A few comments on the news today regarding China.

• What appears common from all news sources is that by 2029/2030, China could eclipse the US as the world’s largest economy. As far as I can tell, this would require China to sustain an 8% growth rate for 20 years, assuming the US will sustain a 3% growth rate over the same period.

Really? I mean - really?

I have no doubt that China could pass the US as the world’s largest economy at some point in the future.  But doing it by sustaining a further 20 years of 8% annual growth? This is the same logic that got us into the housing crisis: assuming linear or consistent growth patterns that appear wildly out of balance with what will probably be a lot more random of a future.

Secondly, what no article did was discuss what this new economy would look like:

• Assuming the US and China had similar size economies, could China sustain a 6-10% current account surplus annually? This would mean in dollar terms a current account surplus annually of $800 million to $1.4 trillion.
• Where would this surplus come from? Japan does not run a current account deficit, neither does Europe on a whole. So that would point to the US, a consistent current account deficit country.
• But the US, while running a current account deficit, has never run a deficit this high. The highest the CA deficit has reached is roughly 6%.
• Current account deficits this high would point to one thing: A currency devaluation. Not just a gradual adjustment, but probably a shock. But a shock would not be good for China, which pegs its currency to the Dollar and relies on the US as one of its largest trading partners.
• A massive US devaluation would boost exports doing three things simultaneously - boosting US growth, decreasing its current account deficit, further increasing US growth, and finally, decreasing Chinese growth by increasing its imports.

All three effects would make it further difficult for China to overtake the US, especially assuming consistent growth under current policy regimes. Consistent growth doesn’t assume a shock, as discussed above. See the last two years as a current example. A faster way for China to overtake the US is to not only grow fast, but let its currency appreciate, as what we’re really discussing is GDP in Dollar terms. Letting its currency appreciate may slow down the export machine, but hopefully it will provide greater per capita wealth across the population.

Ben Bernanke said the following in South Carolina:

“In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions.”

Let’s put this in perspective:

• We have roughly 15,000,000 unemployed people in the United States.
• To return to true level of structural unemployment, we need to create roughly 8-9 million jobs at a minimum.
• The average full time salary for full time workers is approximately $39,000.
• Thus, GDP must increase by $39,000 * 9,000,000 = $350 Billion

What could cause this? Based on Bernanke’s comment, one of two conditions could occur:

• Credit conditions could occur, allowing consumers to borrow against half of current savings ~ $707 billion and spend that entire amount within the United States (no imports).
• Income could increase by wages and salaries increasing by 6%, even though they have been unchanged since 2007 and real wages have remained flat for the last decade.

Unfortunately, I see it being incredibly difficult for either to occur rapidly without some sort of external boost.

I’m still blown away by Arthur Laffer and others espousing the benefits of tax cuts.  Here is discussing the benefits of the Reagan tax cuts, courtesy of the Wall St Journal:

“In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn’t take effect until Jan. 1, 1983. Reagan’s delayed tax cuts were the mirror image of President Barack Obama’s delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%.

But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984. It has always amazed me how tax cuts don’t work until they take effect. Mr. Obama’s experience with deferred tax rate increases will be the reverse. The economy will collapse in 2011.”

Fair enough, but aren’t we forgetting Paul Volcker and his “War on Inflation”?

Look at fed funds rates during 1981, 1982 and 1983. We go from 19% in 1981 to 8.51% in 1983.

And CPI? We go from 10.3% in 1981 and 6.2% in 1982 to 3.2% in 1983.

So, I mean - C’mon.

But here are my two favorite responses to this:

• From Capital Gains and Games
• And Alan Greenspan from this Sunday’s Meet the Press:

“MR. GREGORY:  You don’t agree with Republican leaders who say tax cuts pay for themselves?

MR. GREENSPAN:  They do not. ”

So, let’s focus on job creating government policy that will get the economy going, without breaking the bank.

