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Destination unknown

Large increases in the minimum wage could have severe long-term effects

Jul 25th 2015

FED up with pay increasing only at a snail’s pace, politicians are resorting to the law instead, by increasing the mínimum wages that businesses must pay. But this is taking them into uncharted territory. Britain’s recent minimum-wage increase will take it from the average among OECD countries to the upper ranks. Germany’s new minimum wage, introduced in January, stands at 62% of average earnings in east German states. If a $15-an-hour federal minimum wage were implemented in America, as campaigners want, it would apply to two-fifths of workers.

In the past, cash increases in the minimum wage have been eroded by inflation. America’s federal minimum wage was last set, at $7.25, in 2009 and has not been changed since, so its value has faded over time. This means that in reality most countries have only ever temporarily increased the real minimum wage. If the recently proposed increases are maintained over time (as the electorate will surely expect), there could be long-term effects. Historically, economists have worried that high minimum wages boost the pay of those in work but at the expense of jobs. Take a burger bar, which is forced to pay its employees a higher legal minimum. To avoid making a loss, it might have to raise prices, putting off customers and reducing the need for staff. A permanent increase in the minimum wage could tip the balance in favour of burger-flipping machines, away from employees.

Supermarkets have already replaced many cash-till operators with self-checkout machines.

Displaced workers might find different jobs, though they might struggle to do so if they are low-skilled.

The evidence seemed to support the scepticism of dismal scientists until a study in 1993 by David Card and Alan Krueger found that employment in New Jersey restaurants actually increased in response to a minimum-wage rise. This sparked a huge debate and heated criticism from two rival economists, David Neumark and William Wascher, who used different methods to show that minimum wages did indeed hurt jobs. Twenty years later, the debate is still not settled, but the sides have converged. The debate is now largely between those arguing that there are small negative effects and those who say there are none at all.

That makes higher minimum wages look like electorally popular policies; they do not require unpleasant tax rises, and do not seem to lock the poorest out of work. As a result, proposals for large increases in the minimum wage abound. Some propose tying the minimum wage to inflation or earnings, which would make the increases permanent. But three new papers suggest a more cautious approach would be more sensible.

In the first Isaac Sorkin of the University of Michigan argues that firms may well substitute machines for people in response to minimum wages, but slowly. Mr Sorkin offers the example of sock-makers in the 1930s, which took years to switch to less labour-intensive machines after the federal minimum wage was brought in. He also explains how this finding squares with other research. Most studies look at past minimum wage increases that were not inflation-proofed.

Firms may decide not to go through the hassle of investing in labour-saving machines if the minimum wage will affect them less over time. But they could respond differently to a more permanent increase.

Mr Sorkin crunches the numbers, using a model of the American restaurant industry in which companies choose between employees and machines. He investigates the effect of a permanent (ie, inflation-linked) increase in the minimum wage and shows that the tiny short-run effects on employment normally seen are fully consistent with a long-run response over 100 times larger.

The lack of evidence for a big impact on employment in the short term does not rule out a much larger long-term effect.

In a second paper, written with Daniel Aaronson of the Federal Reserve Bank of Chicago and Eric French of University College London, Mr Sorkin goes further, offering empirical evidence that higher minimum wages nudge firms away from people and towards machines. The authors look at the type of restaurants that close down and start up after a minimum-wage rise. An increase in the minimum wage seems to push some restaurants out of business. The eateries that replace them are more likely to be chains, which are more reliant on machines (and therefore offer fewer jobs) than the independent outlets they replace. This effect has not been picked up before because the restaurants which continue to operate do not change their employment levels, so the jobs total does not shift much in the short run.

Young, gifted and fired
The third cautionary paper is from Jonathan Meer of Texas A&M University and Jeremy West of the Massachusetts Institute of Technology. Studies typically hunt for a fall in employment in response to a minimum-wage increase. But if the increase affects the rate of growth in employment, rather than the level, differences would appear slowly over time. Standard measures would struggle to pick up this more subtle effect.

