Individual investors boosted their allocations to equities last month according to the January 2012 Asset Allocation Survey.

AAII members allocated 60.9% of their portfolio stocks and stock funds in January, an increase of 4.8 percentage points from December. This is the first time equity allocations were above their historical average of 60% since July 2011.

Bond and bond fund allocations declined 0.8 percentage points to 20.9%, a three-month low. Even with the decrease, January marked the 32nd consecutive month that fixed-income allocations remained above their historical average of 15%.

Cash allocations plunged 4.0 percentage points to 18.2%. This was the smallest allocation to cash since May 2011. The historical average is 25%.

Equity allocations rebounded strongly as AAII members became more upbeat about the short-term direction of stock prices. Improving economic data and growing corporate profits haveled to above-average bullish readings in our weekly Sentiment Survey. This optimism has filtered through to portfolio allocations. Equity allocations are close to their historical average, however, as individual investors continue to cast a wary eye toward the European sovereign debt crisis.

Last month’s special question asked AAII members if they thought they were overweighting or underweighting stocks relative to the allocations suggested for their age. The majority of respondents said they were overweighting stocks. Many cited low bond yields as the primary reason for doing so. Several said they were not reliant on their portfolios for income or were otherwise able to handle the higher volatility from overweighting stocks. Some also viewed stocks as having the most upside potential.
Here is a sampling of the responses:

• “Overweight stocks. Yields are too low on bonds. I feel that stocks offer a better risk-reward tradeoff.”
• “For my age, I’m overweight stocks, but I draw income from my portfolio, so I want a more aggressive investment focus.”
• “I’m overweight stocks because I feel that this is a buying opportunity.”
• “Underweighting due to volatile market conditions and personal preference toward risk aversion and capital preservation.”
• “Underweight, but I am looking for opportunities to deploy cash.”

January Asset Allocation Survey Results:

• · Stocks/Stock Funds: 60.9%, up 4.8 percentage points
• · Bonds/Bond Funds: 20.9%, down 0.8 percentage points
• · Cash: 18.2%, down 4.0 percentage points

January Asset Allocation Survey Details:

• · Stocks: 29.6%, up 4.0 percentage points
• · Stock Funds: 31.3%, up 0.8 percentage points
• · Bonds: 5.0%, down 0.8 percentage points
• · Bond Funds: 16.0%, no change

Historical Averages

• Stocks/Stock Funds: 60%
• Bonds/Bond Funds: 15%
• Cash: 25%

Comments were equally optimistic:

• “Overall business conditions to improve. We continue to outperform previous business cycles.” (Information)
• “We are seeing increased contractor bidding and activity in Q1 2012.” (Construction)
• “Small business borrowing continues to be slow.” (Finance & Insurance)
• “New fiscal year, new budgets — expecting to show an increase in sales in first quarter.” (Other Services)
• “Economy continues to show signs of improvement and the company revenue is improving slightly, but is very susceptible to pricing and cost pressures.” (Professional, Scientific & Technical Services)
• “There seems to be some stabilization in the economy as well as [in the] supply chain. This seems to be calming inventory and sales positions.” (Retail Trade)
• “Business is still stable; however, inflation in food prices is still a problem.” (Wholesale Trade)

That said, it never ceases to amaze me how the pendulum of investor sentiment swings from one end to the other.  4 months ago you could hardly find anyone who was optimistic about the economy.  The ECRI was giving their guarantee on recession and Europe was collapsing.  Now, we’re swinging to the opposite end of the spectrum….The irrationality of human psychology is the one constant in the marketplace….

Europe is going from crisis to crisis as the rest of the World is doing its best to muddle through. Meanwhile, global equity markets do not seem to care one jot. They only recognise one direction at present and that is higher. Many investors are perplexed. Fundamentals stink, or so most investors seem to think. Some commentators even talk of a pending equity meltdown of cataclysmic proportions. What on earth is going on?

The bears have a point. Fundamentals are not exactly rosy. I have just returned to the UK from a week in Mallorca where I have had the opportunity to take the temperature of Spain through the local media and through speaking to people on the ground. The picture I was presented with was not pretty.

