Tag Archives: Economy

THE CLIFFS OF INSANITY

Seven Solutions

VERBATIM – From storied business consultant, J. P. Pierogiczikowski—affectionately known as Joe Perogi,

as told to John Jonelis

Cliffs of InsanityJoe Perogi here. I’m listening to Peter Orszag speaking real clear on The Fiscal Cliff. He comes all da way from Manhattan to give this great talk to us at The Chicago Council on Global Affairs.

This guy’s real smart. Sure, he’s way left o’ my way o’ thinking but he’s got alotta ideas,  Ideas make money move. And he understands the politics as well as the economics – a rare combination.  So after the talk, I read a buncha his articles, put it all together, and here’s what I come up with:Chicago Council on Global Affairs Logo

He says $750 billion per year of income is already vaporized. That’s right—it’s down da tubes fer good. He says it’s as bad as the dot com bust but get this—this time we’re not bouncing back so fast.

Peter Orszag - Bloomberg

Peter Orszag – Bloomberg

Private lending is zilch. And the jobs are just gone. We lost workers permanently. Lotsa skills become obsolete. People give up.

Here’s something new to me: This mess has been going on long enough that disability benefits are rising. And as Orszag puts it, “Once people get on disability, they don’t go off.” While all this is goin’ on, global labor supply quadruples. So no wonder you can’t find a job.

According to Orszag: “People can sense that all this is happening and that nothing is being done to fill that $750B hole. They’re right.”

Bridge Out Ahead!

Now take that same broken-down train and drive it off the Fiscal Cliff. More than $600 Billion in tax increases and spending cuts by the end of 2012. We’re talkin’ a train wreck of epic proportions on a national scale. Probably push Europe over the edge too.

Budget Elements - American Enterprise Institute

American Enterprise Institute

A Little Comic Relief

It’s times like these we gotta keep our sense of humor.  Orszag cites some stats from his Bloomberg column and that takes my mind back to just before the talk. I actually watch Orszag post that article while we’re sitting together in da coffee shop. And I have some fun with that. My old friend, Ethan Sobriety invited me to this shindig and I get here earlier than he does. So I introduce Orszag to him and Ethan almost throws a coronary. Orszag was Obama’s top dog in Management and Budget and the Congressional Budget Office. But he goes back further. Senior economist under Clinton’s Council of Economic Advisors and the National Economic Council.  These days he’s bigtime at Citigroup.Bloomberg Logo

My friend Ethan ain’t no slouch neither. International currency investor who makes a home in England, Asia, Africa, and right here in Chicago, but when the color comes back to his face he says hello to Dr. Orszag and shakes his hand. From his reaction I figure Ethan’s got a whole lot of respect for this guy.

Posting Article

Orszag Posting His Article

Whacha Gonna Do?

But Orszag is still speaking and I snap my attention back to what’s going on now, right in front of me.  He asks, “Will we shoot ourselves in the foot again?”  He says we’re doing stimulus the wrong way. “We need to do specific, gradual, policy that’s hard to reverse over time.” Gradual and irreversible makes for stability. That way business knows what’s gonna happen and has plenty of time to plan for it. Lending opens up. Da economy starts workin’ again. So are we doin’ that?  No, he says, “We’re doing the opposite.” Not good.

Anybody’d think them bums in the White House, the Senate, and the House of Reps could work this thing out. But Orszag shows two simple charts that explain why it’s so hard to fix. The first one explains the way Left and Right thinking used to overlap. All the deals get done in that overlap area. (This guy’s an economist and uses bell curves to make his point. Ethan tells me Venn diagrams might make more sense to most people, so I’m giving you that version.) Here’s the way it looked in the ‘60s:

VENN 1

Now let’s fast forward to today. You see it? There’s no overlap at all no more. No consensus. Maybe no deal.

VENN 2

Polarization

Some say polarization is the natural result of gerrymandering and Orszag says that might be as much as 15% of it. But he thinks it’s driven by the polarization of the population itself. We’re doing it to ourselves,” he says. Then he explains how:

  • If you put like-minded people in a group, the group becomes more extreme. That rings true to me. It’s plain common sense.
  • Landslide elections in voting districts are getting a whole lot bigger. Lotsa candidates run unopposed or with token opposition. That means our neighbors are more like us. Again, more like-minded equals more extreme.
  • Nowadays we can all pick our own reality. Each of us can select our own news feeds and the like. Orszag talks about how he “unfollowed” a Twitter user who criticized him. So now that person is still criticizing him, but it’s not in Orszag’s world no more, so it’s got no impact on his decisions. Again, if you listen only to like-minded people, you get more extreme.

