Economic Policy Right And Wrong

You may remember from your American history that the event that precipitated the Constitution of 1789 was that the newly independent country could not pay its debts, largely incurred to fight the Revolutionary War.  Under the Articles of Confederation of 1781, Congress had no taxing power, and had to request the states to make voluntary contributions.  Each state engaged in gamesmanship to try to get the others to pay.  The debt was in default, including debt that had been issued to soldiers in lieu of paychecks. 

Somehow our Founding Fathers thought this was a crisis.  Clearly, they had not heard of  "internationally-supported sovereign debt restructurings."  They gave the government taxing power almost entirely to pay off defaulted debt.  While they paid down that debt, they spent not one dime on transfer payments, social security, Medicare and Medicaid, a Department of Health and Human Services, a Department of Agriculture, a Department of Labor, a Department of Commerce, a Department of Homeland Security, a Department of Energy, an EPA, crony capitalism, green energy subsidies, a Department of Education, job training, pension guarantees, disaster relief, and I could continue here for quite a long time.  Worse, much of the debt had been bought up by speculators (today they would probably be hedge funds) at pennies on the dollar, and yet somehow they thought it was the right thing to pay it off at 100 cents on the dollar.  Other than paying off old debt, they spent barely 2 - 3 % of GDP on a few minimal government functions and they reserved the large majority of government functions for the states, who could not issue their own currency, and therefore had very little practical ability to spend much more money than they could promptly raise in taxes.

Result:  the most spectacular economic growth in human history for a good two centuries. 

Today, we have a new model of what to do as a country when you have trouble paying your debts, and that is Argentina.  First, you do an "internationally supported sovereign debt restructuring."  Put up a take-it-or-leave-it 20 or so cents on the dollar for existing debt, and then just stop paying anyone who doesn't take it, even though you are sitting on plenty of money to pay them in full today.  Then get the government into dictating all the minutiae of interactions in the economy.  An editorial from IBD on August 5 lists some of the most destructive recent actions.  For example, in February 2013 the government issued a policy that froze all supermarket prices.  Yup, that'll work!  I guess the supermarkets emptied out, because IBD now reports that Interior Commerce Secretary Guillermo Moreno is "reviving a 1974 law that compels holders of suitable stockpiles of flour to sell into the market at frozen prices."   Sounds an awful lot like the approach that Stalin took with Ukraine in 1932-33.  So when current stockpiles are gone, what then?  Will anyone in their right mind grow the next round of wheat under these circumstances?  Actually, the same IBD article reports that wheat acreage in Argentina has fallen from 15 million in 2000 to 12 million in 2011 to 9 million in 2012.  And then they expropriated the largest oil company, YPF.

Result: Both MercoPress and International Business Times are predicting today recession in Argentina by 2014.   Part of the ongoing slide from riches into poverty.

Meanwhile, Argentina seems to be losing some of its friends in its ongoing court battles to avoid paying the defaulted debt.  After losing in the Second Circuit a few months ago, Argentina has filed a cert petition to the Supreme Court, arguing that, despite having agreed to New York law and waived sovereign immunity, the Foreign Sovereign Immunities Act prevents any remedies from being invoked against it.  Back in the Second Circuit, the U.S. government filed a brief in support of Argentina, but the amicus deadline in the Supreme Court has now passed without their weighing in.   Don't assume from that that our leaders have backed off their views that it is good economic policy for a developing country to default on debt, engage in "internationally supported sovereign debt restructurings," and use the money for massive crony capitalism.  No, it's just that they don't want to be associated with losers.  Don't be surprised to see the U.S. weigh in if and when the Supremes ask.

For the Argentine people, being forced to pay their defaulted debt could be one of the best things that could ever happen to them.  Not so for the government of Argentina, of course. 

UPDATE:  An e-mailer pointed out that an earlier version of this article was in error in stating that the IMF had submitted an amicus brief in support of Argentina's position in the Second Circuit.  There also was an implication that the IMF had been directly involved in Argentina's exchange offer for defaulted bonds, as opposed to offering moral support for Argentina's current position in the litigation.  These errors have been corrected.  For details on the IMF's overt rooting for Argentina, see for example here. 