Four data points (from the Market Data section of the Financial Times) start the discussion:

1. Today, the US Dollar to Euro exchange rate is ~$1.29.
2. The one year (longest published out) Dollar Spot Forward is ~$1.29 as well
3. The ~ 1 Year US Treasury Yield is 2,99
4. The 10 Year Yield on a German bond is 2.75

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0275)^10 = $1.32 to the Euro, suggesting the Euro is long term undervalued.

However, what about the following other Euro countries? Here are the following ten year yield and percentages of Euro Currency 2009 GDP:

• Austria - 3.13 (3%)
• Belgium - 3.36 (4%)
• Finland - 2.93 (2%)
• France  - 3.03 (22%)
• Germany - 2.75 (27%)
• Greece - 10.53 (3%)
• Ireland - 5.42 (2%)
• Italy - 3.99 (17%)
• Netherlands 2.94 (6%)
• Portugal 5.52 (2%)
• Spain 4.28 (12%)

By averaging the ten year yield based on the gdp of all Eurozone countries, we find the Eurozone 10 year yield is 3.57%

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0357)^10 = $1.22 to the Euro, suggesting the Euro is long term overvalued. Adjusting this calculation for % of Public Debt to GDP, the value of the Euro drops to $1.21 to the Euro

What is the explanation?

Countries in crisis (such as Portugal, Spain, Greece and even Italy) have taken advantage of Eurozone financing for government financing. This purchasing has negated the need to tap domestic and foreign capital markets for purchases. This lack of foreign exchange has created a void for deciphering where the euro is truly in demand. This is further evidenced by an officer of BBVA’s notorious quote earlier this summer.

What this essentially means is that current account surplus countries such as Germany are forced to help out current account deficit countries such as Greece and Ireland. Yet the Eurozone has a current account deficit. If Germany and German banks are bailing out Greece and Ireland, countries such as China are only buying German bonds. This makes German sovereign bonds the “on the margin” security denominated in Euros sold and traded in foreign currency and not just in Euros.

The “marginally available” security is probably the major explanation why the Dollar Spot is valued closer to the Covered Interest Parity Calculation using the German 10 Year Bond than the composite of European Bonds.

Martin Feldstein’s column, (June 29, 2009) on inflation opines that while federal stimulus is still necessary, a combination of looming deficits, federal reserve bond purchases, and skittishness of foreign investors are pushing yields on the 10 Year Treasury up to alarming levels.

Feldstein’s major premise is detailed in the second paragraph of his column: Higher Yields have led to higher mortgage rates, reducing home buying, depressing net worth tremendously in the last six months. Further, lower home prices have caused more defaults and “weakened bank balance sheets”.

Lets correct some facts: Between 2006 and Six Months ago (December 2008), house prices dropped 27 percent. From December 2008 to March 2009 - the latest month of data,  housing prices fell comparatively 7%. Further, August 2009 Futures for Case-Shiller Composite index is currently trading at 152.0 slightly above where the index level stood in December of 2008, bookmarking the recent rise in treasury yields.

Feldstein, in his column, notes that the current spread between 10-year TIPS and 10 year Treasuries shows an inflation expectation of 2% annually. That inflation predictions have “jumped” to slightly over 2% per year is hardly alarming. 2% is often seen as an inflation target. That the jump in rates is perpetrated by fears foreign investors may no longer continue to buy US debt is simply not true.

China, most notably, while making loud noises is in a “dollar trap”, argued most notably by Paul Krugman. Fail to purchase US Treasuries, and decline the dollar’s value, making our goods cheaper and China’s goods more expensive, ending China’s competitive advantage in manufacturing.

At a high-level, if manufacturing in China continues to keep durable good costs down, and the Federal Stimulus package will improve roads and cargo lines, reducing transportation costs, price increases outside of energy spikes are hard to imagine for durable goods measured in CPI.

Perhaps Feldstein’s view of investor skittishness and his call for the Fed to assure the markets it will curb future “inflationary lending” are really directed at asset inflation: Perhaps investors believe that while policy makers are acting vigorously, nothing structurally has or is going to change to prevent another asset bubble similar to house price inflation witnessed over this past decade.

