Happy Holidays to All --- And Best Wishes for a Higher Market in 2012!



Time for All of Us to Hold Congress Responsible!

The Look of a Man Who Just Agreed to Increase the Take-home Pay of 160 Million American Workers --- Where's the Joy?

Hedge Fund Mangers Still Get Rich Even If Their Clients Take a Bath

Seeking Alpha 3:06 PM John Paulson's Advantage Plus Fund is down another 9% in December, claims a Reuters source, bringing its YTD losses to 52%. Paulson's Advantage Fund, meanwhile, is said to be down 36% YTD, and his gold fund 7%. Hedge Fund Research estimates the average hedge fund lost 4.37% from January-November.

Every Time Europe Seems Close to a Solution :-(

Does This Remind You of Anything --- Like Our Do-Nothing Super Committee Members? Or Maybe Our Entire Do-Nothing Congress?

Even Greece and Italy Have Been Able to Reach Some Compromise

Here we are 10 days from the deadline for the Congressional Super Committee to reach some compromise with respect to a budget deficit/debt reduction package --- and it looks very much at the moment as though the Super Committee Stupor Committee will fail miserably at its assigned task.

Fortunately, I think the equity and debt markets have already priced in failure.  Therefore, when November 23rd comes and goes without a wimper from the Super Committee, I'm not looking for any significant downturn in the markets.  (This, even if there is another downgrade of US sovereign debt -- after all, where are investors going to find a safer haven than the US at the moment?)  On the other hand, if the Committee actually put a meaningful proposal on the table for the entire Congress to vote on (up or down) by December 23rd, the markets could move higher.

In the meantime, I'm maintaining investment positions pretty much where they are today --- 70% debt/equity investments and 30% cash.

Are You Kidding Me? - Why Do We Pay Any Attention to Standard & Poors?

France lashes out at S&P's 'shocking' error

PARIS (AP) — France reacted with outrage after the Standard & Poor's ratings agency accidentally sent out a message saying it was downgrading the country's prized "AAA" credit rating during a tumultuous week in Europe's protracted debt crisis.

The error stood for an hour and a half Thursday before it was retracted by the agency — spooking markets by foreshadowing the event that could sound the death knell for the 17-nation eurozone.

The accident came just as Greece and Italy both were in the process of getting new interim governments led by financial experts to guide them out of the continent's debt crisis. Most European markets were still open at the time, and U.S. financial markets were in full swing.

Despite Standard & Poor's statement saying the original message had gone out to some subscribers because of a technical error and its reaffirmation that France's credit rating remained "AAA" — the highest level — and stable, some damage could not be undone.

The yield, or interest rate that France pays to borrow money for 10 years, has risen 0.32 percentage points since Thursday morning, hitting 3.48 percent Friday afternoon, the highest rate since May.

In the midst of a crisis where fear drives the markets as much as fact, the error has at the very least reminded investors of France's difficulties. And often the suggestion of something amiss is nearly as bad as having something amiss.

French Finance Minister Francois Baroin did his best to quell fears, calling the error a "rather shocking rumor of information that has no foundation."

"We won't let any negative message go," he said in Lyon in comments published Friday on the La Tribune newspaper website.

The French market regulator immediately opened an investigation into the mistake at Baroin's behest, and the minister also called for a European probe.

While the error may have increased the pressure on French bond yields, they were already rising — because, like many countries, France is struggling with slow growth and high debt piled up during the boom years.

The rise of such yields is at the heart of Europe's debt crisis: The increase of those interest rates in Ireland, Portugal and Greece — because investors considered them increasingly bad risks — eventually forced each of those countries to seek massive international bailouts.

Now Italy is coming under the same pressure. That poses a bigger problem because its economy and debts dwarf the others — Italy's economic output is 17 percent of the eurozone's compared to a combined 6 percent for the other three nations. Europe doesn't have enough money to fully bail Italy out.

But a French debt downgrade would be a problem on another order of magnitude. France and Germany's "AAA" credit ratings are the bedrock of Europe's bailout fund. Because the debt of those two countries is considered so safe, the fund pays very favorable interest rates on the bonds it issues.

Some analysts said the accident may have tipped the actual thinking at the ratings agency.

"I can't remember a situation where an agency released a rating movement in error and no doubt there will be many people who believe that there is no smoke without fire and that this cannot have happened unless S&P were preparing the ground for a downgrade," Gary Jenkins, an analyst with Evolution Securities, said Friday.

He hastened to add: "I have no idea if this is the case or if it was just a genuine error."

S&P, however, does not even have France on surveillance — the step that typically comes before a rating is downgraded. Moody's, on the other hand, says it is studying whether to put France's rating on notice.

A downgrade of French debt would also pose a domestic problem: President Nicolas Sarkozy, who is expected to face a re-election battle next spring, has staked his credibility on balancing France's budget by 2016.

Along the way, Sarkozy has laid out yearly targets for reducing France's deficit — each one tied to a growth projection. But those forecasts have repeatedly proved too rosy and his conservative government has already twice this year been forced to introduce extra cuts to stay on target.

It's clear the last thing Sarkozy wants to see is for French borrowing costs to rise as his government fights to clean up its deficits and keep the eurozone united.

On Thursday, the European Commission said it considered France's growth forecast for 2013 too high — and Baroin shot back that Paris has already set aside a reserve fund for that eventuality.

By SARAH DiLORENZO, AP Business Writer

Copyright © 2011 The Associated Press. All rights reserved.

This Roller Coaster - Made in Italy

Now that the Greek problem is moving to the back burner (for the moment), we have the Italians trying to sink the global economy. Will the US Congressional Super Committee be next?

The Greek Problem

So Much For Jobs Creation!