The latest report from Instituto Nacional de Estadistica suggests that the overall level of unemployment in Spain now stands at 22.85% (see here) and youth unemployment has risen to more than 50%. Although a flourishing black economy in Spain ensures that not all these people are without work, the relentless rise in unemployment is crippling the domestic economy.

Hardest hit are retail sales. December sales came in 5.4% below year-ago levels (chart 1), confirming the dramatic loss of purchasing power in Spain. Most other macro indicators confirm this depressing trend, suggesting that GDP should in fact be much weaker than it has turned out to be.

Chart 1:  Spanish Retail Sales Continue to Disappoint

Source: Bankinvest

The subject of Spanish GDP has intrigued me for a while (I am a sad case, I know). When I began to do research for this letter back in December, the working title was Is Spain Cooking Its Books?Inspired

primarily by Frank Veneroso’s excellent work[1], I came to the inevitable conclusion that the economic statistics coming out of Madrid simply did not add up[2].

Then, on a quiet day between Christmas and New Year when most people had their Bloombergs switched off, the new Spanish government which had come into office only a week earlier, broke the news that the 2011 fiscal deficit would probably reach 8% of GDP – a full 2% over the target agreed with the European Union only a few months earlier (see here).

Embarrassingly, the admission came only four weeks after the outgoing government had confirmed that Spain was very much on target to keep the deficit below the 6% agreed with the EU. So, yes, Spain was cooking its books and Frank Veneroso was absolutely right in raising the red flag, but I had lost a good headline for the February letter. Back to square one.

The other big issue facing the Spanish economy is the blatantly overvalued property assets on the balance sheets of the banks and savings banks (see here). From what I heard whilst in Mallorca, the Bank of Spain is becoming steadily more forceful in its handling of the crisis, demanding a far more aggressive approach as to how the banks mark repossessed properties on their books.

To give you an idea as to how bad the situation is, a 2010 profit of about €50 million in Caja de Ahorros del Mediterraneo turned into a loss of €1.7 billion by June 2011 after its property book was marked to market. And that is just one small savings bank (that has since ceased to exist).

The new government has already put out an estimate of how much they expect (read: request) Spanish banks to set aside in additional provisions against bad property loans – €50 billion or approximately 4% of GDP. If that number proves sufficient, the property crisis is probably manageable. It is certainly not of the magnitude seen in Ireland.

On the other hand, consider this: Spain’s financial system has about €338 billion of property related assets on its books, €176 of which are classified as bad loans. If Fitch is correct in its analysis that the average foreclosed loan in the Spanish banking system is 43% overvalued (see here), then Spanish banks should set aside a lot more than €50 billion in provisions. And property prices continue to fall.

Much of the weakness in Spain, and elsewhere, is blamed on austerity but the facts simply do not support this argument. Most of the countries supposedly in the midst of an austerity drive – including the UK whose government has managed to convince the rest of the world that it is doing all the right things but the facts suggest otherwise – continue to run massive fiscal deficits. Something else must be at work.

In a credit-based economy, which would include pretty much every country currently finding itself in a crisis of sorts, aggregate private sector demand is not only a function of income but also of changes in debt. Proponents of this idea include economists such as Richard Koo and Steve Keen but, despite the logic of their message, it is a concept ignored by many economists. As Steve Keen writes:

“Bizarre as it may sound, these arguments by leading economists ignore decades of empirical research into and practical knowledge on banking, which have established that their fundamental premise is false: a new debt is not a transfer from one bank customer’s account to another’s—which is effectively what Krugman models and Bernanke assumes above — but a simultaneous creation of both a deposit and a debt by the bank. A bank loan thus gives a borrower additional spending power without forcing savers to reduce their spending power to compensate.”

In a highly leveraged economy such as the UK, even modest changes in household leverage can have a profound impact on the economy as the debt reduction absorbs capital otherwise ear-marked for consumption. Chart 2 below illustrates precisely how much private debt has escalated in the UK in recent years and how much de-leveraging is still to come, assuming we need to return to debt levels last seen in the 1980s before the explosion in private debt.

