March 2008 Archives

My latest musings...

Are We Talking Ourselves Into Recession?

While you can't talk a strong economy into a weak one, maybe we're making things worse by focusing on the negative news
by Chris Farrell

You can't escape the R-word these days. The question of whether the U.S. is in a recession--or in the process of sliding into one--dominates economic analysis and financial reporting, as well as conversations at work and around the kitchen table.

The signs seem to be everywhere. The National Association of Business Economists' latest survey had 45% of its members predicting a recession this year--over double the percentage of three months ago. The investing legend Warren Buffett grabbed headlines on Mar. 3 when he remarked on cable network CNBC "I would say, by any commonsense definition, we are in a recession." Wall Street took note when economist Edward Yardeni, head of his own economic forecasting firm and a well-known perma-bull, threw in the towel that same day. "I think we are falling into a consumer-led recession," he wrote in his daily newsletter.

The old saw says a recession is only clearly visible in the rearview mirror, and yet it seems Wall Street pros and the financial media are echoing the eternal forward-looking query of impatient children on the long drive to Grandma's house: Are we there yet?

Talk Taking a Dark Turn

That prompts another question: Are we talking ourselves into recession? I'm not suggesting the media caused the economy to stumble. I'm usually skeptical of charges that the press wields enormous influence over economic activity. Most business journalists have heard a real-estate broker complain that the media were pushing down home prices, or a Wall Street money manager rant about downbeat stories driving stock prices lower. Yeah, right.

Yet there's no doubt the discussion about the economy has taken a dark turn lately. And narratives, stories, and metaphors do matter. After all, in a global economy there is so much information (data, rumor, judgment, talk, theories, algorithms, speculations, price movements, and news) that we tend to come up with narratives to make sense of what is going on. "Economists are usually very careful to avoid entering such evidence," writes Robert Shiller, economist at Yale University in his recent paper, Historic Turning Points in Real Estate. "And yet, research by psychologists has found that narrative-based thinking is extremely important in human decision-making."

Of course, there are good reasons for economic pessimism today. Prices in the residential housing market are down sharply and foreclosures are skyrocketing. The job market is deteriorating, and the stock market is downbeat. Oil is trading at record prices (even after adjusting for inflation). Financial institutions have written off billions and billions in loans, with more write-offs coming. Each of these trends affects real people: The homeowner that signed a toxic mortgage now watching the bank foreclose on the house, a worker getting laid off because of Chinese competition, a family forced into austerity to pay the spiraling gasoline, heating oil, and food bill.

Where are the Upbeat Tales?

Nevertheless, a good number of economists still believe the glass remains half full. The federal government's fiscal stimulus is coming. The Federal Reserve Board is aggressively easing interest rates. Exports are flourishing. The agricultural sector is booming. Inventories are well-contained. While the 7% of inflation-adjusted gross domestic product made up by housing and autos declined by nearly 12% over the past year, the segments of the economy that make up the remaining 93% of real gross domestic product rose at a healthy 3.8%, calculates James W. Paulson, chief investment officer at Wells Capital Management. "Sensitivity to signs of economic weakness have been magnified while evidence to the contrary is often ignored," he says.

Think about it. How many dinner table and workplace discussions have you had about the weakening economy, the foreclosed home, the credit-card induced bankruptcy, the corporate downsizing? During those conversations, how many upbeat tales have you offered up?

In his paper on historic turning points, economist Shiller emphasizes how news media stories about people who make stupid mistakes can trigger the end of a boom. "The intensity of the public reaction to the stories of human foolishness was augmented by a feeling that not only were people foolish, but also that in many cases they had been duped, they had been had. The many stories of accounting irregularities and fraud, leading to some heavily-covered trials of corporate executives, intensified these feelings."

The Direction is Down

If that's the case, it isn't hard to imagine that negative economic news can eventually turn into something of a vicious cycle. That seems to be an implication of Consumer Sentiment, the Economy, and the News Media, by Mark Doms of the Federal Reserve Bank of San Francisco and Norman Morin of the Board of Governors of the Federal Reserve System. The scholars delved into how consumers may be influenced not only by the content of the news stories they come across but also by the way the media cover the economy.