The Positions

So here are the positions on da Left and da Right:

  • DA LEFT—Let the Tax Cuts Expire for the Rich– This is the plan to tax the $250K+ crowd. Problem is, it really doesn’t raise much money and it kills jobs.
  • DA RIGHT—Entitlement Reform – Everbody agrees we gotta do this, but gimme a break. If the country was ready to bite da bullet, Obama wouldn’t be in the White House again.

If there’s no deal, we go over The Cliffs of Insanity and da country goes into another Great Depression.

The Cliffs of Insanity from The Princess Bride - Wikipedia

The Cliffs of Insanity from The Princess Bride – Wikipedia

Seven Solutions

Even with no consensus, Orszag sees a number of possiblities:

  • Two-Stage Agreement – A 9-month temporary deal to give the bums in Washington time to work it all out. This is one of the president’s proposals.  Give him what he wants now and he’ll talk about the rest later.  But Orszag asks a good question: “If either side gives in now, why believe the other party will change later?”  So nobody budges. 
  • Tax Reform Refund – Let the tax cuts expire.  Replace them with a $1,600/year tax refund.  Do that till a deal is reached or the economy recovers. This way negotiators start with a clean slate. Both sides might find it easier to swallow. This is one of Orszag’s interesting ideas.  Maybe it works. I dunno.
  • Cut Spending – Orszag points out spending cuts are easy to say but hard to do. The more vague the proposal, the more popular it is and the more useless. When he was in government service, he’d give out a list of tax cuts but nobody could agree on anything significant.  But we gotta cut spending somehow.
  • The 50K Limit – If we limit itemized deductions to $50,000 for everybody, we can raise the same $700 Billion we’d get from taxing the job creators. But 90% of that is deductions from just three things: local taxes, home mortgage interest, and charitable contributions. Of those three, charity is the only one a taxpayer can do anything about. So charities would get clobbered. Not a good thing.
  • Raise the ThresholdExtend the tax cuts for everybody under $1 Million insteada chopping it off at $250K. So far nobody’s hot on this, but who knows? It’s the natural place to reach a compromise.  And as I see it, anybody earning $1M is likely to be runnin’ a corporation, not a mom and pop proprietorship or LLC. Regular corporations are taxed separate from personal income so I figure it shouldn’t oughta hurt jobs too much. But taxing corporations hasta raise prices. We all pay fer it, so either it’s a hidden tax or it’s inflationary.  I think one ‘o these days we’re finally gonna see summore inflation.
  • Scale Back Tax Breaks – Don’t raise rates at all. Chop off deductions the $250K-and-up earners. House Republicans might bite. But the White House hasta make a concession here and this commander in chief hasn’t shown any ability in the art of compromise. Also, the downside is this could hurt any housing recovery big time.
  • Social Security Reform – Orszag is big on this one and it’s real interesting stuff: Lift the $110,000 cap on payroll taxes. He says Democrats will leap at the chance to make Social Security solvent without private accounts. And, this one’s stable ‘cause it can be done in an orderly manner over several years. Again, he’s big on a plan that can’t be reversed and phases in over time. That means everybody knows what’s coming and has time to plan for it.

O’course, we can always kick the can down da road again like Obama did last term.  Orszag don’t raise this issue ’cause it ain’t a permanent fix.  We got a looming debt crisis and it’s only getting a whole lot worse.  

Optimism

Orszag sees some good coming in spite of all this suffering:

  • He sees shale gas and shale oil and a pipeline from North Dakota to Texas because there’s no way around it. So oil prices will eventually plummet.
  • He seems to like the way healthcare is headed because he likes defined contribution and national healthcare. Well, I figure ya gotta make allowances for people’s opinions.
  • He says there’s a lot more to come from the tech revolution.

At least that last one’s for sure.  I hope them bums figure this mess out before New Years Day.  And thanks Ethan for the great invite.  This was worth da trip.

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GO TO – THE FISCAL CLIFF – A SURPRISINGLY SIMPLE STORY

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Find Chicago Venture Magazine at www.ChicagoVentureMagazine.com Comments and re-posts in full or in part accompanied by attribution and a web link are welcomed and encouraged. This is not investment advice.  I do not guarantee accuracy.   It’s not my fault if you lose money.

