January 2009 Archives

One of the weekly newsletters I get and enjoy is by the financial advisor John Maudlin. In his latest newsletter he relays a conversation he had with the private money manager Bill Fleckenstein.

I interviewed Flickenstein in February last year when his book Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve came out. It's well worth reading. Iasked him, "given your views on the Fed, what should an investor do?"

His response: "A lot of investors think everything will be O.K. They don't understand how shaky an edifice has been created. I don't think it's possible for the Fed to solve the unwinding of credit. It's going to get worse. This is a moment to take less risk. To race into stocks because they're down 20% from their highs--I don't think so.

The product investors should load up on is cash. You put yourself in a position to take advantage of things when the risk has been squeezed out. You might lose a little, but you put yourself in a position to win big. Let's say you get a 3% return on cash, and inflation is running 5%. But [eventually] say I can find stocks down 30% to 60%, and in two years they'll double in value. "

It was good advice. That's why his conversation with Maudlin grabbed my attention. Her's what Maudlin writes:

Bill runs a short-only hedge fund and has done so for many years. He is one of the more outspoken and well-known bears. And he told me that he is closing his short fund. Shutting it down and sending all the money back.

"Right now, my list of stocks that I want to be long is longer than the list I want to short." In the current environment he wants the ability to go long as well as short. For those of you who are long the market, that is probably as good an indicator as any that we are closer to the bottom than we are from the future top!"

My latest essay:

These are unnerving days, with fears of an extended recession replaced by growing worries of a Depression. During such times, it's natural to look back at history for lessons to provide perspective on the current crisis. A first glance at the market's performance in deeply unsettled times isn't pretty: During the Great Depression, the Dow Jones industrial average plunged 89% from its 1929 peak to its 1932 trough, partially recovered over the next five years, then tumbled a further 52% between 1937 and 1942.

Delve deeper into the history of the markets, though, and you can find valuable lessons, starting with the reminder that volatility in the Dow is nothing new. While many investing mantras haven't held true in recent history--consider how ineffective the investing trinity of diversifying, buying and holding stocks, and dollar-cost averaging has been over the past decade--there is a discernible rhythm over the long history of the markets. And it offers glimmers of hope to harried investors.

Specifically, the despair and low prices that mark financial catastrophes set the stage for higher prices and loftier returns later on. "Markets tend to overshoot in both directions," the late financier Leon Levy wrote in his memoir, The Mind of Wall Street. "Just as we saw stock prices rise far above the value of the companies, we are likely to see the reverse. Stocks will then be undervalued, and there will be new opportunities for investors."

Here's the rub: The timing of the recovery is uncertain. Take Levy's book. It is, in many respects, a prescient tale of today's environment, with an emphasis on the overly indebted consumer and Wall Street's irresponsible financial wizardry. It was published in 2002, but it really took another five to six years for the deep reversal he anticipated to materialize. But compare this with the debacle of the 1930s: The Dow's 17% drop in 1929 was followed by a 34% decline in 1930, a 53% drop in 1931, and a 23% fall in 1932. "In 1931, people would say, 'How bad can it get? This must be the bottom. I'll buy," says Eugene White, an economist at Rutgers University. "Six months later, you'd have lost everything."

Timing aside, there's no denying that the stock market looks increasingly tempting. By one measure, equities are priced lower against Treasuries than at any time since 1958: The current dividend yield on the Standard & Poor's 500-stock index is almost 3.3%, compared with a 2.2% yield on the 10-year U.S. government bond. Stocks typically carried higher yields than Treasuries before 1958. That reflected the fact that investors viewed stocks as far riskier than bonds and meant companies had to pay out large dividends to attract shareholders.

But that cautious mindset changed during the postwar euphoria of the 1950s. Despite a global economic contraction and an auto industry slump that led to 20% unemployment in Detroit, in 1958 the S&P 500's dividend yield fell below the yield on Treasuries and stayed below those on government bonds until now, a half-century later. The 1958 shift reflected investors' diminishing fears of another Great Depression, as well as rising confidence in Corporate America's earning power. But investor emotions have come full circle again, and markets have priced in a worst-case scenario. "Right now, there are a lot of depression probabilities built into stock prices," says Jeremy Siegel, a finance professor at the Wharton School.

DEPRESSED ABOUT DEFLATION
It isn't just depression risk that's rattling investors. There's the prospect of deflation, or a decline in overall price levels, and what that might do to corporate earnings. (Inflation and deflation are mirror images of one another.) For instance, price levels plunged by a quarter during the Great Depression, and the rapid decline erased company profits. Investors are also struggling to figure out whether fiscal and monetary policy will work to resuscitate the economy. During the Great Depression, equity investors suffered a -20.2% real return from 1929 to 1932. But thanks to investor optimism following the election of Franklin D. Roosevelt and his Administration's New Deal activism, the stock market soared by a record 66.7% in 1933--the biggest one-year gain of the entire past century.Problem is, the market gave up those gains and more, making the 1930s the most volatile decade in U.S. history. "After 1929, people questioned the fundamental premise of investing in the stock market," says William Goetzmann, a finance professor at the Yale School of Management.

