Sunday, May 3, 2015

GDP Number Is A Master Illusion

Its Magic Illusion 101
Years ago a Seinfeld episode was centered around the idea of producing a television show about nothing! Sadly, in many ways this is the direction America has moved towards when it comes to measuring our economic growth. We have allowed numbers that mean "nothing" to seep into how the gross domestic product (GDP) is calculated all in an effort to create the illusion of growth. In years past America far out produced the rest of the world and manufactured goods that it exported across the seas. Today much of our economy is dominated by the service sector, this means if you wash my windows, then I will mow your yard. The recent first quarter GDP number of 0.2% could be no more than a rounding error and makes the hyped pre-election 2014 third quarter 5% growth a distant memory.

As time goes by small events often seem to drift into the distance or be forgotten, it could be I'm getting a little soft in the head or this is how I explain having to do research when I write. The Bureau of Economic Analysis (BEA) has made a significant change on how they calculate the GDP.  It slid by unnoticed by many people but they changed how they classified and recorded expenditures for R&D and for entertainment, literary, and artistic originals. An announcement of this change was made by the BEA during February of 2013, this resulted in an increase in the GDP. This kind of "bump" means that a gain of 2% today is in reality less than a gain of 2% years ago. This means we are comparing apples to oranges.

Gross Domestic Product is defined as the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports.Within that definition it appears those in power have discovered some wiggle room and even before that a debate exist as to what it really tells us. When we delve into all of this it is easy to see this is not simple at all and that the GDP can be a master illusion when we look at how it filters down to both society and the Main Street economy. The first comprehensive set of measures of national income was developed by economist Simon Kuznets who in 1934 told the US Congress the formula was problematic, he said. 

"The valuable capacity of the human mind to simplify a complex situation in a compact characterization becomes dangerous when not controlled in terms of definitely stated criteria. With quantitative measurements especially, the definiteness of the result suggests, often misleadingly, a precision and simplicity in the outlines of the object measured. Measurements of national income are subject to this type of illusion and resulting abuse, especially since they deal with matters that are the center of conflict of opposing social groups where the effectiveness of an argument is contingent upon oversimplification."

In 1962 Kuznets again emphasized that we must keep in mind the difference between quantity and the quality of growth. He made clear a distinction exist between cost and returns, and between the long and the short run. Kuznets went further to specify we needed goals concerning both growth "of what, and for what." Other economist have agreed that GDP is an empty abstraction with a very weak link to the real economy. The framework fails to reflect the difference between real wealth expansion or capital consumption. Kuznets used the example of the government building a pyramid that added nothing to the well-being of individuals, it would be viewed as economic growth, but in reality divert funding away from real wealth generating activities harms the generation of real wealth.

What is not stated can often be far more important than what is. The number we are spoon fed and await with such glee has little to do with real growth but most likely mirrors or is merely a reflection of monetary pumping. The GDP number fails to highlight a slew of important factors that feed directly into our standard of living and the health of our economy, such as;

    * How wealth is distributed and inequality
    * Taxation and how it effects both the economy and society
    * Non- market transactions like volunteer and off book work
    *  Underground economy, illegal trade and many cash transactions.
    * Asset value, meaning GDP ignores changes in what things are worth
    * The non-monetary part of the economy, bartering of goods and services
    * Distinguishing between production that is subsidized and that which is not
    * Quality improvements and new products
    * What is being produced, bombs or butter and a better educated populace
    * The sustainability of growth or misallocation of either capital or resources
    * Cross border parity and changes in currency value
    * External factors such as negative environmental effects or the health of the people

Some countries have even gone as far as to including things like prostitution and other illegal activities in a way to boost GDP and in effect lower their ratio of GDP to government debt. In 2013 in advice to their government the UK's Natural Capital Committee highlighted some of the failures of GDP when they pointed out its focus on flows can allow an economy to run down its assets while recording high levels of GDP growth until a point is reached where this begins to impact future growth. They went on to make it clear the recorded GDP growth rate is prone to overstate the sustainable growth rate. This number as with most numbers once put out there is subject to full blown manipulation and spin. Bottom-line in the words of its creator, "The GDP framework is more or less an empty abstraction devoid of any link to the real world."