More Attention For The State And Local Pension Situation

One good side effect of the Detroit bankruptcy is that it has caused more attention gradually to be paid to the pension situation in other states and localities.  Pensions (and, to some degree, health care benefits) are the place where politicians have taken on literally trillions of dollars of debt while never reporting the numbers to the voters and hiding the debt deeply off-balance-sheet.  Will New York pay attention before it is too late? 

The front page of today's New York Times contains a lengthy report on Chicago's pension troubles, headlined "Chicago Sees Pension Crisis Drawing Near." 

The pension fund for retired Chicago teachers stands at risk of collapse. The city’s four funds for other retired city workers are short by $19.5 billion. At least one of the funds is in peril of running out of money in less than a decade.

An accompanying chart shows that Chicago's contributions to its various employee pension funds, about $600 million in the current year, are set to go to about $1.1 billion next year, $1.6 billion the following year, and then steady increases to about $2 billion by 2020.  That's pretty steep!   One consequence: Last month Moody's Investors Service downgraded Chicago's rating by an unexpected three notches.

Chicago's somewhat unique problem is the degree to which its politicians have simply avoided funding the pension promises they have made.  The Times says that Chicago's pensions are only 36% funded by its own reports -- and remember, those reports use crazy-optimistic interest rate assumptions.  As a rule of thumb, take whatever funding ratio they give you and cut it about in half.  On real assumptions, Chicago's plans are maybe 20% funded.  It's about time this started getting the attention it deserves. 

In my estimation, Chicago has about a 50/50 chance of avoiding a Detroit-like death spiral.   They are already at the point where the problem cannot be fixed by tax increases, because those would gradually accelerate the population shrinkage until there was no one left to pay the bill.  Of course, this takes decades to play out.

And how about New York?  The problem is not really any less than in Chicago, but is so far getting much less attention.  There is one significant difference: under Mayor Bloomberg and state law, New York has made the pension contributions that the actuaries said to make.   The result is that New York City's pensions are much better funded than Chicago's.  But unfortunately, that is not saying a lot.  As I reported here back in March, New York City has long used an 8% discount rate to value its pension obligations, and with that rate showed funding ratios averaging about 70% as recently as 2011.  In 2012 the actuary did a recalculation at 7%, and the ratios dropped down to around 60%, and only 48.2% for the Fire Department fund.  Try that at 5%.  I estimated a funding ratio averaging about 40% and a funding gap of about $150 - $200 billion.

So how much is New York already paying per year for the pensions?  It's $8 billion.  To put that in perspective, we have about three times the population of Chicago, so even when they get to their $2 billion per year in 2020, they won't have caught up to us in per capita expense. 

And our $8 billion is also set to soar further.  Here's the way to think about it.  You can estimate from the allowed retirement age how much pension expense will be relative to expense for active employees.  People who have lived long enough to have a working career are going to have a life expectancy around 85.  If they can retire at 65, you are going to have over 2 active employees per retiree (average 40 years working and 20 retired).  But if you can retire at 45, you are going to reverse that, and have 2 retirees per active employee.  That is the situation for New York police and fire.  Teachers and transit workers can retire at 55, meaning about a 1 to 1 ratio (30 years working and 30 retired). 

If you commit to paying as many retirees as active employees, or worse, twice as many, it doesn't really matter how well you have funded your pension obligations so far.  Sorry, this is not sustainable.  The stock market cannot possibly bail you out.

Mayor Bloomberg, to his credit, is on to this one.    Yesterday he gave a substantial speech on the topic.  Funny, I can't find any mention of it in the Times, but here at Bloomberg News we have a long report.  (I guess it helps to have your own news service!)  Headline:  "NYC's Good Times May Sour Like Detroit's, Bloomberg Warns."

Pension benefits for city retirees have risen to $8 billion a year from $1.4 billion in 2002, when he first took office, Bloomberg said. Health insurance, free to most municipal workers, has almost doubled to $6.3 billion, he added.

Gains from a rising stock market won't increase pension assets enough to offset higher taxpayer costs, the mayor said.

"Just as the financial collapse had only a small impact on our pension bill, as the market improves, it will not solve the problem," he said. "The idea that our costs can be substantially reduced through increased market returns is a fantasy."