.Copyright © 2012 John Jonelis – All Rights Reserved

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3 Comments

Filed under Chicago Council on Global Affairs, Chicago Venture Magazine, CORE Insight Story, Economics, Entrepreneurship and Politics, Fiscal Policy, Innovation and Culture, Taxes

DEATH SPIRAL IN EUROPE

Euro

European Meltdown

I’m at the Federal Reserve Bank of Chicago to find out more about the financial crisis in Europe and why I should care. This is the keynote address–the second in a series of speeches sponsored by Northwestern University. The topic is economics, but don’t let that scare you away. I’ll translate it into everyday language and reduce it to a few pertinent facts that mean something to you and me in a real way.  (My editorial comments are in parens.)

Prof. Martin (Marty) Eichenbaum is good—really good and quite entertaining. He’s a PhD in Macroeconomics at Northwestern University. A Fellow of the American Econometrics Society. A consultant to the International Monetary Fund and the World Bank. He’s currently a consultant to the Federal Reserve Banks of Chicago, Atlanta and San Francisco. He’s co-editor of the American Economic Review, one of the nation’s oldest, most respected and revered scholarly journals. This guy’s got credentials. I’m impressed. You’re impressed too, right? Well you should be. Like President Schapiro, who spoke before him, he’s an excellent teacher and knows how to make his points in ways that everybody will understand.  Here’s the skinny on his speech:

“The recession is global in scope. Europe could easily spiral out of control. The consequences could be enormous.” We all know that, but then he brings up a sage point: “It’s tough to cut spending and raise taxes during a recession to get back to a surplus or even back to reasonable numbers because it slows the economy in the short term. If you wait for the crisis to balance your budget, it ain’t gonna happen.” He goes on: “Spain is at 25% unemployment—like our great depression. Debt is 160% of GDP in Greece.”

Why is this happening? I feel a real need to know.

Martin Eichenbaum

He tells this story: “Back when Portugal, Ireland, Italy, Greece and Spain joined the European Union they said, ‘We’re not so good at monetary policy. We do other things. We do cuisine, we do art, we do literature…’ (Laughter from the audience.) ‘We’re going to hand over the steering wheel to the Germans because they do inflation well.’ But if you can’t pay the bills you can’t pay the bills. If the Germans won’t let you pay them with inflation, then you’re going to default. You can’t raise taxes—they’re already too high. So we’re looking at real sovereign default risk.”

“If you look at unit labor costs in these countries when entering the euro. Germany is little changed. All others have experienced a huge rise. They’re not competitive with Germany and people are going out of business. Only Germany has a trade surplus against everybody else’s trade deficit. Bond spreads between Germans and other countries are huge. Italians, Spaniards, Portuguese, and Greeks have to pay a lot more for money. So much that you can’t borrow at those rates.”

(It sounds like letting the Germans take the wheel was great for Germany, but lousy for everybody else. That’s something I didn’t know before.)

The Crisis is Simple

(It occurs to me that it’s really simple for us to understand the underpinnings of this crisis. I’ve picked the metaphor of housing because so many people can relate to it and understand it.  Let’s compare Europe to your own home mortgage. Say you’ve got a $200K house and rates are low, so you borrow to the hilt. Then, let’s say you take all your cash and invest it all in more real estate. If real estate prices drop, you’re underwater, both on your house and your investments. If your home is really your castle, you’ve got a sovereign debt crisis. You’re broke. And you can’t print money to buy your way out.  Turns out that’s a problem in the EU as well.)  Here’s how he explains the situation in Europe:

“In 2003,” says Marty, “Interest rates were at historic lows and there was no fear of sovereign default.” (So countries borrowed big because rates were so low. I can relate to that.) “The ECB told them to invest in a safer portfolio:EU Logo Sovereign debt.” (Sure—what’s safer than that?)  “So the banks in Europe bought sovereign debt at urging of the ECB.” Now that’s not good diversification of risk so he goes on to explain that they tried to avoid any run on a bank by creating deep pockets. To do that they set up Long Term Refinancing Operations—LTROs—which lent them a trillion euros at 1%. The result? Banks are run by people, just like everything else. People do what looks good to them, even if it’s too good to be true. According to Marty, they doubled down: “They used the cheap money to double down on high-yield sovereign debt.”

