Understanding Food Prices

With commodity prices 35% higher than a year ago, there’s been much talk about food inflation.  Last week, the Department of Agriculture confirmed their earlier estimate that food prices would increase 3 – 4% this year.  Below, you will find what I think you should know about food prices.  At the end of the article, you’ll see my sources.  Many of the ideas in my write-up come from “Rising Prices on the Menu” by Thomas Helbling and Shaun Roache and some sentences in this summary are lifted directly from their article.  If you’re interested in this subject, I highly recommend their article (there’s a link at the end).

Why Have Food Prices Increased?

1.     Emerging market demand. Consumers in emerging markets are becoming wealthier and demanding more high-protein foods (meat, dairy products), edible oils, fruits and vegetables and seafood.  Emerging and developing economies have accounted for approximately three-quarters of the total growth in global demand for major crops since the early 2000s.

2.     Biofuel demand. High demand for biofuels has increased demand for feedstock crops.  In 2010, the production of corn-based ethanol used 15% of the global corn crop.  Biofuel demand also affects cane sugar, palm kernels and rapeseed.

3.     High oil prices. High oil prices also affect the cost of producing food because fuel is used to produce inputs (such as fertilizer).  It’s also used throughout the production process (from sowing to harvesting to distribution).

4.     Slowing agricultural productivity. Food prices have stayed low as the result of increasing productivity growth.  Unfortunately, this productivity growth has slowed.

5.     Temporary weather factors. The run-up since mid-2010 has been largely weather related.  When weather normalizes, prices should return to normal.

6.     Lower stocks. Stocks of storable food products have decreased.  This also results in more price volatility.

7.     Quantitative easing. Fed policy has pushed investors into riskier investments – including agricultural commodities.

Is It True That This is Just a Weather Related Price Spike?

Food prices have risen steadily since 2000.  This disproves the idea that high prices are simply the result of temporary factors.  With that said, these temporary factors have had an impact and may have resulted in the price spike that we’ve seen in the past year.

What is the Impact of Lower Agricultural Productivity?

1. If productivity growth slows, we need to use more land to produce more food products.  But, this results in higher prices.  In addition, the new land may not be as productive (lack of irrigation, poor infrastructure, lower soil fertility).

2. Using land for one crop often comes at the expense of another crop.

Why Are Food Prices So Volatile?

There are many volatile factors which impact prices:

1. Weather

2. International food markets are relatively shallow.  As a result, when a country changes from an exporter to an importer of a particular product, it can have a huge impact.

3. We tend to also see protectionism increase.  Countries may ban exports (in order to keep domestic prices low).  Again, this can have a tremendous impact on prices.

Who Gets Hurt By High Food Prices?

1. Higher food prices hurt emerging and developing markets more.  This is because people in these countries spend more of their budget on food.

2. The poor in the US.  Again, more of their budget goes to food.  For the median U.S. household, food and energy are approximately 17% of both expenditures and after-tax income.  For the bottom 20%, these costs rise to 20.4% of expenditures and 44.1% of income.  (This reflects the idea that some of these people are using credit and savings.  This is because in this group, you have not only the poor; you also have students, business owners with temporary losses and retirees who are spending their retirement funds.)

In General, We Don’t Fear Food Price Inflation in the US.  Why Not?

1. Food is a smaller percentage of our budget.

2. The cost of the actual food is a larger percentage of the total cost in emerging and developing markets.  In the US, a large percentage of cost comes from labor, transportation, marketing and packaging (and many of these costs are not increasing as quickly).

3. The US has done a good job of anchoring inflation expectations.  Food price inflation can translate into core inflation if citizens start to have expectations of higher inflation and then demand higher wages.  This rarely happens in advanced economies.

4. Monetary policy has much higher credibility in the US and other advanced economies.  We tend to trust the Fed to control inflation.

5. In the US, inflation is not a fear right now.  We have tremendous slack in our economy.  But, food scarcity can affect the US mostly because of the impact that they can cause in other countries.

Two Last Thoughts

1. In the event that food prices did start to cause inflation, it’s strange to think about the Fed raising rates to fight this inflation.  What would the goal be – to lessen demand for food?  Obviously, the goal would be to slow the rest of the economy and lower the core inflation rate.

2. Due to the demand for food from other parts of the world, it’s possible that raising our rates wouldn’t have any impact on food prices.  In other words, if there is food price inflation, it’s possible that there is no remedy.

Sources — here’s what I read:

1. “Rising Prices on the Menu,” by Thomas Helbling and Shaun Roache, “Finance and Development”, IMF (March 2011)

2.     Speech by Cleveland Fed President Sandra Pianalto at The University of Akron (March 22, 2011)

3.     The Cost of Food and Energy Across Consumers , by Daniel Carroll, Economic Trends, Federal Reserve Bank of Cleveland (March 14, 2011)

4. “Inflated Worries, ” by Laurence H. Meyer, New York Times (March 24, 2011)

5.     Speech by New York Fed President William C. Dudley (March 11, 2011)

Pent-Up Demand

By the title of this blog, you probably figure that this is going to be all about me and Jenny.  But no, it’s not.  I want to share a few quick ideas.

1. Particularly Strong GDP Number

Below, you will find a chart of GDP growth.  For the last six quarters (until Q4), I’ve complained that the GDP growth has been even weaker than reported.  One way to look at GDP growth is a combination of final sales and inventory adjustment.  In other words, if you’re looking at the value of all goods and services produced, you can look at what was produced and sold and how much was produced to re-stock inventories.  We all knew that the inventory restocking would eventually end.  It looks like it has.  The good news, however, is that final sales grew at a really high rate in Q4.

Contributions to Real GBP Growth Rate
Contributions to Real GBP Growth Rate

2. Great Chart Showing Bubbles

John C. Williams, the Director of Research of the San Francisco Fed gave a speech last week.  His first chart showed the ratio of Net Worth to Disposable Income.  It’s amazing to see the past sixty years and to realize that we’ve had two bubbles in the last 15 years.  There have been two tremendous drops of wealth.

Disposable Pertional Income
Disposable Pertional Income

3. Pent-Up Demand

Even with Cash-for-Clunkers, the demand for cars has been anemic over the past few years.  Williams showed the following chart, which argues for upcoming growth.