Their results suggest that a 10% increase in the minimum wage, made permanent by linking it to inflation, could cut job growth by 0.3 percentage points a year. Over a long period, this could amount to a very large difference indeed, though the authors stress that such long-run extrapolations are difficult given the limited experience of such permanent changes.

Worryingly, the effects on jobs growth they see are concentrated among people under 25, and those without a degree. These are vulnerable groups who risk being locked out of the labour force for good.

The evidence so far may therefore be a poor guide to the effects of the latest wave of minimum-wage rises. Although the short-run effects seem mild, large increases could be storing up big problems for the future.

How to Identify a Classic Bubble

By: Michael Pento

Monday, July 27, 2015

One of the most ironic and fascinating characteristics about an asset bubble is that central banks claim they can't recognize one until after it bursts. And Wall Street apologists tend to ignore the manifestation of bubbles because the profit stream is just too difficult to surrender.

The excuses for piling money into a particular asset class and sending prices several standard deviations above normal are made to seem rational at the time: Housing prices have never gone down on a national basis and people have to live somewhere, the internet will replace all brick and mortar stores, and perhaps the classic example is that variegated tulips are so rare they should be treated like gold.

I am willing to let the Dutch off the hook; back in the seventeenth century asset bubbles were virtually nonexistent because money was still in specie. But central banks have created the perfect petri dish for asset bubbles over the past three decades. Therefore, it's imperative for investors to understand the classic warning signs of a bubble so you can avoid the inevitable carnage in the wake of its collapse.

As I identified in my book "The Coming Bond Market Collapse", there are three classic metrics to determine when an asset has grown into a bubble: it becomes extremely over supplied, over owned and overpriced compared to historical norms.

The real estate market circa 2005 was a great example of a classic bubble. The supply of new homes boomed as new home construction rates peaked around 2 million units per annum in the middle of the last decade. That's about 400k units higher than what would be considered the historical average.

Just prior to the start of the Great Recession the level of home ownership in the U.S. soared.

This rate hit a high of 69% in during 2005, after bouncing around 64-66% for decades. Today's home ownership rate has fallen back to just 63.7%, which is the lowest in 25 years.

And finally, during the real estate bubble homes were massively overpriced. According to Trulia, at its 2006 peak home prices were 39% overvalued based on consumer incomes and cost to rent. On a national level the median home price to income ratio shot to 4.7 in 2006, compared to the 2.6 historical average. The current home price to income ratio has climbed back to 4.4 on a national basis. However, even though home prices are currently vastly overvalued, the housing market is not in a classic bubble because the real estate market is not currently in the conditions of being over owned or over supplied.

But the bond bubble is a classic bubble thanks to Wall Street and the Federal Reserve.

The bond market qualifies as being in a state of over supply because there has been an additional $60 trillion in total global debt that has accrued since 2007.

During the first half of this year, $891 billion in bonds were issued in the U.S. alone. That's up 7.5% from the same period in 2014, which was itself a record year, according to the Securities Industry and Financial Markets Association.

Higher-yielding "Junk Bonds" led the way with $185 billion so far in 2015. Volume for June topped out at $29 billion from 60 issuers, the most for any June on record. The previous June saw just $12.8 billion in volume from 31 issuers. June also follows the two busiest months of this year, with April and May pulling in $39 billion and $37 billion, respectively. That makes for a record quarter of $105 billion, the largest recorded quarterly volume ever. Talk about being oversupplied!

But just as more risk was taken toward the final stages of the housing bubble in the form of sub-prime mortgage issuance, for every speculative-grade company that has had its credit rating upgraded this year about two others have been downgraded. This is the worst ratio since 2009. U.S. companies that issue high-yield debt posted two consecutive quarters without earnings growth for the first time since the financial crisis. And their average level of debt-to-earnings is at an all-time high as well.

Next, bonds are over owned because of investors are yield starved. In the first quarter of this year alone, net cash inflows into bond funds totaled $102 billion, that's the largest inflow since 2001. And last year investors poured $204 billion into bond funds, surpassing inflows of $121 billion into stock funds.