Chart2:  The De-leveraging Process Has Only Just Begun

Source: Steve Keen’s Debtwatch

Given those dynamics, and given the bleak prospects of a sustained upswing any time soon in Europe, there are commentators who argue that the ECB should engage in quantitative easing similar to the policy pursued by the Federal Reserve Bank and the Bank of England. To those people I say: Wake up. Where have you been for the past six months? The ECB together with the national central banks of the eurozone have engaged in massive QE since last August (chart 3) although they have done their best to be quite discreet about it.

As pointed out by Frank Veneroso, the ECB’s balance sheet has expanded almost 50% in the last six months to €2.7 trillion and it doesn’t stop there. The balance sheets of the 17 eurozone central banks have grown even faster and now add up to €1.7 trillion, creating a consolidated balance sheet in the European central bank system of €4.4 trillion, almost twice the size of the Fed’s balance sheet. And this is beforeyou add in the €489 billion provided through the LTRO

programme announced on the 8^th December. This certainly hasn’t gone unnoticed in European equity markets which have performed much better since the announcement.

Chart 3:  ECB Bond Purchases Exploded in 2H2011

Source: Bankinvest

What’s more, European banks are set to more than double their crisis loans from the ECB when the next LTRO auction opens on 29^th February according to a survey in the Financial Times (see here). The conclusion is crystal clear: It is not a question of whether the ECB should or should not engage in QE. The ECB is already knee deep in a QE programme that has been firing on all cylinders since last August, and there is a lot more to come.

There is no question that the liquidity made available by the ECB has eased the liquidity squeeze in the European banking system and thus provided some much needed energy to the equity markets; however, in order to fully understand what is going on, you need to look at chart 3 in conjunction with chart 4. It is no coincidence that M3 (a broad measure of money supply) has begun to fall at the same time as the ECB has expanded its balance sheet aggressively.

Chart 4:  Eurozone M3 in Decline

Source: Soberlook.com. Note: All numbers in billion euros, seasonally adjusted

As the crisis in the European banking industry has mounted over the past couple of years, the only type of interbank lending that has continued to work well is repo lending (secured lending usually, but not necessarily, with government bonds provided as security), but repo lending is not ideal for banks in the current environment as it is mostly short term finance.

Having the ability to finance their liquidity needs longer term would give the banks much needed stability and that is precisely what the ECB programme provides and why so many banks took up the ECB offer. This has had the effect of draining the interbank market of collateral (which is now with the ECB). Since repos are included in the M3 but secured lending provided by the ECB is not, the M3 drops as banks shift from the repo market to the ECB.

You may say, so what? However, this is not only of academic relevance. Obviously the need for the ECB to step in and offer an alternative to repo funding is a signal that the credit conditions in Europe are far from ideal. If one drills one level deeper, it is possible to obtain information as to which countries have seen the biggest drop in repo funding, which should be a proxy for relative credit conditions. Not surprisingly, Italy accounts for almost 50% of the drop in repo funding with Spain accounting for almost 20% and Belgium for about 15% (see here for details).

Now, this information has been used by some commentators to suggest that Italy is being suffering a slow and painful death in the euro system. Ambrose Evans-Pritchard wrote a stinging article in the Daily Telegraph a couple of weeks ago, suggesting that “The euro is pushing Italy into depression” (see here). Using chart 5 below, he argued that:

 “There is no clearer indictment of the dysfunctional nature of monetary union. Italy is being pushed into depression. Criminal.”

Chart 5:  Italy’s Contribution to Euro Area Monetary Aggregates

Source: Banca d’Italia. Note: 12-month percentage changes

Now, remember what I said earlier. Repos count towards M3. ECB secured funding doesn’t. So, when Italian banks move away from the repo market and fund themselves through the ECB instead, the effect on M3 will be profound. Italian banks are much better off with the ECB programme but M3 looks ugly as a result. Sometimes there is more to the story than first meets the eye.

