Carmen Reinhart and Vincent Reinhart write in today’s FT about the recovery time-lines from large scale banking and real-estate crises. The Op-Ed considers the impact of a major disruptive economic event on real-estate prices, credit, human capital and productive capacity. It is a sobering assessment.
Today, the non-partisan Congressional Budget Office (CBO), published a report estimating that government stimulus raised real GDP (Gross Domestic Product) by anywhere from 1.7% to up to 4.5% in the second quarter of 2010. The report is 20 pages long, but is worth a look. Reuters put out a piece this afternoon that summarizes the report.
A revised Q2 GDP number will be released this coming Friday. The consensus from economists polled by Reuters is that the economy grew in Q2 at a rate of 1.4%. Piecing together this number with the CBO’s estimate of the stimulus’s impact leads to the uncomfortable realization that without government stimulus, the US economy contracted in the second quarter, pointing to evidence of a dreaded “double dip recession.”
While this outcome has surprised many market commentators (particularly those in the bullish camp), for almost a year now we have been skeptical that the US economy would come roaring out of our worst recession since the Great Depression, despite the injection of hundreds of billions of dollars in government stimulus.
In our 10 Themes for ’10 we published in January, our #6 theme was the following:
A cold year for growth: We expect the US economy will see almost negligible growth in 2010. Margins will continue to contract for US businesses and profit growth will remain slim. The expiration of stimulus programs and slim prospects for their renewal in a mid-term election year will reduce aggregate demand. Cost cutting and efficiency measures will continue to be necessary to offset top-line deterioration.
We believe the impact of the combined credit, real-estate and stock market crisis of 2007-2009 will take years to resolve. Typically, recovery from such crises has impacted growth rates for 5-10 years as households rebuild savings. Unfavorable demographic trends (such as in Japan), can push growth even further into the future.
In our Q1 quarterly letter, published in April, we wrote the following:
Withdrawal of Economic Stimulus. The other major theme we expect to impact our economy over the rest of the year is the withdrawal of extraordinary fiscal and monetary stimulus programs put in place during the crisis. Various measures by the Fed, European and Asian central banks to provide liquidity support to banks and markets will be withdrawn over the course of the next several months. Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China. As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been. We will also keenly track developments in trade agreements since various countries have enacted or are considering trade barriers and currency related moves to protect key industries and exporters.
As evidenced by the CBO report, it appears the damage to private enterprise has been fairly severe and far reaching. Now that the crutch of government stimulus has been removed (with little likelihood of another round on the immediate horizon), our economy does not appear to be the picture of great health that some market commentators would have us believe.
In our view, the biggest financial market story of 2010 has been the unfolding sovereign debt crisis. The crisis started with Iceland and Greece, moved on to Ireland Spain and Portugal and is now approaching American shores. It’s fitting that the debate should shift to the US, since in many ways a debt crisis in the US would have far graver implications than that in any other nation.
It is not simply that the numbers are bigger, and they are — our USD 1.4 Trillion deficit (the amount the government spends over the amount it collects in taxes) is larger than the GDP of all except a handful of nations. Part of the problem is that the US has been funding two wars without raising additional revenue. In fact, tax rates were reduced in the early 2000s, and the cost of the wars was taken off the official budget and funded through emergency spending bills. The US has also spent a great deal over the past two years to stabilize the financial system and broader economy.
But a larger problem looms in the years to come as record numbers of American workers (the baby-boom generation) retire and begin to draw on the Social Security and Medicare benefits they have been promised. The cost of the benefits has never been fully funded, largely because it has always been in a politician’s self-interest to promise benefits and defer the costs. In a similar way, special interest groups including health care providers, insurers and drug companies have followed their own self-interest and grown a health-care system that delivers the most expensive care in the world, with mediocre results.
