ProfessorBainbridge.com

More on the USA's post-election creditworthiness

A reader sent along a very interesting email, which I thought I'd share with all of you:

Dear Prof. Bainbridge,

Here are a couple of other data points.

Closing CDS (credit default swap) prices on German debt = 32.67 basis points; on US debt sovereign debt = 34.74. Forget about agency ratings; the CDS market gives a much more accurate and timely view of credit quality. So right now the markets view German sovereign debt as slightly less risky than US debt despite the pending collapse of the Euro.

A number of corporates now have CDS prices lower than US treasuries. As you note, this is unprecedented. Here is what I've found:

CDSs on Samsung Electric (a Korean corporation) debt closed at about 32, the same as Germany.

Burlington Northern (Warrent Buffet's RR), CDS pricing @ 16.77. Burlington Northern is the new risk-free security. It's nice to be the chief crony in a crony capitalist society.

I noticed last week that Chevron was also viewed as safer than US treasuries but I don't remember the pricing.

A month or so ago Norfolk Southern CDSs traded at 33.70 and CDSs on US treasuries at 42.85. Subsequently, US sovereign CDS prices dropped quite a bit when it looked like Romney had a chance. I don't know what happened to Norfolk Southern.

In any event, CDS prices on US treasuries have gone up (meaning credit quality has gone down) by over 5 basis points (about 19%) since the election.

Note, however, that CDS pricing does not scale in any obvious way. Compared to the prices for German and US CDSs, the current prices for CDSs on MBIA are around 3,000 basis points per year (that means if MBIA doesn't default, you'll pay 150% of the face amount of the insured debt in premiums over the five year life of the CDS); and for Argentina, about 1,825 basis points per year. I can't find Greek sovereign CDS pricing.

Last point: in my view, default is not a likely option for the US. It's just not necessary. It is far more likely that we will pay our debts through inflation in the manner of other overly indebted countries throughout history. That risk will eventually be reflected in treasury yield but not in CDS prices, which are pure measures of default risk.

Posted with Blogsy

Obama wins, stock market swoons, but the bond market matters more

As I write this at 9:49 am of the morning after Obama's reelection victory, all of the major stock market indices are down. The Dow Jones is down 2.18% and NASDAQ is down 2.40%. It's easy to score political points with those numbers. The market is clearly spooked by (1) the prospect that continued divided government will make resolving the impasse over the fiscal cliff harder and (2) the likelihood of continued heavy-handed regulatory and enforcement practices by the Obama administration.

But there's something more important going on under the rader screen. US Treasury securities historically have been used as a proxy in finance for the so-called "risk free rate"; i.e., the theoretical rate of return of an investment with no risk of financial loss. Hence, as Matthew Philips observed after S&P downgraded the US' credit rating:

U.S. T-bonds and bills have been a proxy for the risk-free rate for decades. Without a risk-free rate, modern finance essentially falls apart, since it is the building block of most financial models. People use it for determining everything from the value of a company, to the price of an option or a bond.

Of course, the very concept of a risk-free rate has always been relative. It assumes a zero chance of default. If you want to get technical, there isn’t a zero chance of anything really. But ... U.S. treasuries are still the least risky place to put your money in the whole world. 

Not anymore, according to today's WSJ:

Treasurys have a new rival for safe-haven status: U.S. companies.

Bonds of Exxon Mobil XOM -3.42% and Johnson & Johnson JNJ -1.10% are trading with yields below those of comparable Treasurys, a sign that investors perceive them as a safer bet. It is a rare phenomenon that some market observers said could be the beginning of a new era for debt markets. It could ultimately mean some companies will borrow at lower rates than the U.S. government.

For now, just a handful of relatively short-term bonds yield less than comparable Treasury bonds. But some market observers said some fundamental changes in the financial health of U.S. companies relative to the government, including the fact that some corporations are more highly rated than Uncle Sam, suggest it could become a longer-lasting trend.

This is what four years Obamanomics has brought us: An historic reversal of the assumption that US treasury securities were so safe as to be essentially risk free. And the astonishing fact that the markets perceive some corporations to be less risky than the United States government.

One wonders what four more years will bring?

"The Redistribution Recession"

Tyler Cowen offers a qualified endorsement of a book I'm reading and enjoying very much, Casey Mulligan's The Redistribution Recession: How Labor Market Distortions Contracted the Economy:

The contributions of this book include:

1. Using data from seasonal cycles and seasonal changes to better understand supply-demand relationships during the Great Recession.  These sections are excellent and highly original.

2. Showing that the normal laws of supply and demand still held and that we were not living in anything resembling wrong-ways sloping AD curves.

3. Calculation of various implicit marginal tax rates during the Great Recession and showing their relevance for labor supply decisions.