The European Mess: How We Got Here

November 2, 2011

By Peter Wallison

‹‹Previous Page |1 | 2 |

The financial crisis in Europe seems very complex, but we understand that how it comes out will have important and perhaps painful consequences for Americans as well as Europeans. At its center is the fear that if Greece defaults on its debts that could endanger the health of European banks, and that in turn may cause a financial crisis not unlike what followed the collapse of Lehman Brothers in 2008. How did we get into this fix, so soon after 2008?

Last week, EU leaders agreed on a rescue plan for Greece that involves investors (primarily banks) writing off 50% of the value of their loans. Is this another case of the banks doing something dumb, or is there more to the story of these investments in Greece?

As a guide for the perplexed, here are some Qs and As that might shed some light on why we are where we are:

What's the underlying cause of this crisis? High debt-to-GDP ratios among the Europe's southern tier countries, resulting in an increase in the risk - and a decline in the value - of their outstanding debt.

What's the effect? The banks - primarily European - that hold this debt have been seriously weakened by the reduced value of these assets. If Greece actually defaults, the debt could become almost worthless.

Why did the banks buy this debt? Bank regulators from around the world encouraged it.
What? How did they do that? The current bank capital rules (known as the Basel rules after the Swiss city in which the regulators meet) give banks a strong incentive to hold sovereign debt.

What kind of incentive? The Basel capital rules make sovereign debt cheaper for banks to hold than other kinds of debt.

Can you give me an example? Sure. Bank capital is basically equity, common shares or their equivalent. It's the first to suffer losses so it's very risky and thus very expensive.

So? Under the Basel rules, banks must allocate at least 8% of their capital to support their loans to corporations, and less than half that for the mortgages they hold. It's called risk-weighting of assets.

OK. How much capital must they hold against sovereign debt? None

You mean the debt of all European countries has a risk weighting of zero? Yes
Even Greece? Yes

Why would the Basel rules treat the debt of all governments the same? Because the rules are made by bank regulators from around the world, all of which are agencies of governments. Governments like banks to buy their debt.

Could it be that the Basel rules would not have been adopted if the debt of all the participating governments had not been given the same zero risk-weighting? Yes

Does this mean that the Basel rules may have caused the financial crisis in Europe? Yes

Isn't this a severe indictment of the Basel rules? Of course.

What would we do without these rules? The market would decide which government's debt represents zero risk.

What's wrong with that? Nothing

Then why were the Basel rules developed in the first place? Regulators were worried that governments might decide to lower the capital standards of the banks chartered in their countries, giving them advantages against banks in other countries and making them riskier.

What were they afraid of? A race to the bottom. Basel is an attempt to assure standardized capital requirements for all internationally active banks.

But didn't governments, through zero risk-weighting of sovereign debt, just give themselves the advantages they were afraid might be given to the banks? Yes

And isn't that the cause of this impending crisis? Yes

So how do we get out of this? Ask your favorite bank regulator.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was general counsel of the Treasury and White House counsel in the Reagan administration and a member of the Financial Crisis Inquiry Commission.

Insanity or Convenient Illusion or Something Else?

Euro-Zone’s Leveraged Solution to Leverage

Posted At : October 24, 2011 5:10 AM | Posted By : Satyajit Das
 

If as Albert Einstein observed insanity is “doing the same thing over and over again and expecting different results”, then the latest proposals for resolving the Euro-zone debt crisis requires psychiatric rather than financial assessment.

The sketchy plan entails Greece restructuring its debt with writedowns around 50% and recapitalisation of the affected banks. The European Financial Stability Funds (“EFSF”) would increase its size to a proposed Euro 2-3 billion from its current Euro 440 billion. This would enable the fund to inject capital into banks and also support Spain and Italy’s financing needs to reduce further contagion risks.

One proposal under consideration entails the EFSF using leverage to increase its size and enhance its ability to intervene effectively. Attributed to US Treasury Secretary Tim Geithner, the proposal is similar to the 2007 Master Liquidity Enhancement Conduit (“MLEC”) super conduit which was ultimately abandoned.

The EFSF would apparently bear the first 20% of losses on sovereign bonds and perhaps its investment in banks. This resembles the equity tranche in a CDO (Collateralised Debt Obligations), which assumes the risk of the initial losses on loans or bond portfolios. Assuming the EFSF contributes Euro 400 billion, the total bailout resources would be around Euro 2,000 billion. Higher leverage, a lower first loss piece, say 10%, would increase available funds to Euro 4 trillion. The European Central Bank (“ECB”) would supply the “protected” debt component to leverage the EFSF’s contribution, bearing losses only above the first loss piece size.

The proposal has a number of problems.

The EFSF does not have Euro 440 billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around Euro 250 billion, assuming that the increase to Euro 440 billion is ratified by European parliaments.

The EFSF must borrow money from the markets, relying on its own CDO like structure, backed by a cash first loss cushion and guarantees from Euro-zone countries. In fact, some investors actually value and analyse EFSF bonds as a type of highly rated CDO security known as a super senior tranche. This means that the new arrangement has features of a CDO of a CDO (CDO2), a highly leveraged security which proved toxic in 2007/ 2008.

The ECB, the provider of protected debt, has capital of about Euro 5 billion (to be raised to Euro 10 billion), supporting around Euro 140 billion in bonds issued by beleaguered Euro-zone nations, purchased as part of market operations to reduce their borrowing cost. The ECB has also lent substantial sums (market estimates suggest more than Euro 400 billion) to European banks without access to money markets at acceptable cost, secured over similar bonds. While the Euro-zone central banking system has capital of around Euro 80 billion that could be available to support the ECB’s operations, this adds to the incremental leverage of the arrangements.

The 20% first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75% of the face value of bonds. 

The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the “rescue” of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default. This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar “confidence tricks”.

The proposal assumes that it will not need to be used, avoiding exposing its technical shortcomings. The EFSF too was never meant to be used, relying on the “shock and awe” of the proposal, especially its size and government backing, to resolve the crisis.