The article then goes through the positions of the various candidates for mayor on the pension issues.  The summary: they refuse to say anything.  The two leading Democratic candidates are Quinn and Thompson.  Those two "have declined to discuss [union] contract issues."  The two lesser candidates, de Blasio and Liu, have even said that they might allow retro-active pay increases.  And how about the unions?  "Michael Mulgrew, president of the 200,000-member United Federation of Teachers, rejected Bloomberg's arguments and characterized the speech as self-serving."  Not clear to me what is "self-serving" about this from Bloomberg's perspective.  Maybe Mulgrew is expecting him to personally pay for the teachers' pensions?

Well, maybe when one of Chicago's funds runs out of money and stops paying the pensions this will finally become a big issue in New York.

Beware Of Thousand Page Laws, Immigration Edition

There's no question that the situation of our immigration laws is a mess.   So, how about a "comprehensive" reform, with a new law of now-standard size for what comes out of Congress, say 1000 pages, plus or minus? 

Unfortunately, it is not possible to come up with a thousand-page law without introducing hundreds of unintended consequences into the system.  I cannot identify with certainty all the minefields that are lurking in the gigantic "gang of 8" comprehensive immigration reform bill now working its way through Congress, and neither can anyone else.  But universal "e-verify" is definitely one of them. 

John Cochrane of the University of Chicago has an important article on this subject in Friday's Wall Street Journal.   Title:  "Think Government Is Intrusive Now?  Wait Until E-Verify Kicks In."  Cochrane makes the obvious point that everyone is missing:  just because it is talked about as part of immigration reform and appears in an immigration bill does not mean that e-verify is just about immigrants.  E-verify is about everybody, and it is a system whereby everybody will need prior government approval to earn a living in the United States.

E-Verify is the real monster. If this part of the bill passes, all employers will be forced to use the government-run, Web-based system that checks potential employees' immigration status. That means, every American will have to obtain the federal government's prior approval in order to earn a living.

Does anybody really believe that once it is established that prior government approval is required to earn a living that the criteria will be limited to just immigration status?  Cochrane lists some of the obvious categories that the government can easily add to its criteria.  Shouldn't we check for child porn convictions before hiring someone to work with children?  How about DWI convictions before hiring someone to drive a bus or pilot an airliner?  Heck, how about a required check of federal records for any and all past criminal behavior?   

And what a great system this will be to enable the government to keep its political opponents down!  Those who think the government would never do such a thing have not been following the IRS scandal.  But how about taking an example from just a few days ago:  On Tuesday July 30 the Chattanooga (Tennessee) Times Free Press published an editorial titled "Take Your Jobs Plan And Shove It, Mr. President."  It happened that President Obama was in town that day to give a speech on his new so-called "jobs" plan.  Key quote from the TFP editorial:  

That’s because your jobs creation plans so far have included a ridiculous government spending spree and punitive tax increase on job creators that were passed, as well as a minimum wage increase that, thankfully, was not. Economists — and regular folks with a basic understanding of math — understand that these are three of the most damaging policies imaginable when a country is mired in unemployment and starving for job growth.

Within two days the editor of the editorial, one Drew Johnson, had been fired, and the title had been changed to "President Obama's Policies Have Harmed Chattanooga Enough." 

Investor's Business Daily on August 2 asks whether the White House had a role in the firing.  They accompany their question with a list of prior White House actions in meddling with press stories about the President and first family:

We have no special information, but it's significant that President Obama was in town that week, visiting an Amazon operation to tout his jobs plan. Johnson's hard-hitting editorial drew unwelcome attention to that failed employment blueprint.

And this is a White House that has called up newspapers and asked them to remove lines in stories.

In 2011, Gina Channell-Allen, president of the Pleasanton Weekly in California, said she "received a call from the White House asking us to take out part of the story because it reflected poorly on the first lady."

The White House also threatened to blacklist San Francisco Chronicle reporter Carla Marinucci from the press pool during Obama's visit to the Bay Area in 2011 because she covered an unflattering-to-Obama protest.

The White House has also targeted the press with the Internal Revenue Service, as happened to Commentary magazine, as described by editor John Podhoretz last May. Accuracy in Media's Cliff Kincaid reported that two other media outlets were also IRS targets.

It is just not possible for government bureaucrats to avoid political mis-use of the tools at their disposal. 

