying taxes on their options gains).




2. The Bush tax cuts were designed to encourage people to work and invest.  But, we can’t set tax rates without regard to our spending.




3. Growth averaged 2.3% from the end of 2001 through December 2007.  Deficits grew during this time.  (Personal comment: if we can’t balance our budget with 2.3% growth and while the baby boomers are still working, that tells you where we’re headed.)




4. The Heritage Foundation says that while projected surpluses from 2002 – 2011 swung by $11.7 trillion to deficits, only $1.7 trillion was caused by the tax cuts.   Other causes were lower economic growth ($3.8 trillion), higher spending (defense, discretionary, Medicare drug benefit, financial bailout, other)($3.7 trillion), interest costs ($1.4 trillion), 2009 stimulus ($700 billion) and other tax cuts (such as 2008 rebates) ($400 billion).




5. While deficits should shrink in the coming years (as the recession ends), the budget picture gets much worse near 2020.  (See earlier blog about the CBO’s estimates.)

The Dispute

1. The dispute between Republicans and Democrats is somewhat small: most Republicans (and some Democrats) want to extend all of Bush’s tax cuts while the President wants to extend them for everyone other than individuals earning more than $200K (or families earning $250K).




2. Macroeconomic Advisers estimates that a “full sunset” of the Bush tax cuts would lower GDP by .9% next year (from the 2.9% consensus to 2.0%).




3. The staff of the congressional Joint Economic Committee estimates that the President’s plan would forgo $2.8 trillion in tax revenue from 2010 through 2020.  The Republican version would result in a cost of another $700 billion (i.e., this is the tax revenue that is estimated to be lost by keeping the highest tax rates at their current level).




4. The Congressional Budget Office has ranked the continuation of the Bush tax cuts last for effectiveness among stimulus options.  Part of their argument is that the wealthy tend to invest their tax savings (rather than spend them).  Investing does not have an immediate impact.

Opposition from Prior Supporters

1. Glenn Hubbard, who helped design the tax cuts (and now serves as Dean of Columbia’s business school) says that the tax cuts have been undermined by years of deficits.  He pointed out that “deficits are just future taxes.  You’re just talking about taxes today versus taxes tomorrow.”  (Hubbard was bothered by the fact that tax cuts were enacted and spending was increased – in particular, the Medicare prescription drug plan had a huge cost.)  With that said, he wants the tax cuts to continue until the next Presidential term.




2. Greenspan, who supported the 2001 tax cuts said that extending the cuts without making offsetting spending reductions could prove “disastrous.”  He’s quoted as saying, “I’m very much in favor of tax cuts, but not with borrowed money.”

Other Views

1. Paul Krugman (seen as the liberal’s voice) suggests that we should let the tax cuts expire and instead bail out states and local governments.  Since that is not politically possible, he favors the President’s plan, but says that the extension of the cuts should be limited.




2. Economist Alan Auerbach (Berkley) says that the tax cuts should be coupled with major spending cuts that go into force in a few years.  An example would be raising the age at which people qualify for Social Security.  (Personal note: this is very consistent with ideas in behavioral finance…commit to doing the hard thing in the future, such as saving more from your paycheck.  In other words, lock yourself in when it seems far away and easy to do.  The problem with this idea is that it furthers the political battle – people will argue that the lowest income wage earners will work longer so that there can be tax cuts for the highest wage earners.)




3. Barry Bosworth, an economist at the Brookings Institute argues that we should just let the tax cuts lapse and take the hit to growth.  (Personal note: this will never happen, but at the end of the day, I’m in Bosworth’s camp.  I think it would be painful.  But, my feeling is that we’re headed for more intense and longer pain if we put this off.)




4. Some economists believe that we should leave tax brackets where they are but lower the amount of deductions that are claimed by those who itemize.  (The idea is to get more taxes out of higher income taxpayers without raising the marginal tax rates.)

Congress Won’t Act

1. Congress doesn’t see things like Bosworth because the bond market isn’t forcing them to.  The ten-year Treasury is yielding 2.73%.  Foreign investors continue to hold our debt.   The CBO has warned that this will eventually end.

