OPINION
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September 16, 2012, 7:03 p.m. ET
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The Magnitude of the Mess We're In
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The next Treasury secretary will confront problems so daunting that even Alexander Hamilton would have trouble preserving the full faith and credit of the United States.


By George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor

 





Sometimes a few facts tell important stories. The American economy now is full of facts that tell stories that you really don't want, but need, to hear.



Where are we now?



Did you know that annual spending by the federal government now exceeds the 2007 level by about $1 trillion? With a slow economy, revenues are little changed. The result is an unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3 trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion on the way this year. The four-year increase in borrowing amounts to $55,000 per U.S. household.



The amount of debt is one thing. The burden of interest payments is another. The Treasury now has a preponderance of its debt issued in very short-term durations, to take advantage of low short-term interest rates. It must frequently refinance this debt which, when added to the current deficit, means Treasury must raise $4 trillion this year alone. So the debt burden will explode when interest rates go up.



The government has to get the money to finance its spending by taxing or borrowing. While it might be tempting to conclude that we can just tax upper-income people, did you know that the U.S. income tax system is already very progressive? The top 1% pay 37% of all income taxes and 50% pay none.



Did you know that, during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens' and institutions' purchases and sales netted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II.
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The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself. It determines the interest rate by declaring what it will pay on reserve balances at the Fed without regard for the supply and demand of money. By replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended economic consequences.



Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process? To pay for quantitative easing—the purchase of government debt, mortgage-backed securities, etc.—the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have exploded to $1.5 trillion from $8 billion in September 2008.



The Fed now pays 0.25% interest on reserves it holds. So the Fed is paying the banks almost $4 billion a year. If interest rates rise to 2%, and the Federal Reserve raises the rate it pays on reserves correspondingly, the payment rises to $30 billion a year. Would Congress appropriate that kind of money to give—not lend—to banks?
The Fed's policy of keeping interest rates so low for so long means that the real rate (after accounting for inflation) is negative, thereby cutting significantly the real income of those who have saved for retirement over their lifetime.



The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government. And the Fed's Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury's traditional debt management.
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This large expansion of reserves creates two-sided risks. If it is not unwound, the reserves could pour into the economy, causing inflation. In that event, the Fed will have effectively turned the government debt and mortgage-backed securities it purchased into money that will have an explosive impact. If reserves are unwound too quickly, banks may find it hard to adjust and pull back on loans. Unwinding would be hard to manage now, but will become ever harder the more the balance sheet rises.



The issue is not merely how much we spend, but how wisely, how effectively. Did you know that the federal government had 46 separate job-training programs? Yet a 47th for green jobs was added, and the success rate was so poor that the Department of Labor inspector general said it should be shut down. We need to get much better results from current programs, serving a more carefully targeted set of people with more effective programs that increase their opportunities.



Did you know that funding for federal regulatory agencies and their employment levels are at all-time highs? In 2010, the number of Federal Register pages devoted to proposed new rules broke its previous all-time record for the second consecutive year. It's up by 25% compared to 2008. These regulations alone will impose large costs and create heightened uncertainty for business and especially small business.



This is all bad enough, but where we are headed is even worse.



President Obama's budget will raise the federal debt-to-GDP ratio to 80.4% in two years, about double its level at the end of 2008, and a larger percentage point increase than Greece from the end of 2008 to the beginning of this year.



Under the president's budget, for example, the debt expands rapidly to $18.8 trillion from $10.8 trillion in 10 years. The interest costs alone will reach $743 billion a year, more than we are currently spending on Social Security, Medicare or national defense, even under the benign assumption of no inflationary increase or adverse bond-market reaction. For every one percentage point increase in interest rates above this projection, interest costs rise by more than $100 billion, more than current spending on veterans' health and the National Institutes of Health combined.



Worse, the unfunded long-run liabilities of Social Security, Medicare and Medicaid add tens of trillions of dollars to the debt, mostly due to rising real benefits per beneficiary. Before long, all the government will be able to do is finance the debt and pay pension and medical benefits. This spending will crowd out all other necessary government functions.



What does this spending and debt mean in the long run if it is not controlled? One result will be ever-higher income and payroll taxes on all taxpayers that will reach over 80% at the top and 70% for many middle-income working couples.


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Did you know that the federal government used the bankruptcy of two auto companies to transfer money that belonged to debt holders such as pension funds and paid it to friendly labor unions? This greatly increased uncertainty about creditor rights under bankruptcy law.
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The Fed is adding to the uncertainty of current policy. Quantitative easing as a policy tool is very hard to manage. Traders speculate whether and when the Fed will intervene next. The Fed can intervene without limit in any credit marketnot only mortgage-backed securities but also securities backed by automobile loans or student loans. This raises questions about why an independent agency of government should have this power.