Which brings me to one of my pet hates. The emergence of the internet as a provider of (usually) independent and (occasionally) high quality research has made it more important than ever not to take everything you read at face value. I am referring to the thousands of market commentators cum economists (let’s just call them bloggers although, strictly speaking, they don’t all blog) who see it as their call in life to

comment on every bit of economic and market news, whatever the relevance to the rest of us.

Now, I shall be the first to admit that many bloggers do a very respectable job and their services are certainly needed as an antidote to the self-promoting investment banks which have always done – and always will do – everything in their power to talk the markets up. Having said that, many bloggers are as negatively biased as the investment banks are positively inclined, so the neutral needs to understand that there is bias in both camps.

The other and bigger problem is that most bloggers do not manage money. Talk is cheap when there is no accountability. Back in the late 1990s, fund manager Tony Dye became a household name in the UK for sticking to his view that equity markets were dramatically overvalued. His employers began to lose clients and finally lost patience with Tony who was sacked in February 2000 (no points for guessing when the markets topped out). Tony was a fund manager with great vision who was prepared to stand by his views, but he paid the price for getting his timing wrong.

Where am I going with this? You are about to find out. In the blogging sphere timing rarely matters. Bloggers can operate on a completely different level from market practitioners, and most of them do. Good friend and fellow investment manager Kim Asger Olsen of Origo (see here) refers to it as Economists’ Hypothetical Time (EHT) versus Real Market Time (RMT). His point – and I wholeheartedly agree – is that, whereas market practitioners (those who manage money and thus have an effect on markets) are forced to operate in RMT if they have any desire to make money for their clients, bloggers tend to work in EHT (this is a polite way of saying that they dwell for too long on what already belongs in the past in RMT).

Market practitioners no longer care about Greece. Neither do they care about Portugal for that matter. In RMT these countries no longer matter in the bigger scheme of things (to my friends in those countries: don’t take it personally, but that is the reality). So, when Portuguese bond yields blow out as they have done in the last week (chart 6), the reaction in the markets is muted to say the least. EHTers think it spells the end of the world. RMTers, on the other hand, know that Portugal doesn’t need to finance itself through the bond markets for at least another 30 months. Hence they ignore the Portuguese predicament. Instead they are now entirely focused on whether Italy and Spain can ride out the storm and, on the evidence of the recent performance of European markets, the verdict is that they can.

Chart 6:  Weekly Change in Eurozone Bond Yields

Source: Bankinvest. As at 1 February 2012. 

Much of the €489 billion that the ECB dished out in December has come back into the coffers of the ECB as overnight deposits (which may have disappointed the ECB somewhat) but, irrespective of that, the programme still did the bond markets in the eurozone’s periphery a world of good. Charts 7 a-b below show the Spanish and Italian yield curves as at 7 December (the day before the ECB announcement) and [28 January] respectively. The improvement is significant, in particular on 2-4 year maturities where the effect of the LTRO has been the greatest.

We can debate from now ‘til the cows come home whether Italy can afford to pay 6% on its 10-year debt, and that is precisely what occupies the minds of those operating in EHT, but what matters to RMTers is that Italy can finance itself cheaper now than they could 8 weeks ago. Doomsday has moved further away and equity markets have reacted accordingly. Who said QE doesn’t work?

Chart 7a:  Spanish Yield Curve

Chart 7b:  Italian Yield Curve

Now to the $64 million question: Are we in the early stages of a major new bull trend or is it simply a bear market rally? Most EHTers will tell you it is the latter. RMTers are divided. Let’s look at some of the risks before I reveal where I stand.

Few people would probably disagree that the biggest risk facing the world today is the unfolding eurozone crisis but, as I have at least

attempted to demonstrate with this piece, that crisis is now in decline, at least temporarily. I say temporarily, because there can be no doubt that the ECB has not solved the eurozone crisis yet. All it has achieved so far is that it has bought a not inconsiderable amount of time which is no small accomplishment given the near meltdown only a few months ago. On that basis, the equity rally is more than justified.

