Category Archives: Economic fundamentals

Guest Post: Leverage, Inequality, and Crises

By Michael Kumhof, Deputy Division Chief, Modeling Unit, Research Department, IMF and Romain Rancière, Associate Professor of Economics at Paris School of Economics. Cross posted from VoxEU

Of the many origins of the global crisis, one that has received comparatively little attention is income inequality. This column provides a theoretical framework for understanding the connection between inequality, leverage and financial crises. It shows how rising inequality in a climate of rising consumption can lead poorer households to increase their leverage, thereby making a crisis more likely.

The US has experienced two major economic crises during the last century – 1929 and 2008. There is an ongoing debate as to whether both crises share similar origins and features (Eichengreen and O’Rourke 2010). Reinhart and Rogoff (2009) provide and even broader comparison.

One issue that has not attracted much attention is the impact of inequality on the likelihood of crises. In recent work (Kumhof and Ranciere 2010) we focus on two remarkable similarities between the two pre-crisis eras. Both were characterised by a sharp increase in income inequality, and by a similarly sharp increase in household debt leverage. We also propose a theoretical explanation for the linkage between income inequality, high and growing debt leverage, financial fragility, and ultimately financial crises.

Floyd Norris Makes Bizarre Comparison to 1983 to Put Smiley Face on Job Outlook

Ben Bernanke was talking up the economy yet again yesterday, and it appears Floyd Norris got the same memo.

I must digress a tad by giving The Daily Capitalist’s translation of Bernanke’s remarks:

Since August when we began to flood our primary dealers in Wall Street with newly printed money the market went up because they used the money to buy financial products, including stocks. We are trying to cause price inflation because the majority of the FOMC is concerned about price deflation. If we cause price inflation then we will fool everyone into thinking that because prices are going up, such as in the stock markets, that it is real growth even though it’s just price inflation. Even better the national debt can be paid down with cheap dollars. Yields on Treasurys initially went up because the bond vigilantes aren’t stupid: they know it will cause inflation so they wanted higher yields. But, ha, ha, the Euro went into the tank because of the PIIGS and money flooded back in to the US and drove Treasury yields back down, for the time being. Screw the vigilantes. The same thing happened when we tried QE1, but as we all know, that failed and we are desperately trying again because we don’t have too many arrows left in our quiver. Hey, if it had worked, would we be doing QE2? We are desperate because if unemployment doesn’t come down, the Obama Administration will be screwed and I’ll lose my job. We are ready to do QE3 because we don’t have a clue what else to do.

Now to Norris’ truly bizarre column, in which he argues that circumstances now are very much like those of 1983, when forecasters were not optimistic about the odds of unemployment falling quickly, when lo and behold, it did.

The problem is that there are some of us who are old enough to remember 1983, like yours truly. And 1983 has about as much resemblance to today as a merely badly out of shape athlete does to one who is in the hospital and is refusing surgery (or in our case, structural change).

Alexander Gloy: What a taifun in Vietnam taught me about the Euro crisis

By Alexander Gloy, CIO of Lighthouse Investment Management

As I was traveling through Vietnam in the mid-nineties our bus drove through an area visited by a taifun. The road was running on a slightly elevated dam, so initially there was no obstacle to continue the journey. Looking out of the window there was water on both sides as far as the eye could see. Eventually the water rose to overflow the road, but the bus kept going.

A Volkswagen transporter, after having passed the bus in a moment of exuberance, was soon found in the ditch with water up to the roof – there was no way to tell where the road ended and the ditch began. The water rose further and started entering the bus through the front door. Still, the driver kept going. I was amazed at how little damage occurred despite the vast flooding. The flood waters slowly receded towards the ocean. Uninhibited by any dams, the water had enough space to expand.