Demand for cars
Demand for cars

4. A Few Interesting Ideas From His Speech

In 1990, China accounted for only 1% of US exports and 3% of imports.  By 2009, US exports to China had risen to 7% of total exports and imports from China had risen to 19%.

He distinguished between the improving growth rate of the economy and the current level of the economy.  While the growth rate is getting better, we are operating at a very low level (we have significant excess capacity).  This was his defense to the argument that the Fed should end their ultra-stimulative policy.

Maybe the most significant / under-reported comment: “I believe a number of factors associated with the crisis and recession have temporarily boosted the natural rate [of unemployment] from its long-term trend of 5.25% to 6 – 6.5%.

5. A Great Story

On Tuesday, Dallas Fed President Richard Fisher gave a speech.  He told about meeting President Reagan and hearing the President tell the following story:

Paddy McCoy, an elderly Irish farmer, received a letter from the Department for Works and Pensions stating that he was suspected of not paying his employees the statutory minimum wages and that an inspector would be sent to the farm.

On the appointed day, the inspector turned up. “Tell me about your staff,” he asked of Paddy.

“Well,” said Paddy, “there is the farmhand. I pay him 240 a week and he has the use of a free cottage.”

“That’s good,” said the inspector.

“Then there’s the housekeeper. She gets 190 a week, along with free board and lodging.”

“That sounds fine,” said the inspector.

Paddy went on. “There’s also the half-wit. He works a 16-hour day, does 90 percent of the work, nets about 25 pounds a week when all is said and done, but takes down a bottle of whiskey and, as a special treat, occasionally gets to sleep with my wife.”

“That’s disgraceful, Paddy,” said the inspector. “I need to interview the half-wit.”

“Well,” said Paddy, “you’re looking at him.”

CBO’s Attempt at Humor?

If you need a good laugh, I recommend reading the CBO’s Budget and Economic Outlook.  (Here’s the link.) It was just released this past week.  Reading the absurd assumptions in this report brings back many fond memories, like when I met Jenny and told her about the fabulous / easy life she would have with me.

Take a look at this chart which shows the CBO’s forecast of future tax revenue and expenditures — and how our deficit will shrink.  I actually don’t blame the CBO, as they need to rely on current law in making their projections. I blame the politicians.


Notice how revenues will reach 20% of GDP in four years and will reach 21% after that!  Awesome.  The only problem is that revenues have averaged 18% over the long-term and only reached the 21% range when executives were paying taxes on stock options from the great tech bubble.

The CBO describes the absurd assumptions that they had to rely on:

1.     Sharp reductions in payments to physicians under Medicare – starting at the end of 2011

2.     At the end of 2011, all of the following will expire: unemployment compensation extensions, the one-year reduction in payroll taxes and the two-year extension of provisions designed to limit the reach of the AMT

3.     At the end of 2012, the following will expire: the lower tax rates (and the expanded credits and deductions) from the 2001 and 2003 tax acts

4.     Discretionary spending will increase with inflation, rather than the higher rate seen over the dozen years leading up to the recession

If you want a more realistic perspective, go back to the CBO’s Long-Term Budget Outlook that they published six months ago.  They show what will happen with our debt under the assumptions that are forced upon them and under the alternative (more realistic) scenario.


In case it helps, I’ve also included the CBO’s projections for my hair under my assumptions:

full head

Unfortunately, the CBO has also published pictures of their more realistic, alternative scenario:


The bottom line is that we’ll never address a problem that we “assume” we’re not going to have.  If we had been honest from the beginning, we would have measured our annual deficit on an accrual basis, rather than a cash basis — and we would have recognized our problem much earlier. Instead, we used the cash basis, counting our Social Security tax revenue as income that could be used to balance our budget each year. Now, we assume that the tax revenue fairy will make it all better.

Bankruptcy Court for States?

Recently, there’s been talk about changing the law to allow states to file for bankruptcy.  Under current law, cities and towns are able to file for bankruptcy, but states can’t.

There have been three recent times when this issue was mentioned:

1. Newt Gingrich delivered a speech in November in which he said, “I also hope the House Republicans are going to move a bill in the first month or so of their tenure to create a venue for state bankruptcy.”

2. A Penn Law School professor wrote an article arguing that a law could be passed allowing for state bankruptcy.

3. A New York Times article last week said that Republican legislators were considering a law to allow states to file for bankruptcy.

Here’s a non-exhaustive list of the key issues:

1. Some states have huge deficits.  California’s deficit is approximately $25 billion.  Illinois has a $15 billion deficit.  Texas has a two-year deficit of approximately $26 billion.

2. States have structural budget problems (unfunded pension liabilities) and this may mean diverting money from essential public services.

3. One major reason why states aren’t allowed to file bankruptcy is that states are sovereign.  Therefore, it is not possible to have a bankruptcy judge imposing terms upon them.  As a result, any new law will preclude any person or entity from forcing a state into bankruptcy.  In bankruptcy, a judge will be precluded from forcing a state to change their tax policy or their spending.

4. If there is no bankruptcy, states will eventually seek a bailout.  With an upcoming election, it may be very appealing to bailout California, Illinois and New York.  Obviously, a bailout will transfer wealth from all US taxpayers to a particular state.

5. The threat of bankruptcy could give states leverage with unions.

6. Bankruptcy could mean altering contractual obligations to retirees and general obligation bondholders.  Both could end up as unsecured creditors.  Bankruptcy would be a wealth transfer from bondholders and state employees to taxpayers.

7. If Congress actually even talks about a bill like this, it could become very difficult for states to raise money.

8. The default / bankruptcy premium could become significant in the muni market.  There have already been $25 billion of outflows from muni funds in the past two months.  (You could argue that this already exists based on credit default swap prices.)

9. Politicians (governors) may appreciate the ability to shift the blame for austerity measures to a bankruptcy judge.

Let me be clear…while I work for the state of Texas, I do NOT have a pension – so I’m not writing about myself.  I have a 403 plan (just like a 401(k)).