Asset inflation, be it houses or equities, is much harder to prevent than inflation in durable goods. Let us hope our fiscal stimulus and monetary policy are giving the economy surer footing to produce more, sharing those productivity gains across a wider spectrum, ensuring a diverse economy in the odds of preventing future asset bubbles.

Paul Krugman, in a blog post last week, offers an explanation for how private investors would think about asset purchases under the treasury plan. With no disrespect, here is my explanation:

Assume the purchase of a “legacy asset” (or purchase of a toxic asset, or the purchase of a pool of subprime mortgage) is a the purchase of cash flows for a period of 20 years. Many mortgages go out beyond 20 years, but let’s keep this at 20 for argument’s sake.

How much would I be willing to pay?

Well, a review of march-27-world-bond-yields, with at least an A rating, that go out 20 years, make me think I should get at least 8%. So, if I buy that asset for $100.00 (for which it is valued on the banks books), I’m expecting annual cash flows of $10.25 for the next 20 years.

It is fair to say, that given the horror stories everyone has heard about subprime mortgages, one would need a return far greater than 8% in order to buy one your own.

So the Treasury and the FDIC step in, and debt financing for up to 85% of the assets, with a matching equity contribution.  Assume then that the FDIC is able to offer 85% of the price on a non-recourse basis (meaning no other assets of me, as the the investor, would be touched eg - my home, my car should I be unable to service the debt). Then assume the FDIC offers 5% financing for the full 20 years. This, however, is a big IF, based on the Legacy Loan Terms sheet offered by the Treasury. Rates and Length could be far less generous.

Yet, if I were to receive 5% and 20 years of FDIC debt, my pre-tax return as the equity investor would be ~21%.

Assuming the FDIC offers these terms, the question then is, is a 21% pre-tax return to equity enough to entice investors to buy bank assets at their listed price? Secondly, is the program, with loans and equity contributions enough to remove the glut on bank books and get lending activity going again?

If the answer to either question is no, then the program has not (by itself) done enough to re-gain control of the credit markets, restart lending, and grow the economy.

But back to the 21% return for a second. In an article earlier this month in the FT, there were some pretty grim statistics about households behind on their mortgages. Nearly 12% of all home loans were either a month behind or in foreclosure. This statistic across of all households, but imagine what it is for those carrying “subprime” mortgages. Was this statistic modeled into the asset, valued at $100, on the bank’s books? That is not clear. As the equity investor, if I stress tested not receiving 12% of my cash flows annually, just to be conservative, my equity return under this scenario drops down to 12%. Given that this is a subprime mortgage pool, it could be fair to say, this investment is now not worth it.

Suppose then that a 21% return is the magic number. How much, assuming my stress test, would I offer a bank then for a $100 asset? The answer is $90, or a 10% haircut. The final question then is: Is losing 10% enough to to entice banks to still sell and remain solvent? Again, if the answer is no, then the program has not helped get lending going again.

Reading over this plan, it is my assessment that it will take time to start this program and get it functioning. The key then will be: what might happen in the mean time to banks and the economy and will we need a new set of assumptions to value these assets at that time?

The Fed mulls an inflation target, to stabilize the economy. Robert Shiller and George Akerlof, in their new book Animal Spirits, argue for a “credit target”, a level of lending to keep the economy near full employment. In the middle is an old question - Should Central Banks consider Asset Bubbles a form of inflation?

Look at the 2008 Commodities Bubble:

• January 2nd, 2008 - According to the Financial Times, One month Oil Futures on the NYMEX were $99.62
• July 2nd, One month Oil Futures were $144.26
• December 30, One month Oil Futures were $39.03

That the Fed insists on Core Inflation, excluding energy, made it miss how energy moves all consumers prices. Consumers pulled back on gasoline purchases in the short term and in the long term, terminated SUV purchases, crippling GM and Chrysler.