For instance, note the authors, the headline "Recession Possible" has a bigger impact than an article entitled "Economic Conference Presents Diverse Views." And for better or worse, we're getting a lot of headlines with the R-word featured prominently--such as this one.

Americans can't talk a strong economy into a weak one. Neither can the press. Only the Federal Reserve can do that. The underlying economic activity is ultimately what determines whether the economy moves into expansion or contraction. Yet at major economic turning points, the tone of the conversation can push the economy further in one direction or another. This time around, it looks like that direction is down.

As predicted, financial institutions are starting to cut credit limits, not raise them. This anecdote comes from money manager John Maudlin.

And it is also starting to hurt ordinary people. I have a friend who does a lot of work on eBay. She has good credit. Rather than a bank line of credit, she simply uses credit cards. Or did. This week she got three letters reducing her limits to levels below what she already had on the cards. There are numerous such anecdotal stories circulating.

The loss of 63,000 jobs in the latest employment report is bad. Worse is the drop of 101,000 private sector jobs, the third straight month of declines.

My latest musing on the economy.

On Mar. 7, when the government reported a loss of 63,000 nonfarm jobs in February (with a decline of 101,000 private-sector jobs), it seemed that both Wall Street and Main Street decided all at once that, yes, the U.S. economy is in recession, or well on its way into one. That's why there's little doubt among the financial cognoscenti that when Federal Reserve policymakers meet on Mar. 18 the central bank will cut its benchmark interest rate again, perhaps by half a percentage point, to 2.5%.

If so, the Fed will have slashed its target rate by 2.75% since last August. But while the central bank's concerted policy of monetary easing is aimed squarely at forestalling a recession and lending a hand to the shaken financial system, other dangers lurk.

Inflation as Bailout

Here's the rub: While the Fed fights recessionary forces, inflation is gathering momentum. "It's the 'Fed to the rescue,'" says Jonathan Guyton, certified financial planner at Cornerstone Wealth Advisors in Edina, Minn. "But I'm worried that their actions will set up a real inflation problem a year from now."

Maybe sooner. The headline consumer price index and producer price index figures are already running at rates double to quadruple above the Fed's target range for inflation. The dollar has plunged to a record low against the euro, to a 12-year low against the Japanese yen, and is now nearly at par with the Swiss franc. After adjusting for inflation and trade flows, the dollar is off some 20% since peaking in early 2002, according to Mark Zandi, chief economist at Moody's Economy.com (MCO). The rise in the cost of imports spurred by the decline in the dollar is putting upward pressure on U.S. prices.

And the ripples are being felt in other markets as well. Gold, the hoary "currency" hedge against inflation, is trading around $1,000 an ounce. Oil, wheat, and other commodities are skyrocketing.

"So far I think all the tea leaves point to inflation as the bailout: thus, the run in oil, gold, and nondollar currencies all makes some sense," writes Bernard Picchi, a veteran oil industry analyst with Wall Street Access. "Very scary nonetheless."

A 1970s "Malaise"

The dollar's decline echoes some frightening moments in the recent past. In Secrets of the Temple, William Greider's magisterial history of the Fed, he recounts how global investors reacted to President Jimmy Carter's attempt to address inflation with his "malaise" speech on July 14, 1979. "The American dollar, bought and sold daily in huge volumes on the currency exchange, had been sliding in value, almost every day. This meant currency traders--banks, multinational corporations, wealthy investors, perhaps even other governments--expected the U.S. dollar to continue to lose its value in the coming weeks and months, and they, therefore, found it safer to hold their wealth in other currencies," writes Greider. "Roughly translated, the dollar's steady decline amounted to an inflation forecast."

Back in the days of disco, the opinion of the international financial community was that American inflation would get worse--a judgment that proved right. Shades of today's wobbly dollar?