Again, there’s no easy solution to this. There’s been some research that argues that public employees are overpaid.  Regardless of whether the research is right or not, we offered these jobs and made these promises.  I think that the vitriol directed at state employees is wrong.  Personally, I don’t want to work in a prison, I don’t want to work the night shift as a Police Officer.  Actually, I don’t even want to work in a public high school or grade school.  I wouldn’t trade with any of these people and I don’t think most of you would want to trade either.  It’s way too easy to speak badly about these employees and it’s just not right.  Most importantly, it’s not going to solve the problem.

The United States of Enron

I’m writing today with some good news and some bad news.  The good news is that we’ve lowered our unfunded liabilities. This is the money that we should have (today’s present value of our future liabilities), but we don’t have.  Last year, we were underfunded by $52 trillion.  As you will see below, we’ve reduced that to $43 trillion.  Hooray for us!


Now, on to the bad news.  This reduction is a total fraud.  When the Trustees calculate the unfunded liabilities, they have to base this on current existing laws.  These laws resulted in the unfunded liability of Medicare dropping by $15 trillion.  You can see this below.  (Note: Medicare liabilities dropped by $15 trillion but other actuarial amounts increased by $6 trillion; therefore, the total liability dropped by $9 trillion.)


Here are a few assumptions (based on the news laws) which allowed us to drop our Medicare liability by $15 trillion:
1.     We will reduce our payments to Medicare providers by 30% within the next three years. We have never been able to do anything like this and I would argue that we never will be able to do this.
2.     Due to the Affordable Care Act, there are assumptions that “aggressive research and development has the potential to reduce Medicare costs in the future.”  This may well happen, but it’s speculative at best.  It certainly hasn’t happened in the past.  The reality is that research often results in technology which allows us to live longer and cost us more.
3.     Physicians must reduce the cost of medical services based on the productivity of the overall economy.  Unfortunately, as the government report admits, medical care is labor intensive and has not been able to increase productivity at the same rate as the overall economy.
As a recent op-ed piece argued in The Wall Street Journal, do you really believe that we can insure the uninsured and this will lower our debt and deficit?  It doesn’t make much sense.  Don’t get me wrong…I want everyone to have access to health care and I’m willing to help pay for it.  I’m personally willing to have less so that others can have more.  I know that many (maybe most?) people don’t agree with me.  Regardless, if we’re going to do this, I want to know the real cost and I want a plan concerning how we’re going to pay for it.  I don’t want to be told that it’s not only free…it will save me money!

If these kinds of assumptions are going to be the basis of our estimates, I would suggest that we rename our country the United States of Enron and we elect Bernie Madoff the president.  The real problem is that if we’re going to lie about our problems, we’re never going to solve them.

Is The Unemployment Rate Really 9.4%?

First, a public service announcement…if you are either a UT alumni or a currently enrolled UT student, I am doing a FREE webinar on Tuesday at noon CST.  The topic is “Thoughts From an Extreme Moderate.”  I will discuss some of the current financial issues as well as the extremism that we see in US politics.  You can sign up at this link.

I have several presentations during the next couple of weeks.  As a result, I plan on posting several simple, short blogs each week.

We’ve all heard the good and bad numbers of the employment situation.  The good news is that the unemployment rate dropped to 9.4%.  We’ve created approximately 1.2 million jobs this past year according to the household survey.  The first time claims for unemployment insurance have dropped and are now close to 400,000.   Many people believe that we’re going to eventually have an explosive month (where several hundred thousand jobs are created).  The bad news is that we’re creating jobs at a very slow rate.  We still have close to 14.5 million unemployed people.  On Friday, Fed Chairman Bernanke repeated the idea that it could take four to five years for the job market to normalize.  The more inclusive unemployment rate (counting the unemployed, people who have accepted part-time jobs even though they want full-time work and people who are too discouraged to look for work) is 16.7% (one-in-six Americans).

I think that the most important number to examine is the participation rate (the percentage of the population which is part of the labor force).  Below, I have plotted the participation rate (simply measuring December of each year) since December 1997.  The participation rate obviously drops during recessions – as people drop out (they don’t describe themselves as looking for a job).  Yet, it’s probably reasonable to assume that the participation rate will return to the 66% – 67% range (unless the Fed continues to inflate the stock market and we’re all able to retire early…).

If the participation rate were simply 66%, our unemployment rate would be 11.7%.  If you really want to compare our unemployment problem to normal times (not to other bad times), this is probably a more reasonable estimate of our unemployment rate.

If the participation rate were 67%, our unemployment rate would be 13%.

Labor Participation rate

One final thought for the day…QUACK QUACK…BEAT auburn!  If I believed that Cam Newton didn’t know what his father was doing, I’d also believe in the Social Security trust fund.


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Awesome Baby!

Last week, Alan Simpson and Erskine Bowles rolled out their own proposal for how to cut the deficit.  This is not the Debt Commission’s proposal.  Rather, it’s the leaders’ first swing at the problem. 

Their ideas included the following (this is a non-exhaustive list):

1. Cut FY 2012 domestic spending back to FY 2010 levels and then cut it 1% each year through 2015; from 2015 – 2020, index it to inflation.

2. Cut military spending by approximately $100 billion.

3. The corporate tax rate would drop from 35% to 26%, but some deductions would be eliminated.

4. Lower personal income tax rates, but eliminate many deductions.  Individual rates would be 9%, 15% and 24% — but capital gains would be taxed at these same rates.

5. Eliminate the mortgage interest deduction.

6. Eliminate the child tax credit.

7. Eliminate the earned income tax credit.

8. Eliminate the AMT.

9. Reduce cost of living adjustments for all programs (including Social Security).

10. Retirement age would be slowly raised (with a hardship exemption for some workers).  The age would be 68 in 2050 and 69 in 2075.

11. Increase the amount of payroll subject to taxation; currently at 85% but the goal is to move it to 90%.

12. Cut the federal workforce by 10%.

13. Limit the increase in federal health spending to GDP + 1%.

14. The 18.4 cent gas tax would rise by 15 cents between 2013 and 2015.

What’s next? Now, the Commission has to battle out what their proposal will be.  The panel’s ideas have to receive 14 votes (from the 18 members) to trigger a vote in the Senate and House.

My view on what they did…awesome baby! Here’s why I love it:

1.     They were supposed to devise a plan that cuts the deficit to 3% of GDP by 2015.  Their proposal would cut the deficit to 2.2%.  (Of course, the Commission won’t agree to all of their changes – so they were smart to offer more than they need.)