Yet during oil’s rise, the Fed had to reduce the Fed Funds rate as the effects of Bear Stearns was first on its mind. It’s not clear the Fed could have raised rates to prevent oil’s rise, without crippling the economy.

Preventing the Housing Bubble though could have eliminated what we currently witness: Global de-leveraging and massive reassessment of household wealth. The sheer amount of leverage also helped fuel stock market booms (of which some was real) giving consumer confidence in 401k statements. Add to this the house market boom, household behavior such as reverse mortgages, credit card spending, an overall negative savings rates would probably not have occurred.

Yet the Fed’s role in determining over-investment is tricky, politically controversial. Without world-wide coordination for world wide bubbles, false arbitrage opportunities such as the Carry Trade can wreak havoc on international trade/commerce.

What Shiller, Akerlof, and all concerned about asset bubbles really want is an economy where the Financial Sector does not a) contribute the most to GDP growth and b) rise too disproportionately in terms of total GDP. This was our economy prior to this crisis. The economy must have real growth, not growth due to paper assets. Once perception is pricked on over priced assets, no one knows an assets true worth, causing trust and lending stop.

If Central Banks can not politically prevent asset bubbles, then our government must improve its risk management program. Two logical improvements are as follows:

1. Regulation and oversight must increase. Madoff’s false profits now cause hospital wings  to go without funding. Mortgage Originators are forcing real family pain on false interest rate promises.  And we all witness a loss in market confidence.
2. Running government surpluses in healthy economic times. 90 years ago, John Maynard Keynes worried about this very issue we now face. Certainly, government surpluses up until now would reduce our worry over how much debt we must now raise.

Only a start, but planning for the future must occur to prevent a future colapse of this proportion.

On February 10th, Secretary Tim Geithner announced the next wave of bank bailouts. The press - from the New York Times to major blogs, ripped the Obama Administration for “not enough detail”.

What does “not enough detail” mean? This is a plan roughly $2 trillion in size. Roughly equivalent in size to California’s GDP. How can “enough detail” satisfy those commenting on a proposed solution to a  problem this complex to write 200 accurate words on it? The problem’s sheer size , the moving pieces, makes it incredibly hard for anyone to understand. But lets start with the largest part: banks holdings of assets, largely those in housing.

Houses and underlying property must be viewed as derivatives, not underlying assets. Houses and property are merely reflective of economic activity occurring on the square feet. As economic activity rises, so should the house. As economic activity falls, so too should the value of that same house. Should I buy a house, I am buying it because:

• I can afford the monthly payments
• I believe my wages will continue to rise above the monthly payments, inflating away the payment burden
• My wages will rise due to my improved performance
• My performance is due to my company’s continuing ability to sell its product to other companies or consumers
• Or my performance is good enough to find another job in the same area

If the company can not sell product, I can not earn a living. If I can not find another job, I can not earn a living. If I can not earn a living, I can not afford my house. If I can not afford my house, it must no longer be worth what I paid for it. Unless someone else buys it for what I originally paid. But if the house’s location prevents this, again, it must no longer be worth what I paid for it.

The key to any communities’ housing values appreciating is its ability to export goods and services to other communities.  No exporting means no chance of true economic appreciation, and no concurrent increase in underlying value. Today’s domestic economy however has been running current account deficits for years - exporting far less than importing. Thus the derivatives that are houses have been completely overvalued for years.

Which brings us back to the banks. If banks hold leveraged derivatives on their books in the form of subprime mortgages bonds, then it is clear they are holding assets valued far more than their true worth. Given the over-leveraged position of most banks, Nationalization is coming and coming soon for some banks. Painful at first, but best in the long run. This is why Geithner left his position open and why he will not make the same mistakes others have made in the past. “Not enough detail” is easy to write, but fixing this correctly takes far more skill.

After the stimulus bill passes, President Obama and Tim Geithner will propose the next bank bailout. The concept of the bailout is the “bad bank”: Toxic assets are lifted from the bank balance sheets so lending can resume.