The public's reaction was understandable, but shunning stocks is the wrong lesson for today's investors. For one thing, the investment record of equities looks different when deflation is relatively mild. From 1872 on, the stock market rose annually by an average 13.9% for 24 years that featured mild deflation--of around 1% to 2% a year. That's second only to the 15.6% average gain achieved during periods characterized by modest inflation.

Moreover, stock market data support the notion that it's smart to own riskier assets after a long stretch of poor performance. The S&P 500 has had an average annual return of 0.9% over the past decade. Steve Leuthold, chief investment officer for the Leuthold Group and a market historian, looked into performance for every decade since 1926: The past 10-year period ranks among the bottom 4%. Yet after each of the worst 10-year periods, the market returned no less than a 7.21% compound annual return the following decade, and the best decade-long return was 15.58%, in 1974-84. Put differently, young investors bold enough to gamble on stocks during the Depression's dark days would have seen their stake grow tenfold by the time they reached retirement in 1957, notes Oxford historian Niall Ferguson.

The stock market rewards the intrepid because most investors steer clear of equities after a debacle. Blue-chip stocks in the 1950s offered dividend yields of 5% to 7%, but the generation that had been burned by the bear market of the 1930s shunned equities. Investors fled stocks in the inflationary '70s, and it took another decade before individuals again embraced equities. This time around, it's likely that many workers will decide that government bonds such as Treasury Inflation Protected Securities, and not stocks, should form the foundation of their retirement portfolio. "The poor individual investor has been hit by the 2000-02 downturn and then, eight years later, there's a second big hit," says Leuthold.

SYSTEMATIC REBALANCING
Of course, it's impossible to know whether the market is hitting bottom now--or might do so in a year. That's why the old proverbs that preach diversification and dollar-cost averaging remain good advice for anyone investing for the long haul. Diversification isn't a hedge against any financial crisis over a short period of time. "After that, the most mispriced asset classes come back more strongly than others," says Ross Levin, a financial planner and head of Accredited Investors in Edina, Minn. "Rebalancing is critical during these periods. By systematically rebalancing, you are forcing yourself to buy low."

Indeed, it's at times like the present that dollar-cost averaging really pays off. It pushes the investor away from trying to time the market. For instance, investors earned a real 2% average annual return on their equity investments during the 1930s, according to Ibbotson Associates, a market research firm. But they pocketed a real 7.1% on their government bonds and 2.7% on short-term Treasury bills. Yet during the 1950s investors earned a real average annual return of 16.8% on stocks, while losing 2.2% on bonds and 0.3% on bills. "Timing is a tough business," says Paul Samuelson, the 93-year-old Nobel laureate economist who was a pioneer in modern financial theory. "It's easy to sell, but then you have to know when to get back in--and we know that hardly anyone is good at it."

The fact remains that stocks and bond are risky. And stocks are riskier than bonds because equities represent the rewards for entrepreneurship, while bonds are contracts that spell out when borrowers must make principal and interest payments. "It's really useful for us today to look at history and know that we've had panics and crises before, and that markets recover," Goetzmann says. "Even taking into account the 1930s, stocks have been a good investment. I take comfort from that." Investing in a diversified portfolio still pays for anyone with time--and fortitude--on their side.

Thanks to Mike Mandel at Business Week, I became aware of this important paper, the "The Aftermath of Financial Crises* by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University. You can read the paper here. (You can read Mike's comments from the American Economics Association annual meeting where the paper was given here.)

The scholars look at all the major postwar banking crises in the developed world--a total of 18. They emphasize the "the big five" (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992). They also include a number of famous emerging market episodes, such as the 1997-1998 Asian crisis and Argentina 2001. Finally, they include two earlier historical cases with good housing data, Norway in 1899 and the United States in 1929.

Here is their summary:

Broadly speaking, financial crises are protracted affairs. More often than not, the
aftermath of severe financial crises share three characteristics. First, asset market
collapses are deep and prolonged. Real housing price declines average 35 percent
stretched out over six years, while equity price collapses average 55 percent over a
downturn of about three and a half years. Second, the aftermath of banking crises is
associated with profound declines in output and employment. The unemployment rate
rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post-World War II episodes.

The scholars make a sober, carefully reasoned and researched case that the U.S. and the rest of the global economy face much darker days ahead. It's research like this that is influencing the economists that are now part of Team Obama, and why the size of the fiscal stimulus package has gotten bigger and bolder..