By no means am I fully on board.  I believe he specifies the aggregate demand view incorrectly and significantly under-measures the impact of aggregate demand.  I don’t think the AD view has to imply sticky prices or completely inelastic labor demand, for instance, although one version of that view does (p.208).  I see Mulligan as underestimating labor supply composition effects and overestimating productivity growth during the period under consideration.  There are other points one can complain about and overall he ends up overstating the size of the effects he is measuring.

Still, there are only a few readable books which integrate actual empirical research with a look at the Great Recession.  This is by no means the whole story, but this is a book which anyone seriously interested in the topic should read.  People still will be consulting it after the invective against it has long since died away.

The WSJ's review opines that:

Mr. Mulligan's thesis is that, in addition to thwarting recovery with unprecedented levels of spending, the Obama administration and Congress have made unemployment much higher than it might otherwise be. To take an obvious example, Congress increased the cost of labor—and thus decreased the number of jobs—by raising the minimum wage. (In fact, it has done so three times since 2007.) On a grander scale, Mr. Obama and his policy advisers have added to government benefits in various ways—in essence paying would-be workers for staying out of the workforce. Mr. Mulligan, an economist at the University of Chicago, estimates that about half the precipitous 2007-11 decline in the labor-force-participation rate, as well as in hours worked, can be put down to such misguided generosity. ...

In short, businesses drove up productivity by shedding workers. Why? "Businesses perceive labor to be more expensive than it was before the recession began," Mr. Mulligan writes. The reason for the added cost was that easier requirements for benefits—even as the government was pumping "stimulus" money into the economy—unwittingly reduced the supply of workers. As output began to rise, firms hired fewer workers. National unemployment has stayed so high for so long because of the government's policies, not in spite of them.

By the way, Mr. Mulligan doesn't challenge the claim that a surge in unemployment benefits, food stamps and other subsidies may have been desirable to prevent hunger or severe poverty for out-of-luck families or unemployable people traumatized by the recession. He simply and inconveniently notes that, though increasing subsidies may be compassionate in the short term, it comes with costs in the long term that eventually cause more hardship rather than less.

Outsourcing FEMA

Predictably, liberal commentators are bashing Mitt Romney for having once suggested that disaster relief should be left to states and private organizations. For example:

The Huffington Post has an absolutely essential piece  noting that Mitt Romney opposes FEMA and believes disaster relief should be either left to the states or to private organizations.  There is, in his world, apparently no role for the national government.  We're not all in this together, apparently. 

Romnery probably will backtrack in the fact of such criticism, but I'd live to see him take ownership of it. After all, in the wake of Katrina, I argued that we ought to outsource disaster relief:

This proposal will shock those who intuitively regard disaster relief as a core government function, but consider how many functions traditionally regarded as public sector responsibilities are already being outsourced to the private sector. Charter schools educate many of our children. Many more of our children are educated in public schools operated by for profit educational management companies. Many prisons are operated by for profit corporations. Even as basic a government function as war making has been partially outsourced, as illustrated by the military's extensive use of private contractors in Iraq and Afghanistan.

If we can outsource war, why not disasters?

Do me a favor: Before leaving some comment about how heartless I am, at least go read the whole post. Okay?

I'll never understand the French

With the Euro-zone crisis still running hot, we might expect the French government to be doing everything it can to make its economy more efficient. Instead, here's what President François Hollande is worried about these days:

Hollande has said he will end homework as part of a series of reforms to overhaul the country’s education system. ...

He doesn’t think it is fair that some kids get help from their parents at home while children who come from disadvantaged families don’t.

The tyrrany of the lowest common denominator. The very definition of the Left.

The Democrat's Economic Policy

John Carney's been watching the DNC and concludes:

The Democrats seem to be completely sold on the narrative that Clinton-era tax hikes and budget surpluses produced low interest rates and widespread prosperity that was later squandered by the Bush administration's deficits, with the end result of the financial crisis and "The Worst Recession Since the Great Depression." (Read more: Want The Truth? Every Politician Wants To Raise Your Taxes)

There’s not really any reputable economic theory that supports the idea that the combination of higher taxes and government budget surpluses leads to greater prosperity. It’s more like a shadow of a theory, something Democratic policy makers created from crib notes from respectable economic theory.

Carney concludes that the Democrat's policy requires one to assume not the proverbial can opener, but rather a free lunch. And there ain't no such thing.

Are we doomed to permanent deficits?

Buttonwood observes:

America has run a deficit for 40 of the last 44 years; Britain for 51 out of 60 and Spain for 45 out of 49. France has not balanced its budget since 1978; Italy since 1960.

I get the theory that in recessions one ought to run a deficit so as to stimulate the economy. But we haven't been in a recession for "40 of the last 44 years." The deficit is not about fiscal policy, it is about trying to have both a military hyperpower and a pervasive nanny state set of entitlements. It's long past time we tried austerity for a while.