When businesses and households confront large-scale uncertainty, they tend to wait for more clarity to emerge before making major commitments to spend, invest and hire. Right now, they confront a mountain of regulatory uncertainty and a fiscal cliff that, if unattended, means a sharp increase in taxes and a sharp decline in spending bound to have adverse effect on the economy. Are you surprised that so much cash is waiting on the sidelines?
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What's at stake?
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We cannot count on problems elsewhere in the world to make Treasury securities a safe haven forever. We risk eventually losing the privilege and great benefit of lower interest rates from the dollar's role as the global reserve currency. In short, we risk passing an economic, fiscal and financial point of no return.
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Suppose you were offered the job of Treasury secretary a few months from now. Would you accept? You would confront problems that are so daunting even Alexander Hamilton would have trouble preserving the full faith and credit of the United States. Our first Treasury secretary famously argued that one of a nation's greatest assets is its ability to issue debt, especially in a crisis. We needed to honor our Revolutionary War debt, he said, because the debt "foreign and domestic, was the price of liberty."
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History has reconfirmed Hamilton's wisdom. As historian John Steele Gordon has written, our nation's ability to issue debt helped preserve the Union in the 1860s and defeat totalitarian governments in the 1940s. Today, government officials are issuing debt to finance pet projects and payoffs to interest groups, not some vital, let alone existential, national purpose.


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The problems are close to being unmanageable now. If we stay on the current path, they will wind up being completely unmanageable, culminating in an unwelcome explosion and crisis.
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The fixes are blindingly obvious. Economic theory, empirical studies and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation and education reform. The need is clear. Why wait for disaster? The future is now.

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The authors are senior fellows at Stanford University's Hoover Institution. They have served in various federal government policy positions in the Treasury Department, the Office of Management and Budget and the Council of Economic Advisers.

 
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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved


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Markets Insight

September 17, 2012 2:40 pm

Bond-buying plan will hurt risk assets

By George Magnus


From the moment in late June that Mario Draghi vowed to do whatever it took to save the euro, investors flocked back to risky assets. The reaction to the European Central Bank’s outright monetary transactions (OMT) announcement, reinforced by the now validated expectations of American QE3, was the icing on the cake.



To the markets’ delight, Mr Draghi’s plan is technically strong, and a smart, if covert, way of doing something that’s been rejected formally, namely leveraging the EFSF/ESM eurozone bailout funds. Unfortunately, the plan is also economically unsound. The Pavlovian market response to monetary financing will again falter because the ECB alone can’t resolve the euro-crisis.



For now, world equity markets are on a roll, returning about 6 per cent since midyear, with comparable returns to European bonds and energy markets. The next best performers include European investment grade corporate bonds, global listed real estate, and even the industrial metals and mining markets.




The ECB can take much, but not all of the credit. QE3, and the recent sudden confirmation by China of 1tn yuan of infrastructure spending spurred the biggest local stock market rally for more than eight months.




The strongest asset returns have accrued to European equities and precious metals. Gold has done even better. What does this tell us about investor psychology? Both asset classes thrive on the already bloated balance sheet of the ECB inflating further. ECB assets as a share of gross domestic product are already substantially higher than those of the Fed or the Bank of England. But gold will draw the more enduring sustenance from monetisation. Equity markets need much more to sustain their optimism.




Mr Draghi has promised to remove the so-called tail risk in markets, allowing investors to focus more on normal asset class correlations, and valuation anomalies than on preserving capital. This risk derives from the self-fulfilling expectations of a eurozone break-up because of penal levels of interest rates in Spain and Italy, for example, especially those on short maturity bonds. The ECB is trying to break a vicious circle of exit risk, high real interest rates, poor sovereign liquidity and solvency prospects, economic depression, weak bank funding capacity, and so on. From this standpoint, the OMT plan is technically robust, and risk assets are right to cheer.




There are caveats. Spain and Italy have to ask for a troika programme soon but might drag their feet. There would be consequences if the ECB didn’t shut down the OMTs if one of its supplicants were in breach of its conditions. And we don’t know if the surrender of seniority on OMTs is legally robust in extremis? OMTs will make official sector funding of sovereigns, and banks, even more crowded. Did someone sayzombies’?




But the principal reason why risk assets will falter again is that the plan is economically and politically unsound. Mr Draghi’s insistence that the ECB’s actions are dependent on strict conditions is the price for German and other creditor government support. But this is precisely the problem. The single-minded emphasis on rapid fiscal restraint has created an unsustainable, pro-cyclical austerity zone. It is undermining weak sovereign and bank funding and solvency, and substituting national central banks, notably the Bundesbank, for private investors in financing regional capital flow imbalances, especially deposit flight from the periphery. Political sparks are flying in Germany.