Part 2: Five Myths About the Bush Tax Cuts (by William G. Gale, Brookings Institute)

William G. Gale (Brookings Institute) wrote a piece that has received a lot of attention.  He identifies five “myths” about the Bush tax cuts.  You can read it here.  Here are the myths:

1. Extending the tax cuts would be a good way to stimulate the economy. In fact, the CBO says that we will only get a 10 – 40 cent increase in GDP for every dollar spent.  The reason is that most of the savings (in dollar terms) go to the highest earning individuals and they tend to save their tax savings rather than spend them.  (This savings could be good for the long term, but the point is that it’s not an effective stimulus measure.)




2. Allowing the high-income tax cuts to expire would hurt small businesses. He argues that less than 2% of tax returns reporting small-business income are filed by taxpayers in the top two brackets.  Also, he argues that only 40% of people in the tax bracket receive a majority of their income from small businesses.  (Personal note: I don’t find this argument compelling.  I think it will hurt the people in the highest bracket and many are small business owners.  Unfortunately, we’re not going to bring in a lot more revenue by taxing the lowest income taxpayers.)




3. Making the tax cuts permanent will lead to long-term growth. He argues that while the tax cuts can foster growth, they have also fostered debt and that could lead to higher interest rates in the long term (hurting growth).




4. The Bush tax cuts are the main cause of the budget deficit. In 2007 (many years after the tax cuts were implemented), the deficit was 1.2%.  By 2009, the deficit had reached 9.9% of GDP.  Obviously, there were other factors to blame (largely the recession…see above for Heritage Foundation’s list).




5. Continuing the tax cuts won’t doom the long-term fiscal picture; entitlements are the real problem. He argues that there is a long-term imbalance between spending and revenue that goes far beyond entitlements.  He argues that even if we return to full employment, we will have problems before considering Social Security and Medicare / Medicaid.  (While I agree that we have long-term problems with this, I think that the entitlement programs are by far our biggest problems.)

Part 3: Stephen Colbert Sums It All Up

Finally, if you want a humorous perspective, watch Stephen Colbert’s take on the tax cut issue.  Here’s the link.


Enjoy the rest of your week.

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Don’t forget that deflation is dangerous.  For an example of a deflationary market, look at the housing market over the past few years.  If we have deflation, it means that we’re paying back our debt with more valuable dollars.  Deflation can mean that real interest rates are higher.  In addition, the cost of labor is higher (since wages are stagnant and prices are dropping), so it could be that less labor will be utilized.

When inflation becomes very low (like we have now), the Fed has signaled that they will keep rates low for a very long time period.  The goal is to actually increase inflation.  But, at the same time, when the FOMC signals that rates will be low for a long period of time, we start to expect low inflation.  Bullard says that when rates become this low, the Fed loses control over the economy.  We need a policy which will be sharp and credible.  But in reality, no change of this sort is being discussed by the Fed.  Everyone (the Fed and investors) continue to speak about interest rates.  As a result, we have an increased chance of a Japanese type environment.  His conclusion is that quantitative easing is the best solution to this problem.


Bullard points out the seven responses to the argument that we are moving toward a Japanese-type economy:

1. Denial – Japan is different.  The Japanese political system is different and the Bank of Japan lacks political independence as well as an inflation target.




2. Stability – the targeted steady state (with 2.3% inflation) is a stable state, while the unintended steady state (with low rates) is unstable.  As  a result, we should not expect to remain at the low rate steady state.  This is another form of denial.  If you want to believe this argument, you still have to believe that Japan is somehow different than the US.




