Thursday, August 25, 2011

Speak Softly But Carry a Big Stick, Dr. Bernanke.

Jackson Hole is risk on the hoof.

This may not be as clear or precise as the St. Louis Fed’s article cited later in this discussion implies that economics can be. That’s because Goodhart’s Law is the important consideration when analyzing “Quantitative Easing.” In economics, Goodhart’s Law states that for policy purposes one can target an economic phenomenon as measured by a particular indicator. However, when one does that, the indicator will lose the information content that would qualify it to play such a role. By targeting the indicator, the policy kills its information content. It no longer conveys the same information about the economic phenomena that one wishes to target.

That is the explanation for the statement: “The issue with quantitative easing is that now they [the Fed] are playing with the shape of the yield curve …since they are buying across multiple maturities. That’s dangerous, and they [the Fed] know it.” ( See: “Something worth thinking about,” November 29, 2010). The posting on August 6, 2011, “US Triple-A Rating And Popular Fiction,” was more explicit about the danger the Fed chose to accept when it initiated quantitative easing. The posting stated: “…basically, when central banks buy bonds across the maturity spectrum and flood the banking system with liquidity, the yield curve and interbank lending rates lose their information content.”

Thus, the yield curve’s shape, one indicator analyzed in “Large Scale Asset Purchases Had Large International Effects” (Christopher J. Nelly, Working Paper from the St. Louis Federal Reserve Bank’s Research Division), may not be indicating what the article concludes. “Large asset purchases” is Fed speak for quantitative easing. There are no doubts quantitative easing influenced foreign exchange rates. Foreign governments started complaining about the weak dollar policy even before it began. However, it is extremely questionable whether the two events the article analyzes provide any guidance about the impact of future similar events.

Operation Twist and the struggle to move to a bills-only open market operation after the Treasury / Fed accord of the 1950’s illustrate the problem the Fed currently faces. Once they take one action that influences the shape of the yield curve, they can’t rely on the shape of the yield curve as a source of guidance for future policy.

Further, my contention is that the traditional post-Keynesian (IS-LM) framework becomes unreliable. Like most macroeconomics, it relies too heavily on comparative statics, and it just pretends to represent time. A dynamic stochastic general equilibrium model becomes a more realistic representation (approximation) of the economic and financial market responses. Variances can no longer be assumed to be constant. The entire discussion shifts. Basically, the economic and financial market responses become path dependent.

Path dependence would explain Vincent R. Reinhart’s comments in the Bloomberg Op Ed, “Markets Go From Nightmare to Bad Dream.” He makes the statement: “In fact, a relatively simple story line runs through recent events. The problem for policy makers, importantly including Fed Chairman Ben S. Bernanke, is that this narrative is consistent with two starkly different paths for the global economy going forward.” He chooses a different explanation for recent events. He notes: “The dizzying price gyrations -- across asset classes and indifferent to national borders -- might be taken as evidence that the market has lost its mooring to fundamentals.” Losing one’s moorings is exactly what path dependency would imply is happening. The dizzying price gyrations determine the future paths the economy could follow. They set a range of attainable future results.

This may appear to be a conclusion with no actionable implications, but it is not. To illustrate again using the St. Louis Fed’s working paper, the article notes: “The increase in bank reserves reflects strong desire for safe, liquid assets that the simple portfolio balance model is ill-equipped to model with its focus on the mean and covariance of asset returns. Therefore the benchmark portfolio balance model does not directly model the market for bank reserves.” One would be hard pressed to fabricate an explanation for current market behavior that didn’t acknowledge an increase in demand for safe, liquid assets. The increase in demand for safe, liquid assets is a logical outcome of path dependence. That is the explanation for the headlines noted in “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!”

An increase in demand for safe, liquid assets is the rational response when covariances are policy dependent. While the jury is still out, one can at least make a coherent defense of the proposition that liquidity-driven asset price cycles should create covariances that converge over an extraordinarily large set of asset classes and national borders. Since the covariances are in question, it undermines other risk management techniques. The net result is that an increase in liquidity creates a greater demand for liquidity. Further, it can’t be ignored since the safe, liquid asset influences the entire yield curve and very nearly every asset’s appropriate relative price.

One can use a Portfolio Management Model (PMM) to illustrate this although more than portfolio adjustment is at work. PMM would suggest that portfolio risk is a function of portfolio composition AND ONE’S LEVEL OF CONFIDENCE IN THE ASSET COVARIANCES.

Assuming away the confidence issue, which may be the more important factor, an increase in a safe, liquid asset could be offset by increasing more risky assets. To some extent, that’s what the Fed is trying to do. But, note that if done en masse, any over-adjustment will make the risk frontier less convex during the adjustment process, but more convex once prices adjust. It introduces the risk of making the risk frontier concave. At a minimum, it risks creating a risk frontier that is not smoothly continuous. A risk frontier that isn’t smoothly and continuously convex introduces multiple equilibriums on all or some risk frontiers. At the extreme with concavity, the two extremes could both be optimums. Personally, the change in levels of confidence seems the more important issue, but they aren’t required for the entire portfolio balance model to be explosive.

In “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” two questions were posed and answered: “Does it create a potential liquidity trap? Does it focus reserve management on the asset that is the current source of systemic risk? Yes, to both.” Using a liquidity injection runs the risk of creating a situation where safe, liquid assets are a larger and larger component of the optimum portfolio. Further, there is no guarantee that the increase in expected returns to risky assets can be raised fast enough to offset the increased expected return from a low risk asset. Under that scenario, the net result would be an optimum portfolio composed of just the safe, liquid asset. In the common vernacular, the market participants conclude that not losing is a higher return than any potential positive return. Heard that lately? If not, get the beans out of your ears.