One of the joys of traveling to New York is reading the headlines at the New York Post. Yesterday, the tabloid had a lot about Ponzi-schemer Bernard Madoff. It was "Bernie's Baubbles," Madoff Mauled," and my favorite from yesterdays hearing when prosecutors tried to get him put in jail, "Piggy skips pokey time once again."

Why isn't this guy in jail?

The unemployment numbers look to be grim tomorrow.

If the early job market indicators are at all sending out accurate signals, tomorrow's employment report will be bad. The main manufacturing orders and production indexes are at their lowest levels in sixty years, manufacturing exports are down, Chrysler has shuttered all its manufacturing facilities until January 19, and manufacturers are slashing payrolls. The service sector is suffering too. Little wonder economist Edward Yardeni, head of his own forecasting firm, says "the labor market indicators are likely to be awful for both December and January."

Watch closely to see how government, education and health care do on the job front. Those are the only sectors of the economy that have held up relatively well.

Clearly, bad news on the employment front...

Payroll employment down 524,000 over the month of December....

11.1 million people are unemployed, and the unemployment rate is at 7.2%....

In the last four months of the year the job losses accelerated....

The broadest measure of unemployment kept by the government--total unemployed, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers--hit 13.5%... up from 12.6% the previous month and 8.7% a year ago....

Education and health services did hold up, so did government....

The Federal reserve Bank of Minneapolis has created a really useful web page for monitoring this recession, and comparing it to other recessions at the same time. The Minneapolis Fed will automatically update the information when it comes out.

The Chicago law professor Eric Posner has a really nicely reasoned post on why policymakers shouldn't treat housing as such a favored asset. I came on the piece through Marginal Revolution.

In the summer of 2006 I wrote a piece for Business Week with a narrower focus: Aguing against the favorable tax treatment of housing compared to stocks, bonds and other assets. I thought I'd recyle the argument, although a lot has changed since I wrote it--such as the housing boom did go bust.

When we get out of the current financial and economic crisis I hope policymakers level the investment playing field (although I'm not hopeful).

JULY 26, 2005

A Housing Boom Built on Folly

Disproportionate tax incentives are keeping the market's rise in overdrive. We need to correct the balance

It seems that everyone from Wall Street to Main Street to Capitol Hill is watching the biggest housing-market boom in history with awe and dread. Awe because trillions of dollars in new wealth has been created ($5 trillion since 1996) and the home-ownership rate has reached a record 69% of U.S. households. Dread because the boom is attracting so much speculative investing that a growing number of market watchers fear that a bust is inevitable and will end in economic catastrophe.

What accounts for the housing boom? Economists have cited a number of fundamental factors, including low interest rates, favorable demographics, and restrictions on development. But the unappreciated force that may have infected a strong housing market with home-buying mania is bad tax policy. Specifically, I mean the Taxpayer Relief Act of 1997, signed by President Clinton.

Under a set of easily met limitations -- mainly that a home has been a primary residence for two out of the past five years -- a family can exempt the first $500,000 in profit on the sale of the home from capital-gains taxes. The comparable figure for a single filer is $250,000.

MONEY PIT. In sharp contrast, capital gains on stocks and bonds carry a 15% levy (the capital gains tax rate had been 20% until the tax law change of 2003.). The powerful lure of tax-free profit is one reason that home prices have risen at a nearly 7% annual rate, vs. about 4% for the stock market since 1997. Sell a home with a $500,000 profit and owe Uncle Sam nothing. But realize a $500,000 gain on Nextbreakthroughtechnology.com and the federal government takes 15%. That's the kind of math most people can figure out.

The issue goes way beyond tax fairness. A growing number of economists are deeply concerned that residential real estate is absorbing far too many economic resources. Money is pouring into concrete foundations rather than high-tech innovation. "Residential investment accounted for 35% of private investment in the past year, a level not seen since the early 1970s," notes Martin Barnes, the perceptive financial-market observer at Bank Credit Analyst.

"We're overinvesting in housing as a nation," says Mark Zandi, chief economist at economic-consulting firm Economy.com. And we have the 1997 tax-law change to thank, because that created much of the economic incentive to buy, flip, and buy again every two years.

UNBALANCED CODE. As much as possible, the tax code shouldn't bias investment decisions. As it is, the tax code is too heavily weighted in favor of housing. The Urban Institute calculates that the government provides about $147 billion in subsidies to homeowners, including the mortgage-interest deduction and capital gains exemption.

"The most politically successful segment in society are homeowners, builders, and realtors," says William Ahearn of the Washington, D.C.-based Tax Foundation. "The tax code is more slanted toward that group's favor than any other group."

Sure, calls by columnists for Congress to treat the home like any other investment typically flounder. The home-mortgage deduction is sacrosanct on Capital Hill, regardless of how many tax economists testify against it every year.