So, for immigration reform, how about scrapping the 1000 page bill and pass a one-pager that loosens restrictions on high skill immigrants? 

Taken In By His Own Fraud

Perhaps the most common financial fraud goes by the name of "channel stuffing."  The basic idea is that a metric - for example, revenue generation - has been selected to serve as a proxy for business success.  As long as the metric is not manipulated, it may be an excellent proxy for business success.  But then management realizes that it can manipulate the metric, and thereby deceive people into thinking the business is succeeding when it is not. 

The classic example arises in a manufacturing business.  The accounting profession somehow decided that the best proxy to use for determining when to recognize revenue is the time when the finished product leaves the factory on the way to the customer.  This metric can give a less volatile and arguably more accurate picture of the success of the business than alternatives such as when contracts are signed or when cash is received.  But then from time to time management realizes that it can goose revenue for a quarter and make the business appear more successful by the expedient of sending a truck filled with product out to a customer a day or two early.  Or maybe it's two trucks, or five, with quiet instructions to "drive slow."  The next quarter, of course, the revenue hole is a little deeper, so make it ten trucks.  This can go downhill very quickly.  Many corporate executives have gone to jail for this.

There is a completely parallel situation in the world of government accounting, namely government manipulation of GDP and jobs numbers to deceive people as to the success of the economy.  For purposes of GDP accounting, the accountants decided to adopt a metric where government spending counts at 100 cents on the dollar in the measure of GDP.  That may have made sense before politicians figured out that they could then manipulate GDP by the simple expedient of wasting government money or giving it to their friends and supporters, and thereby deceive the voters into believing that the economy is growing.  There is nothing fundamentally different between this game and corporate channel stuffing, other than that the government practices its fraud in the trillions of dollars rather than the millions or tens of millions involved in the corporate frauds.  

So here we have President Obama's big "jobs" speech in Tennessee a couple of days ago.  After five years of a languishing economy on his watch, now he is going to lay out his ideas to improve the economy!  And the big idea is ............  channel stuffing!!!  OK, he doesn't call it that; he calls it "job creation" through government spending.  Just to take a few examples:

[W]e need to keep creating good jobs in energy -- in wind and solar and natural gas.  Those new energy sources are reducing energy costs.  They're reducing dangerous carbon pollution.  They're reducing our dependence on foreign oil.  So now is not the time to gut investments in American technology.  Now is the time to double down on renewable energy and biofuels and electric vehicles, and to put money into the research that will shift our cars and trucks off oil for good.

Natural gas development does not require or call for any government involvement at all.  Wind and solar are pure wealth destruction, and any rational measure of GDP would record government spending on them as a reduction in GDP.  But no, the government spending is recorded as adding to GDP at 100 cents on the dollar.  Pure deception.  (You may think that using wind and solar energy is a good idea to "save the planet"; but if so, you should at least be honest with yourself and recognize that you are asking the American people to accept making themselves poorer - through higher energy costs -- to achieve an environmental goal.)

And then this: 

 We've got about $2 trillion of deferred maintenance here in this country.  So let’s put more construction workers back on the job doing the work America needs done.  (Applause.)  These are vital projects that Amazon needs, businesses all across the country need, like widening Route 27 here in Chattanooga -- (applause) -- deepening the Jacksonville Port that I visited last week.  These are projects vital to our national pride.  We're going to be breaking ground this week at the St. Louis Arch.  Congress should pass what I've called my “Fix-It-First” plan to put people to work immediately on our most urgent repairs, like the 100,000 bridges that are old enough to qualify for Medicare.  That will create good middle-class jobs right now.  (Applause.)  And we should partner with the private sector to upgrade what businesses like Amazon need most.  We should have a modern air traffic control system to keep planes running on time.  We should have modern power grids and pipelines to survive a storm.  We should have modern schools to prepare our kids for the jobs of tomorrow. 

I'm not opposed to all infrastructure spending, but this is just complete acceptance of the idea that all government spending on no matter what is an unalloyed benefit.  We'll replace all the bridges!  We'll replace all the schools!  This is exactly the strategy that Japan has embarked on for the past two decades -- massive, uncontrolled infrastructure spending to "create jobs" and "stimulate" the economy.  Result:  twenty years of stagnation and national debt at 200% of GDP.  And that's with full fraudulent 100 cents credit in GDP for all government spending.  Without that manipulation, Japan's economy has declined significantly.  So let's imitate them! 