The idea that an “Operation Twist” type of maneuver can avoid this problem is appealing. If it could be done instantaneously (i.e., if comparative statics were all that was required), it would be very appealing indeed. However, the adjustment process necessitates a period where covariances will break down. Why people assume that the covariance matrix is stable escapes this observer. Stability of the covariance matrix seems like a particularly silly assumption when policies that will destabilize it are the current rage.

In “Default, Downgrade, Lions, And Tigers And Bears; Oh My!” there’s a passing comment: “One has to admit the idea of a risk-free rate of return was truly a beautiful fiction. It allowed a massive financial edifice that spit out certainties at an amazing pace. Never mind that they were fiction.” The St. Louis Fed’s article is a good illustration. It’s an excellent analysis if one remembers: “Beware the risk-free return.”

A disclosure is in order: The St. Louis Fed’s and NY Fed’s research websites are among The Hedged Economist’s most heavily used favorites, which is in no way a slight of the other Fed bank’s research. At some point, The Hedged Economist will add links to favorites. More than likely the Fed will be represented by one link, but clearly anyone seriously interested in the economy should be familiar with every Federal Reserve Bank’s research focus.

Saturday, August 13, 2011

Unfinished Business

That’s what happens when you post blogs in anticipation of events

Well, hopefully, readers of this blog haven't been surprised by the volatility the last few weeks. In fact, this observer has been a little surprised by how orderly the adjustment process has been. People are doing fairly well at coming to grips with the reality that there is no such thing as a risk free return. Now we’ll see whether they can cope with reality without going berserk. Uncertainty is an uncomfortable state.

Their adjustments to the liquidity requirements that uncertainty implies have been going on for a while. Often those adjustments were made over vocal criticisms by our national leaders whose astute financial management has been on display front and center this last month.

The posting “Who’s Crazy?” lamented the fact that people seem to have become a bit “unhinged.” Oh, that it were a generalized phenomenon. If it were, we could just undergo collective counseling. Unfortunately it seems to be concentrated among people who survive on other people’s money (Wall Street and Washington). They, of course, fascinate the media. By contrast, those who focus on managing their own affairs, or the affairs of the companies they manage, have been busy deleveraging.

But, before turning away from this collective foolishness, a few comments are justified. First, a pair of follow ups comments on the downgrade.

Let’s start with a heartfelt request: please take at least one day off from the blame game. It’s getting tired. It also has been, and is getting increasingly, destructive. It’s the opposition party’s fault. It’s S&P’s fault. It’s foreigner’s fault. It’s anyone who disagrees with your position’s fault. It’s everyone’s fault except yours. There, it been said; so give it a rest.

We can also dispense with the absurd. It will be interesting to watch the circus surrounding the investigation of insider trading associated with the S&P downgrade. It might have happened, but S&P did everything it could to telegraph the move. Who the heck were the outsiders? The trade should be interesting, also, since Treasuries actually rallied on the news. Given that it had been so completely telegraphed, what was the trade? Buying Treasuries?

The issue of what to do to promote a recovery won’t go away. Therefore, it isn’t urgent. Nevertheless, let’s finish with a follow up on the issue the last posting sought to address. Macroeconomists can focus on aggregates, but effectiveness is determined at the micro level. So, beware macroeconomists bearing solutions. Whether right or wrong, they sometimes end up just providing cover for waste. That’s very unfortunate because they have a lot to offer.

Sunday, August 7, 2011

Bye, Bye, Triple-A. Gone, But Not Forgotten

Hello AA+.

It’s nice being ahead of the curve. On July 26, The Hedged Economist posted “The US Will Lose It’s AAA Rating.” Since then, the wait for it to happen allowed time to write four other postings that discussed the topic. So, while others are busy figuring out, or writing about, why it happened and what it means, this blog can focus on more constructive things. But, before leaving it, some explanation is warranted.

Back on April 1, 2010 this blog warned “Beware the risk-free return.” A lot of people are going to be throwing around a lot of money as they adjust to the realization discussed in that posting. The steps they have been taking, the impact of those steps on markets, and the risks that creates were discussed in the postings since July 26. For an excellent example of how risk-free return has been incorporated into financial thinking, see “S&P Downgrades U.S. and Dulls Sharpe Ratio” by Richard Shaw on SEEKING ALPHA. It may seem cavalier to dismiss the downgrade simply because it’s just recognition of a reality that always existed. That would be a mistaken impression. It’s a serious concern, but it has already been discussed.

The downgrade will have a negative impact on all of us, and it will touch off totally unpredictable consequences. Yet, to date, market responses have been exactly what one would expect when adjusting to a previously unrecognized risk. The big question is, have enough people adjusted their liquidity to levels where they can weather what will follow to prevent the adjustments from snowballing? Otherwise the liquidity phase and then counterparty-risk phase of the meltdown of 2008 will be repeated.

As this is being written over the weekend of the downgrade, the only comment The Hedged Economist has is that in “Investing Part 3: Setting the Volume” (posted on December 19, 2010) this blog provided some relevant advice for individual investors. It thus explains how some individual investors have positioned themselves to be sanguine about recent and near-term market behavior.

How we made financial markets more vulnerable to risks associated with the adjustment we are undergoing were discussed in “Liquidity Is Dangerous” (posted on May 23, 2010) and “Fictitious Liquidity” (posted May 28, 2010). But, nothing created more risk than the persistent belief that a risk-free return was a viable assumption.

The more important issue is how to get the economy growing at an acceptable rate. If the US, the government, and the population in general, display some modicum of responsible financial management, it will help. With that as introduction the question now should be how do we get triple-A back. After all, the world isn’t going to end just because the US government has demonstrated financial mismanagement. The US can continue the blame game or face reality. We all know the blame game is fun, but perhaps it’s time to start acting like responsible adults when it comes to public finance. That raises the issue of what can be done.