But the capital-gains law is different. It's only eight years old. Action ought to be taken before this bit of policy becomes as enmeshed as the tax break for mortgage interest. Besides, no policymaker is really happy with the froth in the real estate market.

STOCK SHIFT. Congress could level the investment playing field by treating capital gains on real estate, stocks, bonds, and other assets the same. I say levy the same 15% rate on all capital gains -- regardless of how they're realized.

Doing so would also reduce the incentive for speculative investment in real estate and remove some disincentive to investing in the stock market. My guess is that investors would shift more of their money into Corporate America, especially innovative companies that create the wealth of the future.

What's more, in an era of federal red ink as far as the eye can see, the revenue from home sales would help restore some fiscal sanity in Washington. People can be pretty smart with their money when given the chance. I say give them that chance.

THE NEXT BILL GATES. I realize that economists with a more supply-side perspective might prefer that capital gains be treated the same way that ones realized from housing are. But giving couples a break on the first $500,000 in profit -- and singles a break on the first $250,000 -- is hardly a laudable strategy in an era of spiraling budget deficits.

Owning a home may be synonymous with the American dream. But so is finding the next Microsoft (MSFT ).

Here are excerpts from two investment giants. They differ, although both agree that Treasury Inflation Protected Securities or TIPS are attractive.

First, today's Wall Street Journal has an interview with David Swensen, the invetment maven for Yale University. He has a terrific long-term track record, although like everyone Yale's endowment is down. I'm a big fan of his investment book for the average person: Unconventional Success. Here's a highlight from the interview with the Wall Street Journal. (You need a subscription to the WSJ to read the whole article):

Distressed securities are one of the most interesting opportunities for institutional investors. But returns won't come right away because the credit markets are fundamentally broken. TIPS [Treasury-Inflation Protected Securities] are pretty attractively priced. They promise reasonable returns, and protection against inflation is really important. We may not see it in the next year or two, but the government's massive fiscal stimulus can't help but produce massive inflationary pressures. Stocks also look a lot more attractive than they have for a long time. We prefer higher-quality companies with low leverage.

Bill Gross of Pimco runs the world's largest bond fund. He's the Warren Buffet of fixed income securities. I liked his book, Everything You've Heard About Investing is Wrong. You can read his monthly newsletter here:

PIMCO's view is simple: shake hands with the government; make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond. Anticipate, then buy what they buy, only do it first: agency-backed mortgages, bank preferred stocks, and senior bank debt; Aaa asset-backed securities such as credit card, student loan, and auto receivables. These have been well-advertised PIMCO strategies over the past 6 months but there are others in clear sight. An Obama administration will quickly be confronted by the need to provide those hundreds of billions of dollars to states and large municipalities. Their requests total nearly a trillion dollars and to think California or NYC would be allowed to fail is, well - unthinkable. Municipal bonds then, selling at historically high ratios relative to U.S. Treasuries, offer attractive price appreciation potential, or at the very least a defensiveness with high carry that a 2½% 10-year Treasury cannot.

Here's another thought. While TIPS or inflation-protected securities cannot logically be a recipient of Uncle Sam's checkbook over the next 12 months, they can benefit if and when the government's efforts to reflate begin to take hold. 2½% real yields cannot possibly be maintained unless deflation as opposed to inflation becomes the odds-on favorite. What bond investors know as "breakeven inflation rates" are currently signaling a future where the U.S. CPI averages -1% for the next 10 years. Possible, but not likely. As an additional strategy, global bond investors should recognize the value in high-quality investment-grade corporate bonds in many markets. Yields of 6%+ for intermediate maturities are still common and readily available.

Peter Bernstein is the dean of finance economists. His newsletter is widely read--with good reason. We all learn something from it. In his latest missive, he offers up this insight on investment:

"Back in the 1950s, when I began my career in this business, investing "for income" was rapidly becoming old hat, appropriate perhaps for widows and orphans but not for red-blooded business executives who had to pay income taxes and were beginning to accumulate their estates. I remember one new client who told me, "Please remember I just can't stand more income!" Soon after, the institutional investing world began to blossom, and their asset allocations have increasingly reflected the same philosophy - even though most of them these institutions paid no taxes. Income was for sissies.

In the new world spawned by the subprime mortgage crisis, the old view is dying out. Based on what we read, the notion of investing in corporate bonds instead of corporate stocks is gaining momentum. The idea makes a lot of sense in an environment where growth is going to be negative in the short run and likely to be less than vigorous over the longer run. The current income return from corporate bonds is significantly larger and more secure than dividend income and compares favorably with estimates of long-run economic growth. Finally, in case of catastrophe, the bonds will outrank the equities in a bankruptcy settlement. Thus, the superior contractual position of bond interest and the much higher income return form a favorable tradeoff for the investor in bonds. Income is for savvy investors."