Saturday, May 2, 2015

The Great "Time-lag" Effect!

Events Play Out At Different Speeds
Time-lag is defined as the period of time between to closely related events. Not everything happens at the speed of light, often a time-lag exist such as the gap between seeing and hearing the lightning bolt. Some of what we see occurring in the financial markets and the economy should be viewed with this in mind. Only during a panic does it become obvious just how precarious a position we have allowed to develop. Recently, I stumbled across a line describing how the markets have lost their ability to discover fair market value and no longer reflect honest or real value. The lack of true pricing should raise red flags and be of great concern for all of us.

The great "time-lag" effect may soon exert itself in a most wicked way over our economy. Recent data has been underwhelming and once again attempts to spin these numbers in a way that emboldens those trying to paint a picture of a growing economy are beginning to fail. Momentum appears to have turned downward and the time looms ever closer when being able to rally the market on bad news could become a distant memory. At some point bad news will simply become bad news and seen as a sign that the economy has problems that more quantitative easing can not address. At some point it will become apparent that we have only delayed addressing the root cause of what ails both our economy and many of those across the world, that is to much debt that will or can never be repaid.

We should remember two issues are in play that have yet to fully impact both our day to day economy and markets these are the strong dollar and falling oil prices. While these hit months ago it takes time for the effects of such powerful forces to totally work their way through the economy.  The recent drop in drilling is only now beginning to take hold and leave its mark. If oil prices remain in a slump as expected it will become obvious over the next few months that many people overlooked just how important a driver the energy sector has been to the U.S. economy during the last three years. This sector has been responsible for much of our job and growth and investment spending since the onset of the great recession.

As for the strong dollar, as I have written earlier, unstable currency markets can be a precursor to massive shifts in value and a sudden drop in confidence. It is logical to think that in such a situation insiders would be the big winners. The main reason the world has chosen a "reserve currency" is to have some benchmark to peg currency values to and lessen the impulse of countries that have accumulated massive debts to attempt to address their problems by just printing more money, this results in devaluing their currencies but often fails to face the root cause of their problem. This is especially true in our modern world where the carry trade is a major force and money flows across borders at the blink of an eye.

History shows wealth will  flee both from a country when its currency drops in value and temporary flow to a safe haven, that is happening today. The bottom-line is that while many people go about their daily lives giving little thought to currency valuations they leave themselves open to the whims of those that control, manipulate and play in this important area of the global economy. When your currency moves ten percentage points higher or lower against a foreign currency it can have a great deal of impact on how your net worth stacks up against someone across the world and the ability of your country to be competitive in producing and selling products.

The fact is with little in the way of real demand there is not much reason to invest in plants or equipment unless it is to lower cost or with the goal of reducing labor. Over the years artificially low interest rates and easy money have caused a massive rise in the misallocation of capital. Market seem hell bent on imitating a crazy dog chasing its own tail. The huge number of stock buybacks is a direct result in a lack of compelling investment opportunities. An example of such an over-saturated market is the recent announcement that McDonalds will be closing or reducing the number of stores it has in America. Central banks have been pushing on a string with their flawed policies and allowed a false economy to develop by propping up those who should have been allowed to fail.

What is being hailed as our economic future holds a troubling aspect, as more large companies crowd into existing markets they will only dilute profits and fracture those markets further. A recent example is Google's unveiling of its long-awaited phone service which will put the search giant in competition with Verizon, AT&T and other wireless service providers. This should be viewed as bringing lower cost to the consumer but will cripple earnings of those already in the business. It is difficult to argue the current giant distributors of wireless phone will not be affected or feel the pain. Small business has been under such assault for years and as the trend continues to play out it will become even more apparent the gross domestic product is moving sideways rather than upward even as government and private debt explodes.

Sunday, April 26, 2015

Pensions And Promises Will Be Broken

People Will be Stripped Of Their Pensions
Pensions and promises will be broken so get ready for more pain. This should not come as news or a shock because the subject tends to surface every now and then in the news. Back in the 2012 Presidential campaign both Barack Obama and Mitt Romney raised concerns about underfunded pension programs and how poor management has led many pension systems to seek bailouts. The 25 largest U.S. public pensions face about $2 trillion in unfunded liabilities, showing that investment returns can’t keep up with ballooning obligations, according to Moody’s Investors Service.  Even worse is the view from State Budget Solutions a nonprofit group, according to their report State pension funds are underfunded by $4.1 trillion. 