The proposal is driven, in reality, by political imperatives - avoiding seeking national parliamentary approval at a time when sentiment is against further bailouts and lack of support for an increase in the size and scope of the EFSF.

It is also designed to reduce the increasing risk to the credit ratings of France and Germany. This last factor is increasingly important given concerns raised by rating agencies about the quantum of contingent liabilities being assumed by these countries. For example, after the increase in the size of the EFSF to Euro 440 billion, Germany’s commitment to the EFSF is over Euro 200 billion.

The scheme may also facilitate the ECB covertly monetising debt, “printing money”; to generate the protected debt to leverage the structure and also to cover the losses on its own exposures to distressed sovereign debt. It is simply another means of allowing the imply another way of requesting that the ECB to expands its balance sheet to absorb increased credit risk.

It now looks like the proposal to leverage the EFSF via the ECB are unlikely to be pursued - but as this is Europe nothing should be discounted. Instead, different forms of leverage are under consideration - EFSF to enter into credit default swaps to protect holders of bonds issued by weak European sovereign borrowers; EFSF to guarantee the first 10% or 20% or 40% of losses to bondholders; EFSF to act as bond re-insurer.

Unfortunately, all these new schemes like previous proposals are unlikely to succeed. The unpalatable fact remains that Europe may not have the capacity to rescue everybody that now seems to need rescuing without imperilling the financial health and ratings of stronger countries such as France and Germany.

As Sigmund Freud’s observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”

We Can Hope, Can't We?

No Encouragement on the Horizon --- Stocks Get Hammered

On September 2nd I posted some thoughts about areas of concern for the US and global economies (see "Some Random Thoughts About Who We Can Trust and Other Stuff").  It's time to update some of those observations given what has transpired over the past three weeks, namely:  President Obama's address to the joint session of Congress on September 8th re: jobs creation ("the American Jobs Act"); the President's announcement several days later as to how to pay for the jobs legislation he proposed; the President's deficit-reduction proposal that he put on the table a couple of days ago; the Republicans' reactions to those proposals; the Federal Reserve's actions of yesterday ("Operation Twist"); the continuing drama with respect to the Eurozone debt crisis; and various economic numbers re: the US and global economies.

The American Jobs Act, Deficit Reduction and Republicans' Reactions - The cost of the proposed jobs legislation would be about $447 billion.  Perhaps 1/2 of this (maybe more) would not create new jobs --- rather, it would effectively provide cash flows to various groups that would maintain current spending levels and, thereby, not cause economic deterioration and further job losses.  (This is certainly important to assure that the economic softness that we are already experiencing is not exacerbated.)  The other half would be split between creating new jobs (e.g., infrastructure spending) and providing businesses with greater cash flow (e.g., lower payroll taxes).  The problem with this latter issue is whether businesses will spend the increased cash flow in creating new jobs or let it accumulate along with the trillions of cash that already resides on corporate balance sheets.  Overall, I'm not convinced that the American Jobs Act is a bold and imaginative enough program to stimulate the US economy to growth.  Moreover, I don't believe businesses will create new jobs before there is increased demand for their products --- and I don't think the American Jobs Act (even if enacted in its entirely) will stimulate very much increased product demand.

With respect to the President's deficit reduction proposal, the concepts are fine: entitlement reform, tax reform, reduced spending --- but the devil will be in the details and the whole proposal has been effectively kicked over to the Congressional Deficit-Reduction Super Committee.  I still lack confidence that the Super Commitee can reach bi-partisan compromise on the details of any deficit-reduction program.

And then we have the Republicans' (and some Democrats') reactions to the Jobs Act and Deficit-Reduction proposals.  The Rs don't want any tax revenue increases and the Ds don't want any significant entitlement reform.  This is an equation for continuing partisan gridlock, with no end in sight.

   

Finally, my overall reaction to the Obama job and deficit-reduction proposals and the Rs' responses is this --- it's all about campaign politics and not about advancing meaningful policy proposals designed to effect bi-partisan solutions in the next few months to enhance the lackluster US economic recovery.

Eurozone and China - The problems in the Eurozone continue and no resolution is on the horizon.  Further, recent economic data for the Eurozone economy have provided evidence of further slow-down or contraction.  Moreover, it appears China's economy is also slowing more than anticipated.  Bottom line --- the global recovery is in trouble.

The Federal Reserve – Yesterday's actions to implement Operation Twist suggest the Fed is limited in helping the economy by the tools remaining in its monetary toolbox.  Further, the Fed commented "there are significant downside risks to the economic outlook, including strains in global financial markets."  Not very encouraging.

Republicans in Congress - In my post of September 2nd I raised the question of whether we can trust the House and Senate to agree to anything that looks like it will give Obama new life for the 2012 election process.  How can we trust the Republican caucus to agree to meaningful fiscal stimulus to salvage the US recovery and lower unemployment levels before the election?  Based on recent rhetoric, the answer is "we can't" --- and the subtext is "and let the American people be damned" for another 13 months until the 2012 election.

And, in large measure, because of all these issues - Today US and global stocks get hammered. 

No Jobs for Labor Day

Some Random Thoughts About Who We Can Trust and Other Stuff

A week ago I got out of the market as I closed all my volatility/momentum trades when the S&P 500 was @ 1175 --- it’s now @ 1205 (but this morning’s futures are looking as though the index will head considerably lower today because of the terrible August payrolls/earnings/unemployment report).  I don’t mind losing those 30 points (probably less than that when the post-payrolls-report market opens this morning) because I didn’t have to worry about any potential damages from either the Bernanke Jackson Hole speech last Friday (even though it didn’t result in a downdraft for the market) or Hurricane Irene (even though the damage was less than most weather experts anticipated).  Sleeping better at night was worth the trade-off between a somewhat higher market and a potentially significantly lower trading level.