We're in the midst of the biggest financial crisis since the Great Depression. Now, it does appear that the crisis is starting to recede somewhat, thanks to the herculean actions by the Fed and the Treasury. Still, economists agree that a massive fiscal stimulus program is called for, and it's coming with the new Administration. Yet somehow there is a flurry of stories aboutimmigration status of an employee of Timothey Geithner, President-elect Obama's choice to lead Treasury. You've got to be kidding. Over to Blogger Megan McArdle here.

In trying to figure out what is going on as we stumble our way throught the worst financial crisis since the 1930s it's worth reading "The Cycles of American Politics" by the historian Arthur Schlesinger, Jr. I recently read it in his 1986 book, The Cycles of American History It's a rich, nuanced essay--a delight to read. And Schlesinger was early in his prediction that American society was on the verge of a shift from an emphasis on the individual in the Reagan years to a great focus on the public space.

Today, American society does appear to be making one of its periodic shifts in emphasis. In broad terms, we're going from a focus on "private interests" to "public action" to use the typology of economist Albert O. Hirschman.

Over the past three decades we've lived through a period where public policy initiatives focused on markets, open borders, deregulation and lower taxes. The dominating idea behind all these initiatives was that individuals promoting their own interests end up benefitting everyone--the invisible hand lifts all boats. But eventually every revolution breeds a counter-revolution as the neglect of certain problems accumulates, and evidence grows that the invisible hand lifted the yachts while leaving everyone else behind or vulnerable. "People grow bored with selfish motives and vistas, weary of materialism as the ultimate goal. The vacation from public responsibility replenishes the national energies and recharges the national batteries," wrote Schlesinger. "A detonating issue--some problem growing in magnitude and menace beyond the capacity of the market's invisible hand to solve--at last leads to a breakthrough into a new political epoch."

In 2008 the "detonating issue" was record amounts of debt gone bad. It was a wake-up call to all of us.

It's easy to beat up on people for borrowing too much.

Problem is, much of the commentary I'm reading seems misplaced. Most people didn't borrow to emulate Imelda Marcos and buy as many shoes as possible. It wasn't materialism and instant gratification run amuck.

No, they borrowed to move to a safer neighborhood with better schools, to send their children to college. In a sense, much--although not all--of the borrowing boom reflects private efforts to overcome public policy failures, especially when it comes to education. But the private cost--borrowed money--was too much for the average household.

Catching up on my reading. The Harvard University economist Richard Freeman calculates that CEOs are make in a couple months what an average worker makes in a lifetime.

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More evidence that deflation lies in our future.

The Consumer Price Index out today decreased 1.0% in December. December's level was 0.1% higher than December, 2007, according to the BLS. It's the third consecutive monthly decline. Yes, falling energy prices account for much of the decline. But so does falling demand.

The CPI minus energy and food--the so-called core-CPI--was unchanged in December. The core-CPI is up a mere 1.8% for the past 12 months, and the increase for the year came in the early part of that time period. For the past 3 months the core CPI has been negative to zero.

A combination of a global recession and deflation is really worrisome.

The Wall Street Journal on Jan. 17 has a good article on target date funds. (You need a subscription to look at many WSJ articles. Here's the link.)

In essence, these are supposed to be one-decision buys. You invest in one fund. It allocates your money among a handful of assets--stocks bonds, cash, international equities, and the like. The portofolio grows more conservative as retirement nears. hence the term "target-date" funds.

The 2006 Pension Protection Act encourages employers to enroll new employees automatically into their retirement savings plan. A target date fund is now an acceptable default option if an employee isn't sure where to invest among the choices offered by the employer. (Before 2006 the common default option was a money market mutual fund.)

Zvi Bodie, finance professor at Boston University, argued against using target date funds as the default option. He said it was to risky a strategy. He proposed that if target date funds were so great then the mutual fund company should make up any shortfall at retirement time. As you imagine that idea went nowhere.

Too bad. According to the Wall Street Journal, most target funds with a retirement date of 2010 were still heavily invested in equities. "Most of these lost at least 20% -- and some more than a third -- last year. That's better than an all-stock portfolio would have fared, but losing a big chunk of your balance a year before your anticipated retirement can obviously derail those plans."

Bodies and other critics were right. Bodie argues that the default option should be TIPS--Treasury Inflation Protected Securities? That way the savings will be there, adjusted for inflation. There is no credit risk.

One of the more enjoyable and stimulating blogs is by Nobel Laureate Gary Becker and Judge Richard Posner. The two scholars at the University of Chicago and they carry on a discussion on major topics. Both are brilliant.

Recently, they have been debating the efficacy of fiscal stimulus on infrastructure projects for combatting the downturn. Becker remains wary. Posner is more favorably disposed--for this reason:

I suspect that we have entered a depression. There is no widely agreed definition of the word, but I would define it as a steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and a sense of crisis.

