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Ways of the World

Carol Stone, business economist & active Episcopalian, brings you "Ways of the World". Exploring business & consumers & stewardship, we'll discuss everyday issues: kids & finances, gas prices, & some larger issues: what if foreigners start dumping our debt? And so on. We can provide answers & seek out sources for others. We'll talk about current events & perhaps get different perspectives from what the media says. Write to Carol. Let her know what's important to you:

Monday, May 10, 2010

European Bailout Plan Follows Violence in Greece and Malfunctioning U.S. Stock Market

This past weekend, while most of us were off celebrating Mother's Day, European ministers and economic policymakers were laboring in Brussels to cobble together a scheme to alleviate the current euro financial crisis. As the declines in stock markets elsewhere attested Thursday and Friday, the government debt debacle in Greece was on its way to inflicting harm quite far away from the Mediterranean Sea. The policymakers met late Sunday night and on into Monday morning in an effort to get an agreement before markets opened in Asia. The announcements came around 9:00PM Sunday night Eastern time, which was 3:00AM Monday in Brussels and 11:00AM in Tokyo. World stock markets indeed surged on the news, with Tokyo up 1.6%, Germany up 5.3% and London up 5.2%; markets in France, Italy and Belgium were even stronger. In the late New York morning as we write, the Dow Jones has gained just over 4%.

Violence in the Streets of Athens . . .
This drama came about in the wake of several disturbing events. The rioting in Greece we talked about here last week continued and on Wednesday a bank was firebombed and three people killed. We've heard about people committing suicide over financial reverses and turmoil, and that's sad enough. But we have to say, in a decades-long career, we've never heard of such mass violence directed at government financial policies. Yes, the people are angry that their wages and pensions will be cut. But government isn't seizing their property and kidnapping their families or constraining their civil rights, or even censoring the press. At the same time, German voters yesterday showed their displeasure at having to help the Greeks by voting out some members of parliament from the majority party and eliminating that majority in the upper house of parliament. Tough stuff.

. . . Prompts Formation of Huge Bailout Program
The plan calls for almost $1 trillion in potential bailout funds to be contributed by all the members of the European Union. To distinguish, the Euro Zone (sometimes called the Euro Area) is the group of 16 countries that use the euro as their currency. Additionally, 11 other countries are banded together with them in a customs union, or free trade zone; the broader group of 27 then is called the European Union, or EU. The rescue money is meant to be available for any member country running into debt financing strains or other major financial tangles.

Greece Is Just Part of the Problem
Finances indeed got tangled on several fronts at the end of last week. Stock markets everywhere had reacted to the Greek budget deficit problem and the expectation that other governments, especially Spain and Portugal, might face the same situation. The trading glitch that caused U.S. stocks to plummet Thursday afternoon upset everyone (more on this below). The oil spill in the Gulf of Mexico is making people tense about risks, as are repeated interruptions in air travel in Europe due to volcanic ash in the atmosphere. Also, last week, less visible but more fundamental, liquidity showed further strains in European bond markets. In their nervousness, investors who had U.S. dollars didn't want to lend them to others, so interest rates on short-term dollar loans headed markedly higher. This is problematic because such short-term transactions may be needed to pay for imports, to cover some payrolls, to complete some other financial interchanges in the highly interconnected global financial network. It was getting perilously close to the market freeze conditions of autumn 2008.

Thus, besides the large weekend EU bailout arrangement, the U.S. Federal Reserve arranged a dollar-lending facility with its counterpart central banks in Europe, the U.K., Canada, Switzerland and Japan. It announced this renewed program at 9:15 Sunday night, about the same time the main EU bailout facility was being announced. The Fed will lend dollars to these official banks, who can, in turn, lend them on to banks in their countries. This is meant to increase the supply of dollars in world markets and help pull related interest rates back down. This same "swap facility" was used from December 2007 through this past January; at its peak in December 2008, it provided $580 billion to foreign banks.

Budgets Still Have To Be Cut
Clearly, these two huge programs of the EU and the Fed only address symptoms. They are meant to "buy time" for fundamental issues to be dealt with. The Greek Parliament actually did at least some of what it is supposed to do last Thursday in enacting legislation that will cut government spending and raise taxes. But the Greek people need time to calm down. And other Parliaments need to take similar kinds of budgetary actions. The U.K., with its own government presently in a blur after last Thursday's inconclusive election results, will also need to buckle down when the new leaders get into place and get its own budget situation rationalized. Nobody gets a free ride.