This leads me to consider where we now find ourselves and who can (and, more importantly, who will have the courage to) lead the US and global economies toward recovery and away from a double-dip recession.  To that end, the following are some random thoughts on various issues.

Eurozone and European Central Bank – New sovereign debt problems (or the same old problems) in Italy and Greece are again negatively impacting the Eurozone and the European markets.  Can we trust the Eurozone countries and the ECB to work together to bolster the sagging Eurozone economy?  In the short-run, austerity by the offending countries without some stimulative actions by the ECB doesn’t seem to be the immediate answer.

US Exports to the Eurozone – According to a Brookings Institution research report¹, we export over $300 billion a year to Eurozone countries and virtually all of the rest of our exports go to nations that also export to the Eurozone.  If the European economy continues its sag, this would have a measurable effect on the US recovery.  We can’t afford inaction or ineffective action by the ECB and the Eurozone countries.

¹ source: http://www.brookings.edu/papers/2011/0822_euro_crisis_elliott.aspx#note1, Why Can’t Europe Get it Right the First Time… or the Second… or the Third?

The Federal Reserve – Chairman Bernanke’s speech in Jackson Hole last Friday didn’t lay out any new actions it might take with respect to stimulating economic growth.  Was that just a kick of the can down the road to motivate the Congress and the WH to engage in meaningful fiscal policy before the Fed committed to any additional actions --- or is the Fed limited by the remaining tools in its monetary toolbox --- or both?  In spite of the no-news Jackson Hole speech, the market moved higher.  I think prematurely.

President Obama – Can we trust Obama to have the imagination and courage to put a big jobs package on the table in his Joint Session of Congress Address next week and really fight for it?  And, more importantly, even if the answers are affirmative, does he have the political skill and capital to effect a bipartisan result?

Congress - Can we trust the House and Senate to agree to anything that looks like it will give Obama new life for the 2012 election process?  Speaker of the House Boehner won’t even agree to the date and time of a speech by Obama --- how can we trust him to get his Republican caucus to agree to meaningful fiscal stimulus to salvage the US recovery and lower unemployment levels before the election?

Congress’ Super Committee - Lots of questions and little optimism on my part at the moment.

Infrastructure Investment – This is something that needs to be put in place now to effect long-term economic growth.  Will the WH and Congress have the courage to do something big now when borrowing costs are so low?

Big U.S. Banks - These banks and smaller banks need to make loans available to small/mid-sized businesses (the real job creators).  Can we trust the banks to do this or will the big banks, subsidized by the Fed over the past three years with near-zero interest rates, just keep on arbitraging the effectively-free funds with low-risk investments (i.e., US Treasury securities and the like)?

Consumers – We had one decent consumer spending number this past Monday.  This gave some encouragement to the markets that the consumer isn’t totally sitting on the sidelines --- but we need consumers to keep spending.

Gold and Swiss Franc Investors – As global uncertainly has been the watchword of late, investors have sought the “safe-haven” of gold and strong currencies.  However, if we are to see the equity markets move to the upside, a prerequisite will be that these investors see less risk in the global economy and redeploy funds into other than these “safe-haven” investments.

Corporations – Can we trust them to hire without legislated fiscal incentives or without an increase in demand for their products?  In a word, no.  And, as a free-market capitalist, I wouldn't expect or advocate corporations to do anything that isn't in their own long-term self interest (to be read as including all their constituencies --- shareholders, employees, customers, communities, etc.).

Having said all that, there may be some hope that September will be better for the equity markets than was August.  (In August the S&P 500 opened the month @ 1292 and closed it @ 1219, a decline of 5.6%.)  Some of what normally happens in September happened in August, such as economic forecast revisions.  Also, some of the shocks from the Eurozone and the US debt ceiling debate/S&P credit downgrade were put behind us in some fashion or other.  However, can we trust that there won’t be new or renewed shocks in September to create more volatility in the equity markets?

As a final comment, I noted within the past couple of days (after we regained communication with the world following Hurricane Irene’s pass through our area) that earlier this week CNBC conducted an interview with Abbey Joseph Cohen of Goldman Sachs (an equity market guru who merits considerable respect).  It was reported on CNBC’s website that Cohen “reiterated her forecast for the Standard & Poor’s 500 reaching 1450.”  At first read, this really surprised me and with good reason.  This is terrible reporting --- and I have commented to that effect on the CNBC website.

Cohen’s 1450 forecast was made in June 2011 --- this when the S&P 500 was trading near the 1300 level.  Specifically, the Cohen/GS prediction, based upon all the information available in June, was that the S&P 500 would close out 2011 in the 1450 range.  However, if you view the tape of the recent interview², what Cohen actually says is this, “the US portfolio strategy team believes that over the next 12 months we can see the S&P 500 reach about 1450.”  1450 by year-end 2011 vs. 1450 by the end of August 2012 are two entirely different animals.  This is clearly not a "reiteration" of Cohen's forecast.  Shame on CNBC.

² source: http://www.cnbc.com/id/15840232?play=1&video=3000042486

To end on a positive note, the Yankees beat the Red Sox last night and are tied in the loss column for first place in the AL East.  The Yankees have one more three-game series with the Red Sox this year --- on September 23^rd, 24^th and 25^th at Yankee Stadium.  If both teams take care of business between now and then, it will make for an exciting close to the regular season.

The Need for Additional Fiscal Stimulus

As Fed Chairman Ben Bernanke made clear today in his Jackson Hole speech, policy makers beyond the Fed need to actively participate in stimulating aggregate demand in the economy (i.e., Congress and the White House need to do their fair share with respect to fiscal policy stimulus.)  Nobel Prize-winning economist Peter Diamond comments on the need for additional fiscal stimulus, especially in the form of infrastructure investment, to help grow the US economy and reduce unemployment. 