First on The Hedged Economist’s list of what has to be done is to get rid of politicians who say give me more money or I’ll default on what was lent to the government in the past. Trying to hold previous lenders and the economy hostage as a way to negotiate for tax increases is wrong. That’s not a statement on taxes: it’s a statement on financial management. If taxes are justified, make the case based on a real justification. A good financial manager would reassure lenders first. Then he or she would turn to methods of generating the cash needed to pay them. In short, we need leaders who say our credit is good, not one who puts politics first.

Right behind that comes getting rid of financial managers who say borrowing is the only way to meet our current obligations. It may be the best way, but it is never the only way unless the financial situation is already in the proverbial debt death spiral. As a country with control of its currency and its exchange rate as well as many national assets, the US is far from that. Further, as argued above, taxes are an alternative to borrowing. So, anyone who would say or believe more borrowing is the only solution should be given a job more commensurate with their capabilities.

For sure get rid of a financial management team that combines the two missteps above. Getting a triple-A rating back while the current financial management team is in place would only indicate that someone in the government got to someone at S&P. Because of that, it probably won’t be taken too seriously by financial markets.

Now, this isn’t a partisan issue. Those in Congress who advocate a default are dangerously close to the often quoted example of yelling fire in a crowded theater. Advocating no taxes is not the same as advocating no debt payments. The first relates to cash flow management. The second relates to the balance sheet. What’s particularly odd about combining the two is that “no more taxes” is often defended by drawing a parallel between taxes and confiscation. How this is combined with an explicit call for confiscating wealth held in Treasuries escapes this observer.

Ultimately, the triple-A rating should be based on a widespread belief that one should take paying back debts seriously. Politics isn’t the only place where American’s fail to project that image. We are a compassionate people, but our efforts to be compassionate often come off as a collective view that paying debts is optional, only to be done if convenient. Well, deleveraging is never fun, yet many American’s are doing it. It isn’t convenient.

Decent financial management isn’t a partisan issue. If it were, it would seem members of one party or the other should be indifferent to their personal credit scores developed by the consumer credit bureaus. Unfortunately, we collectively, through our politicians in both parties, have displayed just such indifference. Yet, no one in either party should overlook the fact that only one party manages the national government at any time. They’re called the executive.

The debt rating is a small part of what is needed to restore growth. Numerous bipartisan and partisan recommendations are floating around. The initial concept for this posting was to focus on one proposal. As a good economist, The Hedged Economist planned to address opportunity costs, but to avoid a broad discussion that invited philosophic debates. To do that, the plan was to restrict the options that could be discussed. The planned approach was to take a Democratic proposal, essentially concede the conceptual desirability of the proposal, and restrict the discussion to method.

In preparation, the following information was circulated to a few economist and others who have commented on this blog.
The quotes are from “White House Renews Push to Extend Payroll-Tax Cut.” WALL STREET JOURNAL (August 6, 2011)

“The payroll-tax holiday for employees was enacted in December and expires at the end of this year. By lowering Social Security payroll taxes paid by employees to 4.2% of earnings from 6.2%, it saved taxpayers as much as $2,136 each this year…The break did not extend to the 6.2% payroll tax paid by employers.”

“Treasury Secretary Tim Geithner thinks the Democrats have a winning argument, and expressed confidence Republicans would not stand in the way of extending the tax break for workers…'I think it's very hard for them to stand up and say that they're going to try to block the extension of that tax cut that's worth about $1,000 a year for the average American family,' Mr. Geithner told ABC News.”

The quotes were accompanied by a question: “Does it seem to you that they’d get more job creation if the cut were on the employer side?” To the economists, I added an acknowledgement that theoretically they are both reductions in labor costs, the intent being to avoid their having to address that issue. Well, this little experiment was a total flop in terms of its original intent. Nevertheless, it was extremely informative.

Two things stood out. The people who responded almost universally indicated a belief that this policy had no (to no measureable) impact on jobs or growth. The strongest Democratic backer endorsed it as income redistribution, but criticized the deficit impact and lack of economic impact. The strongest Republican criticized the political posturing embodied in the current structure of the tax break and its lack of impact on the economy. Economist’s focus on aggregate demand or capital formation depending on their orientation, but they viewed this particular issue as a sideshow. But, there was an almost unanimous lack of belief in the effectiveness of the measure as stimulus.

Second, an overwhelming majority of respondents, couldn’t, or wouldn’t, separate this issue from broader policy issues. Those broader issues drew them away from addressing opportunity costs within the confines of the structure of this policy initiative. One might expect that to have related to the deficit and debt issues given the downgrade, but that wasn’t the case. Deficits and debt were mentioned by some respondents, but generally the focus was elsewhere. Perhaps opportunity costs outside the confines of this issue just overwhelm this issue.

The Hedged Economist’s conclusion is that structured the way it is, this policy seems more like a vote buying program than an employment stimulus. What scares me is our Secretary of Treasury thinks that’s a win. It may be a winner on a popularity poll, but I’m not so sure it’s a win for Treasury, the unemployed, or the economy. Any small difference in effectiveness would mean fairly significant differences in new taxes paid, some greater reduction in unemployment, and more demand.

All that may seem interesting, but hardly worth noting except that opportunity costs are an important issue. My discussion of “the stimulus” focused specifically on the shortcomings of previous analysis of “the stimulus.” They set up a fictitious counter factual in order to avoid the difficult issue of addressing the true opportunity costs. (See: postings throughout September 2010 starting with “Stimulus more or less? A failure not being acknowledged. PART 1”).