3. FOMC 2003 – if you look at the circled data in Figure 1, we had a Fed Funds rate of 1% and inflation of 1% – 1.5% and the Fed worried about deflation.  In other words, we’ve been here before and we recovered (higher inflation and higher rates).  One problem with this argument, however, is that we did not have interest rates that were zero or near zero.  During this time period, the Fed started to publicly mention the risk of low inflation (and said it was greater than the risk of high inflation).  Bullard theorizes that this signaled to the market that the Fed had identified the existing inflation rate (in 2003) as the lower boundary for inflation.  This resulted in an increase in the inflation rate.  We saw inflation expectations increase (as measured by the spread between ten year Treasuries and the ten year Treasury Inflation Protected Security).  It’s hard to know whether the Fed had brilliantly changed market expectations or the Fed was simply fortunate that the economic data supported a belief that inflation was higher than earlier expected.




4. Discontinuous – if the problem is the existence of a second, unintended steady state, and this is partly caused by the choice of a low Fed Funds rate, why not just choose a different Fed Funds rate?  In other words, we should have an accommodative policy, but still higher than zero.  An example would be a Fed Funds rate near 1.5%.  The idea is that when inflation gets low, we can’t continue to lower rates so significantly.  If you believe this, you must believe that current Fed policy is dangerous (it creates the possibility of the low steady state…which is Japan-like).




5. Traditional Policy Rule – the Bank of England never allowed rates to fall below 2% (for over 314 years!), regardless of what happened.  The idea is that the “bad” steady state is associated with a higher rate (which has a higher expected level of inflation).  The idea is to avoid a situation in which we have rates that are “too low” and we lose ability to impact the economy.  Of course, if we say rates can’t go lower than 2%, we are also losing the ability to impact the economy (sometimes for a long period of time).




6. Fiscal Intervention Given the Situation in Europe – one suggestion has been that governments could embark on aggressive fiscal expansion resulting in higher government liabilities.  In other words, the government threatens to behave unreasonably (overspending) until it forces the market to expect higher interest rates.  Bullard says that this approach is completely unreasonable after seeing how the market responded to Greece.  In addition, countries that have been on the brink of insolvency have also had terrible economic performance.  Japan has increased fiscal spending, their debt-to-GDP is now 200% and they are still in a low steady-state environment.




7. Quantitative Easing – buying our own debt, often described as “monetizing the debt.”  When the government does this, it can have a short-term impact of pushing rates down, but it pushes up inflation expectations.  To the extent that investors perceive the increase in monetary base to be long-term, it increases inflation expectations.

Bullard’s Conclusion

During recovery, we are susceptible to negative shocks which could lower inflation expectations.  It is difficult to escape from a deflationary environment.  We are closer to a Japanese-style outcome than at any time in recent history.


A lot of our problems come from the FOMC policy to keep rates near zero for an “extended period.”  We seem to react to shocks (like the problems in Europe) by promising to keep rates low for a longer period of time.  While this may sound inflationary, it seems like inflation expectations have dropped (again, comparing UST yields with TIPs).  The policy could lead to higher inflation expectations, but it may also tell the market that we have no inflation fears.  Instead of sending a signal to the market that we’re going to be in a low interest rate environment forever, we should engage in quantitative easing (if there is a negative shock).

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1. it is fair to use either and I can’t criticize someone for saying it either way
2. it is impossible when you are speaking or writing to explain every single caveat and exception – so if you say it in a fair way, we can’t find fault;
3. Geithner and Bernanke always use publicly held debt
4. You can think of the US as having $8.6 trillion in debt and nothing in Social Security or you can think of us as having $13 trillion and some US Treasuries in Social Security (and other “trust funds”)
5. If you think about the debt that we financed from the public, foreigners financed half of it
6. If we say that this Congressman’s comment is a lie, we are diminishing the problem that we have

One of the interesting questions that the writer asked me was why it even matters that foreigners own our debt.  While this wasn’t part of the article, I told him that there were several reasons, including:

1. As our debt grows (see prior blog about our debt increasing to 185% of GDP), more and more interest is going to foreigners.  We are moving to a situation where foreigners will own more of our bonds and stock.  That means interest and dividends will go overseas and will not result in spending in our economy.




2. Foreigners don’t hold our Treasuries out of loyalty to our country – so they could be quicker to sell.  We are more likely to have mass selling of our debt by foreigners than by domestic investors.  Japan has a VERY high debt-to-GDP ratio, but virtually all of their debt is held by Japanese citizens and Japan’s pension fund.