Earlier this week, the Congressional Budget Office published a report on the Federal Budget and The Risk of a Fiscal Crisis which contains a litany of alarming statistics. The bare facts are that the US government spends more on programs for its citizens than it charges them in the form to taxes. It has been doing this for decades, and financing the spending with debt, except for a brief period of surplus in the 90s. This debt now totals USD 13 Trillion and it can only be repaid through tax revenues. Either income and other tax rates go up, or spending comes down.
The problems seems so intractable, the political views so entrenched, and the distrust so pervasive, that it is difficult to know where to begin. David Stockman’s Op-Ed in the NYTimes earlier this week makes an excellent start and is well worth the read. He has also been making the rounds on TV, and there is an excellent interview on Bloomberg well worth watching:
We agree with Mr. Stockman that bringing the US deficit, and by extension the debt, under control will require increasing revenue and controlling spending. We also agree that the problem has been nurtured and grown under both political parties, and in fact the Republicans may have more to answer for than the Democrats since they have presented a policy of revenue/tax reduction without bringing spending under control.
Mr. Stockman was partly responding to an Op-Ed in the Wall Street Journal by Arthur Laffer (another Reagan adviser). In his piece, Mr. Laffer argues that lower taxes will spur investment and growth, raising revenues in the process, while raising taxes would do the inverse. We find two aspects of Mr. Laffer’s argument misleading. Raising taxes from 33% to 36% is a very different proposition from raising them if they are already at 60% (as they were in the 1980s). Secondly, the top 1% of earners now pay a higher portion of GDP in taxes is because their share of GDP has grown while that of the rest of the population has stagnated. Extreme income inequality ultimately leads to a breakdown in the social contract. It is also important to remember that the Bush tax-cuts were implemented at a time when the US federal budget was running a surplus. Sunset provisions were incorporated into the cuts because there was a concern that the
However, the political environment is extremely polarized and it is hard for us to imagine reasonable measures being undertaken prior to the mid-term election. In our view, all legislative action between now and November 6th will be driven by its impact on congressional races.
The flip side of the debate on taxes revenue is the impact on spending and infrastructure. Paul Krugman writes about this in the NY Times this weekend.
The immediate question is whether the temporary tax cuts enacted in 2000 are to be extended. These cuts had a sunset provision embedded in them and were enacted at the height of the tech boom, when revenues were inflated and the US was running substantial fiscal surpluses. Soon after they were passed, the tech-wreck of 2001-2002 and the events of 9/11 shrank US growth and we have seen deficits rise steadily. The financial crisis and its aftermath have simply exacerbated a problem that was already quite severe.
In our view, the responsible course of action is to let the temporary Bush-era tax cuts expire. They will result in small increases to the federal income rates for most taxpayers, and they are a small step towards tackling the larger problem which is explaining to the American populace that the generous benefits they enjoy must be paid for and we may as well start now since we have been incurring the costs for a while.
As for the timing of any further tax increases, we believe they must be delayed. The US economy will experience the withdrawal of extraordinary fiscal stimulus and expansionary monetary policy over the next two years. Raising taxes simultaneously could well stall or reverse any recovery. However, there must be some commitment to simplifying the tax code and progress towards a balanced budget. Ideally, we would like to see Congress debate and pass a tax reform and increase bill which would take effect in a phased manner over a number of years, with a clear goal of paying down the extraordinary debt the US has accumulated. If the governing classes in the country don’t have the backbone to deliver this unpleasant medicine now, we may be forced to swallow an even worse pill down the road, much like Greece is today.
Below are links to an article, pod cast and blog post we found interesting this week.
In his article Banking Needs More Robust Stress Tests Than These, John Kay writes in the Financial Times about the inadequacy of the European Bank stress tests. He argues that while the language of “stress tests” is borrowed from engineering, the standards being applied are nowhere near as rigorous as those demanded in engineering. As many banks learned first hand in 2008, ”industry-standard” stress assumptions can create complacency. Wimpy standards blessed by primary regulators may be worse.