Pensions Are A World Wide Problem
The blame for the underfunding of public employee retirement systems often lies with legislatures, which have raised pension benefits to unaffordable levels while failing to contribute enough to properly fund obligations. If economic growth slows as the world matures we should also expect a new normal in the way of lower returns on investment. The super low bond rates of today and recent years as well as zero interest rates do not bode well for pension funds or those saving for their later years. Many planners and funds have not accounted for this. Moderate portfolios these days still are hoping for an annual gain of 5 to 7 percent.

By assuming they will receive a high rate of return those managing pensions are able to make plans appear better funded than they are. The reality that they will consistently earn such a high a return on a conservatively managed portfolio, as anticipated by its fund managers is both optimistic and unlikely. Lately the markets have been hooked on monetary morphine and ignoring fundamentals. Many of the financial structures we have built are on flimsy foundations or unsustainable. If the wheels come off the financial system pension plans will take a direct hit. To those who base their future on money coming from these monthly payouts I urge caution, it is not unreasonable to suggest they be prepared to take a "haircut" or worse. Sadly, this goes beyond pensions and will probably include a slew of other promises have been piled on to give the impression our golden years will be more enjoyable. 

The 25 biggest systems by assets averaged a 7.45 percent return from 2004 to 2013, close to the expected 7.65 percent rate, Moody’s said in a report released recently. The bad news from the New York-based credit rater is that pension liabilities have tripled in the eight years through 2012. Despite the robust investment returns since 2004, growth in unfunded pension liabilities has outstripped returns. Inadequate pension contributions, as well as the sheer growth of pension liabilities as benefit accruals accelerate, salary increases and additional years of service are increasing the gap. A report from State budget Solutions found state pensions funded at 39 percent while they claimed a 73 percent rate. States with the lowest funded ratio include, Illinois, Connecticut, Kentucky, Kansas, Mississippi, New Hampshire and Alaska. In addition to low funded ratios, states like Alaska, Ohio and Illinois also have some of the largest unfunded liabilities per person weighing in at Alaska with $32,425, Ohio with $24,893, and Illinois at $22,294.

It is a fact the generation that is now beginning to retire has leveraged its size into favorable policy that it will enjoy in later life. All this must be coupled with the fact many baby boomers have little or nothing in the way of savings and will be totally dependent on the promise that government will step in and care for them in their older years if they need help. We should remember governments slashed tax rates in the 1980s to revitalize their lagging economies just as boomers approached their prime earning years. The average federal tax rate for a median American household, including income and payroll taxes, dropped from more than 18% in 1981 to just over 11% in 2011. This means less revenue for the generous benefits boomers have continued to vote themselves. Programs like a prescription-drug benefit paired with inadequate premiums have caused deficits to explode and they will dramatically worsen after 2017.

The arithmetic leaves few ways out of the approaching storm, the numbers are ugly and much of it is only now becoming visible in our soaring National Debt. Faster growth would help, but the debt left by the boomers adds to the drag of slower growth in the labor force. Carmen Reinhart and Kenneth Rogoff, two Harvard economists, estimate that public debt above 90% of GDP can reduce average growth rates by more than 1%. Meanwhile during the boomer era we have seen falling levels of public investment in America. Annual spending on infrastructure as a share of GDP has dropped from more than 3% in the early 1960s to roughly 1% as of 2007. Austerity is one way we might address this problem, but the consolidation needed would be large. The IMF estimates that fixing America’s fiscal imbalance would require a 35% cut in all transfer payments and a 35% rise in all taxes, far too big a pill for our creaky political system to swallow.