Indeed, investment manager and financial writer John Mauldin invokes the days of malaise in commenting about Bernanke's zealous course of reviving the economy and ignoring inflation: "Won't that guarantee a repeat of the '70s and require a new Volcker to come in and cause a deep recession to bring inflation back down?" he asks. (For those who don't remember the 1970s, either because they weren't old enough or, well, because they were the 1970s, Paul Volcker was Federal Reserve chairman from 1979 to 1987.)

Bring back Volcker? Is the inflation problem and international financial crisis that bad? Let's hope not. Still, the risk facing the U.S. economy is that investors lose confidence in Ben Bernanke.

Lessons from the Great Stagflation

Let's take a trip back in time to see why. During the Great Stagflation of the 1970s, the Fed talked a good game against inflation. But in reality Fed Chairman Arthur Burns and his successor, G. William Miller, ran inept monetary policies that stoked the fires of inflation. By the end of the 1970s the Fed had no credibility internationally or domestically as an inflation-fighting central bank.

The numbers are enough to make anyone wince. For instance, during the 1973-74 bear market, stocks plunged by more than 40% before touching bottom and the bond market suffered a 35% loss--and the cost of living jumped some 20%.

It got worse. Inflation seemed to spiral ever higher. Prices kept going up--at the gas pump, the supermarket, and the car dealership. The dollar spiraled lower and gold surged to record levels. Nothing seemed to stem the inflationary tide. Wall Street treated Fed Chairman Miller, President Carter's appointee, as a joke. So Carter replaced Miller with Volcker, the extremely independent president of the Federal Reserve Bank of New York. (Miller was moved to the Treasury Dept.)

Volcker was determined to crush deeply ingrained expectations of ever-higher inflation among consumers, business, investors, and the international community. He stomped on the monetary brakes. Interest rates skyrocketed from about 11% in 1979 to 17% in April, 1980, and reached 20% in early 1981.The economy went through two contractions, including the worst downturn since the Great Depression. Millions of workers lost their jobs. Farmers went bankrupt in droves.

But the strong medicine had its intended effect: Inflation came down. Volcker's successor, Alan Greenspan, continued the fight and the consumer price index came down from a peak of 14% in 1980 to the 2%-or-so range, until now.

A Little Tolerance Goes a Long Way

This history suggests why we don't need a Volcker--yet. It's important to remember that the stagflation of 2008 is nothing compared to the stagflation of the '70s. What's more, Volcker predecessor Miller, a former business executive, was in way over his head at the helm of the Fed. In sharp contrast, Bernanke is one of the nation's leading scholars of the central bank, steeped in its traditions and well aware of its monetary mistakes.

Still, what the past suggests is that once the systemic financial crisis calms down, Bernanke and his colleagues will have to turn their attention toward combating inflation even if the economy continues to drift lower. It's one thing to tolerate a burst of inflation in order to manage a crisis; it's another to let inflation take root to wreak havoc for several years. After all, the lesson of the 1970s is that once inflation expectations get ingrained, it's a tough, painful habit to break.

We're not there yet. Let's hope we don't have to call Volcker--or his hard-nosed policy prescriptions--out of retirement, either.

We know that the Federal Reserve will cut its benchmark interest rate this week, perhaps by as much as percentage point. That would bring its rate down to 2%.

One genuine and growing risk is that a rate cut by the Fed will send the dollar cascading lower. That's why I expect (or perhaps more accurately hope) that we will see a coordinated and concerted action among central bankers and Treasuries around the world to prop up the value of the dollar.

What we don't need is a financial catastrophe sparked by a sudden run on the greenback.

Booms and busts are inevitable in a capitalist system. Right now, the Federal Reserve and, belatedly, the U.S. Treasury, are out to avoid facing the terrifying prospect that the credit crunch currently bedeviling Wall Street could morph into a sharp and sickening economic downturn--or even a full-fledged depression.