Where does this lead? While good, responsible financial management is easy to identify, economic policy questions like the right level for the deficit or taxes are much harder to discuss without appearing partisan. Even separating out one small policy issue seems almost impossible. That in itself doesn’t bode well for developing an effective growth strategy. But, if we politicize our judgments about what is good financial management, continuous crisis is inevitable.

Saturday, August 6, 2011

US Triple-A Rating And Popular Fiction

Previous postings addressed triple-A “as” fiction so why not one on “and” fiction

In “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” and “Default, Downgrade, Lions, And Tigers And Bears; Oh My!” the difficulties and risks associated with abandoning fictions were discussed. So far mass delusions haven’t been address. It’s time. So much fiction is associated with triple-A that it will be necessary to skip many fictions, perhaps to be addressed later. So, let’s dive into the important stuff. Hopefully, previous postings have made clear that the very idea of a risk-free return is a fiction, so it can be skipped.

Back in May of 2010 in a posting about bonds as an indicator entitled “Debt markets as an indicator or trade,” The Hedged Economist introduced the discussion with this summary of why bond markets weren’t an indicator; they were the cause: “Once debt markets realized how many people weren’t going to pay back their borrowing, debt markets froze. It started with mortgage debt, but spread via the shadow banking system. The cause of the spread was that liquidity was needed to adjust for the mis-priced Mortgage Backed Securities. The rush to liquidate (i.e., get liquid) rippled through every market in the shadow banking system. Any market and therefore any organization with a liquidity mismatch became vulnerable. That transformed a liquidity- driven contraction into a generalized fear about counterparty solvency. That was one of the unintended consequences of mark-to-market accounting as interpreted under Sarbanes Oxley.”

Well, the indicators of bond market stress have changed since then. They changed mainly because steps taken during the financial meltdown have suppressed the informational content of the behaviors in the markets discussed in that posting; they transfer the indications of stress to other markets. It would require a broad, complicated discussion to explain it in detail. But, basically, when central banks buy bonds across the maturity spectrum and flood the banking system with liquidity, the yield curve and interbank lending rates lose their information content.

One thing that is clear right now, regardless of whether the triple-A is lost, whether it was ever deserved, and what its loss will do. In mass, investors are adjusting to the reality that another group of borrowers aren’t “going to pay back their borrowing.” This time it’s sovereigns. Sovereigns have all sorts of ways to avoid paying back their debt. However, despite the showmanship in Washington, as the last three posting show, there should never have been an issue of outright default in the US.

By contrast, downgrade is a real risk and probably inevitable. We elected a president who says that if the public doesn’t cough up more money in taxes, we may default, and we have a Treasury Secretary who says that if we can’t borrow more, we’ll default. That just isn’t a triple-A financial management team. Either they don’t understand the real financial status of the government or they’re lousy financial managers. Even if what they said were true, that would indicate we’re hardly a triple-A credit. The fact that they represented it as true demonstrates that we’re not a reliable credit while they’re in office. But, as mentioned in “The US Will Lose It’s AAA Rating,” having a vocal fringe advocating a default only compounds the perception that we don’t take paying back our debts seriously enough to deserve triple-A.

What spreads the dislocation is the realization that the new risk means there are mis-priced assets, in this case Treasuries. That has a balance sheet impact on any organization holding Treasuries as prices adjust to the downgrade risk. Banks held $1.6 trillion in U.S. debt, agency securities, and government-backed mortgage bonds at the end of the first quarter according to Federal Reserve data. These firms also held over $80 billion in debt issued by states and local governments. State and local government ratings tend to be downgraded with the nation’s rating.

That has economic implications. When, and if, the new risk to Treasuries is priced in (“if” because the Fed could offset it), the banks will have to lend less to the private sector in order to rebuild their balance sheets. Further, banks face some obstacles to diversifying in order to reduce the risk. Why? For regulatory capital purposes, U.S. Treasury obligations normally receive a 0% risk weighting, while debt associated with agencies such as Fannie Mae and Freddie Mac are typically at 20%.

Pension funds and insurers have a similar exposure, but the focus on banks illustrates the link to the economy. Pension funds and insurers are also much bigger, so even if they hold more Treasuries, the Treasuries may represent a smaller portion of their portfolios. Banks hold more combined Treasuries and Treasury-backed bonds than either China or Japan. Sovereigns tend to only hold actual Treasuries. They all pale compared to the SS and Medicare funds. But, mark-to-market loses have little impact on SS and Medicare trust funds. They just ignore them. Similarly, the Fed, which also owns Treasury-backed debt, can just ignore the balance sheet impact.

As this was being written on Thursday August 4th, the markets were making exactly the move to increase liquidity as were described above in connection with the 2008 crisis. In some markets, it’s very orderly, while others were gapping (i.e., showing big price and volume changes between trades, called ticks). Commodities, including gold, stocks, bonds and currencies were all displaying the same underlying traders’ motivation.

However, the big difference this time is that no one was surprised by the sovereign debt issues. So, the move has been occurring over time. For example, complaints about corporations and banks holding cash have been on display for months. When borrowers aren’t a good credit risk and the sovereign debt is mis-managed, cash is a rational asset. Almost everyone who doesn’t understand that fact has chimed in, often without even checking their definition of cash. By threatening default the administration almost guaranteed a liquidity trap. They did it in a way that precludes their taking the steps one should take to address a liquidity trap, thus increasing the risk of a recession.

Friday showed another aspect of discarding fictions. As predicted in “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” volatility increased. The previous posting explained: “Because so much of the financial system as well as the public have been forced to make the adjustment rapidly, the risk of over shooting is very real. Consequently …volatile behaviors [previously] brushed aside are made more volatile” and “The ‘culture shock’ as people abandon one paradigm and adjust to another is another risk. It can freeze people in place or set off volatile behavior in totally unpredictable ways.” By the close, Friday didn’t disappoint in terms of volatility.