In another post, Posner says:

One objection to public-works spending as an anti-depression measure is that by the time work on the public projects actually begins, the depression will be over and all that remains will be the bill for the projects, in the form of an increased national debt, since public-works spending that is financed by taxes rather than borrowing has no effect on increasing demand for goods and services. What is given with one hand is taken away with the other. But construction projects, especially those interrupted or postponed because of the economic collapse, can be started up (or resumed) pretty quickly. Moreover, this depression (as I think it is, and not merely a recession) is likely to last at least two more years, and that should be time enough for much of the $90 billion (plus additional money allocated to construction) to be spent.

It's bad out there, and getting worse..

My suspicion is that nationalizing the banking system isn't far off. It may be the stroke the economy needs to start turning around the ominous combination of deflation and depression

A disturbing sign of the parlous state of the newspaper industry. The New York Times is a junk bond.

One of the nation's two flagship newspapers (the other is the Wall Street Journal) raised $250 million from the Mexican billionaire Carlos Slim to shore up its faltering finances. The company will pay him 14.1% interest rate. That's a junk bond coupon.

He also gets warrants that can be converted into nearly 16 million common shares. If he exercises the warrants Slim will control about 18% of the company

Is it any wonder consumers aren't spending? Even if consumers could borrow--would they?

Look at what's happening to consumer net worth. This chart is courtesy of the Quarterly Review and Outlook for the Fourth Quarter of 2008 by the Hoisington Investment Management Company. The money management firm (with a reputation as among the savviest bond investors around) note that monetary and fiscal policy is overwhelmed by the "unprecedented decline in household wealth... Moreover, the wealth loss is now being augmented by significant job losses and a shorter work week."

Consumer net worth.bmp

They figure that from the final quarter of 2006 through the third quarter of 2008, the real value of homes fell $3.5 trillion. The households' real holdings of stocks fell by $2.1 trillion. That's a $5.6 trillion loss in total household wealth.

real estate.bmp

The firm expects the wealth loss may exceed $10 trillion when the fourth quarter figures come in. More losses are in store for 2009. Consumer spending will continue to retrench.

There's a lot of discussion in the econ blogsphere and editorial pages about the fiscal stimulus "multiplier" effect on the economy and whether tax cuts have a bigger or smaller effect on economic growth. I think Mark Thoma, professor of economics at the University of Oregon, has written a well-reasoned and simple argument that cuts through the whole multiplier debate. He makes a persuasive case why the fiscal stimulus package makes a lot of sense--it's good policy for both a short-term and long-term reasons. You can read it on his blog here We've neglected critical "public goods" for too long.

Tax cuts won't build schools, or any other public good.

And right now, with so much of our infrastructure in need of attention, we need public goods.

We tried the tax cut approach to stimulating the economy once, we had no choice since Bush and the Republicans would not have passed any other type of stimulus package.

Guess what? It didn't work very well, and we have little to show for it. Had we, say, rebuilt water systems instead, at the very worst we'd have better water. That's not so bad in any case.

And it's been interesting, if that's the right word, to watch the same people who delayed fiscal policy for months and months and months as they insisted that we try tax cuts first now tell us that it will take too long to put the spending in place. They don't seem to realized that's because of their insistence on the use of tax cuts rather than spending. If we had started on these projects a year ago instead of enacting the tax cut package to appease the right, timeliness would not be such an issue - we might already be repairing sewage systems, rebuilding roads, and so on. I've even heard some who ought to know better argue that because forecasts say the recession will end soon, we can't possibly get the spending in place soon enough. That is, they argue that by the time the spending hits the economy, the economy will have already recovered (these are often the same people who reassured us that there was no housing bubble, and there was not worry anyway because the recession, if it hit at all, would be very mild and easily absorbed by our dynamic, flexible economy). Never mind that forecasts beyond around six months ahead are not much better than a coin flip, and they know it, some forecast somewhere says that the recession will end before spending is in place, and that's enough for them to take the argument public. What if the forecast is wrong?

It's not completely clear to me that the fact that the recession might end soon undercuts the case for government spending anyway. If the money is spent on large, socially beneficial projects - and lots of infrastructure comes under this heading - then so what if the economy recovers? These are things we very much need, and that won't change just because the economy is doing better. There will be net benefits no matter the state of the economy, but the net benefits will be higher if we pursue these projects when the costs are low. If we are lucky, and the economy recovers very fast, much faster than expected, then there will still be benefits, they just won't be as large.

We need to do these things, and right now, with so many idle resources in the economy, the opportunity cost of employing resources is low. For this reason, this is an opportune time to meet the challenges that we face in repairing the infrastructure and in meeting other needs that are critical to maintaining robust economic growth, and in maintaining our health and welfare.