Think about what the Fed has done in recent months: cut its benchmark interest rate by 3 percentage points (including a 75-basis-point easing on Mar. 18), injected massive amounts of liquidity into the financial system, set up an alphabet soup of funding mechanisms for big U.S. banks (a Term Auction Facility, or TAF; a Term Security Lending Facility, or TSLF; and a Primary Dealer Credit Facility, or PDCF), and wielded extraordinary powers to engineer the rescue of investment bank Bear Stearns (BSC).

The Fed's unusual burst of activity has a clear, specific purpose. In the jargon of Wall Street rocket scientists, the Fed wants to avoid a "fat tail" catastrophe event or "regime shift." In simpler, terms, it's trying to stop a financial-system meltdown. The Fed's urgent efforts to shore up the financial system are understandable, when depression fears have shifted from society's "crackpot fringe" to the power centers of Washington and New York. For Ben Bernanke & Co., there was no real alternative.

Who's Responsible?

While Fed officials scramble to contain the damage, financial markets reel, and taxpayers get ready to foot the bill for the rescue efforts, a nagging question remains: What about the Wall Street titans who got us into this mess?

"The Federal Reserve continues to bail out major financial institutions without imposing meaningful conditions to improve their conduct and performance," complains Peter Morici, professor at the Smith Business School at the University of Maryland.

Here's a staggering figure to contemplate: New York City securities industry firms paid out a total of $137 billion in employee bonuses from 2002 to 2007, according to figures compiled by the New York State Office of the Comptroller. Let's break that down: Wall Street honchos earned a bonus of $9.8 billion in 2002, $15.8 billion in 2003, $18.6 billion in 2004, $25.7 billion in 2005, $33.9 billion in 2006, and $33.2 billion in 2007.

Those years were the heyday of the hedge fund pirate, the private equity buccaneer, the 9- and 10-figure-salary quant jock, and other financial creatures who created all kinds of complex securities and highly leveraged transactions, many of which are now coming a cropper, from LBOs to CDOs.

Paying for "Free" Markets

What a deal. Financiers preached the free-market gospel and pocketed unheard-of sums of money--yet when times got tough, they called for a government bailout. "Markets work if participants are at risk to both positive and negative consequences," says Raghuram Rajan, an economist at the University of Chicago Graduate School of Business and a former chief economist at the International Monetary Fund. "But on the upside, [financial firms] said, 'Hands off, don't upset the party,' and 'Don't even think of regulating us,' yet when things go the other way they say, 'We need help.'"

To be sure, not everyone has escaped unscathed. Nine months ago, Bear Stearns stock sold for $150 share. JPMorgan Chase (JPM) bought the beleaguered investment bank for $2 a share over the weekend, wiping out much of the wealth of the firm's employees.

So far that financial hit seems to be more the exception than the rule. After all, when Stanley O'Neal lost his job as head of Merrill Lynch (MER), he retired with more than $160 million in benefits and stock while Charles Prince, former CEO of Citigroup (C), left with a walk-away package worth almost $70 million.

Regulation Is Necessary

In our system it's impossible to insist that Wall Street cough up the vast sums earned during the go-go years. That said, when the turmoil calms down regulators should sharply step up their scrutiny of the industry, demand more transparency, and require greater accountability among financiers. The pendulum had swung too far toward "anything goes,"

The President's Working Group on Financial Markets--the heads of the Federal Reserve Board, the New York Federal Reserve Bank, the Securities & Exchange Commission, and other financial policymakers and regulators--recently issued recommendations for overhauling mortgage finance (BusinessWeek.com, 3/13/08). The recommendations are certainly a good start. But much more needs to be done. For instance, "if the regulators now say that investment banks have a line to the Fed in bad times, then the Fed has to have monetary authority over the investment banks in good times, too," says Rajan.

Economist John Maynard Keynes described the essential dynamic of a capitalist economy as a struggle between the lure of financial safety, or "hoarding," and the entrepreneurial instinct, or "animal spirits." As in many other areas of life, a sense of balance is essential. We've all learned that too much deregulation unleashes an abundance of animal spirits that can be dangerous to our economic health. The trick for the men and women that guide the nation's financial affairs will be to create a regulatory regime that encourages innovation while discouraging bailouts. In that regard, a little moral hazard can go a long way.