And finally, bonds are overpriced compared to historical norms. Bond yields and prices are inverted; as bond prices fall, yields rise. Today, the yield on the bench mark US 10-year Treasury sits at around 2.3%. This is very close to its historic low and far below the 7% average over the last 40 years. Making the price of bonds massively expensive at the current level--especially in light of record debt levels and the increase in central bank balance sheets.

I first explained the classic signs of a bubble at the start of the real estate crisis to help investors identify a problem before it grows too far out of control. Perhaps the Fed should now take heed and ask the question if seven years of zero percent interest rates could possibly lead to a bubble in fixed income. But even more importantly, the question everyone should be asking is: what happens when bond prices crash and who is going to buy all that debt?

Once the Fed starts raising interest rates investors may start to sell their high-yield junk bonds in the same manner as sub-prime mortgages were the first to crack in the housing bubble in 2008. This would exacerbate the drop in prices and cause yields to rise yet further and faster.

Prices will also tumble because government regulations have stripped banks of their proprietary trading desks; and bids for plummeting bond prices may become as rare as a variegated tulip. Spiking debt service payments will crumble the stock and real estate markets that have been built on synthetic, free-money based economies.

The bottom line is that the bond market is the most dangerous bubble in history precisely because every asset class derives its value from the cost of money. Therefore, even though stocks and real estate aren't in a classic bubble they have still become vastly overvalued due to the frantic search for yield over the course of seven years. When, not if, this classic bond bubble bursts central banks will be the only buyers left in the market. And this bid from central bankers will have to be massive, protracted and unprecedented in nature. The resulting market chaos should be vastly more baneful than the Great Recession of 2008.

Volcker rule

Much ado about trading

The next great regulation to tame banks is now in place

Jul 25th 2015

Better call Paul

FIVE years is the length of a modern British Parliament and one of Stalin’s economic plans.

Apparently, it is also the time needed to bring in a new American financial regulation. When the Dodd-Frank act was passed in 2010, the so-called Volcker rule was seen as one of its key provisions.

But the rule only formally took effect on July 21st this year.

The pertinent clause of Dodd-Frank amounts to all of 165 words (with the key points covered in 40). Banks are banned from two activities: proprietary trading and ties (through investment and relationships) to hedge and private-equity funds. Putting that into practice involved a collaboration of five regulatory agencies: the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (OCC). This group produced an 891-page preamble leading to a 71-page rule, all of it written in dense bureaucratese.

The aim of the rule is to stop banks (and their worldwide affiliates) with the implicit support of the American government from indulging in speculation and becoming enmeshed in conflicts of interest. In reality, distinguishing such activities from more beneficial financial operations has proved daunting. “It’s impossible for banks to know if they are completely in compliance with the rule, because there are so many interpretive questions remaining,” says Gabriel Rosenberg of Davis Polk & Wardwell, a law firm.

Exceptions have been carved out for market-making, risk-mitigation, underwriting and (surprise!) trading American government bonds. But complying with the rule has forced banks to close or sell whole divisions. Goldman Sachs has closed down two proprietary-trading operations without much ado, and wound down various funds in which it co-invested with clients, without suffering any visible calamities. JPMorgan Chase has done the same.

Banks have created compliance systems designed to ensure that every single transaction meets the Volcker standard. This has not been easy. Every time a bank buys or sells a security it is in effect taking part in a proprietary trade. This is also true, for example, when it expands its holdings of foreign currency in anticipation of demand. Bank examiners will not only have to judge assets and liabilities, but also intentions. Some foreign banks, judging that they simply lack the political clout to navigate such a complex regulatory environment, have cut back their American operations, to the delight of their American competitors.

Has this upheaval been worth it? Although many provisions of the Dodd-Frank act require cost-benefit analysis, the Volcker rule does not. The OCC has provided some cost-benefit estimates, which could be the basis of further investigation.

The benefits, the OCC concludes, are largely unquantifiable but include better supervision, better risk management, greater safety, fewer conflicts of interest and the hope that a crisis will be avoided.