(I can picture them doing just that. The interest rate spread must have seemed like free money. So they licked their chops and plunged. A big bet got a lot bigger. Casinos make a business off people who do that.)

As it turned out, it was a bad bet. In 2009, sovereign debt got downgraded. Now these banks faced accelerating capital losses on non-diversified investments that might default.

(They’re heavily invested in themselves and each other. That sounds like a form of incest and something even more embarrasingly personal. Again it’s like the homeowner that took out the maximum mortgage and used the money to buy a vacation home and a time share just as the housing bubble burst.)

Death Spiral

The Death Spiral

Let’s watch it unfold step-by-step:

1—European banks are highly exposed to sovereign debt. Then they double down.
2—If rates rise, the old low-rate bonds go down in value. Every time there’s an interest rate rise on sovereign debt, the banks suffer capital losses on the sovereign bonds they bought.
3—Banks look shaky and the government bails them out. Spain spends billions to prop up their banks. Where will the money come from? Nobody wants to hold their debt. Money is leaving Spain in huge gobs. No solution in sight.
4—As a result, the rate charged governments goes up. The rates charged Italians, Spaniards, Portuguese, and Greeks are way higher than what Germany pays. You can’t borrow at such rates. So the banking systems in these countries are in trouble. Because the banks are in trouble, they won’t lend to the people of the country.
5.—When banks don’t lend to the people, recession deepens. Tax revenues plummet. That causes countries to spend more on unemployment and other social programs. That raises the rates on sovereign debt. That hands the banks further losses on their sovereign bonds. Add to that, banks get walloped with non-performing loans. So the banks look even worse than before.

It’s a death spiral.

A Problem of Perception

Who cares if the banks look bad? Well, it’s actually a huge problem when people feel that the banks are no longer safe. It results in a kind of suicide called “a run on the bank.” Even if the bank is okay, it can go broke if everybody demands their money at once. It’s a self-fulfilling crisis. Greece and Spain really are broke. What about the others?

Let’s look at Italy. Their economy is huge–so big, they make Greece seem insignificant. Italy carries1.2 Trillion in debt. But actually, they’re doing fine—as long as the markets think they’re not broke. They’ll keep paying 2% on debt and chug along, fat, dumb and happy. But if people think they’re broke, they’ll get charged 6% or more and then they WILL be broke. At low interest, Italy is in surplus. At high interest, they’re broke. Their fate is tied to market perception. It’s self-fulfilling.

So the banks take out Credit Default Swaps or CDS to insure their portfolios. But that type of insurance keeps getting more and more expensive and the death spiral continues.

Euro Ten Dollars

Takeaways from the Speech

1—Can the EU orchestrate a short-term stimulus and impose long-term fiscal reform? Probably not. That’s hard to do during a crisis.
2—They can raise taxes. But taxes are already way too high and this is a recession.
3—They can print more euros—it’s illegal but there are ways around it. But Germany doesn’t like that option because Germany hates inflation.
4—One non-intuitive solution is to raise German wages. That would stimulate German consumer buying and boost the economies of the other EU countries. A happy solution for the German worker. But again, Germany hates inflation.
5—Yes, Greece may actually exit the European Union, but there’s a bigger option than that—one considered unthinkable three years ago: Germany leaves the euro. Then other countries can print more euros, create inflation, devalue their currencies, and take all sorts of measures to buy themselves out of trouble.

(I notice that he hasn’t raised the specter of war.  History shows us that it tends to breed at times of financial crisis.  My bet—for what it’s worth—is that Europe will wring its hands and delay any meaningful decision as long as possible. Then, at the last possible moment, they’ll take the only course left open to them—the worst one.)

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GO BACK TO – THE CLIFFS OF INSANITY

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(Afternote–I find it amazing how much of this has already come to pass–actually come to pass in the short time it’s taken for this article to reach the head of the line.)

Contacts

Reach Prof. Martin Eichenbaum PhD Email: eich@northwestern.edu

Download PDF version of this Article

Find Chicago Venture Magazine at www.ChicagoVentureMagazine.com Comments and re-posts are welcomed and encouraged. This is not investment advice – do your own due diligence. I cannot guarantee accuracy but I give you my best.

Copyright © 2012 John Jonelis – All Rights Reserved

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Filed under Chicago Venture Magazine, Fed, Federal Reserve, Financial Markets, Kellogg, Northwestern