But the eurozone crisis is not my only worry. After a decent run in equity markets, individual investor euphoria is on the rise and is now in dangerous territory – at least in the US (chart 8). This is not a dead sure indicator, but when sentiment reaches these levels, it often precedes a sell-off (small or large).

Chart 8:  Investor Sentiment in Dangerous Territory

Source: American Association of Individual Investors, Pragmatic Capitalism

If individual investors are perhaps getting a bit carried away, Wall Street analysts certainly aren’t. Earnings estimates for 2012 have come down significantly over the last few months (chart 9) at a time where the US economy has surprised pretty much everybody by its strength. This doesn’t add up. Are analysts overly pessimistic (not usually in their DNA) or is this an indication that the current upswing in US economic fundamentals will prove short-lived? The last thing Europe needs now is for the US to lose momentum again. It can hardly afford it.

Chart 9:  US Earnings Estimates Under Pressure

Source: Morgan Stanley

I wish the list would stop there but it doesn’t. I am concerned about China (don’t think they tell the truth about the true extent of the current slowdown) and I agonize over the situation in Iran (the world economy is too fragile right now to withstand an oil price at $150). Most of all, I worry about pension liabilities in Europe (see here) which continue to grow without any serious attempts being made to address the problem.

In other words, there is plenty to keep me awake at night; however, to use an old cliché, equity bull markets have always had to climb walls of worry and this is no different. At least for now, valuations are sufficiently attractive (see our October 2001 letter here for a detailed discussion of current valuation levels) to keep this bull market going.

Is it the beginning of a structural bull market? I doubt it. We are still in a risk-on / risk-off environment where investors blow hot and cold. One of the fallouts of the crisis of the past 3-4 years is a shortening of investors’ time horizon (stat of the day: did you know that the average holding period for US equities is now 22 seconds?). Long term investors have become an endangered species and the effect on markets is there for everyone to see. I doubt this will change any time soon but, for now, it is risk on.

This is not the time to be fully invested but neither is it the time to be side lined. We are in a nervous market where great opportunities present themselves at regular intervals. We recommend holding 25-50% in cash or cash like instruments (depending on your risk profile) which can be deployed at short notice when those opportunities arise.

We have recently produced a brief strategy document where we outline a number of investment strategies which we believe fit into this type of environment. This document is available to clients of Absolute Return Partners. Please contact either Nick Rees or myself if you would like a copy.

Econoday has the details on this morning’s employment report which showed a healthy jump in private sector employment to 240K jobs in January as well as a decline in the unemployment rate to 8.3%:

“The January jobs report posted stronger than expected with payroll gains and unemployment dip. Payroll jobs in January advanced 243,000 after jumping 203,000 in December (originally 200,000) and rising 157,000 in November (prior estimate up 100,000). The net revisions for November and December were up 60,000. Analysts projected a 135,000 boost for January. Today’s report includes annual revisions to payroll series, including benchmark revisions to payroll levels and new seasonal factors. Household data received annual revisions last month but reflect updated population estimates in January data.

As for some time, private payrolls outstripped the total, increasing 257,000 in January, following a gain of 220,000 in December. Expectations were for a 150,000 rise in private payrolls. Private-sector employment was led by gains in professional and business services (+70,000), leisure and hospitality (+44,000), and manufacturing.

In the private sector, goods-producing jobs advanced 81,000 after a 71,000 boost in December. Manufacturing jobs increased 50,000 in January after rising 32,000 the month before. Construction employment gained 21,000 after increasing 31,000 in December. Mining increased 10,000, following an 8,000 advance the prior month. Private service-providing jobs jumped 176,000 in January, following a 149,000 expansion in December.

The public sector continued to shrink as government employment slipped 14,000, following a 7,000 decline in December.

Average hourly earnings rose 0.2 percent in January, following a 0.1 percent increase the prior month. The consensus called for a 0.2 percent gain. The average workweek for all workers in January held steady at 34.5 hours. Analysts projected 34.4 hours.

From the household survey, the unemployment rate dropped to 8.3 percent from 8.5 percent in December. The market median forecast was for an 8.5 percent unemployment rate.”