3. Some foreigners seem to be cutting back on their holdings of US Treasuries.  China holds $60 billion less debt now than they did in October.  In other words, foreign demand can change.  It’s a problem when we need to borrow more and creditors want to lend us less.

Below, I have put the chart that has the most recent foreign holdings of our debt.  While this is May’s records, this is the most recent federal release of the data.  I’ve only included the largest foreign holders.  If you want the entire list, here’s the link to the data.

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From an investment perspective, UTIMCO’s move could be taken as a simple reminder that when we put together a portfolio, there is a need to search for securities that not only have attractive risk / return tradeoffs, but also don’t move up and down at the same time as the other securities we own.


An investment in gold does well in an inflationary environment.  Inflation is the enemy of bond investors and can also hurt stock multiples.  UTIMCO’s CEO, Bruce Zimmerman cited the fiscal and monetary stimulus as a potential source of inflation.


The Darker Side of the Gold Coin

Unfortunately, there’s another scenario in which gold might help to hedge UTIMCO’s portfolio.  That scenario is a loss of confidence in the US dollar and our ability to repay our debts.  In other words, while unstated by UTIMCO, we should consider the possibility that they are hedging against a US meltdown.


The financial problems we face are immense.  In addition to our trillion dollar deficit, our total debt is approaching 85% of GDP.  A recent academic study by Reinhart and Rogoff suggested that 90% seems to be a tipping point for countries and that a debt level above 90% of GDP results in slower growth.


In reality, I would be ecstatic if our debt level was only 90% of GDP.  The real issue is that we have approximately $50 trillion of unfunded liabilities – Social Security, Medicare and Medicaid.  This is a daunting liability.  Public investors such as mutual funds, pension funds, endowments, hedge funds, foreign governments and individuals have all combined to loan the United States approximately $8.5 trillion to fund our accumulated deficits.  If we wanted to be fully funded in today’s dollars, we would need to issue another $50 trillion of debt!


Of course, it would be impossible for us to issue this huge amount of debt.  Our biggest creditors (China and Japan) have actually been decreasing their holdings of our debt during the past year.  In other words, we need to borrow more and our creditors want to loan us less.  This is a dangerous combination.


Is a Budget Meltdown Inevitable?

In the next 25 years, the aging of the baby boomers is going to result in our budget blowing up.  The situation was best described by the Congressional Budget Office in their report “The Long-Term Budget Outlook” that they released at the end of June.  They said, “the aging of the population and the rising cost of health care will cause spending on the major mandatory health care programs and Social Security to grow from roughly 10 percent of GDP today to about 16 percent of GDP 25 years from now if current laws are not changed.”  The problem is that our tax revenues have averaged 18% of GDP for the past 65 years.  In effect, the CBO is telling us that Social Security and healthcare will use virtually our entire budget within 25 years.  There will be nothing left for our national defense, healthcare spending or responding to disasters.


This is an upcoming disaster.  Republicans and Democrats who study the situation both see it.  Former Fed Chairman Alan Greenspan said this week, “Unless we start to come to grips with the long-term outlook, we are going to have major problems.  I think we misunderstand the momentum of this deficit going forward.”  Erskine Bowles, the Chief of Staff under President Clinton and the co-chairman of President Obama’s Debt Commission said, “This debt is like a cancer.  It is truly going to destroy the country from within.”


I will speculate that UTIMCO is hedging against more than just a huge stimulus program.  They’re hedging against the risk that our politicians will continue to kick the can down the road and not address our structural deficit.  They are hedging against the possibility that our “leaders” will not make the hard decisions and that our leaders will continue to treat our debt crisis as a partisan issue.  We should all hope that UTIMCO’s hedge is unnecessary.

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Please forward this email to others who may enjoy learning more about the United States’ upcoming debt crisis. If someone forwarded this email to you and you want to be on the email list, see instructions at the bottom of this article. We all need a better understanding of the issues in order to force politicians to do the right thing.