2.     They have attacked from all different angles.  Everyone has to realize that no one side can have it all their way.  Spending was cut and taxes were increased.  The plan cuts $2 in spending for every additional dollar in revenue.

3.     The proposal does more than simply say $100 billion should be cut from defense spending.  It shows examples of the cuts.  It’s the same thing for defense spending.

4.     This proposal (and the lack of support that it will receive) will be further evidence of our political logjam.  At some point, it has to affect our bond ratings.  Maybe then we’ll get serious?

The Frauds Are Exposed

If we want to solve this upcoming debt disaster, we have to make huge changes.  It’s not going to come all from one side.  It’s not going to be all spending cuts and it can’t be all tax increases.  Everyone has to accept this.  Of course, the moderates seem to accept this and the far right and the far left don’t.

Here are some of my favorite comments.  First, the Democrats…Nancy Pelosi called it “simply unacceptable.”  Democratic Debt Commission member Jan Schakowsky (Rep. – Illinois) said “I think every member of the commission would agree that this is not the plan.”  Senator Durbin (D – Illinois) said that “there are things in there that I hate like the devil hates holy water.”  (I’m not sure, but I think that the devil is a registered voter in Chicago.)  The AFL-CIO President said that the plan tells working Americans to “drop dead.”

Now onto more conservative groups.  The conservative group Americans for Tax Reform said that the commission is merely an excuse to raise taxes on Americans. Some Tea Party members said that there would be a backlash against any Republican who voted in favor of any increase in taxes.

Interestingly, some of the Republican leaders said that this proposal was provocative (I think that’s fair).  Others said that it should be considered.  Overall, I think that the moderate Republicans and moderate Democrats think that this was a good start, but the extremists are providing the sound bites.  Many politicians aren’t saying anything because they think that there’s no chance that most of this will ever be enacted.

Truly amazing.  The Washington Post reported that one in four employees (i.e., staff members) of the Debt Commission are paid by an outside entity.  Many of these outside entities have a particular agenda that they are pushing.   Some are conservative groups and others are liberal groups.

Part 2: An Unrelated Matter

Moving on to an unrelated matter, but interesting all the same…

If you saw the following in a prospectus, would you buy the stock?

We have determined that our disclosure controls and procedures and our internal control over financial reporting are currently not effective. The lack of effective internal controls could materially adversely affect our financial condition and ability to carry out our business plan.

Our management team for financial reporting, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our internal controls. On December 31, 2009, because of the inability to sufficiently test the effectiveness of remediated internal controls, we concluded that our internal control over financial reporting was not effective. On June 30, 2010 we concluded that our disclosure controls and procedures were not effective at a reasonable assurance level because of the material weakness in our internal control over financial reporting that continued to exist. Until we have been able to test the operating effectiveness of remediated internal controls and ensure the effectiveness of our disclosure controls and procedures, any material weaknesses may materially adversely affect our ability to accurately report our financial condition and results of operations in the future in a timely and reliable manner. In addition, although we continually review and evaluate internal control systems to allow management to report on the sufficiency of our internal controls, we cannot assure you that we will not discover additional weaknesses in our internal control over financial reporting. Any such additional weakness or failure to remediate the existing weakness could materially adversely affect our financial condition or ability to comply with applicable financial reporting requirements and the requirements of the Company’s various financing agreements.

If this would scare you, don’t buy GM. Of course, who would ever expect a company controlled by the government to not know how much money they have?  Go figure.

Was Fed Policy to Blame?

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This week’s blog has two parts.  The first part reviews a recent paper by John Taylor.  The second part has some random thoughts (but these are dominated by some comments about the big political issue – the Bush tax cuts).

Part I: Getting Back on Track

This week, I read a short paper by Stanford Professor John Taylor.  The paper is called, “Getting Back on Track: Macroeconomic Policy Lessons from the Financial Crisis”.  Here’s the link.

As always, please understand that I am often lifting complete sentences (and charts) from this paper.  This is John Taylor’s work, not mine.  I am trying to make ideas more accessible.

This paper is significant.  It should really make us think about the role of the Fed, whether the Fed has lost its independence and whether today’s low rates will cause future problems.

A. Primer Before Reading the Paper

John Taylor is best known for “the Taylor Rule”.   This rule is an equation that quantifies the appropriate level for the Fed funds rate based on inflation and GDP growth (relative to potential growth).  The Taylor rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1.   According to his blog, the Fed funds rate should currently be .75%.

If you want to read a Fed paper about the Taylor Rule, here’s a link.

B. Key Points from Introduction

1. While government intervention in the crisis was well-intentioned, much of it did a great deal of harm.  We need to get back to the policies that worked well for a long period of time.

2. From the early 1980’s until the crisis, business cycles had lengthened and recessions had become less severe.  He describes this as the “Great Moderation.”  He suggests that the Great Moderation ended because of a “Great Deviation” from what had worked so well in the past.

3. The Great Deviation was a period in which policy became more interventionist, less rules-based and less predictable.

C. Monetary Excesses

1. In the first part of this decade, the Fed kept interest rates too low (according to the Taylor rule).  Rates went too low and were kept too low for too long a period of time.  See Figure 1 below.

Federal Funds Rate

2. Even without the Taylor rule, you just have to know that the real interest rate was negative for too long a period of time.

3. Low interest rates added fuel to the housing boom which led to risk taking in housing finance.  This lead to balance sheet deterioration at many financial institutions.  Much of this boom and many of the problems could have been avoided by better Fed policy.

4. This Fed policy was a discretionary intervention – it was an intentional departure from the policies that were followed for decades.

5. While other factors were important (Fannie and Freddie also encouraged the boom and capital inflows from abroad may have added to the problem), it is clear that monetary policy had deviated and would likely lead to poor policy performance.

D. More Interventions

1.  When it started to become apparent that we had problems (August 2007), the crisis was misdiagnosed as a liquidity problem, rather than a counterparty risk problem.