Personally, I'm starting to believe that getting Paul Ryan into ever-increasing seats of power may be our last shot at sensible fiscal policy. Certainly, there's no reason to think the incumbent will make any progress. Obama's solution--to the extent he has one--depends on increasing taxes on the 1%. The troubel with solving the deficit with tax increases, of course, is obvious. As Milton Friedman explained:

... postwar experience has demonstrated two things. First, that Congress will spend whatever the tax system will raise—plus a little (and recently, a lot) more.  Second, that, surprising as it seems, it has proved difficult to get taxes down once they are raised.  The special interests created by government spending have proved more potent than the general interest in tax reduction.

If taxes are raised in order to keep down the deficit, the result is likely to be a higher norm for government spending. Deficits will again mount and the process will be repeated.

The solution remains a combination of starving the beast and cutting spending.

The continuing global impact of central bank policy on savings

Buttonwood notes some shocking facts:

As Deutsche Bank points out in its long-term asset return study, the longest series of bond yield data is for the Netherlands dating back all the way to 1517. In June, those yields reached a record low. Not just any old record, then, but a 500-year nadir. In America, yields go back only to 1790 but they too have been at all-time lows.

In other words, the developed world's central banks have (a) failed to stimulate the economy and (b) created an environment in which saving essentially is pointless because returns have been so low for so long. Maybe it's time to try some new central bankers and some new ideas.

The lesson of LIBOR: If we can't trust regulators to enforce current law, why would more regulation be a good idea?

Schumpeter makes a point I've been emphasizing in discussing the LIBOR scandal:

BOOSTERS of financial regulation are making hay from the widening scandal over allegations that LIBOR, a key interest rate, was rigged repeatedly for at least five years since 2005. Yet the trove of documents that have emerged also reveal the very flawed nature of regulation, in which government bureaucrats are asked to keep tabs on high-flying financial sorts. Transcripts of calls between officials at the Federal Reserve Bank of New York and traders at Barclays show that regulators didn’t really pick up on cues, even when they spelled out misbehaviour.

LIBOR, of course, is not the only pertinent example. Also in current news are the regulator failures at Peregrine Financial Group:

The Wall Street Journal reviewed the letters, which a person familiar with the situation said were left by Peregrine Chief Executive Russell Wasendorf Sr. They offer the first account of where Peregrine's missing money might have gone in a case that has left holders of thousands of accounts facing possible losses and fueled new concern over regulation of the futures-trading industry.

One of the notes, which was a general statement describing Mr. Wasendorf's alleged fraud and signed by him, says regulators first examined Peregrine's use of client funds as far back as 1993, triggering Mr. Wasendorf to start his alleged fraud. Deceiving the regulators was "relatively simple," said the statement. ...

The statement indicates a potentially closer involvement by the CFTC in overseeing Peregrine, commonly known as PFGBest, than previously thought. The CFTC has said it left the day-to-day regulation of Peregrine to the National Futures Association, an industry self-regulatory body. Thus, the note could put further pressure by investors and lawmakers on the CFTC for missing the scandal, particularly given the intense scrutiny alleged in the note.

If we can't trust regulators to capably enforce the laws on the books, why would we remotely think that more regulation is the right answer?

Favorite all-time TV shows

YMMV, but here's my list:

Is Venture Capital in Crisis?

The recent financial crisis cannot totally be blamed for the marked drops in venture capital fundraising, reduced venture investment and the hindrance of successful exits around the world, but it may have exacerbated the existing problems. Poor returns over the past decade indicate most fund managers do not earn their fees, and investors have been increasingly wary of taking on added risk without getting the reward. Structural changes are inevitable to the venture capital marketplace to preserve an essential source of funding for nascent high-growth companies.

--Cumming, Douglas J. and Johan, Sofia A., Is Venture Capital in Crisis? (June 11, 2012). World Economic Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2082062

via papers.ssrn.com

Chicago Economist Luigi Zingales on Crony Capitalism and the Crisis of the West

Musing on the implications of the Eurozone crisis:

Americans should be concerned for a deeper reason. High deficits, high debt and unsustainable entitlements are symptoms of a common disease infecting Southern Europe and the U.S. That's crony capitalism, a problem with which I, having lived in Italy, am unfortunately familiar. ...

For the U.S., the moment to act is now, before the cancer of crony capitalism metastasizes. The tax code needs an overhaul that eliminates special treatment and bans any form of corporate subsidy—starting with too-big-to-fail banks. We must find ways to introduce more competition into sectors such as education and health care, while expanding economic opportunity for those at the lower end of the income spectrum. And we must curb the political power that large industry incumbents have over legislation. Not only does it distort legislation, it also forces new entrants to compete on lobbying instead of concentrating on making more innovative and cheaper products.