Well, we could call President Obama the fraudster in chief, but to his credit I truly believe he really thinks that uncontrolled government spending benefits the economy.  He has been taken in by his own fraud!  (OK, and to be fair, by that of his predecessors.) The problem is, if this were corporate fraud, the fact that the CEO truly believed that his channel-stuffed numbers represented a correct picture of the corporation's financial position would be no defense whatsoever.  Off to jail with you!

What Is The Difference Between "Flexible Underwriting" and "Predatory Lending"?

Even as Fan and Fred reinflate rapidly out of sight of everyone, there is a new nominee to head their "regulator," now going under the name of the Federal Housing Finance Agency (FHFA).  He is Congressman Mel Watt, Democrat of North Carolina.  Haven't heard of him?  He is the representative from the most preposterously gerrymandered district in the country, NC-12, which snakes in a narrow band across half the state to take in portions of Greensboro, Winston-Salem and Charlotte.  

More on the merits, Paul Sperry at Investors Business Daily in its July 29 edition has a long piece on Mr. Watts and FHFA.  Watts is one of, if not the, leading advocates of "flexible underwriting" as a means of increasing home ownership among low income groups.  IBD gives some of the history:

On the eve of the financial crisis, Watt actually proposed the creation of the regulatory agency he now seeks to run — only, he designed it not to reform Fannie and Freddie but to pressure them to underwrite even more affordable housing, exposing them to even more risk.  The bill he co-sponsored with then-banking panel Chairman Barney Frank — the Federal Housing Finance Reform Act of 2007 — would have forced the federally backed mortgage giants to meet even tougher quotas for affordable lending, while contributing to an "Affordable Housing Fund" to rebuild blighted urban areas.  "The real benefit of this bill is that it will provide a big stimulus for more affordable housing," Watt said at the time, ignoring concerns the agencies already were overexposed to low-income loans.

Shortly after Watt's proposed bill to let Fan and Fred inflate things even further n 2007, the twins collapsed to the tune of a direct $189 billion cost to the taxpayer, not to mention the additional indirect costs of the financial crisis.   A further article from IBD on May 6 lists some of the proposed reforms to Fan and Fred that Watt resisted and voted against over the years:  for example, a proposal to require them to hold more capital, and a proposal to cut off their line of credit from the Treasury.

Of course what occurred in 2008 and after was that Watt's "flexible underwriting" turned overnight into "predatory lending."  Suddenly the banks that had had the chutzpah to follow Fan and Fred's guarantees into making sub-prime loans turned instantly from good guys providing "affordable housing," into bad guys leading the unsuspecting and unsophisticated into underwater mortgages from which there was no escape.

IBD points out that there is no indication that Watt has changed his views, and every reason to believe that he will use his post at FHFA to goad Fan and Fred into inflating the next housing bubble as fast as possible and to make it as big as possible.  Is there any possible good that can come of this?  Does Watt, or his sponsor President Obama, really believe that it helps the intended beneficiaries to use Federal guarantees to get people of low income and iffy credit into large loans that they can barely afford?  Well, we're now getting started on another round of that, with little to no chance that it will come out any better than the last round.

Our "Disinterested, Neutral, Expert" Regulators In Action

The theory under which we have dozens of Federal and state regulatory agencies overseeing our economy is that they are disinterested, neutral experts who can set fair and just rules and oversee a transparent and clean marketplace.  Another theory is that they are venal and self-interested human beings like everyone else, having as their primary goals personal advancement and self-aggrandizement and caring little or not at all about the public interest.

So let's consider an example or two.  Back on July 1 in a post entitled Annals of Government Self-Promotion, Big Bank Edition, I considered the large number of huge recent settlements between government regulators (state and Federal) and big banks, and suggested that it would make sense to look at them as a "very sick game of government aggrandizement" whereby the government passes big profits to the banks by keeping interest rates low, and then "any Federal agency that wants its name in the paper can pick one of the big banks and go out and get at least a few hundred million" by purporting to enforce some incomprehensibly complex regulation. 