2. Because of the misdiagnosis, the medicine was inappropriate.

3. The evidence that the remedy was inappropriate can be seen by the fact that the LIBOR-OIS spread did not contract as the result of government action.  See exhibit 2 below.  This spread measures the difference between the interest rate on three month unsecured loans between banks (LIBOR) and an estimate of what the Fed funds rate will be (on average) over those three months (OIS).  The spread is a good measure of the tension in the interbank market.

term auction Facility and the libor ois spread

4. Of course, we now know that the banks held many toxic assets (we didn’t know that with such clarity in real time).  But, this spread was our clue.

5. Remedies such as the term auction facility had no long-term impact on the spread.

6. Most importantly, this policy intervention prolonged the crisis because it did not address the balance sheet problem at the banks and other financial institutions.

E. Interventions to Rescue the Creditors of Individual Financial Firms

1. The most unusual and significant actions were the government interventions to rescue financial firms and their creditors.  This culminated with the rollout of the Troubled Asset Relief Program (TARP) during the week of September 21, 2008.

2. The LIBOR-OIS spread jumped during this period of panic.  See exhibit 3 below.

Worsening Crisis

3. It is particularly interesting that the spread jumped with the announcement of TARP, not with the Lehman bankruptcy.  Investors were skeptical of the plan.

4. As TARP was rolled out, we were warned of “systemic risk” and the possibility of a “Great Depression.”

5.  The chaotic pattern of these interventions could have been avoided if the markets and the general public had been guided by the Fed and the Treasury regarding the reasons behind the Bear Stearns intervention and the direction and intentions of policy going forward.

6. The turning point in the panic (measured by the LIBOR-OIS spread) occurred when the uncertainty about TARP was removed.  Originally, the TARP’s purpose was to buy toxic assets (and no one understood how it would work).  On late Sunday (October 12) and early Monday (October 13), the plan was changed so that TARP would involve injecting equity.

7. While focusing on the TARP clarification, Taylor also states that the Fed’s action in restoring confidence in the money market mutual funds and commercial paper market also helped.

F. Interventions After the Panic

1. After the panic, two other programs were enacted: the program to buy MBS and the Term Asset-Backed Securities Loan Facility (TALF).  (TALF has been very small.)

2. Taylor believes that the purchase of $1.25 trillion of MBS had a small impact on mortgage rates once we control for prepayment risk and default risk.

3. The fiscal stimulus in 2009 was larger than 2008, but the checks were smaller and more drawn out.  But, there is no noticeable effect on consumptionSee chart 4 below.

Personal Disposable income

4. Cash for Clunkers did impact consumption, but it did not last and can not be considered an effective method to stimulate the economy.

5. Taylor’s analysis of government spending is that it had too little positive impact.

G. The Legacy of the Interventions

1. The crisis has distracted us from our debt problems.  He showed our historical debt-to-GDP ratio.  See chart 5 below.

Federal debt as a percentage of GDP

2. Obviously, many of our problems are legacy problems.  But, then you have to add stimulus, recession and more importantly, the inability to rein in spending for our entitlement programs.

3. If debt progresses as the CBO projects (see exhibit 6 below), the United States will not be the United States.  Something has to give – the question is what.

Federal debt as a percentage of GDP

H. Long-Term Effects of Monetary Policy Actions

1. There are now questions about Fed independence.  The programs implemented were not pure monetary policy.

2. Unwinding the programs creates uncertainty.  The reserve balances (of financial institutions) is huge, as is the Fed’s portfolio.  We don’t know what the impact will be on mortgage rates when the Fed reduces its balance sheet.  We also don’t know what is the long-term amount of reserves that banks will want to hold.

3. There is the risk of inflation.  The two biggest risks are the possibility that the Fed is not able to reduce its balance sheet as the economy recovers and the increase of public debt.

I. Policy Implications

1.  The government interventions did more harm than good.

2. Fiscal policy needs to avoid debt-increasing and wasteful discretionary stimulus packages, which do little to stimulate GDP.  Fiscal policy needs to focus on reducing the deficit and the growth of the debt-to-GDP ratio.  It is essential to reform the entitlement programs.

3. Monetary policy must return to using the Fed funds rate (and the monetary supply) to control inflation or stimulate growth (in other words, follow the Taylor rule) and the Fed must maintain its independence and focus on its main objectives of controlling inflation and promoting macroeconomic stability.  The Fed must not allocate credit or engage in fiscal policy by adjusting the composition of its portfolio toward or away from certain firms or sectors.  The Fed needs to downsize its portfolio as soon as possible.

A Few Comments (from Leeds)

1. I had always been skeptical of the argument that monetary policy was to blame for the crisis.  But, this article leads me to respect its impact in a greater way.

2. The timing argument (the LIBOR-OIS spread didn’t blow out right after Lehman declared bankruptcy) is a tough argument.  It may have been a few days until we realized the significance.

3. Not everything can be solved with monetary policy.  You can’t solve weak balance sheets with cheap money.

4. Professor Taylor emphasized the clarification of the plan.  I’m not sure how much of this was a “clarification issue” or more of a plan that we just didn’t believe it.  Maybe if you can’t clarify something, it’s not a good plan.

Part II: A Few Random Thoughts

1. At least seven mayors in various Mexican states have been assassinated in 2010.

2. Reggie Bush is no longer a Heisman winner.  OJ Simpson still is.

3. The FT reports that global bond issuance by companies rated BBB and below is $177 billion YTD, up 96%.

4. You MUST look at this link. This has a ton of poll results about the Bush tax cuts and opinions as to who is to blame for the economy, etc.  I have to tell you that these polls SHOCKED me.  I’ve often felt like I’m the only person I know who thinks that the Bush tax cuts should all be allowed to lapse or that we should let them lapse for the top brackets.  Yet, in the last poll, Americans are basically split equally between keeping all tax cuts in place and letting them lapse for the top brackets and letting them all lapse.  It may be that I simply hear more from the people who strongly believe that all of the Bush tax cuts should be maintained.

5. The Tax Policy Center (the Urban Institute and the Brookings Institution) say that Obama’s plan would retain approximately 82% of the dollar value of the Bush tax cuts and would keep taxes the same for approximately 98% of taxpayers.