One of our favorite weekly radio programs/podcasts is This American Life. The show does not generally cover finance, but does a remarkable job whenever it gets around to covering the topic. For example, they present a very good explanation of the financial crisis in an episode titled The Giant Pool of Money. In a recent episode, the team took a look at US state budget deficits through the unique mix of political dysfunction, profligacy and entrenched distrust that characterizes the politics of Albany. The episode also contained a cautionary tale for states and countries with polarized political landscapes. In what comes as close to a controlled experiment in economics as one gets, we have the tale of Barbados and Jamaica. Both countries confronted a ruinous economic landscape in the late 70s. The nature of their local politics and the level of social cohesion led to small difference in the way they tackled their crises, but these small differences appear to have had an out-sized impact on future growth. The episode is titled Social Contract, and is worth listening to in its entirety.
and apropos of nothing in particular, we quote The Epicurean Dealmaker:
There are those who style themselves intellectuals—a notably large portion of whom, in my personal experience, happen to be economists—who are deeply suspicious of anecdotal data in general and anecdotes about finance, economics, and the behavior of market participants in particular. This has always struck me as revealing both a superficially shallow skepticism about the primary sense and experience data of others—which, after all, is the most reliable data each of us individually possesses—and a similarly unwarranted credulity about its opposite, broad and impersonal third party datasets.
…
Oh, and by the way, while quality has certainly improved since I started in investment banking 20 years ago, it remains true, for example, that the banker who wishes to remain employed will always check the accuracy of third party data against original sources before he incorporates it into his own work product. So much for the reliability of external datasets when real money—as opposed to, let’s say, a research grant—is on the line. Oh snap.— TED, unpublished remarks
A couple of news articles on the topic of China caught our attention last week. In an article titled Cooling Property Market Tests Beijing’s Nerves, the Financial Times reported on the sudden, marked slowdown in apartment sales within mainland China and the potential government response to this phenomenon. What stood out amongst all the anecdotal information is that apartment prices in Tongzhou (a suburb of Beijing) are currently hovering around USD $3,500 per sq. meter (or USD $325 per sq. ft.), perhaps more if you consider the CNY (Chinese Yuan or Renmindi) is undervalued to the USD. We admit that we’ve never visited China, so we don’t have firsthand knowledge of real estate market trends in Tongzhou (it could be the Greenwich of Beijing for all we know, and in fact, it looks like a pretty nice place from space). We also readily admit that we aren’t experts when it comes to navigating the complexities of the Hukou system of permits. Perhaps Tongzhou is the recipient of pent-up demand from people who cannot buy apartments within Beijing proper. Still, we think $325 per square foot is a bit high, especially when you consider the real estate market in suburban New York (the wealthiest city in the wealthiest nation in the world). We conducted a quick (completely unscientific) analysis of the property market by looking for new developments in the NYC suburbs (accepting at face value sq. ft. area claims made by the developer). We end up with asking prices in the range of $250-400 per sq. ft. (across the river in Jersey), $400-600 per sq. ft. (in Brooklyn and Queens) and $250-400 (Westchester). Median household income in New York City (2008) was $56,000. Beijing’s statistical bureau doesn’t publish median household income, but they do say that in 2009, disposable income per capita was CNY 26, 700 (USD $4,000). By our estimate, that puts median household income around USD $12,000-15,000, or 20-25% of that in New York. Yet prices are roughly comparable. In our view, these levels are unsustainable and highlight the growing disparity between real estate prices and what Chinese citizens can reasonably be expected to pay for these properties.
Last week also saw the IPO of the Agricultural Bank of China (ABC), the last of China’s major state-owned banks to go public. Like all the other state-owned banks, ABC spun-off a package of bad loans prior to going public. What we’re wondering is whether they’ve also spun-off all the employees who made those bad loans (over 10% of ABC’s USD 828 Bn balance sheet at end 2007). We’re also wondering it is possible to make USD $110 billion in bad loans in an economy that is growing at a 10% clip. Fitch Ratings has some ideas.