Ben Bernanake and Hurricane Irene

Between Fed Chairman Bernanke's upcoming comments this morning and the approach of Hurricane Irene this weekend, I think I'll just stay hundered down for the next few days.  I liquidated all equity positions yesterday and find little reason to take any new investment risk until the BB speech and Irene damage can be assessed.

Approaching Bernanke’s Jackson Hole Speech – 2011 Version

For the past couple of weeks I’ve been engaged in short-term momentum/volatility equity trading (including leveraged ETFs) on a limited basis.  This has worked very well as I’ve bought when I thought the market has over-reacted on the downside and sold when the market has recouped the over-reaction on the upside.

However, as we approach Fed Chairman Ben Bernanke’s speech tomorrow in Jackson Hole, I’m preparing to liquidate at the open of the market today my current equity positions.  I’m concerned that the equity markets are expecting BB to say something to further buoy stock prices --- and I’m not sure what he can say to meet those expectations.

It seems to me there is more downside risk than upside potential attaching to the BB speech.  There are many who believe the Fed has exhausted the tools in its toolbox and won’t be able to do much more to promote more employment in the economy.  It appears fiscal policy will be the best way to create jobs --- and we all know how dysfunctional Congress is at the moment for this to be a realistic short-term result.  (For an example of this monetary- vs. fiscal-policy discussion, see http://economix.blogs.nytimes.com/2011/08/24/how-much-more-can-the-fed-help-the-economy/.)

If this is a correct assessment, the markets could again fall to their lows of the past month --- and if not correct, what’s the loss of a few upside points by comparison?

Getting ready to fasten my seatbelt for the bumpy ride ahead.

A Word of Caution

Why Is The Eurozone So Important?

Here's a lead-in paragraph to a Brookings Institution article by Douglas Elliott that is a good summation as to why we need to be concerned about the Eurozone economy and its effect on the US economy.

"The Euro Crisis has struck again, hammering not just European markets, but doing real damage to U.S. markets and to economic prospects around the world. The U.S. could easily be pushed into another recession if the eurozone collapsed. We export well over $300 billion a year to those 17 countries; virtually all of the rest of our exports go to nations that also export to the eurozone and would feel ripple effects; roughly two-fifths of our overseas assets are invested in the eurozone; and our major financial institutions have large credit exposures to eurozone banks and other businesses."

source:  http://www.brookings.edu/papers/2011/0822_euro_crisis_elliott.aspx#note1, Why Can’t Europe Get it Right the First Time… or the Second… or the Third?

Hope You Weren't Looking For A Cheerful Beginning To The Day

Here's an article by Richard Posner which outlines some of the economic challenges we face.  For the most part I agree, although you'll note a couple of concepts with which I take exception (see my comments in [...] following pink highlighted text).

---

Let’s Be Honest: We’re in a Depression, Not a Recession, And There’s No End In Sight

Richard A. Posner

August 23, 2011 | 12:00 am

This article is a contribution to 'Is There Anything That Can Be Done? A TNR Symposium On The Economy.' Click here to read other contributions to the series.

If the notion that we are merely living through the aftereffects of a mere “recession” that ended in 2009 sounds somewhat ridiculous, that’s because it is. If we were being honest with ourselves, we would call this a depression. That would certainly better convey both the severity of our problems, and the fact that those problems have no evident solutions.

The American economy currently has both a short-term problem and a long-term problem. The short-term problem is that the economy is depressed; it is growing more slowly than the population, with the result that per capita income is declining. The high rate of un- and underemployment is a factor, but is itself the product of other factors, having mainly to do with the reluctance of over-indebted consumers (over-indebted in major part because of loss of equity in their houses, the major source of household wealth) to spend, the reluctance of the impaired banking industry to make risky loans, and the reluctance of businesses to invest and to hire, which is due in part to weak consumer spending and in part to profound uncertainty about the nation’s economic future.

The roots of this catastrophic situation [i.e., the short term problem] lie primarily, I think, in the incompetent economic management of the Bush administration and the Federal Reserve. The persistence of the depression, however, is due in part at least to surprising failures of the Obama administration—poor leadership, poor management, the sponsorship of incomprehensibly complex health care and financial regulation laws that have created widespread uncertainty that has discouraged consumption and investment, and the inability to explain the nature of the economy’s problems to the general public. These failures caused the stimulus enacted in February 2009 to be botched in both in its design and its administration, resulting in the discrediting of deficit spending as a response to depression.

So what can be done now? Probably nothing. Anything that involves spending, such as a new stimulus program, would come too late to be effective. Measures that would not involve spending, such as devaluing the currency (which the Federal Reserve could do by buying a great many bonds, thus flooding the world with dollars), could stimulate our exports and hence production and hence employment and reduce imports (which would further help domestic production), but they are too risky given the interdependence of our economy and the economies of the rest of the world. Europe is staggering and would be hurt by our devaluing, and our banks and other financial institutions are heavily involved in those European economies.

The long-term problem should be easier to solve. The problem is not the federal budget deficit per se, huge as it is. The public debt of the United States, which is what the federal government owes to persons who have lent money to the government (mainly purchasers of Treasury securities), and thus excludes debt incurred to finance entitlements and discretionary spending, is currently $9.7 trillion, with 46 percent of it owned by foreign governments and other foreigners. Although $9.7 trillion is big even for the United States, we can roll it over more or less effortlessly and at very low interest rates, at least at present and in the immediate future.

The [long-term] problem is not the level of the debt but its growth. In the seven years between 2000 and 2007 (the last year before the financial crisis that triggered the current depression), the public debt grew in real (that is, inflation-adjusted) terms by 56 percent, the consequence of reckless spending and tax cuts by the Bush administration. Between 2007 and 2012 (the debt in fiscal 2012, which ends September 30 of next year, is of course an estimated number), a shorter period, the nation’s public debt will have grown by another 134 percent. The annual increase from 2009 to 2010 and the (estimated) annual increase from 2010 to 2011 are both 17 percent, and the estimated increase for 2012 is 18 percent. These annual rates of growth vastly exceed the rate of the nation’s economic growth even in prosperous times, and if they continue will bankrupt the federal government.