With that as background, let’s turn to popular myths. This one seems to be a fiction associated with the growth of media. It relates to the 24 hour news cycles, and also relates to the need to fill 24 hours. Basically, it involves fictitious segmenting of a single phenomenon.

To illustrate, let’s examine the stock market. There will be an explanation of the drop that purports to explain Thursday’s fall. It will differ either slightly or dramatically from what has been used the last few days, in fact all of July. The volatility on Friday will generate a different explanation. That’s the fiction created by the 24 hour news cycle. Similarly, there will be separate explanations for gold, oil, metals, stocks, bonds, and, if you dig, currencies. That’s needed to fill the 24 hours. The driver has been the same: adjusting to the risk associated with sovereign debt, specifically, in the US, the downgrade risk.

On some days a unique phenomenon may produce some quirky behavior in one of the markets (e.g., a crop failure or new harvest estimate, a margin squeeze, a default), but often one market’s performance is driven by another with a single factor driving both. But, by segmenting news, the fiction that what happened running up to August is now over is thus created. That ignores the obvious fact that when the President threatens default, people remember. It influences their behavior for a long time.

While one political party’s linking the debt ceiling to the budget was bad enough, the administration’s linking it to default will do more long-run damage than any single budget could do. The President’s and Geithner’s behavior was particularly irresponsible because they weren’t even negotiating with the principals on the debt issue. Ultimately, lenders, not Congress, will put an absolute ceiling on the debt. To illustrate, envision a future Congress raising the debt ceiling to infinity with no strings attached. Could the government then borrow an infinite amount? No. In fact, the real debt ceiling in the sense of what we could actually borrow would probably fall.

The notion that the debt ceiling deal “kicked the can down the road” is an increditable common fiction. As mentioned, the administration and Democrats approached the negotiations as if they were negotiating with a principal. In their posturing, they weakened their position with the principals by threatening a contrived default scenario. By threatening default they actually reduced the confidence of lenders which moved the threat of poorer borrowing terms forward in time. Further, as widely recognized, they made the AAA rating a bit of a joke internationally.

The genie is out of the bottle, and the new 24 hour news cycle won’t make it go away. To those of both parties who think paying national debt is an option or even that it can be discussed as if it was considered an option, the answer is simple. That’s not the behavior of a triple-A creditor. While the nation isn’t bankrupt, those philosophies are.

Now, let’s deal with the silly notion that the rating on the national debt is only a government issue. Seems to me we elected these people. If one didn’t vote, one allowed them to be elected. Our nation’s debt rating is a reflection on all of us. It’s funny that people will follow their credit score and think it’s important, but be cavalier about our collective credit rating as if they are an island standing apart.

At the other extreme, there are people who don’t care whether others expect them to try to pay their debts; they feel that paying their debts should be their unencumbered choice. Worse yet, there are people who think it’s unfair for people to expect to be paid back. They ignore the fact that it will have an impact on credit availability. Why? Because it is close to impossible to make someone lend money.

Now, a very important fiction: many people have a very self-centered view of what’s important. Since the triple-A rating has only an indirect link to their wellbeing, they assume indirect implies unimportant. The two aren’t equivalent. This has reduced the wellbeing of everyone.

One final fiction must be noted: some readers will think this posting reflects a political posture. The response to them is: please, remember this posting said nothing about any of the issues that the last posting ducked, like size of government (See: “Balanced Budget And Balance Budget Amendment: Dangerous Fiction”). It also never said whether the debt ceiling should have been linked to the budget, and it actually implied it shouldn’t have been linked. Finally, it never addressed whether the debt ceiling should have been raised or how much it should be raised. Even those who wish to see blame should have been disappointed. It’s about what happened and what it implies. Throughout this posting the focus was on financial management and economics.

Friday, August 5, 2011

Balanced Budget And Balance Budget Amendment: Dangerous Fiction

Sense or non-sense and will it ever happen?

First some ground rules. Both the idea of a balanced budget and a constitutional amendment are discussed in terms of an amendment. But, everything said applies to both. Also, this posting isn’t going to address the “right” size of government, nor the question of whether the right size of government changes over time. It’s also going to keep as much distance as possible between the posting and questions about what determines the right size of government. Now that all the people who stumbled onto the posting looking for a rant have left, let’s look at what is discussed.

Every effort is made to approach the issue as a budgeting and financial management question. Just in those terms, a balanced budget amendment isn’t a quick fix or silver bullet. In fact, it’s not even a quick fix for some other issues such as those the posting chose to ignore, and just from a financial management perspective the issue is more complicating than one might think.

The first question one should ask is: Could a balanced budget amendment work? Keep in mind we still haven’t addressed whether one is desirable or what it would be designed to accomplish. However, the starting point should be to acknowledge who makes the accounting rules that determine whether the budget is balanced. For all practical purposes, the government makes up its own accounting rules. So, in the strictest sense the answer is: A balanced budget amendment can’t force the government into a specific budgetary action.

The second question, one that follows directly from the answer to the first, is: Short of “control,” could a balanced budget amendment influence the government’s behavior? There can be little question that it conveys intent. Further, for good or bad, it could involve the judiciary in the process if someone decides to take the interpretation of the rules to court. That would make it necessary to change the rules, not just bend the interpretation. Bending interpretations is loophole government’s love.

Also, there is overwhelming evidence balanced budget amendments influence behavior at the state and local government levels. However, as many state pensioners and taxpayers are learning the hard way, the resulting behavior isn’t always what was envisioned. Unfunded promises and hokey forecasts are far too easy a response. They’re tricks every politician knows.

Finally, the consequences of violating the rules could be structured in a fashion that encourages compliance so that sanctions for violation are irrelevant. (An example using term limits will follow). So, the answer is clearly: Yes, a balanced budget amendment would influence behavior. But, not always in the way intended.