The tax cuts are better than spending proponents generally ignore public goods when they argue that the private sector is always better at spending money, but it seems to me that leaves out an important part of the argument.

If the argument that the private sector is more efficient than government always prevailed, we wouldn't have any public goods at all, and that's not an economy I'd want to live in. Obviously, there are times when spending on public goods is justified economically, and I'd argue strongly that this is one of those times, i.e. that there are lots of places the government can spend money that have large social returns. Why would we want to wait until the opportunity cost is very high to reap these returns instead of pursuing these projects now when the cost is lower? If we are going to have to make these expenditures anyway, it doesn't make any sense to wait.

And one last question. The tax cuts are best crowd argues that government makes poor spending decisions, and this is one of their key objections to spending measures. But doesn't government make bad tax decisions too? The tax cut advocates like to promote some tax they've designed that has wonderful properties on paper, and sounds great on the editorial page, but it's just as easy to do that with fiscal policy. If you don't have to confront the reality of the legislative process, and you are free to argue from a theoretical perspective instead, not a dollar will get wasted. But as we saw during the first fiscal stimulus attempt, the one where the "it has to be tax cuts or nothing" types prevailed, the tax cuts that were actually enacted were far from optimal, and there was quite a bit of disappointment in the actual tax cut package that was put into place. And perhaps because of that, the tax cuts had less effect than hoped. I know that the tax cut advocates say that this time government needs to do it right, and they have lots of advice about what "right" is, but, really, given the realities in congress, what makes them think this time will be any different?

Tax cuts won't build schools.

How to regulate the financial system will be critical once we are past the crisis. One of the more thoughtful writings on the subect is by Clive Crook at The Atlantic. In Small World he makes a nuanced argument about the long-term war between financial regulation and financial regulation:

This decades-long compromise--an evolving and uneasy accommodation with the forces of financial innovation--has been smashed by the crash of 2008. But what comes next is far from obvious. The popular view that the current mess is all the fault of "deregulation" is misleading, at best. The implication that all we need do is return to an earlier era of stricter supervision is an illusion. To repeat, regulators did not choose to retreat; they were forced to. In the United States, Democratic administrations, rarely inclined to see deregulation as an end in itself, ceded at least as much ground as Republican ones. The main forces that spurred the retreat--the incentives to evade close supervision, and the technological opportunities to do so--continue to grow more powerful. So what do we do?

A new approach to financial regulation is already taking shape. The Treasury began to dissolve the distinction between banks and non-banks, for instance, when it widened access to emergency borrowing from the Federal Reserve--a privilege once held only by deposit-takers. Having extended the assistance they are willing to offer, the authorities must extend their supervision as well. The logic is the same as with deposit insurance: if you socialize the costs of failure, you have to regulate against recklessness. The broadening of intervention and supervision will need to go further.

There is much more to his argument. Check it out.

Boston University economists Christophe Chamley and Laurence Kotlikoff sent me this argument for a limited purpose bank. .

...Don't let banks take risky positions. Make banks stick to their two critical functions - mediating the payments system and connecting lenders to borrowers.

What will change this behavior is to not let it happen. Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 percent-down and payments below 25 percent of income. The government, via the Federal Financial Authority (FFA), would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell "their" loans within mutual funds.....

The Federal Reserve Bank of Boston has created an interactive set of charts on Income inequality and mobility, 1994 to 2004. I just started to play with it.

One way of looking at what is happening to the eocnomy is that people are adjusting their expectations, and that takes time.

Over time people develop rules of thumb. They're based on experience and conversation. So, it used to be a reasonable expectationn that if someone lost their job they would get another one within 3 to 6 months (at the outside). That was the foundation of the common personal finance advice that you should set aside 3 to 6 months of savings. Fact is, that's hard to do. The reality is that when someone lost their job they would cut back on spending, tap into savings and borrow on their credit card. It's a good approach for 3 to 4 months of looking. And the rule of thumb is that you'd get something comparable, maybe not quite as much pay or as generous benefits, but within striking range of your rpevious job.

But then the world changed, and it took time for us to adjust. What if instead of 3 to 6 months it took 6 month to a year to find a job. And what if it turns out that the risk of taking a 50% paycut in your new job go up dramatically. All of a sudden the use of a credit card becomes onerous. Instead of tapping into it for 3 months, you end up using it over a year. And then, not only is your debt burden bigger, but your earning less in your new job and it takes longer to pay it off.

People weren't stupid. People weren't lazy. The world has changed, and we're adjusting our expectations.

Now, expand this to the economy. In the 1990s, students and their parents complained about the high and rising cost of a college education. But we paid it. The reason is that the earnings of a college graduate more than paid for the big debt burden. But while the real student loan debt burden has gone up by 50% in the 2000s, the real wages of college graduates has declined since 2002. The risk of taking on all that debt has gone up.