Today’s blog is the second in a non-successive series of articles about the CBO’s Long-Term Budget Outlook (LTBO). This article addresses the issue of why we need to take action immediately.

Quick Review

In LTBO #1, we saw the idea that the CBO analyzed our future budgets under two scenarios:

1. extended baseline scenario – assumes laws don’t change (e.g., Bush tax cuts expire, AMT is not adjusted and millions more people pay higher taxes as a result, etc.)
2. alternative fiscal scenario – assumes that laws will change (e.g., Bush tax cuts will be extended for all tax brackets other than the highest income group, etc.)

Most people would agree that the alternative fiscal scenario is more realistic. Obviously, we don’t know what the future holds, but the extended baseline scenario is modeling tax revenue that is equivalent to 23% of GDP (even though we’ve averaged 18.1% for the past 65 years). While this may be the direction we’re headed, we certainly have not made that decision yet. In addition, we don’t know what effect that will have on GDP growth.

We Must Act Now!

Using the alternative fiscal scenario, the outlook is dismal. By 2035, our debt will be 185% of GDP. Interest will be approximately 9% of GDP – meaning that half of our tax revenue will simply be paying off interest. It’s pretty obvious that something needs to be done.

The CBO analyzed the fiscal gap for the next 25 years (through 2035). The fiscal gap measures the shortfall over a given period (25 years in this case). They are asking the question of what has to be done in order to keep our debt-to-GDP at a constant level.

If you look at the next 25 years, our fiscal gap is estimated to be 4.8%. In other words, if we want to have the same debt-to-GDP ratio in 2035 (that we have now), we need to immediately either increase taxes or decrease spending (or some combination of the two) by 4.8% of GDP.

You need to realize that this is a HUGE amount. Remember that taxes have averaged 18% of GDP and spending has averaged 19% of GDP. So, we are talking about the need to either increase tax revenue or decrease spending by approximately 25% of current levels.

Look at what happens over the next 25 years if we don’t start right away:

1. if we don’t start until 2015, the fiscal gap is 5.7% (so we’ll have to cut spending or increase taxes by 5.7% of GDP for the following 20 years)
2. if we don’t start until 2020, the fiscal gap is 7.9%
3. if we don’t start until 2025, the fiscal gap is 12.3%

It should be obvious…we haven’t started fixing the problem and we’re going to have a significantly higher debt-to-GDP ratio in 2035.

The Bad News

The bad news is that I just told you the good news. It gets worse. I was just telling you what we had to do in order to have the same debt-to-GDP ratio in 2035. The demographics get worse over time (fewer people working, more people drawing benefits).

If we want to have the same debt-to-GDP ratio in 75 years (that we have now), we need to immediately solve a fiscal gap of 8.7% (of GDP). In other words, we’d have to either cut our spending in half or increase taxes by 50%.

The situation that we are in is like parents who are not saving for college. They are sending their child to private school right now. Everything seems to be fine. Some people are warning them that college is a lot more expensive. It seems obvious to everyone. At the same time, this family has always been fine and they’ve overcome obstacles before. Everyone figures that this will be okay…just like before.

Of course, if you want this to be a more realistic analogy, we’d find out that the family only makes $40,000 per year and has found a way to pay for private school. It turns out that they’ve been borrowing money and now they have a lot of debt. They’re not going to get any scholarships and China won’t give them a loan for their child’s education. To really make matters worse, the way that the family makes $40K is by having both parents work. Unfortunately, one is approaching mandatory retirement age. Their expenses are about to increase, fewer people will be working and their revenue is about to drop. Welcome to the United States.
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1. The UK has a new government and they have some time to work through austerity measures.  Our government is looking at November elections and responding accordingly – spending money for votes.




2. The UK has a system in which the ruling party sets the budget (and it really doesn’t get changed).  In the US, our politicians horse trade and I would argue that this will never lead to the optimal situation.