The third question is: Does a balanced budget amendment make sense? We’re still at a fairly abstract level since we haven’t defined a balanced budget amendment. Yet, even at this abstract level, annual budget balancing is a silly idea. People don’t do it, sometimes in folly, but often for good reason. People have capital accounts or balance sheets. Money is flowing in and out of those capital accounts making a balanced budget for any year unnecessary and often highly undesirable.

It is folly to balance cash flow accounts for any fixed period of time, certainly on an annual basis. That would make NO provision for the purchase of any asset with less than a one year payback period. There would basically be no fixed capital. Kiss the manufacturing base good-by if everyone does it. Similarly, it would preclude time-purchase of any consumer good where the value of the first year’s benefit of having the good was short of the purchase price. Basically, there would be no owner-occupied homes, few if any appliances, probably no cars, and probably no horse and buggy for that matter. Fortunately, people both acquire assets and borrow to invest and consume, but as discussed previously in “Truth In Lending” and “Borrowing For Investment,” not always for good reasons.

People do manage balance sheets as well as cash flow, although not always consciously or well. By contrast the Federal government does its accounting on a cash flow basis. It very conveniently ignores its balance sheet. That approach substantially increases the likelihood of errors – errors in each step and cumulative errors. To illustrate the risk on each step, both the initial Boehner and the Reid proposals to end the deadlock on the debt ceiling came up short when scored by CBO. For cumulative error, how have the forecasts of Medicare and Social Security faired?

The absence of a balance sheet seems to totally confuse some people. The Hedged Economist is of the opinion that some people in government don’t even understand a balance sheet. They’re expert cash flow managers, but wouldn’t have a clue about relating cash flow to a balance sheet. That’s not all bad. Others understand the relation, but intentionally use it to their short term advantage. Cash flow managers are important, but they aren’t enough.

The conspiracy theorists fabricate sinister motives for the absence of a balance sheet. It never occurs to them that the government can’t construct a balance sheet.

Why can’t the government construct a balance sheet? Well, what is the present value of the right to print the money? What’s the present value of the authority to collect taxes? You need those calculations since they are government assets. Think you’re getting close despite the obstacles? Well, what’s the present value of the ability to influence, some would say control, even set, the interest rate used to determine all those present values? Can’t be determined is the answer.

Some extremists resort to: “Well, the government shouldn’t be doing all those things.” Sort of, if I can’t figure it out, it should be illegal. But, then what’s the right to make it illegal worth? Furthermore, if they can make it illegal, they can decide to not make it illegal. What’s that worth? Note that we haven’t even broached the subject of the value of the exclusive right to make war or enforce laws.

It gets just as complicated when one starts thinking about the physical assets the government purchases. Does one carry an aircraft carrier at its acquisition cost, and how is it depreciated? Is it worth more if there is a war? Or, is its purpose deterrence? If so, should all defense expenditures be written off in the event of a war? Perhaps, written down based on the size of the war? What’s the value of the capital building, white house, Air Force One, the entire federal triangle, every military base, all public lands, mineral rights, and control of the offshore? How should they be depreciated?

Given the absence of a balance sheet, any balanced budget amendment would have to focus on cash flow. It would be flying blind in the same sense as people who borrow or invest without thinking about their balance sheet are flying blind. Thus, a balanced budget is almost guaranteed to lead to mistakes if based on annual fiscal years. So, a balanced budget amendment based on balancing the budget in each of the government’s annual accounting years would be financially irresponsible. It was put more bluntly in the earlier statement: Annual budget balancing is a silly idea, and as discussed in “The Only Truth About Finance,” it’s a sure fire way to always be broke.

Back in 1776 Adam Smith pointed out that the wealth of a nation is determined by the productivity of its people. If the wealth of a nation is the productivity of its people, it seems logical that the government which is, after all, a creation of those people, is somehow related. The relationship is fairly direct: the more productive the people, the higher the value of most of the government’s assets. What they’re worth is a guess, but they are worth more in a wealthy (i.e., productive) nation; that isn’t questionable.

So, while constructing a balance sheet for the federal government is impossible, the exercise of thinking in terms of balance sheet and cash flow is possible and desirable. It defines the appropriate accounting period. Since the value of the government’s assets, what it has that serves as collateral, is largely determined by the economy, the economic cycle is a reasonable accounting cycle. But, since policy influences the cycle, a policy error can influence the accounting cycle. Given the feedback, some “normal” cycle expectation is needed as a control.

As cycle analysts, the dreaded cycle theorists, have documented, there really isn’t one cycle. But, absent some substitute for a balance sheet and a defined accounting period, we have seen that the potential for cumulative errors mentioned earlier isn’t a potential, it’s a darn good forecast. In the US and around the world, governments make the same cumulative error. So, the logical question is, can the uncertainty and need for some control of cumulative errors (whether deliberate or mistakes) be addressed through a balanced budget amendment?

Fortunately, the founding fathers had some good ideas about how to structure a government. (No, there isn’t a question about the present value of the constitution even though it has great value). Let’s look at the structure and note a few things. First, they divided power between branches of the government and the chambers of the congress. Second, they set up different length of time in office for different institutions.

So, there isn’t a way to clearly link cycles, the appropriate accounting period, to everyone’s terms in office; the terms differ. But, clearly it is the people who are in office that a balanced budget amendment has to influence. Government is those people functioning within the framework of government. Perhaps the framework for a balanced budget amendment can be adjusted in a way that takes advantage of differences in periods of time in office, and takes economic cycles into account.

The separation of power and the different periods of time in office provide some levers that can be used. Here’s how. Link the balancing of the budget to the ability to run for re-election (i.e., term limits). This would be most important for the legislature. But, in order to accommodate the uncertainty associated with economic cycles, don’t make the limits the same for all chambers of the legislature.