Compliance costs, inevitably, come with a more explicit price tag. The OCC reckons the seven “market-making” banks (ie, the biggest) will have collectively spent over $400m in 2014 and a bit less going forward. The OCC’s annual supervision costs will rise by $10m. Another 39 banks it examines will have additional direct costs of only several million dollars a year.

The largest costs, however, like the biggest benefits, can be hard to quantify. There may be less competition for large banks because smaller rivals will want to avoid the steeper compliance costs. With banks now forced to limit their efforts to make markets in securities only to activities that can be tightly linked to customers, their inventory of securities has declined.

Reduced dealer inventories in the corporate-bond markets has already become the subject of investor concern. They reduce the possibility of big bank losses in a crunch, but they also decrease market liquidity. Investors have usually required a higher return to compensate for holding less liquid securities, raising the cost of capital for some companies and making it harder for others to raise money. Perhaps the most likely outcome is that trading shifts to unregulated firms in the “shadow banking” sector. Instead of being extinguished, financial risks may just become harder to spot.

China: Major Devaluation Coming

By: John Rubino

Monday, July 27, 2015

The whole "market economy" thing is turning out to be a little trickier than China's dictators expected. To set up the story: After the 2008 crash the country borrowed about $15 trillion (an amount that dwarfs the US Fed's quantitative easing programs) and spent the proceeds on history's biggest infrastructure program.

China bank assets

This pushed up the prices of iron ore, oil, copper, etc., igniting a global commodities boom.

Then China liberalized its stock trading rules, setting off a stampede into local equities that doubled prices in less than a year. The result is a classically unbalanced economy, with massive physical malinvestment, overpriced financial assets and way too much debt.

The inevitable crash began in June, and Beijing responded by tossing about 10% of GDP into equities to stop the bleeding. This worked, as such interventions tend to do, for a while. But last night it failed:

Chinese shares tumble 8.5 percent in biggest one-day drop since 2007
(Reuters) - Chinese shares slid more than 8 percent on Monday as an unprecedented government rescue plan to prop up valuations ran out of steam, throwing Beijing's efforts to stave off a deeper crash into doubt.  
Major indexes suffered their largest one-day drop since 2007, shattering three weeks of relative calm in China's volatile stock markets since Beijing unleashed a barrage of support measures to arrest a slump that started in mid-June. 
"The lesson from China's last equity bubble is that, once sentiment has soured, policy interventions aimed at shoring up prices have only a short-lived effect," wrote Capital Economics analysts in a research note reacting to the slide. 
The CSI300 index .CSI300 of the largest listed companies in Shanghai and Shenzhen tumbled 8.6 percent to 3,818.73 points, while the Shanghai Composite Index .SSEC lost 8.5 percent to 3,725.56 points.
China's market gyrations have stoked fears among global investors about the broader health of the world's second biggest economy, hitting prices of growth-sensitive commodities such as copper, which fell on Monday to not far from a 6-year low.
Devaluation time?

While the prices of commodities and equities have been bouncing around, China's currency, the yuan, has been relatively stable in US dollars, because the government pegs the former to the latter.

China yuan July 2015

But because the dollar is way up against virtually every other currency, so is the yuan, which is a major cause of today's crisis. Other things being equal, a rising currency makes exports more expensive and slows growth, and China's trade has responded exactly as theory predicts:

China exports

So here's the dilemma: A too-strong currency is making it impossible for China to service its excessive debts, which is contributing to a bear market in equities, which further slows the economy and makes it even harder to service debts, and so on.

This probably seems like uncharted territory to the central planners, but is actually a pretty standard problem -- for which the traditional solution is to devalue and stiff your creditors by repaying debts with cheaper currency. The US did it in the 1970s, Europe is doing it now with the euro's recent steep decline, and much of Latin America is in various, mostly disorderly, stages of the process.

Put another way, the world is following the standard currency war script, in which countries take turns devaluing, reap modest temporary benefits, and then give up those gains when their trading partners respond in kind. China's coming devaluation, however, will be a much bigger deal than most.