The key to stimulating lending is to resume interbank lending. Interbank lending can not fully resume until banks are comfortable their bank counterparts do not have any toxic assets, which under-performance could trigger a default. A default would make it difficult for the lending bank to receive its cash.

Look at the LIBOR yield curves on

feb-9th-2007-interbank-lending

feb-6-2009-interbank-lending

The steepness of today’s yield curve shows how skittish banks are in lending money for long durations, including one year.

Many worry the “bad bank” will cost the taxpayers money. Banks will not sell toxic assets for their true worth. Yet if banks agree to sell, many fear the taxpayer will pay too much. These “toxic assets” are packaged “subprime” mortgages. As job losses continue, home prices continue to decline and defaults continue to increase. Volatility makes valuing these assets almost impossible. Worse, this volatility is starting to damage mortgages further up the food chain.

Restarting the ability to make these mortgages worth anything are the following two statistics.

1) Real Median Household Income has not increased since 2000 - incomeinamerica1

2) Since 2000, The US Current Account Deficit has increased as a percentage of World GDP

Since consumers are (were) 70% of the US Economy, any increase in home values in the bast eight years has been on the backs of household borrowing. Until US Families can annually earn more, home values and mortgage portfolios will not follow suit. Homeowners need to pay back existing loans and earn more for future consumption at the same time.

The economy that increases real median household income is the next question. The recent share, both overall size and contributions to growth of the Finance Sector, contributed to our current state.  This is not assigning blame. We need capital to back people, ideas, bringing improvements to today and tomorrow’s economy. But we need to make more than financial products if we are going to lead the world, resume growth, and further pay for social security and medicare/medicaid.

Which brings us to the bailout. Must we do something? Yes. But lending can not resume to its 2006/2007 state unless we have an economy with a stronger manufacturing base to support it. Leverage on leverage only brings defaults and further trouble.

That is the challenge of this administration and the the private sector -aka - everyone. If we can create an economy that creates wealth for everyone, our future will be far brighter.

Yesterday’s news was not encouraging. Home value declines will continue to make families and home owners second guess their net worth. In a recession, this prompts only one reaction: saving.

The macro economic accounting identity states savings equals investment. This static steady theory is becoming a large force against fiscal stimulus, now awaiting Senate Approval.

Let’s review the facts. With the Fed meeting today, Fed Funds ended trading at 0.18% according to the Financial Times. As rates are not able to go below zero,  interest rates are essentially fixed. And bank reserves held at the Fed increase. There thus is no further mechanism to force private investment to equal savings.

As savings not offset by investment (which would lead to new jobs) and unemployment increase, taxes decline. If government expenditures just stayed the same, our federal deficit would have to increase, even without fiscal stimulus.

Faced with the choice of

• Large Federal Deficit
• Infrastructure Investments => New Jobs and a Large Federal Deficit

Its best to choose jobs, new infrastructure and a large federal deficit.

Today’s news was even less encouraging. That jobs are lost in record numbers makes valuing mortgage bonds, even if simply constructed, even harder. Yet mortgage bonds are not simply constructed, they are incredibly complex.

Job losses will not decelerate for a while. It will take time for fiscal stimulus to take effect. This makes the idea of the “bad bank” incredibly complex. Many like Reich still hold out hope for a solution that protects the tax payer. The economic reality makes it impossible that mortgage assets still on the books are worth anything close to what they were previously valued. To unclog lending, we -the taxpayer- must further take it on the chin.

Yet as the fiscal stimulus and bad bank solutions work through the economy (and slowly), we must ask ourselves: what kind of economy do we want to now create? Should the Financial Sector contribute 31% of GDP as it did in 2006?

Which should we value more? Financial engineering or mechanical engineering?

This is again why infrastructure investment as the stimulus for tomorrow’s economy is so important: The only way long term balance will be restored (and one could measure this by the current account balance) is to choose engineering over financial engineering. The more we build (not out of paper) at home, the more our economy will grow in a balanced, mature way for generations.