Fiscal imbalances rise with the share of population over 65 and with partisan gridlock, this is troubling news for America, where the over-65 share of the voting-age population will rise from 17% now to 26% in 2030. As this voting block grows and strengthens it is unlikely they will loosen the noose. Another possibility is trying to inflate the problem away. A few years of 5% price rises could help households reduce their debts faster. Other economists, including two members of the Federal Reserve’s policy making committee, now argue that with interest rates near zero, the Fed should tolerate a higher rate of inflation and try to speed up recovery. The generational divide makes this plan a hard sell. Younger workers are typically debtors, who benefit from inflation reducing real interest rates, older people with large savings dislike it for the same reason. A recent paper by the Federal Reserve Bank of St Louis suggests that as a country ages, its tolerance for inflation falls.

The bottom-line is that all these promises result is some rather ugly math, as things stand an American born in 1945 can expect nearly $2.2m in lifetime net transfers from the "state" far more than they pay in, and far more than any previous group. A study by the International Monetary Fund in 2011 compared the tax bills of what different age citizens pay over their lifetime with the value of the benefits that they are forecast to receive. The boomers are leaving a huge bill. Those aged 65 in 2010 may receive $333 billion more in benefits than they pay in taxes. This is  an obligation to the government, 17 times larger than that likely to be left by those aged 25, this is a huge burden that the young is about to inherit.

A massive four trillion dollar underfunding in State Pension funds alone represents roughly $12,000 for every man woman and child in America. This means we should place pensions into the category of a giant Ponzi scheme or lie. The fact is both the public sector and private companies have simply promised too much to workers that are living longer at a time that business pressures are changing, but what remains unclear is who will pay to clean up the messes. Will it be the millions of retirees owed trillions of dollars in benefits that take the hit or the bondholders who lent states and cities trillions more, or local taxpayers who may have to pay more to cover the shortfalls? We are already seeing that pension liabilities are crowding out spending for services, roads and schools. One thing is certain, regardless of how this is resolved the process will be painful and likely play out over many years.



Footnote; For more about what the youth of this Nation are facing read the post below. Other related articles may be found in my blog archive, thanks for reading and comments are encouraged,
                  http://brucewilds.blogspot.com/2013/01/ugly-math-made-simple.html

Friday, April 10, 2015

Silly Or Delusional?

The Dollar Dropped On News Job Creation Slows
I caution those who are silly or delusional enough to think a bad jobs report should bolster other currencies and weaken the dollar. While it may lessen the call for raising the interest rates sooner rather than later little else changes. The dollar remains the best house in a bad neighborhood,or the cleanest dirty shirt in the closet, this means it is still the least worse option or currency to place your wealth. The bad news that blows a weak dollar theory out of the water is that consumption by Americans is what fuels the export economies of countries like Japan and China. Without the continued flow of goods from their shores such economies are "toast" and will further slow, this has a negative effect on their currency. As the world's reserve currency the dollar has gained as faith in other currencies has diminished because of central banks pursuing policies of printing evermore money.

These policies to support and prop up both derivatives and economies have morphed into the main driver of economic data but has generated little real growth. Between the low interest rates that propel investors into high risk assets in search of a positive return and all the money being pumped into the system the markets have become distorted and disconnected from the economy. The myth that poor quality growth can be sustained or generate escape velocity and free us from our economic woes is again proving false. No matter how hard we try to forget, it is becoming more apparent that America's last big economic surge just before the 2014 elections was driven by a 10% jump in federal spending, mostly on Pentagon hardware. This "pre-election" spending was the biggest increase in spending by the federal government since 2009 when the Obama administration put in place its huge economic stimulus package. This means that 2014 third quarter growth was directly tied to government action rather than true demand, this is not a formula for sustainable growth.

The chickens may be coming home to roost on a policy the Fed has pursued for seven long years. Over this time the Federal Reserve has failed to take serious efforts in pushing the government to take the necessary reforms needed to move the economy forward. Not dealing with what we were told were massive problems has only reinforced the idea that far too much has been made as to the ramifications of an out of control budget. Remember the horror stories surrounding sequestration and the financial cliff? I recall one Sunday morning talk-show host referring to them as "draconian" and predicting "dire consequences." Up to this point a strong case can be made that sidestepping financial responsibility has been rather painless, sadly to many people this only reinforces the idea that we can continue down this path.