3. The UK’s budget is actually set by one person, the Chancellor of the Exchequer.  Once a year, he will set the tax rates and what each department will be allocated.  This means that one person is accountable for what happens.  If you are going to be accountable for the results, it is easier to make the hard decision.




4. The US is currently in gridlock.  Republicans don’t want any more spending.  Democrats are split.  Some don’t want to cut benefits and others want to cut spending.  It depends on what district they represent and how tough their election will be.  But this is certainly not an environment which would lead to austerity measures.




5. The British pound has been weaker and this will help their exports.  This makes it a bit easier to impose austerity measures at home.  (For Britain, it’s a perfect world to impose austerity measures at home and hope other countries keep spending.)




6. Even though the US has many problems, the dollar is still seen as a store of value.  It’s a reserve currency.  This has allowed the US to postpone handling our problems.  The UK doesn’t have this (and they fear a currency run).




7. The UK is expected to have lower growth than the US and this scares investors.  To some extent, they are trying to restore confidence through austerity measures.




8. The UK is fearful of being associated with some of their weak European neighbors.  We don’t have that problem.




9. The UK has lower unemployment than the US.  This makes austerity measures easier to announce.

There is one thing that keeps sticking in my head about what I learned – it’s the fact that the British Chancellor really has an incredible amount of discretion.  In other words, one person has the duty of making the numbers work.  I find this really interesting.


Without question, you could have the wrong person in this position.  In addition, I can’t argue with the fact that this system has resulted in Britain having identical problems to us – so it doesn’t seem to have provided much benefit.  But, if you told me that one person was going to set our budget and our tax rate, I’d actually take my chances rather than leave it to the group of 535 who are doing it now and who got us into this mess.  I want one person who recognizes that we have problems and is willing to try to solve it without expensive compromises.

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1. Bush tax cuts lapse (and tax rates increase).




2. The Alternative Minimum Tax continues and will reach a huge number of taxpayers (increasing the CBO’s assumption of tax revenue).




3. By 2035, tax revenue would be 23% of GDP.  This is significantly higher than the past 65 years (in which tax revenue has averaged 18% of GDP…see Monday’s blog from last week where I discussed this).




4. All non-mandatory spending (mandatory spending includes Social Security and Medicare / Medicaid) would shrink as a percentage of GDP to their smallest levels since World War II.




5. As a result of the increases in revenue and reductions in spending, debt-to-GDP is only expected to increase from 62% to 80% (by 2035).




6. Interest payments would increase from 1% of GDP to 4% of GDP.  In other words, even in this positive scenario, interest payments are expected to be 1/6 of total tax revenue (and this is inflated tax revenue).

Under the alternative fiscal scenario, the CBO made the following assumptions:

1. Medicare’s payment rates for physicians will gradually increase (this doesn’t happen under current law).




2. Several policies that would restrain health care spending (enacted in the recent healthcare legislation) would end by 2020.




3. Spending on programs other than healthcare, Social Security and interest would drop to lower levels (relative to GDP) than their historical average, but not as low as the extended baseline assumptions.




4. The Bush tax cuts of 2001 and 2003 would be extended.




5. The Alternative Minimum Tax would be restrained so that it didn’t reach huge numbers of people.




6. Tax revenue would be approximately 19% of GDP (slightly higher than our 18.1% average over the past 65 years).




7. With lower revenues and higher outflows, debt-to-GDP will reach 87% by 2020.




8. After 2020, higher payments for Medicare, Social Security and interest will result in debt reaching 185% of GDP by 2035.

Here’s what it looks like graphically:

Here are a few things to think about…

1. The Alternative Fiscal Scenario is more realistic (and may even be too conservative).  If high unemployment persists, debt-to-GDP will hit 87% much sooner than 2020.




2. When we get to 185% debt-to-GDP, if you assume a 5% interest rate (which may be very conservative under these conditions), interest expense (on the debt) would be more than 9% of GDP.  THIS MEANS THAT HALF OF OUR TAX REVENUE WOULD SIMPLY BE SERVICING OUR DEBT.  At this point (and probably before), everything blows up.

Have a cheery week…

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