Mish's Global Economic Trend Analysis

Schwarzenegger on Public Pensions and the Cost of the "Protected Class"
Market Cheers 1.6% Growth; Treasuries Hammered; What's Next?
Former Fed Vice Chairman vs. Mish: Is the Fed Out of Ammo?

Schwarzenegger on Public Pensions and the Cost of the "Protected Class"

Posted: 27 Aug 2010 01:31 PM PDT

Now that Schwarzenegger is a certifiable lame duck (dead duck may be a more appropriate term) Schwarzenegger sees fit to take on public unions in a major way. It's too late now (for him) even as he speaks the truth.

Please consider Public Pensions and Our Fiscal Future by Arnold Schwarzenegger.

Recently some critics have accused me of bullying state employees. Headlines in California papers this month have been screaming "Gov assails state workers" and "Schwarzenegger threatens state workers."

I'm doing no such thing. State employees are hard-working and valuable contributors to our society. But here's the plain truth: California simply cannot solve its budgetary problems without addressing government-employee compensation and benefits.

Thanks to huge unfunded pension and retirement health-care promises granted by past governments, and also to deceptive pension-fund accounting that understated liabilities and overstated future investment returns, California is now saddled with $550 billion of retirement debt.

The cost of servicing that debt has grown at a rate of more than 15% annually over the last decade. This year, retirement benefits—more than $6 billion—will exceed what the state is spending on higher education. Next year, retirement costs will rise another 15%. In fact, they are destined to grow so much faster than state revenues that they threaten to suck up the money for every other program in the state budget.

At the same time that government-employee costs have been climbing, the private-sector workers whose taxes pay for them have been hurting. Since 2007, one million private jobs have been lost in California. Median incomes of workers in the state's private sector have stagnated for more than a decade. To make matters worse, the retirement accounts of those workers in California have declined. The average 401(k) is down nationally nearly 20% since 2007. Meanwhile, the defined benefit retirement plans of government employees—for which private-sector workers are on the hook—have risen in value.

Few Californians in the private sector have $1 million in savings, but that's effectively the retirement account they guarantee to public employees who opt to retire at age 55 and are entitled to a monthly, inflation-protected check of $3,000 for the rest of their lives.

In 2003, just before I became governor, the state assembly even passed a law permitting government employees to purchase additional taxpayer-guaranteed, high-yielding retirement annuities at a discount—adding even more retirement debt. It's as if Sacramento legislators don't want a government of the people, by the people, and for the people, but a government of the employees, by the employees, and for the employees.

For years I've asked state legislators to stop adding to retirement debt. They have refused. Now the Democratic leadership of the assembly proposes to raise the tax and debt burdens on private employees in order to cover rising public-employee compensation.

Much needs to be done. The Assembly needs to reverse the massive and retroactive increase in pension formulas it enacted 11 years ago. It also needs to prohibit "spiking"—giving someone a big raise in his last year of work so his pension is boosted. Government employees must be required to increase their contributions to pensions. Public pension funds must make truthful financial disclosures to the public as to the size of their liabilities, and they must use reasonable projected rates of returns on their investments. The legislature could pass those reforms in five minutes, the same amount of time it took them to pass that massive pension boost 11 years ago that adds additional costs every single day they refuse to act.

...

All of these reforms must be in place before I will sign a budget.

I am under no illusion about the difficulty of my task. Government-employee unions are the most powerful political forces in our state and largely control Democratic legislators. But for the future of our state, no task is more important.

Schwarzenegger Washes His Hands

Schwarzenegger drones on and on about who is to blame. He also acts as if he was fiscally responsible.

That is far from the truth. In Turn out the lights California, the party is over I blasted Schwarzenegger's fiscally reckless proposals.

Flashback March 2, 2007: Schwarzenegger wants $500 billion to rebuild California

Sound Bites

$42.7 billion in general obligation bonds issued last year is "only the foot in the door, to whet the appetite."
It will take $500 billion to "rebuild California the way it ought to be".
$500 billion is "too big for people to digest, so you don't talk about that" even though he is talking about it.
California needs $500 billion even though it has "done tremendously with the revenue increases".
California will not issue less debt even if the economy slows.
California "could face lower tax revenues" but he opposes tax hikes.

Well here we are, 9 months later and the $4.1 billion reserve went to a $14 billion deficit in the last 4 months.