At one point, the water had washed out the elevated road, and a gaping hole forced even our bus to stop. I thought this to be the end of the trip. Miraculously, a bunch of locals showed up, and, with the help of a bulldozer, quickly filled the hole with large rocks. All passengers were asked to de-board as the bus slowly wiggled across the rocks. And we were ready to resume our trip. Closer to the coast we saw the effects of wind damage; at least every third home had been cut in half by a fallen palm tree. Pigs and chicken ran around disoriented, as their barn had probably disintegrated. Despite the damage there was no feeling of this being a catastrophic event; the houses would probably be repaired (they were covered with palm leaves) within a few days, and life would get back to normal.

Compare this to what happens in our “developed” countries when house prices decline by 10 or 20 per cent: the wheels of the entire financial system come off.

I am not suggesting we all live in thatch covered huts. But building higher and higher dams with flimsy sandbags just increases the pressure (and leads to much greater damage when the dam finally breaks).

Look at how Euro-zone politicians and central bankers are increasing the risks by building higher and higher dams with flimsy sand bags.

Josh Rosner and Your Humble Blogger Discuss the Roots of the Financial Crisis on Radio Free Dylan

In addition to his weekday television show, MSNBC host Dylan Ratigan also has a regular radio/podcast. He interviewed Josh Rosner and yours truly on the origins of the financial crisis, which we both agreed started well before the housing bubble.

You can read the transcript at the site, but it has quite a few errors, and I’d recommending listening instead. Rosner is an emphatic, almost theatrical speaker, so I think you will enjoy the conversation.

Get the podcast here: http://www.dylanratigan.com/wp-content/uploads/2011/02/RFD-Ep-25-Rosner-Smith.mp3

John Bougearel: Claims the Job Market Will Boom Are Entirely Unsubstantiated

By John Bougearel, author of Riding the Storm Out and Director of Financial and Equity Research for Structural Logic

A decade ago, the Bureau of Labor Statistics predicted that the U.S. economy would create nearly 22 million net jobs in the 2000s.

Obama said with the benefit of his stimulus measures, the US economy would create three million jobs in 2010. The actual number of jobs created in 2011 was 1.12 million (before final benchmark revisions). Now, the CBO is projecting 2.5 million jobs will be created annually from 2011 to 2015.

Faith in the US gov’t’s ability to create 2.5 million jobs for the next 5 yrs (one of the several silly and preposterous CBO projections) is sorely misplaced. The CBO has sugarplums dancing in their heads. Their 2011-2016 forecast for the US jobs market is disingenuous, misleading poppycock.

What if China’s GDP is Seriously Overstated?

Michael Pettis has released one of his carefully reasoned posts, this one on the dark art of guesstimating what China’s GDP really is, given the notorious unreliability of its official data.

The strength of Pettis’ approach sometimes works to his advantage. He does a great job in breaking down his arguments to clear, easy to understand, step-by-step reasoning. That tends to make his posts pretty long. In this case, that meant that the part I though was most provocative came towards the end, when impatient readers might have figured they had gotten the drift of his gist and moved on.

In this one, he starts with the last GDP release, and in particular, the implications the fact that its alarmingly high investment rate continues to increase at a stunning clip. But he then turns to the rather tiresome debate as to when China’s economy will overtake that of the US, and discusses the possibility that the GDP figures touted now could well be overstated by a considerable degree:

Marshall Auerback Speaks on BNN About Implications of Unrest in the Middle East

Portfolio strategist, hedge fund manager, and sometime Naked Capitalism guest blogger Marshall Auerback spoke on BNN about the implications of unrest in the Middle East for the economy and investors. Enjoy!

State Banks, or, If You Can’t Regulate TBTF Banks, Why Not Compete Instead?

Once in a while, you’ll see stories pop up about state governments looking into setting up a state bank, Washington being the latest sighting, along the lines of the only state bank in the US, the Bank of North Dakota. And there’s good reason. The Bank of North Dakota has an enviable track record, having remained profitable during the credit crisis. Moreover, in the ten years prior, the bank returned roughly half its profits, or roughly a third of a billion dollars, to the state government. That is a substantial amount in a state with only 600,000 people. The bank was also able to pay a special dividend to the state the last time it was on the verge of having a budget deficit, during the dot-bomb era, thus keeping state finances in the black.