6. Moody did some research and argued that tax cuts led to higher savings rates for the wealthy and tax increases (under President Clinton) resulted in a lower savings rate.  Moody’s found that spending by the top 5% of households is much more closely tied to the stock market rather than tax cuts.  This gets to the heart of the argument (and reasonable people can disagree)…the issue is whether tax cuts for the top bracket are stimulative or not.  (While I agree with what Moody’s said, I also recognize that Moody’s told me some securities were AAA rated and that didn’t turn out that well for me…)

7. Greg Sargent blogged on washingtonpost.com that letting the tax cuts lapse for the highest income bracket is supported by the majority of voters.  Yet, the Republicans seem very willing (even eager) to fight for the tax cuts.  His theory is that the Republicans love talking about this issue because talking about taxes makes voters think about Democrats and their reputation for higher taxes and greater spending.  The fact that most Americans agree with letting the tax cuts lapse for the highest income bracket gets lost.  I thought that this was interesting.  As I described above, it does seem to me (after seeing the polls) that most people agree with letting the tax cuts lapse but that the Democrats are losing the political battle.

8. For a really interesting survey showing that 36% of Americans either think that it’s okay to walk away from a house if you’re underwater or think that it’s okay under certain circumstances, see this link. .  This survey also gives some estimates regarding the demographics of those people who are underwater.

Holiday Weekend Done; How About Greece?

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If you are a McCombs alumni in Houston, please consider coming to the alumni event on Thursday, February 18th.  I’ll be speaking about the economy. 

Now, on to a summary of what I read…

1. Markets

The Dow dropped 45 points on Friday, after being down as much as 160 points.  The market received bad news about the European economy and also digested China’s increased reserve requirements.

The corporate bond market is getting weaker. Prices have had their biggest decline since the rally started last March.  Credit default swaps have risen to their highest level in three months.  In the past week, investors withdrew $984MM from high yield bond funds, the largest outflow since September 2005.  New debt issuance has slowed: US investment grade and high yield debt new issuance totaled $5.1 billion this week, compared to $32 billion the prior week.  Some offerings were pulled.

The dollar rally is at its highest level since May.  There are 57,000 net short contracts by speculators against the euro.  This is $9.9 billion of bets – which is large by historical measures, but small as a percentage of the market.

Lumber prices are up 32% this year. This is bad news for homebuilders.  My recommendation to homebuilders…buy some houses out of foreclosure.

2. Economic News

Retail sales rose .5% in January (vs. December). Core retail sales (which exclude autos, gas and building materials) increased .8%.  Interestingly, people are buying appliances and electronics.

Maybe this is part of the explanation for retail sales. Northeastern University’s Center for Labor Studies reports that unemployment for the top income decile (individuals earning > $150K) was 3% in Q4.  That compares with 31% for the bottom decile and 9% for the middle decile.

Consumer sentiment fell. The University of Michigan / Reuters preliminary consumer-sentiment index fell in February to 73.7 (from 74.4).  Future expectations dropped.

Two corporate studies (by John Burns Real Estate Consulting and S&P’s Financial Services) predict that more waves of foreclosures will maintain pressure on home prices for several years.  They also said that modification efforts will result in delay of foreclosures, but will not avoid foreclosures.  The firms also said that there is huge inventory that will need to be sold.

3. Municipality Issues

State problems flowing through to education. There are estimates that 25 – 30 states cut funding for K-12 education in fiscal 2010 and at least 15 expect to do the same in 2011.  The result is that many classes are becoming larger.  In California, approximately 75% of the state’s public elementary schools increased class sizes this year.

We are seeing similar cuts in police, fire and emergency medical services. In the past year, 14% of cities have cut public safety budgets.  Public safety accounts for 22% of general municipal spending.  (Education accounts for 27%.) You’re going to see fewer police departments respond to property crimes, more abandoned vehicles on the road (because the police won’t get involved) and fewer administrative officers.  Some police departments aren’t even responding to assaults!

Municipalities are struggling with issues related to home-based businesses. Many unemployed people are starting businesses from their homes.  That can result in customers coming to neighborhoods and creating traffic and noise.  It seems like it’s one thing for a customer to come to your house for a haircut or to design a wedding dress.  It’s another when you start to warehouse fish in your garage.  (These were all stories from the article!)

4. International Economy

China raised the share of deposits banks must hold as reserves. Now, Chinese banks will have to hold 16.5% of deposits as reserves.  This is the second increase of the year.  China relies on reserve requirements while the US relies on interest rates.  January loans totaled $203.6 billion, approximately 1/5 of their goal for the year! Property prices were up 9.5% in January (YOY).  Consumer inflation was up 1.5% YOY (and this is a drop from December’s 1.9% YOY increase).  Power demand rose 40% in January.

This creates fear that China’s slower demand will hurt the global recovery.  In addition, there is further fear that the Chinese government will not get the tightening correct and China will slow too much.

The euro zone expanded .4% on an annualized basis in Q4. This is down from the 1.7% rate in Q3.  This was bad news for the euro.  It tells us that even with all of the government policies, the EU can hardly muster any growth. France’s 2.4% growth is what saves the EU numbers.  Germany’s growth stagnated (after 3% growth in Q3).  It’s hard to believe that this is the type of environment which will allow Greece to cut their deficit.  (Greece is assuming 1.5% growth in 2011.)

Spain and Ireland have unemployment of 19.5% and 13.3%. Youth unemployment in those countries is 45% and 31%.  Greece unemployment is 9.7%.

A little good news for Japan. Amid all of the Toyota problems and Japan Airlines bankruptcy, Japan’s GDP grew at a 4.6% annual rate.  Japan’s exports to Asia increased 31/1% YOY in December.  Unfortunately, prices show a 3% decline.  For all of 2009, GDP is down 5%.

5. Sovereign Debt

On Monday, the finance ministers of the EU told Greece that they had to reduce their budget deficit by 4% of GDP within one month (by March 16).  Otherwise, the EU will demand spending cuts and new taxes.

Bailing out Greece is necessary in order to protect European banks. In addition to bond holdings, there was fear of higher interest rates (which would increase the banks’ financing costs).  Also, government tightening could lead everyone back into recession.

A NY Times article argues that the investment banks helped to hide the debt of Greece and other countries.  I don’t know if that’s true or false, but the article certainly didn’t convince me of that.  It sounds like Greece sold future rights to income (such as airport fees and lottery revenue).  That tells me that Greece is in significant trouble and that they are even more likely to have a catastrophe in the long term, but it doesn’t bother me that this is an unrecorded loan.  I could see it as simply a sale.