Thank God Schwarzenegger did not get what he asked.

Now in massive revisionist history he attempts to take credit for being fiscally conservative. Please, let's stop the charades.

While there is some truth he wanted concessions from unions, unlike Governor Chris Christie, he never fought for them very hard. Only now is he saying "All of these reforms must be in place before I will sign a budget."

He should have said that in 2009, 2008, and 2007. He is saying that now that he is a lame duck. While I commend the idea, the problems he was elected to fix are more broken than ever.

It will be interesting to see how this budget battle plays out, but no amount of hand-washing can absolve Schwarzenegger of his share of the blame.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Market Cheers 1.6% Growth; Treasuries Hammered; What's Next?

Posted: 27 Aug 2010 10:56 AM PDT

Today the DOW has crossed the 10K line for the umpteenth time (at least 3 times in the past 3 days alone depending on how you count), smack on the heels of "fantastic news" that second quarter GDP was 1.6%.

For a change, economists were a bit too pessimistic but to get to that point, their estimates had to be ratcheted down twice from 2.5% to 1.4%. Now the market, temporarily at least, thinks 1.6% is good.

It isn't. More importantly, GDP expectations looking forward for 3rd quarter are in the neighborhood of 2.5%, a number that is from Fantasyland. I expect a negative print.

GDP News Release

Inquiring minds are digging into the BEA's report National Income and Product Accounts
Gross Domestic Product, 2nd quarter 2010 (second estimate) for additional details.

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 1.6 percent in the second quarter of 2010, (that is, from the first quarter to the second quarter), according to the "second" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 3.7 percent.

The GDP estimates released today are based on more complete source data than were available for the "advance" estimate issued last month. In the advance estimate, the increase in real GDP was 2.4 percent (see "Revisions" on page 3).

The increase in real GDP in the second quarter primarily reflected positive contributions from nonresidential fixed investment, personal consumption expenditures, exports, federal government spending, private inventory investment, and residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.

The deceleration in real GDP in the second quarter primarily reflected a sharp acceleration in imports and a sharp deceleration in private inventory investment that were partly offset by an upturn in residential fixed investment, an acceleration in nonresidential fixed investment, an upturn in state and local government spending, and an acceleration in federal government spending.

Real personal consumption expenditures increased 2.0 percent in the second quarter, compared with an increase of 1.9 percent in the first. Real nonresidential fixed investment increased 17.6 percent, compared with an increase of 7.8 percent. Nonresidential structures increased 0.4 percent, in contrast to a decrease of 17.8 percent. Equipment and software increased 24.9 percent, compared with an increase of 20.4 percent. Real residential fixed investment increased 27.2 percent, in contrast to a decrease of 12.3 percent.

The change in real private inventories added 0.63 percentage point to the second-quarter change in real GDP, after adding 2.64 percentage points to the first-quarter change. Private businesses increased inventories $63.2 billion in the second quarter, following an increase of $44.1 billion in the first quarter and a decrease of $36.7 billion in the fourth.

Positive Contributions

Nonresidential fixed investment increased 17.6 percent
Personal consumption expenditures increased 2.0 percent
Real residential fixed investment increased 27.2 percent
Equipment and software increased 24.9 percent
Real private inventories added 0.63 percentage point to the second-quarter change in real GDP

Take a look at that list and ask "How many of them will increase again in Q3?" Any?

Amazingly, the deceleration in second quarter GDP was "partly offset by an upturn in residential fixed investment, an acceleration in nonresidential fixed investment, an upturn in state and local government spending, and an acceleration in federal government spending."

Think housing will add to GDP in Q3? State and local government spending?

Evolution of Estimates

Dave Rosenberg discusses GDP in today's Breakfast with Dave.

REVISIONISTS UNITE!

Like the equity analysts, the economists are now in the process of cutting their GDP forecasts — but in dribs and drabs, and nothing very draconian just yet. It is interesting to see that the hopes of a 3%-plus growth for this quarter have been marked down to 2.5% in just three short months and frankly, it looks like the economy may even be contracting right now. The consensus has only now begun to touch Q4, and there is probably much more work to do on this score as well.

The bright light in the Q2 revision was the uptick to consumer spending, to a 2% annual rate from 1.6%, while at the same time we had the inventory line revised lower to a $63.2 billion build from $75.7 billion. This configuration is alleviating concerns that a move to take inventories down in the third quarter will be necessary since household spending held up better than earlier expected.