U.S. Stock Market Goes Bungee Jumping
Then, there's that awful U.S. stock market trading glitch. On Thursday, the Dow Jones Average was already down about 500 points at mid-afternoon, when a sudden downdraft pushed it off another 500. The charts of that look like a bungee jump. Fortunately, the bounce of the bungee did take place, and almost as fast as the downward plunge. What is this? There is extensive electronic trading and in some transactions no human input is involved. Surely no human intervention caused Accenture's shares, as one example, to fall from $40 to 18 cents in minutes. One electronic trading company did announce that they had stopped trading on the downside since they felt their "algorithm" would exacerbate the drop, but others argue that the removal of that automated response system may have made it worse by removing liquidity – there's that word again – from the whole system, causing it all to fall even more.

These mathematical trading routines, or algorithms, activate when prices cross thresholds determined by analytical formulas. Not all trading is conducted this way, indeed, perhaps only a fraction. Generally, it is very efficient, helping to smooth the timing of trades, particularly when investors are shifting a large holding. But as we saw the other day, things can go wrong and they can get very wrong in a hurry. There can be two types of problems. The formulas might be based in statistical probabilities, and it's possible that prices and trading volumes can move outside the usual probability range. We can measure the margin for error, but when a result comes there, sometimes the best we can do is say, "Oh, that's an outlier." We may not be able to react to the outlier before the trading formula pushes prices on a trajectory outside the carefully demarcated region. Secondly, these algorithms work as long as the players are "us" versus "the rest of the market". Then our action can be counterbalanced with a re-action. But when "the rest of the market" is using a similar tool, then we're all on taking the same kinds of action at the same time and it all goes one way – as it did Thursday.

Stock exchange officials were to meet this morning at the Securities and Exchange Commission in Washington to assess more carefully what might have happened. We hope they have better answers than we do. Automatic trading stoppages, called circuit breakers, have been used in the past to interrupt undesirable patterns, and perhaps strengthening those for today's bigger, faster market systems can help.

Better News, Though, on the Jobs Front
Fortunately, in the middle of all this turmoil, there was good news on U.S. economic fundamentals with the April jobs report showing sizable and widespread employment growth. Banks and other financial institutions are also in much better shape than they were in the 2008 crisis period. So perhaps we won't have a major setback to recovery. But these recent events serve as serious warnings that all of us need to stay cautious in buying, selling, investing and especially borrowing.

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Tuesday, May 04, 2010

Sustainable Debt: Greece vs. the U.S.

Greek civil servants are on strike today and tomorrow, following riots over the weekend, as the Government prepares to enact various austerity measures promised in return for bailout funding from the EU and the International Monetary Fund. The country has debt maturing on May 19 and would not likely otherwise have had the cash to pay it off. International investors have stopped granting Greece new credit.

As we described in our previous article on debt sustainability, civil service wages and public pensions are both more generous than Greece's economy can generate revenue to cover. So the European financial authorities and the IMF are trying to spur the Greek government to start reforms. Obviously, those are not popular with people whose salaries and pension benefits are likely to be reduced.

Meanwhile, back at the ranch, what is the situation in the U.S.? Is the U.S. debt "sustainable"? Also, Mother Crafton recently commented in a note to us, "So many make the simple analogy between a family's need to live within its income and a nation's relationship to its own debt. I know [this is] not that simple, but am not sure how. "

U.S. Debt Has Been "Sustainable"
On the "sustainability" question, there are two key ingredients. (1) How does the growth rate of the economy match up to the real interest rate on the debt? And (2) what is the debt's weight on the overall economy? If the economy is vigorous, it can generate more revenue to finance government activity. So even if there is some current budget deficit and some outstanding debt, the country can service that debt, that is, it can meet its interest payments, and in that otherwise vibrant scenario, investors would be likely to roll maturing debt they hold into new issues. The U.S. has been here for a long time. Gross domestic product (GDP) growth averaged 3 to 3-1/2% annually over the 25 years to 2007, while interest costs have actually declined in real terms (after netting out inflation) and have run noticeably below the growth rate since 1998. Thus, the margin of economic growth over interest cost has been favorable. The budget deficit has averaged about 2.5% of GDP over the last 20 years. As to item (2), the debt ran about 36% of GDP over the last decade, rising just the last two years during the recession. Overall, the budget and debt situation have been manageable up to now.