Markets don't go up forever. We saw that with dot.com stocks and residential real estate. Today the speculative excesses are in commodities. Pension funds, hedge funds, money management firms, and just about every other pool of investment money is pouring into commodities. In recent days oil, gold and other commodity prices have declined sharply. But I expect a lot more to come. I don't know the timing, but this boom will go bust.

Here's a sobering article by David Roche, the savvy thinker at Independent Strategy in London. It was published in the Financial Times. The bottom line:

The speculative element in commodity markets has grown sharply; non-commercial trades now constitute more than half of all trading, with hedge funds the biggest movers into the market. And in 2007, global equity funds switched away from financials and real estate into commodities in a big way.

But that's about to change. Global growth is declining fast. Recession will ensue and no region or asset class will be immune from its ravages. Contrary to received wisdom, economic decoupling is unlikely....

It's too early to say we're at a turning point in the banking and Wall Street financial crisis. One week does not make a trend. Still, it's intriguing to note that following the bailout of Bear Stearns and other actions by the Fed (supported by the Treasury) that commodity markets tanked, the dollar strengthened (somewhat), and stocks rallied. Perhaps global investors are signaling their approval at Ben Bernanke & Co.'s boldness.

This is an intriguing comment/proposal by a listener, Matthew in Los Angeles. My own sense is that there is growing resentment, maybe even anger, at the Fed-driven bailout. I believe the Fed is doing right by the economy and Main Street. Still, it's hard to stomach that the same financiers that pocketed huge sums of money during the go-go years have now turned to the public sector to bail them out during tough times. Private profits and publc losses. What a deal.

Ok, the bailout and buyout of an investment bank might be one of many solutions
by the feds but what about the forgiving of all the student loans made under the
federal loan programs. This solution would free up a tremendous amount of debt
that people amassed to further their education which is what we should focus on
instead. Many low, moderate and middle income families and individuals went
into debt to advance their education and career. A tax rebate is not the long
term solution but education debt forgiveness would be. It is easy to do, easy
to accomplish, and would not fill the pockets necessarily of those top 10% of
the wealthy families in the US.

But who are we, definitely not the CEO of Bears Stearn or JP Morgan Chase or
Chairman of the Federal Reserve, or an economist, just a hard working middle
class family of two professionals with two kids.

The Social Security Trustees just released their 2008 report. The Trustees predict that Social Security will run surpluses until 2017. The trust fund will remain solvent until 2041. Both figures are the same from last year's report.

But here is a key difference: The 75 year forecast projects smaller deficits in the years following 2041. The improvements come thanks to immigrants that work and pay taxes, but return home before collecting benefits. The contribution of these immigrants reduces the system's long-term shortfall from 1.95% of future wages to 1.70%--a dramatic difference. According to Andrew G. Biggs, formerly principal deputy commissioner of the Social Security Administration and currently a scholar with the American Enterprise Institute, that means an immediate and permanent increase of 1.7% in the payroll tax--from 12.4% of wages to 14.1%--would keep the program solvent for 75 years.

Of course, not everyone agrees that's what we should do. But the notion that there is a Social Security crisis, well, there isn't one.

My latest musing on the economy....

Two Cheers for Free Trade

Pacts like Nafta are essential to the health of the U.S. economy, but we could do a lot more to relieve the unpleasant side effects

by Chris Farrell

Remember the "giant sucking sound"? That was 1992 Presidential candidate Ross Perot's colorful auditory description of how multitudes of Americans would lose their jobs to low-wage competitors in Mexico.

Well, it's more than a decade and a half later, and Perot's bête noir, the Nafta agreement, is once again the subject of heated debate in a campaign for the White House. Democratic Presidential candidates, Senators Barack Obama (D-Ill.) and Hillary Clinton (D-N.Y.) have both criticized the agreement (BusinessWeek, 3/19/08).