Over the years investors have been lulled into complacency by the extraordinary actions taken by central banks and governments. These actions have temporarily masked major flaws and structural problems, but by not demanding the right kind of growth and merely throwing money at problems we have only delayed and added to a financial day of reckoning that faces us in the future. In what most of us view as a fast moving world many people have come to think if a financial crisis doesn't occur today or in the next few weeks it is simply not going to happen at all. But when looking at the numbers the thought that we will be able to grow out of our problems is a bit simplistic and an unrealistic strategy. "Future growth" is often promoted as the best path forward because it is viewed as a painless easy solution to problems and avoids confronting hard choices to address deeper rooted flaws that undermine our economic system.

Those in power have embraced and taken it to a new level financial engineering with MMT or Modern Monetary Theory. Unfortunately, a critical flaw exist in the concept and while it is viewed as our salvation by many economist and much of the world MMT has a Achilles heel. That flaw is revealed by the question, what do you do when it becomes apparent the economic efficiency of credit is beginning to collapse? This means that as more money is poured into the system and lower rates are no longer effective in driving the economy forward options evaporate. As the extra GDP growth generated by each batch of loans drops and momentum ends this become the equivalent of pushing on a string and is a sign of exhaustion. Now that companies have ushered in the savings from interest they paid on debt into their earning columns we should consider that a huge onetime tailwind is now mainly behind us.

As artificially low interest rates promoted by America's Federal Reserve and other central banks in time proves to be a massive one-off in driving corporate earnings only then will people realize the size of the problems before us. Now that rates are in the cellar and may even reverse the positive effect of MMT is about to ebb and become a major headwind. Keep in mind a major reason inflation remains low is that companies are sitting on a hoard of cash, this contributes to the drop in the velocity of money and is apparent by the large number of stock buybacks that have pushed the markets higher.  Also, adding to instability are falling oil prices and unrest in the currency markets. With massive government debt in many countries and the economy still weak these factors if untethered have the potential to create a devastating situation.

We are constantly bombarded by the message that we have rounded the corner and things are getting better, this invites optimism to return and generates a feeling that blue skies with promising times will soon arrive, but avoiding real action comes at a great cost that we will have to pay in the future. A great deal of our problems come from the poor quality of what we call growth, again we have seen policy makers aided by the media promising simplistic answers to solve both economic and society’s problems with little or no effort required from the masses. We often forget how interesting the times we are living through will be when viewed from a historic perspective. Hope tends to blurs reality, but understand the worst of the financial crisis most likely is still before us. I hate to beat the same drum, but proof that the economy is not well is obvious in that the numbers simply do not work.









Wednesday, April 1, 2015

Interest Rates, Inflation, And Debt Matter

Back in September of 2012 I wrote an article reflecting on how the economy of today had been greatly shaped by the actions that took place starting around 1979. Interest rates, inflation, and debt do matter and are more significant than most people realize. Rewarding savers and placing a value on the allocation of financial assets is important. It should be noted that many Americans living today were not even born or too young to appreciate the historical importance and ramifications of the events that took place back then. The impact of higher interest rates had a massive positive impact on corralling the growth of both credit and debt acting as an crucial reset to the economy for decades to come. Below is a copy of the article. 

                       A Time For Action, 1980?

In his book "A Time For Action" written in 1980 William Simon, a former Secretary of the Treasury tells how he was "frightened and angry".  In short he sounded the trumpet about how he saw the country was heading down the wrong path. William Simon (1927 – 2000) was a businessman, and a philanthropist. He became the Secretary of the Treasury on May 8, 1974, during the Nixon administration and was reappointed by President Ford and served until 1977.

I recently picked up a copy of the book that I had read decades ago and while re-reading it I reflected on and tried to evaluate the events that brought us to today. As often the future is unpredictable, looking back, it is hard to imagine how we have made it this long without finding long-term solutions and addressing the concerns that Simon wrote about so many years ago. Back then it was about billions of dollars of debt, today it is about trillions of dollars. It appears that something has gone very wrong.