Similarly, the real estate bubble. There is a loot of blame to go around and I'm not minimizing all the greed and craziness. Still, Mike Mandel, the chief economist at Business Week, and I were discussing the other day an aspect of the boom and bust that isn't emphasized enough. People expected the economy to keep on growing and wages to catch up with productivity improvements. It wasn't a foolish expectation. It wasn't a mass mania. It was a reasonable expectation.

But economic growth was weak. Wages did not catch up with productivity in the 2000s. The optimistic bet that paying up for a house and other borrowings would end up okay--which was the experience from the 1950s through 1995 or so--turned out to be very very wrong. Yes, a bad bet, but not stupid.

What's happening right now, with all the emphasis on paying down debt, is that people are assuming growth and wages aren't going to be good for years to come. We're devising rules of thumb that are far more cautious--and that's the right thing to do.

But it's truly worrisome. It's easy to make fun of optimism. The bubble-moralizers are having a field day. But its the belief that tomorrow will be better than today is the entrepreneurs credo. It's what every middle class family wants for their children. It's the engine of economic growth. The spread of pessimistic rules of thumb isn't a good sign..

The headlines are saying the 3.8% decline in gross domestic product for the last quarter of last year isn't as bad as feared. That's cold comfort. It's a bad report that will likely be revised downward. It confirms the economy is picking up downward momentum. It's getting worse, too, if the stunning job cut figures of this week are any indication.

These are not good numbers:

Consumer spending fell 3.5%, following a 3.8% fall the previous quarter.

The core consumer price index (excluding food and energy) rose at a mere 0.6% annual rate in the fourth quarter. Headline consumer inflation plunged at 5.5% annual rate. That's the biggest drop on record. It's also really scary. The combination of a steep drop in demand and falling prices defined the Great Depression.

I don't like this either: Business investment is down 20.1%, and investments in equipment and software fell almost 28%.

Exports are down sharply too. This is a global recession, gaining momentum.

And Wall Street thinks it's business-as-usual. Workers are losing their jobs. Businesses are falling into bankruptcy. There are no profits on Wall Street--in fact, there are no investment banks left--taxpayers are bailing out the industry, and the industry forks out over $18 billion in bonuses?

In Wages and Human Capital in the U.S. Financial Industry, 1909-2006, a recent paper by economists Thomas Philippon and Ariell Reshef, looks at compensation in the industry over nearly a century . Here's the abstract:

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.

In other words, your suspicion that Wall Street is vastly overpaid is right. Their conclusion, which touches on regulation, is worth highlighting:

Finally, we address the issue of the level of compensation in the financial industry. On the one hand, the change in the relative wage of finance employees is part of an efficient market response to a change in the economic environment. We show in particular that corporate finance needs from the non financial sector help explain the demand for skills in the financial industry. On the other hand, we find that rents account for 30% to 50% of the wage differentials observed since the late 1990s. In that sense, financiers are overpaid.

Our results have another important implication for regulation. Following the crisis of
1930-1933 and 2007-2008, regulators have been blamed for lax oversight.45 In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly-skilled financial workers, because they could not compete with private sector wages. Our approach therefore provides an explanation for regulatory failures.

Brad Delong, the economist and blogger at the University of California, Berkeley, has written a wonderful, brief piece on wealth, living standards, needs and wants. It's an important reminder on a number of levels. Check it out:

The current recession may turn into a small depression, and may push global living standards down by five percent for one or two or (we hope not) five years, but that does not erase the gulf between those of us in the globe's middle and upper classes and all human existence prior to the Industrial Revolution. We have reached the frontier of mass material comfort--where we have enough food that we are not painfully hungry, enough clothing that we are not shiveringly cold, enough shelter that we are not distressingly wet, even enough entertainment that we are not bored. We--at least those lucky enough to be in the global middle and upper classes who still cluster around the North Atlantic--have lots and lots of stuff. Our machines and factories have given us the power to get more and more stuff by getting more and more stuff--a self-perpetuating cycle of consumption.

Our goods are not only plentiful but cheap. I am a book addict. Yet even I am fighting hard to spend as great a share of my income on books as Adam Smith did in his day. Back on March 9, 1776 Adam Smith's Inquiry into the Nature and Causes of the Wealth of Nations went on sale for the price of 1.8 pounds sterling at a time when the median family made perhaps 30 pounds a year. That one book (admittedly a big book and an expensive one) cost six percent of the median family's annual income. In the United States today, median family income is $50,000 a year and Smith's Wealth of Nations costs $7.95 at Amazon (in the Bantam Classics edition). The 18th Century British family could buy 17 copies of the Wealth of Nations out of its annual income. The American family in 2009 can buy 6,000 copies: a multiplication factor of 350.

The consulting firm McKinsey has a useful chart on health care spending.