But the regional fears Nafta inspired in 1992 have gone global in 2008. In addition to Mexico, most of the world's dynamic emerging markets, including China, India, and Brazil, have become strong players in the global economic arena. Americans worry about competition from overseas companies and workers from other lands emigrating to the U.S., especially with the economy faltering amid falling home prices, tottering financial markets, and shaky consumer confidence.

The case for freer trade and open markets is overwhelming. Economic evidence and economic history alike support the view that freer trade over time invigorates economic growth by encouraging the spread of new commercial ideas, new technologies, and new ways of organizing everyday life. Consumers enjoy lower prices and greater choice. Competition from overseas rivals encourages corporate efficiency and innovation.

The Politics of Trade

To be sure, free trade is a powerful economic medicine that can have some unpleasant side effects, and policymakers could do a better job of ameliorating attendant job losses and other economic dislocations. But the problems associated with free trade are manageable compared to those caused by closed economic borders. (Just ask Messrs. Smoot and Hawley.)

Yet many economists worry that election-year pressure from voters to "do something" about income inequality, stagnant wages, and pink slips is pushing Washington toward protectionism. Invoking the Harry Potter books, Greg Mankiw, Harvard University economist and former head of the White House Council of Economic Advisors, writes in a recent New York Times opinion piece that "no issue divides economists and mere Muggles more than the debate over globalization and international trade." Mankiw sees the crux of the problem as this: "Where the high priests of the dismal science see opportunity through the magic of the market's invisible hand, Joe Sixpack sees a threat to his livelihood."

With all respect to Mankiw, a terrific economist with a best-selling textbook, that's nonsense. First of all, give Joe Sixpack credit. The knowledge gap between the "high priests" and ordinary Americans is exaggerated. It seems to me most voters have a pretty good grasp of the gains from freer trade with the rest of the world. Protectionists and immigrant-bashers garner plenty of media attention, yet voters have handed over relatively little power to the apostles of protectionism over the past three decades or so. Just ask free-trade opponents Ross Perot, Pat Buchanan, and Tom Tancredo, each of whom failed in a Presidential bid. Meanwhile, Bill Clinton and George H.W. Bush each pushed through a number of free-trade agreements during their Presidencies.

Yes, the politics of trade is often a dance with two steps forward and one step back. Yet at the end of the day the embrace of globalization is strong.

Keeping the Faith

Even more important, it's not Joe Sixpack who is at fault. It's economists such as Mankiw who bear much of the blame for the current backlash in many quarters against international competition. As everyone who took Economics 101 knows, the gains from trade are dispersed throughout the economy while the costs are highly concentrated. Too many employees in recent years have felt the downside of "creative destruction." Thanks to the routine corporate restructurings, downsizings, reengineerings--pick your favorite euphemism--in Corporate America, there's little job security and stagnant wages.

Yet the economic priesthood continues to devote enormous intellectual firepower to making the case for freer trade and writing op-ed pieces extolling the benefits while ignoring the downside and dismissing the losers. "They have been quick to denounce opponents of this [free trade] agenda as 'protectionists' who should not be allowed in polite circles," writes Dean Baker, co-director of the Center for Economic & Policy Research in the latest issue of the Real-World Economics Review. "Yet, they rarely acknowledge the unavoidable implication of trade theory--that a large segment of the U.S. workforce will have to endure lower living standards as a result of the current course of trade liberalization."

In the battle of public-policy ideas, American economists do wield influence. It's time to claim victory in the free-trade debate. But if economists want Washington and the general public to keep the free-trade faith they need to get more involved in helping out the "losers." And it doesn't matter whether the culprit is international competition, deregulation, technological innovation, or some combination of the three.

No, protectionism is not the answer. Let's all agree on that, and move on. But preserving the economy's dynamism calls for the considerable brainpower of the economic profession to help come up with ways that offer workers better security in an era marked by rising fears of wage stagnation, job turmoil, long-term unemployment, and underemployment, unaffordable or unavailable health insurance, and increasingly at-risk pension plans. Now that's a challenge worth taking up.