Do Not Underestimate The Importance Of The Reset By Paul Volcker In 1980
By the end of the 70s inflation started to soar. Only by taking interest rates to nose bleed levels was then Fed Chairman Paul Volcker able to bring inflation back under control. Paul Volcker, a Democrat was appointed as Federal Reserve chairman by President Carter and reappointed by President Reagan. Volcker is widely credited with ending the stagflation crisis where inflation peaked at 13.5% in 1981. He did this by raising the fed fund rate which averaged 11.2% in 1979 to 20% in June of 1981.  This caused the prime rate to hit 21.5% and slammed the economy into a brick wall. This also effected and shaped the level of interest rates for decades

Rates Today Are Ready To Fall Off The Chart!
This action and the increased interest rates in following years is credited by many to have caused  Congress and the President to eventually balance the budget and bring back some sense of fiscal integrity and price stability to America.  As the debt from the Vietnam war and soaring oil prices became institutionalized we moved on. Interest rates slowly dropped and the budget came under control. In recent years spending has again started to grow and at the same time taxes have been cut. This has slowly occurred over years and been ingrained in the system.

The path has again become unsustainable and many people will be shocked when the reality hits, this is not the way it has always been. Today many Americans feel just as frightened and angry as Simon did so many years ago. America has kicked the can down the road, failing time and time again to face the tough decisions, and failing as well to take action. Part of the problem is the amount of dept has grown so large that we can no longer imagine or put a face on it. The day of reckoning may soon be upon us, how it arrives is the question. Many of us see it coming, but the one thing we can bank on is that after it arrives many will be caught totally off guard.


Footnote; This post dovetails with many of my recent writings, for more I might suggest reading the article below. Other related articles may be found in my blog archive, thanks for reading, your comments are encouraged.
                      http://brucewilds.blogspot.com/2013/03/the-young-will-be-burdened.html
  

Saturday, March 21, 2015

Momentum May Be Waning Again!

Momentum, Are We On The Way Down?
Momentum may be waning again as it appears we are currently witnessing a falling off of economic activity. This is not the first time during a so called economic "recovery" that after we celebrate we find we have failed to achieve escape velocity. An article from early 2013 explored the concept of momentum and how economic growth is based on an ever growing trend of year over year increased production. Below we revisit some of the key points as to why we are losing the momentum game.

The drop from 5% GDP growth only a few quarters ago to what is now seen as under a half a percent growth in the current quarter is an indication all is not well. Many factors come into play as to how successful the launch of a recovery is. The amount as well as the kind of stimulus are both components that mix together and combine with the cause and severity of the recession to be crafted into an economic solution to promote growth. Sadly, those in charge have forgotten the quality of growth matters and it must be based on a sustainable foundation, this means allocating money and resources in a way they will contribute to the economy for many years and result in long-term dividends that add to our ability to compete. It is blatantly clear the crux of current central bank policies have been geared to "extend and pretend" and ignore the necessary structural changes that need to be made.

For years the wisdom of our current path has been questioned as the interest of Wall street and the too big to fail have been placed in front of those of Main Street. The recent downgrading of future growth has been ignored by many even while it has been repeatedly pointed out that due to QE much of the economic landscape was beginning to look like something out of  "Alice And The Looking Glass." A bizarre and unrecognizable land has developed, a land distorted and papered over by ream after ream of paper. This paper has been rolling off the printing presses of central banks all across the world for seven years in an attempt to mask reality. Peter Schiff says, printing money is to the economy what taking drugs is to a drug addict. In the short term it makes the economy feel good, but in the long run it is much worse off.

Again, it must be cautioned that what was once the "long run" or "distant future" may be getting much closer. We must remember the influx of monetary stimulus from QE and massive government deficit spending has moved consumption forward creating the illusion of more pent up demand than exist or can be substantiated. This results in an elevated baseline for comparing year on year growth, in short we have to move forward faster next year just to keep growing. For example, if we manufacture and sell twelve million automobiles this year up from ten million because of low interest rates and easy money, we now must sell  the same number for the economy not to contract.

The whole concept of economic growth is based on an ever growing trend of year over year increased production. At times we see a sector rotation such as computer sales increase when clothing falls, but overall we seek numbers that reflect an upward and onward slope. History shows that such trends falter when they become overdone and unsustainable. Economist often talk of headwinds and tailwinds, much of what has been done in recent years has acted as a "artificial tailwind" but this is not a normal state and cannot be sustained. We have recently seen currencies coming under attack because of the policies of low interest and easy money from central banks as well as a drop in oil prices from overproduction at the same time as the GDP forecast is quietly downgraded.
 