It is not too late for the United States, but the clock is ticking. We have already begun to look like Italy. If we don't do something to stop that soon, we will end up like Greece.

via online.wsj.com

Let's just suck it up and take our medicine

I'm reluctantly coming around to the idea that stalemate might be a good thing:

As Ezra Klein explains:

The “extended baseline scenario” means we let the Bush tax cuts expire, the spending sequester take effect, etc. The “alternative” scenario means we extend everything.

In the “extended baseline scenario,” which is the one currently written into law, we don’t have a debt problem, but we have much higher taxes and, in the short-term, a likely recession. In the “alternative” scenario, we’ve got a huge debt problem, but lower taxes and less short-term austerity.

We can only go on kicking the can down the road so long. So maybe we ought to just go ahead and take our medicine now.

"Only a pessimist owns gold, and pessimists who do not also own guns are laughable"

The title of our post comes from a wonderful essay entitled Fool's Gold: Why Ordinary American Citizens Ought Not to Invest in Gold.

I don't own either, FWIW.

"Civilized People Don't Buy Gold" (Updated)

CNBC reports:

Warren Buffett's right-hand man, Charlie Munger, agrees with his boss on most things but there's one area they disagree — gold."

"Gold is a great thing to sew into your garments if you’re a Jewish family in Vienna in 1939," the Berkshire vice chairman said, "but I think civilized people don’t buy gold, they invest in productive businesses."

I'm reminded here of Terry Pratchett's wonderful Discworld novel Making Money, in which Lord Vetinari maneuvers reformed criminal and current Ankh-Morpork Postmaster General Moist von Lipwig into taking on the job of running the Bank of Ankh-Morpock and the Royal Mint. Lipwig eventually discovers that the 10 tons of gold supposedly in the bank's vaults is now longer there. Panic almost ensues. Naturally, however, Lipwig saves the day, gets the girl, and persuades the citizens of Ankh-Morpock to abandon the gold standard.

In doing so, Lipwig is interviewed by The Ankh-Morpork Times' crack reporter Sacharissa Cripslock, in the course of which Lipwig comes up with what I have always regarded as a compelling argument against the gold standard:

"The world is full of things worth more than gold. But we dig the damn stuff up and then bury it in a different hole. Where's the sense in that? What are we, magpies? Is it all about the gleam? Good heavens, potatoes are worth more than gold!"

"Surely not!," [said Ms. Cripslock]

"If you were shipwrecked on a desert island, what would you prefer, a bag of potatoes or a bag of gold?," [replied Moist]

"Yes, but a desert island isn't Ankh-Morpork!"

"And that proves gold is only valuable because we agree it is, right? It's just a dream. But a potato is always worth a potato, anywhere. A knob of butter and a pinch of salt and you've got a meal, anywhere . Bury gold in the ground and you'll be worrying about thieves for ever. Bury a potato and in due season you could be looking at a dividend of a thousand per cent."

"Can I assume for a moment that you don't intend to put us on the potato standard?" said Sacharissa sharply.

Update: A comment over at Walter Jacobson's blog opines that:

I think that we are in the same situation as the Jews in Vienna in 1939. In other words, it is going to hit the fan in the next few years.

Which calls to mind a passage from Edward McQuarrie's essay Fool's Gold:

In making a rational decision about whether to invest in gold, two possible outcome scenarios must be considered:

1. Society does not collapse
2. Society does collapse

Gold can only be a winning investment under the second scenario. If society does not collapse-if we continue to muddle through, as we more or less have in the United States for several centuries now-then gold is a losing investment. To see why, we have to explore what it means to be a "store of value."

I'm going to skip his explanation of why gold makes a lousy store of value. Instead, I want to go on to the survivalist argument for gold:

Please run the following movie in your head: society has just collapsed and you, whistling cheerfully, tossing your gold coins in hand, stroll down to the store, shouldering ahead of those wretches with their wheelbarrows of worthless paper currency, to buy a loaf of bread …

What's wrong with this picture? Two things: either you will be beaten bloody, and your gold robbed, before you ever get to the store; or, you will be followed home and murdered in your sleep-and your gold robbed.

First moral: if you are going to buy gold, you have to buy a shotgun too. Under precisely those conditions where gold will finally pay for itself, it will be far too dangerous for an unarmed person to carry gold. If you truly believe that you need to own gold, then it follows directly that you need to own a shotgun too. Bars on the windows and a Doberman wouldn't hurt either. ...

Second moral: under precisely those circumstances where gold would pay off as an investment, you can't possibly trust anyone else to hold your gold for you. And if you are thinking that you will keep your gold in a repository just until things start to look grim…have you ever seen pictures of a run on a bank…it isn't very pretty. Besides, how are you going to get that gold home, without a shotgun-do you really think the repository employees are going to keep mum about this guy in the red Camry, now heading West on Main Street, with thousands of dollars of gold in the trunk? ...

If you are going to buy gold, you must think and act like a survivalist.