Investors are talking more about UK debt. The UK’s four major banks held $110 billion in UK government debt.  If this debt is seen as risky, these banks may have to pay more to attract funding.  In early September, it cost $57K (per year) to insure $10MM of UK debt.  Now, the cost is $97K.

Dubai is back in the news. Dubai World may offer creditors just 60 cents on the dollar, paid back after seven years.

The cost of insuring Dubai’s debt increased $50K to $636K / year. Dubai is estimated to have $80B of debt and their property prices have plummeted.

6. Ideas About the Market

Interesting article about stock market indexes in the WSJ. As I often discuss in class, certain round numbers in the index (e.g., Dow 10,000) get a lot of attention, even though it makes no sense.  Our brains tend to focus on particular triggers that seem to allow us to have order.  Some studies show that trading is actually different when the indexes approach a round number.  Stocks tend to exhibit “herding” – where they all move in a coordinated way (rather than based on the merits of the individual stocks).  One researcher also found that stocks do better when they pass $5 or $10 increments.  It’s possible that some investors will only buy stocks when they are above these levels.

Quadrophobia. There’s a ton of research that suggests managers try to meet earnings expectations.  But some new research is getting press because of its approach.  Researchers studied close to half a million earnings reports and found that when you look at EPS down to tenths of a cent (e.g., $.321 – in other words, 32.1 cents), you find that 4, 3 and 2 are underrepresented in the tenths column.  The idea is that companies find ways to get to a higher level so that they can round up to the next cent.

Two thirds of institutional investors under-estimated how much turnover they had in their portfolio.  On average, they under-estimated turnover by 26%.  According to Morningstar, mutual funds with the highest turnover have underperformed those with the lowest trading by an annual average of 1.8%.

7. Olympic Thoughts

More evidence that skating isn’t a sport.  Read the quote below:

“We don’t want to give him too heavy a workload. We treated him carefully, like a flower bouquet that should look fresh on the day of the competition. –Russia’s figure skating coach Alexei Mishin, on Evgeni Plushenko’s preparation following his European Championship victory.

If your “coach” compares you to a “flower bouquet”, what you do is not a sport.

People have no sense. The International Luge Federation said that there was no deficiency in the luge course in which a Georgian luger died.  They basically blamed it on the athlete.  Who would have ever thought that something bad could happen when these guys are going 90 MPH and there are exposed steel beams if you crash.  It’s slightly difficult to believe that there was nothing wrong with the course after the Olympic Committee shortened it and covered the steel beams.  If I were the Olympic Committee, I’d get my checkbook ready.

I don’t want to brag, but I watched figure skating last night. It might sound odd to you (after past posts) that I’m bragging about this.  I can’t disclose details, but you can figure that I must have done something really bad to have to watch this crap.  I’m not even sure what the hell I was watching.  I think it was the men’s pairs or something like that.

8. Random

Losing popularity. A recent WSJ / NBC News survey showed that 65% of voters believe that President Obama inherited the nation’s economic problems.  (The other 35% were busy sniffing glue.)  But, voters disapprove of Obama’s handling of the economy by a 49% to 43% vote.

Google “Karl Rabeder.” He is an Austrian millionaire who is giving away all of his wealth ($4.5MM).  His goal is to have nothing left.  He thinks that it is making him unhappy.  Personally, I wouldn’t mind being a little less happy.

The FHLB of Seattle filed 11 lawsuits against investment banks, claiming that the FHLB was misled during the sale of mortgage backed securities.  Apparently, it’s difficult for an institutional investor to recover in this type of suit.  But, if there was ever a time that it could happen…this seems like the time.  Some of these bonds have a 25% foreclosure rate (for the mortgages they hold)!  My fear is that this will cut into bonuses.  (That was a little Populist humor.)

Irony can be so ironic…Sunday was the Chinese New Year.  It’s the year of the Tiger.  I could be wrong, but I think the last few years on tour were the year of the Tiger.  But, I certainly don’t think it’s this year.

Don’t Worry…I’m Forming a Bi-Partisan Commission

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Now, on to what I’ve read…

1. Market Drops – Another Thing to Blame China For

Market dropped 122 points. Commentators pointed to the concern that China is going to slow their economy.

Slow down there! China’s economy expanded 8.7% in 2009 – faster than their 8% goal.  Growth in Q4 was 10.7% higher YOY.  Consumer prices were 1.9% higher YOY, which was a huge uptick from the .6% YOY increase they reported in November.

Closing in on Japan. If China continues to grow at 8.7%, they will pass Japan at the end of this year and become the second largest economy.

Chinese real estate bubble? Prices of new residential property have been rising at a 20% (annualized) rate over the last several months.  This has encouraged further development.  Construction starts are up 75% YOY.   Housing prices are only affordable for the top 20% of the population (of each city).

Lenders will be shot. To slow inflation, the Bank of China will stop making new loans for the rest of the month.  Some smaller banks are going to have to hold higher reserves.  In prior days, I’ve mentioned slightly higher interest rates in China.

China’s Banking Regulatory Commission said that banks will extend $1.1 trillion of loans this year, a 22% decline from last year.

It wasn’t just the US stock market that was hurt. Chinese stocks fell 2.9% on Wednesday.  Commodities were down 1.6% on fears of tighter monetary policy in China.  Copper fell 2.7% — it is very dependent upon worldwide GDP growth.

US stock multiples. The S&P 500 forward P/E has increased from 11.5 last April to 15.2 now.

WSJ argues that there will be more share repurchases. Nonfinancial firms now hold $290 billion more in cash than they did in 2007 because they have not been repurchasing shares, paying dividends, spending on PP&E or doing M&A.

With capacity utilization at 71.3%, don’t expect much capital expenditure.  There could be more M&A.  Global M&A increased 90% in Q4 (vs. Q3) to $626.8 billion.

But, buybacks are particularly likely.  Stock buybacks dropped from $597.8 billion in 2007 to just $89.7 billion last year.  Citi estimates that the 100 largest firms relied on buybacks for 1/3 of their growth in EPS from 2003 to 2008.

Of course, be careful what you wish for.  Morgan Stanley recently studied 26 industrial companies and found that more than half had made a zero or negative return on stock repurchases since 2000.  But, if you don’t have growth opportunities and you’re trying to justify high earnings expectations (implied by high multiples), buybacks may be the answer.