The main flaw in the plan is the presumption that if countries need to apply to the EFSF/ESM for help, and for the ECB to authorise OMTs, it is because their austerity programmes need strengthening under international monitoring. This makes no economic sense because it aggravates fiscal and economic instability, and no political sense because it is highly divisive within and between countries. There is nothing conducive here to the so far meagre but urgent progress needed for a banking union, including both a central resolution authority and pan-European deposit insurance, or for further fiscal integration, including centrally-determined behavioural rules and common debt issuance.



A sustainable recovery in equity and other risk assets would be accompanied by the return of stable, private financing of the eurozone periphery. The weathervane is a sharp rise in German bond yields, making the drift up over the summer just noise. For these things to happen, investors want two things.



First, a plan to end the depression, which is not likely. Second, credible progress towards political union, which requires Germany and France and their supporters to agree radically different sequencing and substance agendas when it comes to sovereignty concessions. Mr Draghi has drawn the markets’ attention away from these things, but not for long.


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George Magnus is a consultant economist, and senior economic adviser, to UBS


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Copyright The Financial Times Limited 2012.



Emperor Bernanke, 3 Castles, And An Inevitable Unwind

September 15, 2012

by: Colin Lokey




I have talked quite a bit lately about how investors' hunger for more stimulus has created a perverse marketplace where bad news is good in terms of economic indicators. The key point is that when the market wishes for bad economic data, it is
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"...putting the cart before the horse. The market shouldn't hope for bad economic news because such news would prompt the Fed to act when the whole reason for the Fed's action in the first place was to improve economic conditions."
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With the announcement of an open-ended asset purchase program wherein additional purchases beyond year-end will be contingent upon - to use the Fed's own words - "the outlook for the labor market", the Fed has implicitly encouraged this behavior. Indeed, after December (the central bank will be buying until then regardless) there will be an explicit, quantifiable link between bad economic data and more asset purchases: bad data equals $40 billion or more in new stimulus. As David Rosenberg of Gluskin Sheff & Associates puts it,
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"The payroll data always move the market but now more than ever and the Fed's explicit goal of generating "substantial" improvement in the jobs market will ensure that this 'bad news is good news' psychology will remain fully intact."
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If you think about what this psychology encourages it is truly disturbing. The market is already grossly disconnected from global economic fundamentals and rising solely on P/E multiple expansion as consensus EPS estimates continue to fall. The Fed's actions have ensured that the market will continue to rise with bad data resulting in equity prices that are ever farther removed from underlying fundamentals. In short, we are building a bigger and bigger castle on a foundation made of quick sand.

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Right next door to the equities castle, the Fed is constructing two more giant chateaus and these too are built on shaky foundations. The Fed is monopolizing mortgage backed securities and Treasury bonds, a move that will invariably destabilize the underlying market for those assets. In a previous article, I discussed how much of the monthly supply of MBS the Fed will likely be in the market for once QE3 kicks into full gear. Now, courtesy of a Bank of America note to clients, we have a more complete picture of what the market for Treasury bonds and MBS will look like over the next two years.

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According to Bank of America, the Fed will end up purchasing around 60% of the monthly supply of MBS, and if its current pattern of buying persists, it may end up purchasing 90% of 30-year conventional issuance. By the end of 2014, Bank of America sees the Fed owning 33% of the entire market.

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For Treasury bonds, the prognosis is even more shocking. Bank of America, like many other commentators, expects the Fed to announce unsterilized purchases of Treasury bonds once it runs out of short-end bonds to sell in December. Extrapolating from that assumption, the bank estimates that by the end of 2014, the Fed will own 65% of Treasury bonds with maturities of between 6 and 30 years. Notably, Bank of America says that,
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"...the Fed will begin to run out of issues in the 8y-10y bucket and will be forced to buy newly issued 10y notes should they choose to maintain the same distribution"
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That would mean direct financing of the deficit by the central bank.

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There are two key takeaways here. First, Bank of America estimates the Fed's balance sheet will be $5 trillion by the end of 2014 which, by some estimates which factor in the current trajectory of prices with the increase of the Fed's holdings, equates to $190 oil and $3,350 gold (SPDR Gold Trust ETF: GLD). While these estimates are admittedly rather speculative, what is not speculative is the notable underperformance of the dollar index compared to the CRB commodity index over the last few weeks. In other words, whether you believe in $200 oil or record high gold prices or not, what you can bet on is a decline in the dollar relative to commodities.

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The second key takeaway - and I think this is more important - is the prospect that the Fed will own 65% of Treasury bonds with maturities between 6 and 30 years. When rates start to rise and the prices on those bonds begin to fall this giant market which for several years now has been manipulated by the Fed, is going to unwind. As David Stockman notes,

"Trillions of treasury paper is funded on repo: You buy $100 million in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out. If that happens, the massive repo structures - that is, debt owned by still more debt - will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked."
 
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This will be the trade that makes careers: short U.S. Treasury bonds (iShares Barclays 20+ Year Treasury Bond ETF: TLT). The emperor is indeed naked and eventually, the castles he has built will collapse.