Unfortunately, even when the economy recovers, and tax revenues increase, the federal deficit will continue to rise because of the rapid growth of entitlement expenditures—primarily Medicare and Social Security and, because of the health-reform law, Medicaid. Leaving politics to one side, the increase in Social Security costs can easily be controlled, by a combination of raising the age of eligibility, revising the formula for calculating cost of living adjustments, and means testing—limiting eligibility to persons who do not have substantial other income. Medicare costs are more difficult to control, but not impossible. Medicare too can be means-tested—there is no reason to subsidize the medical costs of affluent people. Copayments and deductibles can be increased to make people think harder about whether they want expensive treatments of marginal efficacy. Medicare can be transformed, as proposed by Congressman Paul Ryan, from a government- administered heath care program to a subsidy program to enable non-affluent persons to buy private health insurance.  [This seems easier said than done, as Posner doesn't address the issue of what companies would provide insurance at a reasonable cost.  A voucher system for these medical costs reduces the burden on government, only to place that burden on the more vulnerable in our society -- the aged.]  And medical research can be refocused on finding cures for medical conditions such as blindness and dementia, which require protracted, expensive care because they create severe disability in the elderly without killing quickly.  [This seems too simple --- why not just cure cancer too?]

Efforts to curb increased entitlement spending can be complemented by closing tax loopholes, some of which are as enormous as they are unjustified, notably the deduction for mortgage interest. Half the adult population, moreover, pays no income tax. Everyone with an income should pay income tax equal to a modest percentage of his income. [This ignores the most regressive tax on income -- the payroll tax.] 

So the deficit, politics aside, should be manageable. But it’s worth pointing out that anything that takes money out of the economy, such as reducing federal spending or increasing federal taxes, will exacerbate the current depression. Consumers will have less money to spend, and this will discourage employers from hiring. So the reforms that I have been discussing should be phased in gradually over a period of years.

But it’s not clear that we have enough years. Suppose that the economy recovers by the end of 2012, and in 2013 and subsequent years grows at a 4 percent annual rate. (The long-term growth rate is about 3 percent, but growth is usually more rapid when it starts from a low level.) The public debt won’t continue to grow at 17 or 18 percent a year, but suppose it grows at 7 percent a year. Then the already very large federal deficit will continue to grow, and indeed, to compound: At a 7 percent annual growth rate, our public debt in 2012, estimated at $12.4 trillion, will grow by 40 percent in five years if none of the reforms designed to limit that growth are implemented before the end of that period. Yet if they are implemented while the economy is still struggling, the result may actually be to increase the deficit by driving tax revenues down (because incomes will be depressed) despite the elimination of loopholes, and by increasing transfer payments to the unemployed and others hard hit by the economic crisis.

The result is a quandary. I don’t see a way out of it. I hope others do.


Richard A. Posner is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School.

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Source URL: http://www.tnr.com/article/economy/94055/posner-recession-depressions-entitlements

With Friends Like These ...

Euro Debt Crisis: No Solution in Sight

By Ben Rooney @CNNMoney August 19, 2011: 10:24 AM ET

NEW YORK (CNNMoney) -- European leaders are under intense pressure to come up with a long-term solution to the debt problems straining the European Union to its breaking point.  But given the enormous challenges involved and the unpalatable options available to them, few analysts expect EU policymakers to announce any meaningful changes soon.

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"There is no solution to the Euroland's sovereign debt crisis in sight," said Carl Weinberg, an economist at High Frequency Economics. "Markets will continue to be fundamentally unstable and volatile as long as we can think."

French President Nicolas Sarkozy and German Chancellor Angela Merkel gave it their best shot on Tuesday.  The leaders of Europe's largest economies announced proposals they said will encourage fiscal discipline and increase economic competitiveness across the euro zone.

Investors were not impressed.  Stock markets across Europe fell Friday, extending Thursday's big sell-off. Shares in Frankfurt fell 3%, while the main market indexes in London and Paris were down about 1.5%.

"The market gave Merkel and Sarkozy their chance to stop the Euro crisis," said Clem Chambers, chief executive of European financial market website ADVFN. "Today it is responding to their inaction."

Shares of European banks have been hit particularly hard. Concerns about the banking sector flared Thursday following reports that an unnamed institution borrowed $500 million from one of the European Central Bank's emergency lending facilities.

Will Europe come tumbling down?

Investors were hoping for more concrete measures to stabilize shaky government finances. They want to see a big increase in the size of the EU stability fund and many are calling for the creation of a so-called euro bond.

Sarkozy and Merkel dashed those hopes, saying the 440 billion euro stability fund is sufficient and a bond backed by the euro zone as a group would not solve all the region's debt problems.

The proposals the leaders did put forth -- requiring all 17 euro zone nations to commit to balanced budgets, giving the EU bureaucracy more fiscal authority and imposing some sort of transaction tax -- were widely seen as inadequate.

0:00 / 3:09 Nein? Can more debt help Europe?

Analysts said serious questions remain about how effective the proposals would be and whether member nations will agree to them.  Jennifer McKeown, an economist at Capital Economics in London, said "decisive steps" towards a more uniform fiscal policy are necessary "if the currency union is going to hold together in its current form."

EU leaders have pledged to do what is necessary to protect the euro. And the latest rhetoric has been about fiscal "integration" and economic "convergence."

So far, the EU has responded to the debt problems in Greece, Portugal and Ireland by throwing billions of bailout euros at them in the hope that harsh austerity measures would do the rest.

As the crisis intensified over the last few weeks, the European Central Bank started buying Spanish and Italian bonds in a bid to prevent a broader debt contagion.  But the aggressive moves that investors are looking for would require fundamental changes in the business model, such as it is, of the European Union.

