THE 3 FORCES BEHIND THE SLOW RECOVERY
Pretty good macro commentary here from John Williams of the SF Fed (no, not John Williams of hyperinflation fame!). He pinpoints 3 causes of the slow recovery – tight credit, uncertainty, and contraction in government spending. I’d only add that there are two sides to that credit coin. Demand for debt has been extremely weak due to the effects of the balance sheet recession. Other than that small clarification, these are good thoughts:
“Powerful forces have kept us stuck in a slow-growth pattern. Some of those forces reflect the direct effects of the housing collapse on household finances. The connection with housing is less direct for other forces holding back the economy. I’ll highlight three of those forces: tight credit, uncertainty, and government contraction.
Tight credit was clearly a product of the housing bust. But it took on a life of its own when fallout from housing almost brought down the global financial system in 2008. The repercussions of those dramatic events still affect markets today. Let me explain how this played out.
When home prices crashed, mortgage delinquencies and foreclosures surged. Exposure to risky U.S. subprime mortgages was spread globally through investments held by financial institutions. Those mortgages had been repackaged to create financial instruments of mind-bending complexity. When the music stopped, it was hard to tell who was left with all those toxic assets. Financial institutions became afraid to lend money to anybody, including other financial institutions. The result was a massive credit crunch that choked off the flow of funds financial institutions and nonfinancial businesses depend on for their day-to-day operations. Many financial institutions that had placed big bets on housing posted massive losses. Some of them failed.
Thankfully, central banks and governments around the world stepped in to provide emergency loans and other support. Those interventions prevented complete financial collapse. In the United States, the financial system has healed to a very considerable extent. The Fed recently conducted a series of tests on the largest U.S. banks. We found that most of them would have adequate capital even if the economy went through another extreme downturn.
As financial institutions have regained their footing, access to credit has improved. Nevertheless, we haven’t returned to normal. Many small businesses and consumers still struggle to get loans. For example, to get a mortgage, a borrower must have a top-notch credit rating and the cash to make a substantial down payment.
Uncertainty is a second factor holding back the recovery. Businesses, investors, and households remain skittish, even in the face of better economic news. Many of my business contacts say they remain cautious about expanding because they’re unsure about future conditions. Ordinary Americans worry about job prospects and future income. Everybody is unsettled by the highly charged political environment.
Financial turmoil in Europe has added another dimension to the unease here. The imminent threat of European financial meltdown has diminished. But the underlying problem of countries with unsustainable debt has not been resolved. Over the next few years, the total debt load among countries that use the euro will grow larger. I’ve heard Europe’s policy described as kicking the can down the road. But the risk is that Europe might be rolling an ever-growing snowball down a hill.
Government cutbacks are a third obstacle to growth. Typically, government spending rises when the economy turns down. That’s because the cost of safety net programs, such as unemployment insurance, go up. And sometimes governments deliberately boost spending to stimulate the economy. But the federal government’s long-term budget problems loom large. And state and local government finances are reeling from the economic downturn. As a result, government stimulus has been unusually limited.”
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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“For example, to get a mortgage, a borrower must have a top-notch credit rating and the cash to make a substantial down payment.”
That’s not really true. A 620 credit score, with 3.5% down payment nets you a FHA loan up to $730,000. If anything, the credit rating + down payment requirements are not nearly stringent enough.
To put that in perspective, if my parents — whom I love so very dearly — came to me with a 620 score and asked me to borrow half a million dollars, I would tell them to take a hike. The FHA should do the same.
And in case anyone thinks this is not a problem, consider that the FHA has an unlimited line of credit at the Treasury. Its portfolio reserves in September were at 0.24% ($2.6 billion) below the mandated 2%. If we want to talk about creating net new financial assets, the FHA has a helicopter that would make Ben blush.
Maybe the real problems are valuation and a lack of confidence that you will have the income for 30 years to pay back the debt. Houses are still overpriced, so you can’t assume that you will sell the house for more than you pay for it. People borrowed (and lent) recklessly during the bubble years because they made the assumption that house prices only go up. Everyone now knows that assumption is false.
A basic problem is insufficient consumer demand. The well-recognized gap in incomes has affected the standard of living compared to what it might have been if a 1960-1970 income spread existed in recent decades. Parents might even afford sending children to college. There is a limit in the number of yachts a multi-millionaire wants. So his extra income is safely tucked away from consuming more. But now we are using more food stamps. Greed has won.
“Government stimulus has been unusually limited.” The federal deficit has been $1.3 trillion (give or take $100 billion) annually for the last four years, and this guy thinks government stimulus has been limited? I suppose he’s referring to a central planning directed stimulus, but really, isn’t any deficit spending stimulative?
As for state and local governments, their spending has been limited mainly by the need to increase their pension contributions–a condition brought on in large part by ZIRP (lack of investment cash flow means the benefit payments need to be financed more and more on a pay-as-you-go basis.)
Here is another perspective for Mr. Williams…… When the Fed first dropped interest rates in 2003 it incentivized not only the housing bubble and a spending binge, but forced the dollar pegging countries to buy more dollars to exchange US sovereign credit for the goods sold to us…. The surplus dollars were used to buy up U.S. debt. This increased the demand for safe assets…..making an already easy monetary policy easier…… and the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.
With a shortage of safe assets in the world, Wall Street rose to the moment and began engineering risky assets into safe assets to meet the demand. Putting AAA ratings on cow manure and selling these assets to countries like Iceland and fixed income managers every where……. then a crises and all those engineered safe assets vaporized………. not only forcing the FED to buy them back, but forced the Fed to provide liquidity to the massive credit crunch that choked off the flow of funds financial institutions and non financial businesses depend on for their day-to-day operations due to the vaporizing of safe assets.
Guys like Bill Gross at PIMCO went around and bought as much of the remaining supply of safe assets they could get their hands on…… Europe imploded and capital flowed to the safety of US Assets……. LTRO
The Fed created this crisis through failed monetary policy IMHO.
So…… we need to increase the supply of safe assets in the world……
http://www.scribd.com/doc/81290053/74791210-2011-12-01-2012-Global-Outlook
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
http://www.imf.org/external/np/seminars/eng/2011/res2/pdf/crbs.pdf
http://www.federalreserve.gov/BoardDocs/HH/2003/July/Testimony.htm
http://macromarketmusings.blogspot.com/2011/12/why-global-shortage-of-safe-assets.html
Discussion of the economy on NPR’s ‘Diane Rehm Show’:
Re recent drop in small business confidence – uncertainty hits hardest on this sector; also ‘job creation’ here largely driven by new business start0ups (which have high failure rate).
Also total turnaround: manufacturing/exports leading the ‘recovery’. Especially in areas like agriculture where increasing demand seems inevitable (barring catastrophe), Cullen’s faith in the US’s John Deere’s may prove warranted.
Cullen- Saw you covered your shorts, did they make any $$?
Yeah, algo kicked off a cover signal into today’s big down move. I made about ~3% overall putting the strategy gains at 4.5% YTD. Pretty good considering that I initiated the position about 7% below the market peak….Goes to show – good hedging is largely about position sizing. I wish I could write about the specific position because it would be a great little case study in managing a position and money management in general.
Hmmm… I bet you could find away around revealing too much and get the point across.
Uncertainty and government cutbacks? Insanity. Impossible to think fiscal deficits of 8%+ of GDP for years now and interest rates very near record lows in nominal terms and at lows in real terms constitute “government cutbacks.”