Future Prospects Are Clouded, Though
But there is concern at present, since the deficits last year and this are so very large. And the long-term outlook doesn't appear promising. The fiscal year 2009 deficit was $1.413 trillion or 9.9% of GDP and pushed the debt to 53% of GDP. [Fiscal years run from October 1 to September 30, so we are just over half way through fiscal 2010.] Recent estimates of this year's deficit run about $1.3 - $1.5 trillion, again about 9%-10% of GDP. These outsized numbers are clearly a product of the aftermath of the recession, and they should diminish as the recovery builds. However, two sets of long-term budget projections highlight looming issues.

Federal government expenditures have run right at 20% of GDP for the last 15 years. During the recession, in fiscal 2009, they were 24.7% and are estimated at 24.8% for this year. According to a Congressional Budget Office analysis of the Obama Administration's current budget[1], the lowest amount projected in coming years is 23%, with an average of 24% across the span to 2020. This is without the effects of the new health care law. Revenues have run about 18% of GDP historically and this same CBO work projects a ratio of 19% through 2020. Thus, if all this comes to pass, the long-run deficit will widen from the recent 2.5% of GDP to 5%, and the trend will be increasing toward the end of the decade. The debt-to-GDP ratio by then would be about 90%.

A widely respected survey of private forecasters reports projections of GDP growth over the next ten years at 2.7% and real interest rates at about 2.5%, basically equal, thereby bringing to an end the recent favorable relationship of high growth to low real interest costs.[2]

A Commission Works To Rework the Federal Fisc
On the face of it, then, the U.S. budget situation is worrisome, and President Obama has constituted a deficit commission to study ways to resolve it. The commission met for the first time last week and will issue a report in December. Some expect them to recommend the imposition of a Value Added Tax, or VAT, a kind of national sales tax, to close or at least narrow the budget gap. Our own recommendation would concentrate more on spending, since that is the source of the issue. The rapidly expanding elderly population will put increasing pressure on a number of so-called entitlement programs, and substantive deficit reduction can't really be accomplished if those aren't somehow reshaped. That's one reason we were disappointed that the new health care law used cuts in Medicare only to make room for a brand new entitlement initiative. Containing these big, broad outreaches is the only genuine long-term answer to persisting deficits. Perhaps it indeed needs a commission to conjure how to make cost-effective changes that are still respectful and compassionate.

When All Is Said and Done, the U.S. Remains a Safe Haven
All this said, as today has progressed while we have been writing this article, stock markets in Europe and the US have fallen sharply in response to the riots and strikes in Greece. Despite the development of a bailout plan over the weekend, new numbers suggest it still may not enough to solve Greece's short-run troubles, and the negative reaction of the workers there has spooked stock investors and driven down the euro currency. Worries about other southern European countries, especially Spain and Portugal, are mounting, as are concerns over the whole euro arrangement.

As investors sell euros and sell stocks today, they're buying something. And that something is U.S. Treasury securities. So despite our careful numerical analysis and all our ratios that are flashing warning signals, there remains a special place for U.S. Treasury debt in the portfolios of the world. It's still where people turn when they get scared. The promise that the U.S. government will pay remains the closest thing to a risk-free asset that anyone can conceive. Perhaps it is not exactly the U.S. government, but the U.S. nation that people can believe in. This could certainly change as other nations emerge and mature, but right now, there's no close, visible rival. And yes, Mother Crafton, most of the time, most countries, as most families, have to live within their means – with "means" defined pretty broadly. But there are exceptions, and right now, the U.S. seems to be just that.
[1]Congressional Budget Office. An Analysis of the President's Budgetary Proposal for Fiscal Year 2011. Washington DC: The Congress of the United States. March 2010. Page 5.

[2]Federal Reserve Bank of Philadelphia, "Survey of Professional Forecasters". February 2010, via Haver Analytics, Inc., New York.

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