So again we must ask the question, what happens after the momentum ends? What happens after QE can no longer increase demand. After most or all of this easy money has flowed into the investment "of the day," what happens when it begins to flow out? Much of this recovery has been constructed on the unstable base of false demand. It seems that we always think that we will see "it coming," we always think we will have ample time to react if it becomes apparent the markets are about to crash but the speed at which events can occur is often a surprise. One thing remains certain and that is it is pure folly to base any economic recovery on selling automobiles to people who must take out a sub-prime loan in order to complete the purchase.

Thursday, March 19, 2015

Low Interest Rates And Unintended Consequences

In a recent article written by bond king Bill Gross titled "Going To the Dogs" Gross describes some of the current economic conditions we face. He refers to the wave of currency devaluations that have taken place across the world and points out almost all of them were promoted by policy rates that went negative. This means the short term rates banks lend at and pay small savers have been skewed. Currently, he sees little in the way of the historic "good old fashioned" positive rates that at least offered something in return to those putting away money for their future. This also means we have downgraded risk as a factor when lending as we search for higher yields, history shows this tends to be a bad strategy.  His thoughts strongly dovetail with my concerns as to how these low rates distort and cause massive misallocation of resources throughout the economy.

Current Policies Carry Unintended Consequences
Gross states, "The universe of negative yielding notes and bonds in Euroland now total almost $2 trillion. Not even "thin gruel" is being offered to our modern day Oliver Twist investors. You have to pay to come to the dinner table and then sit there staring at an empty plate." He goes on to say, "The possibility of negative interest rates was rarely if ever contemplated in academia prior to 2014. No textbook or central bank research paper even mentioned it, although fees for safe haven "storage" have long been in existence at Swiss banks. Ben Bernanke in his famous 2002 paper titled "Deflation: making sure "IT" doesn't happen here", mentions helicopters dropping money from the sky, but nowhere was there a hint of negative yields once a central bank reached the zero bound."

The fact that such policies have unintended consequences is not lost on Gross who in his article highlights the following. A more serious concern, however, might be that low interest rates globally destroy financial business models that are critical to the functioning of modern day economies. Pension funds and insurance companies are perhaps the most important examples of financial sectors that are threatened by low to negative interest rates. To make things worse he says, Negative/zero bound interest rates may exacerbate, instead of stimulate low growth rates in all of these instances, by raising savings and deferring consumption.

It seems the households of savers suffering from low/or even negative yields are being forced to address their inability to save enough money to pay for education, healthcare, and retirement obligations. Many of the most financially responsible people are hunkering down and saving more while many non-savers have gone on a "spendathon" and reacted by taking on more debt. Americans owed nearly $12 trillion overall in 2014, an increase of 3.3 percent over 2013. Declines in some debts, including a decline in credit card debts since 2011 is in no small part attributed to numerous defaults and  not from being repaid. These facts are more proof that we cannot depend on many of the statistics being bantered about by the media, government, or those with an agenda because they are outright fraudulent, flawed, or mask the real picture.

In between the lines of all of this information, good and bad, it is hard to find the truth. When we peel back the facade we find real unemployment is still at high levels and personal debt at unsustainable levels. This is a large part of the collapse in global demand and and U.S. consumers no longer being able to support their historical consumption habits. If all this does not seem all that new it is because the trend 10 years ago of Americans using their homes as ATM machines has merely been replaced by low interest rates and the Federal Reserve fueling questionable loans. The growth in sub-prime auto loans is a glaring confirmation of this and the main reason for surging sales in the auto sector. This effort to offset the dwindling buying power of the public sector by encouraging them to take on more debt by easing terms and artificially low interest rates will not end well.


 Footnote; As always your comments are encouraged. I have written many other articles concerning bonds, debt, currencies, where value comes from, and inflation. You will find these in the archive. Below are two other articles that might be of interest.
          http://brucewilds.blogspot.com/2015/01/currency-markets-reflect-diminished.html
          http://brucewilds.blogspot.com/2014/06/the-economic-efficiency-of-credit-can.html