For example, if a House member has served some number of terms, he or she can only run for re-election if the budget has been balanced on average during the most recent some number of terms of service. The Hedged Economist favors three terms or six years. That’s long enough to accommodate Keynesians who want deficits during economic slowdowns without being so long that it accommodates those pesky cumulative errors mentioned earlier. But, the key is that whether it three terms or four, it provides an incentive to run both deficits and surpluses.

The Senate doesn’t need incentives that are exactly the same. So, again, some number of terms seems appropriate; two terms or twelve years seems a good starting point for discussion. You may wonder: Why different periods? 1) The constitutional framers envisioned spending bills usually originating in the House. 2) Keynesian demand-driven cycles aren’t the only things that produce economic cycles. Having one chamber that could focus on longer cycles wouldn’t be harmful. (Granted that’s irrelevant if all politicians continue their short-run focus). 3) It would give the far left a focus. Face it; there are people like Paul Klugman who has never seen a deficit he didn’t like, except that he always feels they should be bigger. Yet, the term limits set at two unless the budget is balanced would keep their mistakes from becoming cumulative.

Finally, since the executive branch proposes rather than enacts, either leave it out or link a re-election run to executive budget proposals. Theoretically the executive is administering a budget set by the legislators. Letting a president serve two terms regardless seems reasonable. But, we can’t just ignore the veto. Yet, two terms doesn’t seem too long. Hopefully the judiciary can be left out of it.

Now let’s look at what’s left to consider. What’s been discussed so far only addresses the cyclical issue. The entire discussion originated from the implications of the economy for the assets on the government’s balance sheet. The economy doesn’t just fluctuate; it tends to grow from cycle to cycle. One could argue that as GDP grows, the assets increase in value creating greater debt-carrying capacity. It’s a legitimate balance-sheet-based argument.

However, debt carrying capacity also involves cash flow. One can easily envision expenditure and tax responses to changes in income that could make balanced budgets a disaster under either a growth assumption or during contractions. It involves speculating about the elasticity of asset value, revenue (cash income), and expenditures.

There is, however, a saving grace in the term limits approach. The parties involved have the control to change the structure before the consequences force them from office. For example, if economic growth produced expenditure growth that accelerated too rapidly, the legislators could change either the revenue structure or the expenditure structure. In this respect, previous periods under a balanced budget regime would make the process easier since simultaneous disequilibrium on the balance sheet and in revenue or expenditures would be less likely, not impossible but less likely.

Finally, once one broaches the subject of the response to long-run trends, it is impossible to avoid all the issues this posting tried to avoid. But, contrary to the belief of many people on both sides of the balanced budget debate, a balanced budget doesn’t address the size of government. If both revenue and expenditures grow faster than the economy, the government could grow to include most of the economy. The opposite is also true. People forget that many expenditure and revenue-related government items are indexed because of the funky way they respond to changes in nominal income.

So, back to the question of could a balanced budget amendment be structured in a way that makes sense? The answer is: Yes, a balanced budget amendment can be made sensible in the US. But, it sure wouldn’t look like what most people think of when they say balanced budget amendment, and it would accomplish few to none of the objectives of either advocates or those who oppose it.

So, that brings us to the real concern: Is a balanced Budget amendment desirable? Here’s a unique answer. A balanced budget amendment is an embarrassing admission of the failure of our governing system as currently designed to automatically generate responsible budgetary behavior. In that respect, one answer is: It seems just having to ask the question is undesirable.

There is a broader negative associated with a balanced budget amendment. First, if the US starts out in disequilibrium, a balanced budget provides no mechanism for restoring equilibrium. To illustrate, after World War Two, the war effort had created a debt-to-GDP ratio similar to the current ratio. It had also created tremendous pent-up demand (for investment in plant and equipment to retool from war to civilian production and for consumption after a period of rationed consumer goods and forced consumer sector saving). While growth was the major mechanism for bringing equilibrium to the GDP-to-debt ratio, surpluses, not balanced budgets also contributed. While the example uses a high debt to GDP ratio, the opposite situation can also exist.

Second, a balanced budget amendment ignores the real issue which is, in fact, the balance sheet. While the debt-to-GDP ratio provides some guidance because GDP bares a rough relation to asset value, debt has become a lousy proxy for liabilities. The reason is exactly the same reason some states are in a fiscal crisis mode. Politician have long since learned that promises of future “entitlements” are a more effective way to buy votes than current expenditures. More effective because the absence of a current cash cost and no balance sheet on which the liability appears make it possible to deliver more goodies for less. Basically they get more bang for the buck. Thus, governments have shifted from resource allocators to entitlement allocators.

So, a balanced budget amendment isn’t desirable because it ducks the important issues. It ducks the issues this posting intentionally avoided. Worse still, it ducks the issue of responsible debt management at the federal level. It perpetuates the myth that politicians can ignore the difficult and uncertain (and yes indeterminate) chore of thinking realistically about the government’s balance sheet.

So, that leaves the question: Will it happen? This last question is the point where the issue of an amendment to the constitution has to be separated from the question of whether the budget will be balanced.

The second question is addressed first because the answer is easier. Yes, at some point the budget will be balanced. More than likely it will occur temporarily on a path from deficit to surplus. If not, a balanced budget will be forced on us by an absence of lenders. On the question of an amendment, let’s hedge the bet. Probably enough people will recognize that a balanced budget amendment is financial mismanagement to keep it from happening. If it does, it will be repealed faster than prohibition. But, the entire discussion of linking it to term limits was a hedge. People do the darnedest things, especially when it comes to financial management, and The Hedged Economist is never surprised when, collectively, politicians do dumb things. Smart individuals can do increditably foolish things when they become a crowd.