Well, the tide continues.  Last week J.P. Morgan put out its latest earnings release for the second quarter of 2013, showing net income of $6.5 billion for the quarter -- a very large number, clearly blown up by the continuing if perhaps slightly diminished efforts of the Fed to keep the banks' cost of funds at or near zero.  And literally days later comes a big front page article in the Wall Street Journal that yet a new Federal agency, this time the Federal Energy Regulatory Commission (FERC) is about to hit up JPM for a few hundred mil.   And yes, there on page 2 in the print edition, there is a photo of FERC Chairman Jon Wellinghoff, formerly obscure energy regulator now launched into greatness by his realization that he just needed to go after the right designated villain for some big money.

What is the alleged wrong?  The WSJ article says "market manipulation," but a July 22 article here at Reuters goes into more detail.  Seems that there are basically two electricity markets in California, one for the next day and the other immediate.  JPM figured out that there were pricing discrepancies between the two markets such that it could bid one price in one and a different price in the other, and almost always make money:

JPMorgan's trading strategy, the ISO said, was to submit bids [in the day-ahead market] with high minimum load costs but exceptionally low - sometimes negative - power prices, making them attractive enough for the grid to schedule the plant to run the next day.  But in the following day's real-time market, JPMorgan would change its prices, submitting very high bids that discouraged the grid from "dispatching," or running, the plants.  That would leave the unit running below its minimum level or not at all, triggering a "minimum load" payment to cover those costs.

Is it just me, or that basically just smart trading?  I thought the whole idea of trading for a financial player was to figure out a strategy to exploit pricing discrepancies between different markets or between similar but not identical products so that you could make money no matter which way the market went.  Go long on the stock and short on the option, or long on the convertible debt and short on the stock, or something like that. 

According to the WSJ, the question of whether to settle has divided executives at the bank.  The head of commodities trading was taking the position that "these employees and the bank did nothing wrong."  Maybe not, but that's not how this game is played.  These Federal regulators must not be embarrassed, and must get their names in the paper, and hey, we just earned $6.5 billion as a back door gift to enable the game to go forward.  So the word is that a settlement of around $400 - 500 million is in the works.

I wonder which agency will get the next one? 

Meanwhile, Fortune Magazine in the June 28 edition carries a big story on the rebirth of Fannie and Freddie.  Remember them?  They are the giant "mortgage twins" who securitized and/or guaranteed most of the housing mortgage market, leading to the housing bubble and the financial crisis.  Oh, and they "stuck the taxpayers with a $189 billion bailout bill after their collapse in 2008."  Did you think that after that debacle they were being wound down or phased out?  Guess again.

It seems that in order to conduct "quantitative easing" I, II, III or whatever we are now up to, the Fed needs to buy some $85 billion of bonds per month.  Where to get them?  Well, they have decided that Fan and Fred debt qualifies.  Thus, buy as much as you can, as fast as you can, with the infinite checkbook.  You probably have already guessed where this is going.  First, Fan and Fred get far more money for housing finance with far lower cost of funds than any other player can even approach.  So nobody else can compete with them in buying up and securitizing mortgages.  So the Fan/Fred market share in buying and/or guaranteeing mortgages soars, now back to about 80%. 

But isn't this exactly what got us into the last mess?  As far as I can tell, yes.  All orchestrated by the disinterested, neutral experts at the Fed, who have just multiplied their own balance sheet by a factor of about 5 in the last few years.  Thankfully, no self interest involved there. 

In other news from the Fed, today's WSJ, page 1, reports that none other than Larry Summers is one of the leading candidates to replace Ben Bernanke as head of the Fed.  Larry Summers, former President of Harvard, is the guy who's so smart that he knows that more spending causes less debt and less spending causes more debt.   At the Manhattan Contrarian, we have dubbed him the man among all men with "more credentials and less actual competence."  But he does know to say the most ridiculous of things that the President wants said.  Make him head of the Fed!  He'll be a good "disinterested, neutral expert."

UPDATE, July 26:  I was thinking more about this last night and I suddenly realized that the alleged wrong of JPM in the California electricity matter is that its trading somehow marginally increased the cost of electricity in California to consumers.  Wait a minute!  California has an entire "cap and trade" carbon restriction scheme, the whole idea of which is to artificially increase the cost of electricity to consumers.  Does FERC not understand that that's how to save the planet?  JPM, I have figured out your defense!