But the good financial performance is simply an important side benefit. The bank’s real raison d’etre is to assist the local economy. And it has done so for a very long time. It was established in 1919 as part of a multi-pronged effort by farmers to wield more power against entrenched interests in the East.

And the most important potential use of this type of bank in our era could again be to level the playing field with powerful interests, in this case, the TBTF banks.

Connecting the Dots Between China’s Falling Consumption Level and Its Banking Crisis

One of the striking features of China’s continuing growth as an economic power is its extreme (as in unprecedented in the modern era) dependence on exports and investments as drivers of growth. Even more troubling is that as expansion continues, consumption keeps falling as a percentage of GDP.

As countries become more affluent, consumption tends to rise in relationship to GDP. And the ample evidence of colossally unproductive infrastructure projects in China (grossly underoccupied malls, office and residential buildings, even cities) raises further doubts about the sustainability of the Chinese economic model.

The post crisis loan growth in China, in tandem with visible signs that a meaningful proportion of it has little future economic value, has stoked worries that Chinese banks will soon be struggling with non-performing loans. China bulls scoff at this view, contending that China’s 2002-2004 episode of non-performing loans was cleaned up with little fuss (I never bought that story and recall how Ernst and Young was basically bullied by the Chinese government into withdrawing a 2006 report that NPLs at Chinese banks were a stunning 46% of total assets of its four largest banks. Note estimates of the NPLs as a percent of total loans from that crisis vary widely, even excluding Ernst, from 20% to 40%).

The latest post by Michael Pettis links the two phenomena, the fall in Chinese consumption and the cleanup of its last banking crisis. If his analysis is correct, this bodes ill for any correction in global imbalances.

Sugar High or Growth from Sustainable Economic Policy?

Last week, I caught some very good commentary by a number of well-known financial industry experts. I wanted to share my own thoughts with you on their commentary, especially in light of my posts at Credit Writedowns on Eisenhower’s Farewell Address and The New Monetary Consensus. I had featured two of the commentaries at CW, from Roach and Faber. I will add a bit from Gross and Grantham and try to unify them into a single theme regarding corporatism and the sustainability of this upturn.

2011: The Year For Cautious Optimism?

Edward Harrison here with my economic view for the new year. I am generally cautiously optimistic on the U.S. and global economy for 2011. Policy makers have done a pretty good job of avoiding egregious errors so far. I think that gives us enough oomph to get over the hump so the cyclical agents like inventories and cyclical hiring can do their magic. I do have lingering concerns. Let me explain both pieces of the puzzle – the cautious part and the optimistic part – in this post.

What a “Get Tough With China” Stance Would Really Look Like

Before every get-together with China, the US goes through some ritualized complaining (the value of its currency has been the recent big talking point), the Chinese do some sabre rattling of their own, and perilous little of substance happens, except that the Chinese continue to have an economy with a substantial current account surplus, which not only works to the detriment of its major trade partners, but at this scale contributes to financial instability. So in a perverse way, China’s ongoing trade surplus is everyone’s problem.

The Imagination Trade, or the Tinkerbell Market 2.0

I’ve refrained from discussing the stock market for quite some time, in part because this is not an investment website and in part because I find the netherworld of credit more interesting. But a big reason of late is that the stock market has become so utterly unhinged from fundamentals that anyone opining on it, other than momentum trades and technicians with particularly good crystal balls, is likely to look silly.

We seem to be in a toxic replay of what I called the Tinkerbell market in 2007 and 2008: if the officialdom can get enough people to applaud, the economy will live. They weren’t too successful back then, but the crisis has appeared to have upped the game of the Powers That Be in talking up the price of financial instruments. And having the Fed at ready to provide boatloads of liquidity should anything go awry appears to have put much of the world in “don’t fight the Fed” mode.

Market action is looking a tad manic, yet the dot-com mania proved that unwarranted optimism can persist far longer than cooler heads deem possible. Hedge fund leverage, for instance, is allegedly back to pre-crisis highs.