The overall goal is basic.  We want to create a simple go-to source for understanding the modern monetary system.  We also want to try to eliminate politics and biases as best we can from the main page.  I know that’s not entirely feasible, but I think we can focus 95% on operational aspects and helping people learn this content better.  If we have any prayer of taking this mainstream we need to focus on the facts and eliminate the politics that poison so much of economics.

But we need your help.  Let us know what we can do to improve the process of teaching people and informing the public.  At the end of the day this is all about getting the message out to the public and influencing public opinion and ultimately public policy.  As Carlos often says, the goal isn’t to get in a textbook.  The goal is to get in the US tax code.  We’re not going to be able to do that without your help.   So hopefully, this is the start of something good.  But building it and spreading it is going to be a long road….

“A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets—-bonds, stocks, real estate and commodities alike—-is now deleveraging because of excessive risk and the price of money at the zero-bound.  We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.”

This quote from Bill Gross’s February comment for Pimco neatly summarizes in one sentence the main theme we have been emphasizing in our own comments for many years.  Periods followed by credit crises are almost always followed by many years of below average growth, anemic expansions and frequent recessions.  The most recent example is the experience of Japan since 1989.  It is now happening in the U.S. and much of the world, and will not end anytime soon.

In the U.S., total domestic debt is now 341% of GDP, compared to about 150% in 1980.  Gross federal government debt is about 100% of GDP, up from 32% in 1980.  Household debt is 87% of GDP, compared to 49% in 1980. The period of abundance ended with the severe credit crisis of 2008 that was followed by the worst recession since the Great Depression.

Similarly, the recovery has been the weakest since the 1930s. Real GDP, over the last four quarters, has grown at the meager rate of 1.6%.  Although the recently reported fourth quarter GDP growth of 2.8% was the best of 2011, the underlying data was extremely weak.  The growth was driven largely by inventory accumulation, while final sales were up only 0.8%.  Consumer spending increased by only 1.5%.  Furthermore, nominal GDP growth (before deducting inflation) was only 3.2%, down from 4.4% in the prior quarter as the implicit price deflator was only 0.4%, against 2.6% in the third quarter.  Had the same deflator been applied to the fourth quarter, growth would have been only 0.6%.

Looking ahead, consumer spending is likely to remain weak as households seek to deleverage and increase their savings. December real retail sales were down 0.1% as consumers raised their savings rate from 3.5% to 4%.  The savings rate generally averaged between 8% and 9% from the 1950s to the 1980s. Declining household wealth, mostly a result of dropping home prices, is another factor inhibiting spending.  While initial unemployment claims have dropped, new hiring is still in the doldrums, and wages increases are minimal.  Since capital spending growth generally follows consumer spending by a quarter or two, this segment is likely to remain tepid as well.  In addition, 2011 capital spending was boosted by a 100% tax credit that expired by year-end, thereby pushing some potential 2012 spending into the prior year.

Inventory accumulation will probably decline after the fourth quarter rise.  Exports should be under pressure as a result of weakness in Europe and declining global growth.  Fiscal stimulus will be less this year than last, while government spending is dropping at federal, state and local levels.  Furthermore, last week’s FOMC meeting and Bernanke’s testimony today indicate to us that the Fed is essentially out of ammunition, while government is likely to remain dysfunctional in a hotly contested election year.  Given all of these factors it is difficult to see where economic growth will come from.

Although the strong point of the economy until now has been corporate earnings, even this area is showing some early signs of faltering.  Only 59% of corporations so far have beat fourth quarter earnings expectations, the lowest since the third quarter of 2008, while only 43% exceeded revenue forecasts, the lowest since the first quarter of 2008. The combined results for those who have reported and the estimates for those yet to report show an increase of 11.5% over a year earlier.  The increase, however, would be only 1% without AIG and Apple.  Furthermore, the number of companies reducing guidance exceeded those raising guidance by about 3%.  In view of our outlook, we think that earnings disappointments will mount throughout the year.