Europe's debt crisis: Expect more trouble

In essence, the larger EU economies will be required to shoulder more of the burden stemming from the fiscal indiscretions of their smaller neighbors.  That presents a difficult political problem for Germany and France, where voters must approve such measures.

"In the end," said McKeown, "the euro zone's strongest economies might decide that the potential costs of allowing the euro zone to fail, perhaps in the form of a banking crisis, are even greater than those of supporting it."

First Published: August 19, 2011: 10:15 AM ET

Sitting on the Sidelines

For the most part, I've been sitting on the sidelines for the past month with cash reserves in all the investment accounts I manage.  The debt ceiling debacle together with the do-nothing-but-stymie-our-economy debt ceiling legislation together with weak US and Eurozone economic numbers together with the Eurozone debt problems together with weak (or non-existent) economic leadership on both sides of the Atlantic have only added to my resolve to wait until there is some light at the end of the global economy tunnel before committing to non-cash investment alternatives.

On the other hand, with 30-year US Treasury yields sitting at 50-year lows, is there an opportunity (albeit longer term) to short the US Treasury market and ride the yield curve up as yields inevitably rise over the next few years?  I'm considering this possibility, but there's no rush since the Fed has effectively said they will maintain a low-interest-rate policy for the next two years.

But, for the moment, still sitting on the sidelines ---

Will This Roller Coaster Go Up Anytime Soon?

Last week I thought the market bottom was about 1120 on the S&P 500 (the intraday market low last week was actually 1101) --- now, I'm not so sure.  The latest economic numbers for the US and Eurozone economies show more weakness than the forecasters expected.  In addition, neither the US nor the Eurozone is getting any of the bold leadership that will be required to achieve global economic growth and avoid global recession.

Buckle up and let's hope some in Washington and Europe find the courage to be bold.

This Path Leads Us To Global Recession

What is most bothersome about the blah-blah-blah we are now hearing from the Republican Presidential candidates and from President Obama is that none of the blah-blah-blah contains any solutions to the economic malaise we are experiencing in the US.  And the same is true of European leaders with respect to the Eurozone's economic problems.

The US economy remains the largest in the world, while the aggregate of the Eurozone country economies is second largest.  If these economies falter any further, we are almost certain to be on a path toward global recession.

We need bold leadership on both sides of the Atlantic to move the global economy toward growth and away from recession --- and we aren't getting any kind of leadership at the moment.

What We Need --- Aggregate Demand

There is lots of talk in Washington (or Iowa or New Hampshire or wherever the presidential wanna-bees are campaigning) about "jobs programs."  Unfortunately, many of these ideas are on-the-margin concepts which will not do very much to stimulate massive aggregate demand.  And aggregate demand is the best way to turn our economy around and to create jobs and lower the unemployment rate.

Further, private enterprise will not add jobs until there is either demand for their goods and services to warrant creating more jobs, or incentives are legislated that encourage self-interest decisions on their part to create more jobs.

My own view is "infrastructure, infrastructure, infrastructure."  (See my prior post on infrastructure investment --- http://theviewfromthemiddleoftheroad.blogspot.com/2011/08/congress-and-president-are-bankrupt-of.html)

Bruce Barlett opined on "aggregate demand" today.  Here is his view --

August 16, 2011, 6:00 am 

It’s the Aggregate Demand, Stupid

By BRUCE BARTLETT  (Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul.) 

With the debt limit debate temporarily set aside, the Obama administration is talking about finding some way to create jobs and stimulate growth. But the truth is that there really isn’t much it can do and it knows it. There may be some small-bore things it can do without Congressional action that may help a little, but the operative word is “little.” The only policy that will really help is an increase in aggregate demand.

Aggregate demand simply means spending — spending by households, businesses and governments for consumption goods and services or investments in structures, machinery and equipment. At the moment, businesses don’t need to invest because their biggest problem is a lack of consumer demand, as a July 21 study by the Federal Reserve Bank of New York documented.

The federal government could increase aggregate spending by directly employing workers or undertaking public works projects. But there is no possibility of that given the political gridlock in Congress and President’s Obama’s desire to appear moderate and fiscally responsible going into next year’s election.

That really leaves just consumers as a potential avenue for increasing spending. But that will be difficult as long as unemployment remains high, thus reducing aggregate income, and households are still saving heavily to rebuild wealth, which was decimated by the collapse in housing prices. Saving is, in a sense, negative spending.

Changes in wealth affect spending because people will spend a percentage of their increased wealth. And they are more likely to raise their spending when the wealth increase is perceived to be permanent rather than transitory.

Historically, people have viewed increases in home equity as more permanent than increases in stock market wealth because they know the latter is more volatile. A recent Federal Reserve Board working paper estimated that the long-run increase in spending from an increase in housing wealth may be as high as 9.1 percent per year.

As home prices increased, many people came to believe they had no real reason to save since they could always tap their home equity — which banks were more than happy to help them do — in the event that they needed funds. Thus the personal saving rate fell from 3.5 percent in the early 2000s to just 1.4 percent in 2005 at the peak of the housing bubble.

Home prices roughly doubled between 2000 and 2006, according to the Case-Shiller index, and many homeowners talked themselves into believing they would continue rising indefinitely. Thus they increased their spending and reduced their saving based not only on actual price increases, but also on expectations of future increases.

A prescient 2007 Congressional Budget Office study explained how this would affect spending and growth in the economy. It said that if people were expecting a 10 percent rise in home prices and instead they fell 10 percent, the impact on spending would be equivalent to a 20 percent fall in prices. The budget office estimated that this might reduce growth of gross domestic product by 2.2 percent per year. Since actual home prices have fallen by about a third, this suggests that G.D.P. may be $500 billion less this year than it would be if home prices had simply remained flat since 2006.