Monday, August 1, 2011

Default, Downgrade, Lions, And Tigers And Bears; Oh My!

Report from the Land of Oz

The last post, “Default: Won’t Happen. Downgrade: Fear Not; Our Best Generals Are In the Field!” talked about the difficulty of adjusting to the reality of uncertainty. Embedded in the discussion was the misplaced comfort associated with a good, working fiction.

To illustrate, In Congressional hearings Standard & Poor's President Deven Sharma was questioned about contacts his agency had with Geithner and others in the administration before it issued its initial downgrade warning in April. Sharma pointed out that consulting with those issuing a bond is standard. Of course congress was told the same thing in connection with bank- issued mortgage-backed securities and asset-backed securities issued during the credit bubble. Then congress members, especially Democrats, flipped out about it being proof of conflict of interest, thus contributing to the very convenient fiction of the great Wall Street conspiracy.

Sharma told the panel that officials at the agency had allowed Treasury officials to review a draft of the S&P press release warning before it was issued. He said that was done to make sure that there were no inaccuracies in the press release. He pointed out that this was standard S&P practice and did not involve any special favors for the U.S. government. Think the same congress members will flip out again? Where are Barney Frank and Henry Waxman and their rants about conflict of interest? No, they’re far too despondent watching their pet fiction turned on its head. But, at least we have a new fiction to embrace. It is so much more comfortable to believe there’s something sinister at work. It’s a good working fiction.

Jules Kroll, chairman and chief executive of Kroll Bond Rating Agency questions whether private enterprise should be in the business of rating sovereign debt. Mr. Kroll's firm was launched last year to challenge S&P, Moody's and Fitch. Talking his book, me thinks. But his statement struck a cord with many Americans. What’s behind the sympathy his comment evokes. Well, if the government has a good working fiction, damn freedom of speech; don't rock the boat. But, it’s hard to keep a fiction working once someone notices. To keep the AAA fiction going, it may be more important to address the media rather than rating agencies. We also need to control opposition parties. Worse yet, we may have to address the reality of our debt. No, no, what a bad idea; after all what’s fiction for if not to escape reality.

The conspiracy theorists’ conflict of interest argument favors the belief that the US should have been downgraded before. Egan Jones, who is paid by bond holders rather than big issues like the US, downgraded the US about a month ago. Europeans’ can’t understand the absence of a downgrade. It’s a fiction that the experts always know. But, that’s a more comfortable fiction than accepting the fact that in some instances no one knows.

Since The Hedged Economist never believed the popular fiction of a risk-free return, AAA verses other prime ratings like AA isn’t as big a concern, certainly not lions and tigers and bears from a financial management perspective. As stated in the posting entitled, “The US Will Lose It’s AAA Rating,” it will be a disappointment, but not a surprise.

As noted in a previous posting, this blog noticed that people tend to be more interested in postings on policy than postings on an individual’s financial management. The downgrade or default issue is a perfect illustration of why both are important. It also illustrates why the focus of this blog bounces between them. The series on investing was an exception in that it focused exclusively on financial management. It was a necessary detour.

Without the series “On Investing” some of these comments about policy could lead to financial folly. For example, adequate liquidity, a diversified portfolio that includes real estate, stocks (domestic and international), bonds including Treasuries (risk and all), non-publicly traded firms, commodity exposure, and tax deferred, long- term investments are all necessary in order to rationally respond to uncertainty. That’s true whether the uncertainty was recognized by all or hidden by a good working fiction. But, it is a comfortable fiction to believe that one would be OK without an investment plan if only those evil (fill in the blank) weren’t messing up.

In this instance, having addressed the folly of a risk-free rate of return, the issue of others realizing US Treasuries aren’t risk free can be addressed without panicked adjustment in investments and without the waste of time involved in a search for blame. One has to admit the idea of a risk-free rate of return was truly a beautiful fiction. It allowed a massive financial edifice that spit out certainties at an amazing pace. Never mind that they were fiction.

With that noted, it’s time to look at what an individual investor should do. Most have heard all sorts of advice. Newsletters from brokerage and mutual funds, talking heads on TV and radio on both financial channels and “mainstream” media, newspapers and magazines, you name it, have all chimed in. Not surprisingly, individuals who have well-designed portfolios should do very little if anything. But, it’s a comfortable fiction for those without a well-designed portfolio to think there are emergency steps that they can take to overcome the problem.

Of all the nonsense floating around, the piece that most appealed to The Hedged Economist was one that basically said no one knows what this means because no one could possibly know. The piece took a lot of words and had some excellent analysis. It mapped out a tree. For example, going out one branch: Default or downgrade? If downgrade, was it a downgrade with debt ceiling agreement or without? If with an agreement, was the agreement big or small? If big, did cuts come early or down the road? If early, did the Fed loosen via QE3-like steps or not? In each step there were different consumer and international responses. Hopefully that conveys the approach.

What really made the analysis useful was that it didn’t try to predict the results of any branch. Rather it just pointed out the risks / uncertainties each path created. It made no effort to pretend is could remove uncertainty; it just identified the uncertainties associated with each branch. How refreshing is that after legions of politicians, government officials, and assorted pundits have made fools of themselves assuring anyone who’d listen that they could protect us from the inevitability of uncertainty? Uncertainty is no fiction. Neither is it lions and tigers and bears.

As this posting was being wrapped up, there was a rush to microphones in Washington by crowds who wanted to report that they singlehandedly cut the Gordian knot. Well, there’s a fiction we’ll all love. We can each believe our hero saved the day in the nick of time. Tomorrow morning we’ll see.

The Hedged Economist? Look for someone skipping down the yellow brick road saying “risk and uncertainty and reality; oh my!”