Gallup released their latest employment poll today and the news doesn’t bode well for tomorrow’s January employment report.   According to the most recent survey U.S. employment, without seasonal adjustment, increased to 8.6% as of the end of January and 8.7% as of February 1st.  Either way you look at it the recent upward trend is the opposite of what we want to be seeing at this point.

The percentage of U.S. employees who are working part time but want full-time work increased sharply to 10.1% in January, from 9.8% in December. The January reading is also substantially higher than the 9.1% of January 2011 and is the highest percentage for this segment of the workforce since Gallup began monitoring it in January 2010.

Underemployment, which is a measure that combines the percentage of workers who are unemployed with the percentage working part time but wanting full-time work, surged to 18.7% in January.  This is substantially worse than the 18.3% in December and is only slightly below the 19.0% of a year ago.

Lastly, the percentage of individuals employed FULL-TIME by an employer has dropped drastically in recent weeks and doesn’t bode well for future employment figures.  The decline in the percentage employed full time shows that much of the employment figures that we have witnessed recently are likely in temporary and contract positions.   Easy to hire and terminate with lower benefit costs – this remains a driver to maintain corporate profitability at the expense of the individual.

The takeaway here is that these numbers do not bode well for a strong employment report tomorrow.  We are expecting numbers to come in well below expectations but will publish our monthly Real Employment Situation Report tomorrow after the release.

“SANTA ANA, Calif., February 2, 2012––CoreLogic (NYSE: CLGX), a leading provider of information, analytics and business services, today released its December Home Price Index (HPI®) report, the most timely and comprehensive source of home prices available today, giving the first look at full-year 2011 price changes. The CoreLogic HPI shows that, including distressed sales, home prices in the U.S. decreased 4.7 percent in 2011 compared with December 2010. This year-end report shows that home prices continued the trend of year-end decreases—this is the fifth consecutive year with a decrease in the HPI. The HPI excluding distressed sales shows that home prices decreased by 0.9 percent in 2011, giving an indication of the impact of distressed sales on home prices in 2011.

‘While overall prices declined by almost 5 percent in 2011, non-distressed prices showed only a small decrease. Until distressed sales in the market recede, we will see continued downward pressure on prices’ said Mark Fleming, chief economist for CoreLogic.”

“Under these assumptions [by the CBO], the budget deficit would be more than 4 percent of GDP in fiscal year 2017, assuming that the economy is then close to full employment. Of even greater concern is that longer-run projections, based on plausible assumptions about the evolution of the economy and budget under current policies, show the structural budget gap increasing significantly further over time and the ratio of outstanding federal debt to GDP rising rapidly. This dynamic is clearly unsustainable.” (emphasis mine).

But let’s look at the facts.  Since 1952 the government’s budget deficit has averaged 2.6%.  Not quite the 4% level that Bernanke cites, but certainly “in the red” according to the way that we are all taught (wrongly) to think about a government budget deficit being analogous to a household’s budget.    Not surprisingly, Paul Ryan was fueling much of the heat on the deficit today.   The odd thing is that under the Republican’s hero Ronald Reagan (from 1980-1988), the budget deficit averaged 4.8%.   You can clearly see the sea of red in the government’s deficit since just about the beginning of the chart:

The government always runs a budget deficit!

So if it’s “unsustainable” then we could have had the exact same conversation in 1982 when the budget deficit was 6.3% (right before an epic economic boom).  The confusion of course is surrounding why this is unsustainable and that’s where Dr. Bernanke’s comments were most alarming.  He said:

“…Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. “

Dr. Bernanke doesn’t explicitly mention Greece and Europe, but he certainly alludes to Europe.  And of course, he’s entirely misinterpreting the difference between being an autonomous currency issuer and being a currency user (like European nations).   An autonomous currency issuer doesn’t “run out” of money.  Their true constraint is inflation (and we always inflate, but notice that living standards haven’t collapsed since 1950!).

Thankfully, someone close to Dr. Bernanke knows the difference.  Paul Krugman has recently been highlighting the importance of being a currency issuer.  Let’s hope he invites Dr. Bernanke back up to Princeton to clue him in on this important fact….