One way that the rise and fall of spending can be visualized is by looking at the velocity of money. This is the speed at which money turns over in the economy. When velocity rises, more G.D.P. is produced per dollar of the money supply. When velocity falls, the economic impact is exactly the same as if the money supply shrank by the same percentage.

The chart below comes from the Federal Reserve Bank of St. Louis and shows velocity as the ratio of the money supply (M2) to nominal G.D.P. It rose from 1.85 in 2003 to 1.96 in 2006. It has since fallen to a current level of 1.66. Thus one can say that each $1 increase in the money supply produced almost $2 of G.D.P. in 2006 and only $1.66 today.

This suggests that the Federal Reserve could have offset the decline in spending and velocity resulting from the fall in home prices with a sufficient increase in the money supply. And it tried. Since 2006, money supply has increased by about $2 trillion. But velocity fell faster than the money supply increased as households reduced spending and increased saving — the saving rate is now over 5 percent — and banks and businesses hoarded cash.

Nonfinancial businesses are now sitting on close to $2 trillion in liquid assets that could be invested immediately if there was an increase in sales, and banks have $1.5 trillion of excess reserves that could be lent as well.

Fiscal policy could raise velocity and growth by getting money moving throughout the economy. But since that is not feasible, the Fed is the only game in town. Joseph Gagnon, a former Fed economist, says that it should immediately increase the money supply by $2 trillion and promise to keep increasing it until the economy has turned around.

But the Fed is already under pressure to tighten monetary policy from its regional bank presidents, three of whom dissented from last week’s Fed decision to keep policy steady. They fear that inflation is right around the corner. But as the Harvard economist Kenneth Rogoff has argued, a short burst of inflation would do more to fix the economy’s problems than any other thing. One reason is that inflation raises spending by encouraging consumers and businesses to buy things they need immediately because prices will be higher in the future.

The right policy can be debated, but the important thing is for policy makers to stop obsessing about debt and focus instead on raising aggregate demand. As Bill Gross of the investment firm Pimco put it recently: “While our debt crisis is real and promises to grow to Frankenstein proportions in future years, debt is not the disease — it is a symptom. Lack of aggregate demand or, to put it simply, insufficient consumption and investment is the disease.”

Shared Sacrifice and the "Super Committee"

In an op-ed piece investor Warren Buffett discusses the concept of shared sacrifice, which should be at the forefront of the dialogue when the "Super Committee" begins its discussions about the ways in which deficit-reduction should occur.  We can only hope ---

August 14, 2011

Stop Coddling the Super-Rich

By WARREN E. BUFFETT

Our leaders have asked for “shared sacrifice.” But when they did the asking, they spared me. I checked with my mega-rich friends to learn what pain they were expecting. They, too, were left untouched.

While the poor and middle class fight for us in Afghanistan, and while most Americans struggle to make ends meet, we mega-rich continue to get our extraordinary tax breaks. Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as “carried interest,” thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they’d been long-term investors.

These and other blessings are showered upon us by legislators in Washington who feel compelled to protect us, much as if we were spotted owls or some other endangered species. It’s nice to have friends in high places.

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

If you make money with money, as some of my super-rich friends do, your percentage may be a bit lower than mine. But if you earn money from a job, your percentage will surely exceed mine — most likely by a lot.

To understand why, you need to examine the sources of government revenue. Last year about 80 percent of these revenues came from personal income taxes and payroll taxes. The mega-rich pay income taxes at a rate of 15 percent on most of their earnings but pay practically nothing in payroll taxes. It’s a different story for the middle class: typically, they fall into the 15 percent and 25 percent income tax brackets, and then are hit with heavy payroll taxes to boot.

Back in the 1980s and 1990s, tax rates for the rich were far higher, and my percentage rate was in the middle of the pack. According to a theory I sometimes hear, I should have thrown a fit and refused to invest because of the elevated tax rates on capital gains and dividends.

I didn’t refuse, nor did others. I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation.

Since 1992, the I.R.S. has compiled data from the returns of the 400 Americans reporting the largest income. In 1992, the top 400 had aggregate taxable income of $16.9 billion and paid federal taxes of 29.2 percent on that sum. In 2008, the aggregate income of the highest 400 had soared to $90.9 billion — a staggering $227.4 million on average — but the rate paid had fallen to 21.5 percent.

The taxes I refer to here include only federal income tax, but you can be sure that any payroll tax for the 400 was inconsequential compared to income. In fact, 88 of the 400 in 2008 reported no wages at all, though every one of them reported capital gains. Some of my brethren may shun work but they all like to invest. (I can relate to that.)

I know well many of the mega-rich and, by and large, they are very decent people. They love America and appreciate the opportunity this country has given them. Many have joined the Giving Pledge, promising to give most of their wealth to philanthropy. Most wouldn’t mind being told to pay more in taxes as well, particularly when so many of their fellow citizens are truly suffering.

Twelve members of Congress will soon take on the crucial job of rearranging our country’s finances. They’ve been instructed to devise a plan that reduces the 10-year deficit by at least $1.5 trillion. It’s vital, however, that they achieve far more than that. Americans are rapidly losing faith in the ability of Congress to deal with our country’s fiscal problems. Only action that is immediate, real and very substantial will prevent that doubt from morphing into hopelessness. That feeling can create its own reality.

Job one for the 12 is to pare down some future promises that even a rich America can’t fulfill. Big money must be saved here. The 12 should then turn to the issue of revenues. I would leave rates for 99.7 percent of taxpayers unchanged and continue the current 2-percentage-point reduction in the employee contribution to the payroll tax. This cut helps the poor and the middle class, who need every break they can get.

But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

My friends and I have been coddled long enough by a billionaire-friendly Congress. It’s time for our government to get serious about shared sacrifice.

Warren E. Buffett is the chairman and chief executive of Berkshire Hathaway.