2. Greece Hasn’t Gone Away…Yet

Greek bonds are down. Yields on Greece’s 10-year bond touched a record high, while the cost of insuring these bonds also reached a record.   At one point yesterday, the spread between Greek bonds and German bonds reached a record 3.08%.

Fears about Greece are hurting the euro. The euro fell below $1.42 for the first time since August – out of fear about Greece.  And remember, it’s not just Greece.  While Greece’s deficit is 12.7% of GDP, Spain’s is also expected to top 10%.

3. Financials

Lots of power! BAC, WFC and USB hold 24% of all US deposits and operate more than 15,000 retail branches.

Lots of risk! President Obama is expected to propose limits on Thursday concerning the size of banks and how much risk that they can create for our country.  He would give regulators the power to limit size and activities (such as limiting proprietary trading by commercial banks).  This could have a big impact on BAC, WFC, JPM, GS, MS and C.  The argument goes like this…if you take in deposits, which you can do cheaply because the government insures them, you shouldn’t be trading subprime mortgages.

Lots of write-offs. BAC’s credit card division lost $1 billion.  USB had residential loan write-offs of 2.4% (up from 2.1% in Q3) and nonperforming assets increased to 3.1% (from 2.6%).

The good news? Merrill Lynch banking created $2.8 billion profit for BAC.  BAC’s provision for credit losses shrank from $11.7 billion to $10.1 billion.  Of course, that’s only good news if they’re actually provisioning enough.  While their provisions dropped, their nonperforming assets increased 5.7%.

Mixed bag on non performing assets. Wells Fargo’s nonperforming assets grew 18% in Q4.  BAC’s increased 5.7%, Citi was flat and JPM’s fell 3.1%.  WFC’s nonperforming loans are now 3.12% of outstanding loans. But, WFC said that consumer losses may have peaked.  If this optimism is correct, this is the most important news of all.

Lots of bank refinancing in the near future. Financial institutions in the US, UK and Europe have $1.5 trillion of debt maturing by 2012.  A lot of this debt was issued with government guarantees during the crisis.  Recently, some stable banks have been able to issue debt at really low rates – as spreads have dropped.  The question is whether this will continue…will risk in the sovereign debt market make investors fearful of bank debt or will investors actually prefer bank debt?

We’re all waiting to see Goldman’s compensation. Historically, compensation has been between 44% – 49% of revenue.  Estimates are that it will be lower and less of it will be paid in cash.

We’ve seen Morgan Stanley’s and it’s not going to make them any friends. MS missed expectations and closed its second consecutive losing year.  But, not everyone lost.  Bankers and traders received compensation that accounted for 57% of the investment banking revenue.  (MS has said that if you exclude an accounting charge, the compensation to revenue is 40%.)  I encourage you to pull up a ten-year price chart of this stock and think about how shareholders probably feel about these bonuses.

4. The Economy

Increased growth estimates. The World Bank increased their global growth forecast from 2% to 2.7%.  Their forecast for 2011 remains at 3.2%.  They warned, however, that if the private sector continues to save, a double dip recession is possible.  The US is expected to grow 2.5% in 2010 and 2.7% in 2011.  Europe is expected to grow 1% and 1.7%, while China is expected to grow 9% each of the next two years.

New home starts fell 4% in December (from November). Single-family construction dropped 6.9% and multifamily units increased 12.2%.   The drop was attributed to weather – this was the coldest December in nine years.  Starts fell 19% in the Northeast and 18.5% in the Midwest – where the weather was particularly bad.  Starts fell .9% in the West and increased 3.3% in the South.

Get some perspective of where we are with housing starts. The total number of housing starts in 2009 was 553,800, down 38.8% from 2008 and approximately 1/3 of the fifty-year average.

Permits rose (promising for the future). New building permits rose 10.9% in December to 653,000.  This is the highest level since October 2008.  Permits are less affected by weather.  Of course, I’m not sure that we need many new houses.

Producer prices increased .2% in December. The core number was flat (food prices increased 1.4% and energy fell .4%).  Year over year, producer prices were up 4.4%.  But, the core number is only up .9%.  Fortunately, I don’t eat or use energy.

5. Company News

Youtube is going to start renting videos. There will be five movies from the Sundance Film Festival available for $3.99 each.

We’re back to high-end coffee. Starbucks same-store sales increased 4%.  This resulted from an average ticket price increase of 4% and the company attributed this to Via (instant coffee).

Amazon is recruiting self-published authors by paying them 70% royalty on sales of all electronic books priced between $2.99 and $9.99.  They must be published through Amazon.

Buffett said that Kraft is paying too much for Cadbury.  Kraft is paying $19.1 billion and 60% of this is cash.  He also said that Kraft sold their pizza business for too low a price (they sold it to Nestle for $3.7 billion).  Other than the fact that the CEO overpays when she buys and she sells for too little, Buffett expressed confidence in the CEO.  Shortly thereafter, Jerry Jones expressed confidence in Terrell Owens and Wade Phillips.

6. Politics

This should go over well. The US is going to make unrestricted access to the Internet a top foreign-policy priority.  In addition to the recent news about China, there have been “honor” beatings and killings of Middle Eastern women who have been caught using social media on the internet.  (Personally, I would like a little protection too.  I received quite a whipping from Jenny for some of my internet use recently.  But, I can’t really talk about that story.)

So this is bi-partisan? The “bipartisan commission” that is supposed to tackle our debt crisis is supposed to be made up of 18 members: six appointed by congressional Democratic leaders and six by Republican leaders and the President is supposed to select two Republicans and four Democrats.  For those of you who are quantitatively challenged, that means ten Democrats and eight Republicans.  Ten Democrats and eight Republicans doesn’t sound that bi-partisan to me.  Of course, regardless of what denomination they are, aren’t these the guys who caused this problem?

If we’re going to put together bi-partisan commissions, I have another idea. Maybe we can also put together a bipartisan commission composed of ten members of China’s communist party and eight members of the Taliban to figure out how to solve human rights issues.  (I have a guess as to the solution…ban the internet so that no one will know.)  On a positive note, I think both commissions have an equal chance of success.