Real GDP in the U.S. came in higher than expected, coming in at 1.6% versus market expectations of 1.4% in Q2. Boy oh boy, 1.6% never felt so good. Be that as it may, much of the upward revision on consumer spending was in services and non-durables, and it looks to be energy related (gas, electricity). In real terms, consumption of gasoline/other energy goods rose at a 4.7% annual rate whereas in the previous "take" on Q2 GDP it was reported to be up only at a 0.7% annual rate. Spending on utilities also swung from what was reported before as a 0.7% decline to a 1.5% increase. Strip out the energy components, and consumer spending did not improve at all from the last Q2 report we were issued a month ago. In other words, if not for the fact that more of the household budget was diverted to the energy bill in Q2, consumer spending would have shown a 1.6% growth rate and GDP would have actually come in BELOW consensus, at +1.3%. Notably, consumer spending on big-ticket durable goods came in lower than initially estimated — trimmed to a 6.9% annual rate from 7.5%.

Here's what is important to take away:

We had 5% real GDP growth in the fourth quarter of last year, followed by 3.7% in Q1, 1.6% in Q2 and now what looks to be little better than 0% this quarter. So the notion that the economy has hit stall speed has not changed in this report —if anything, it was enhanced.

Real final sales — GDP excluding inventories — was actually marked down in this report to a meager 1% annual rate. That is really soft and underscores the overall weakness in the demand guts of the economy. We know from the monthly data that much of this paltry 1.6% growth in Q2 was baked into April — four months ago! — and that the pace of activity has weakened markedly ever since.

The monthly GDP data have actually shown declines for two months running and there is a negative "build in" so far for Q3. There is practically no growth in real consumer spending heading into the current quarter and we know that back-to-school sales so far have been sluggish.

One more comment on Q2 — just to put 1.6% into context. Historically, four quarters following a bottom in GDP, growth is running over a 6% annual rate. Rejoicing over 1.6% because it wasn't 1.4%, particularly in the context of the most radical bailout, monetary and fiscal stimulus in U.S. history, totally misses the point that we are operating in a totally abnormal and fragile economic environment.

Treasuries Hammered

After a massive rally in treasuries since April, at some point there was bound to be a correction. Exciting news of an unexpectedly "good" GDP at 1.6% was a nice trigger.

The selloff looks sharp but it's not. 10-year treasury yields were above 4% in April. The 10-year yield after today's hammering is 2.64%.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Former Fed Vice Chairman vs. Mish: Is the Fed Out of Ammo?

Posted: 27 Aug 2010 12:08 AM PDT

Alan Blinder, a former Fed Vice Chairman says the Fed still has options if more monetary easing is needed.

Please consider Fed Is Running Low on Ammo by Alan S. Blinder.

Chairman Ben Bernanke has told the world that the Fed is not out of ammunition. It still has easing options, should it need to deploy them. The good news is that he's right. The bad news is that the Fed has already spent its most powerful ammunition; only the weak stuff is left. Mr. Bernanke has mentioned three options in particular: expanding the Fed's balance sheet again, changing the now-famous "extended period" language in its statement, and lowering the interest rate paid on bank reserves. Let's examine each.

From exit to re-entry. The first easing option is to create even more bank reserves by purchasing even more assets—what everyone now calls "quantitative easing."

When the Fed buys private-sector assets like MBS it is trying to shrink interest rate spreads over Treasurys—and thereby to lower private-sector borrowing rates such as home mortgage rates—by bidding up the prices of private assets, and so lowering their yields. Judged by this criterion, the MBS purchase program was pretty successful.

Mish Reply:

It is not at all clear the Fed was "successful". Blinder is making an assumption that the Fed's purchase of MBS is what drove rates lower. Is that really the case or did Congressional guarantees of unlimited bankrolling of Fannie and Freddie losses do it? Perhaps it is a combination. Remember, at best the Fed can enhance the primary trend, it cannot change it.

Regardless, New Home Sales Consensus 330K, Actual 276K, a Record Low; Nationwide, Zero New Homes Sold Above 750K .

By what practical measure can Bernanke's efforts be considered a success?

Alan Blinder:

But when the Fed buys long-dated Treasury securities it is trying to flatten the yield curve instead—by bidding up the prices on long bonds. That effort also seems to have succeeded, perhaps surprisingly so given the vast size of the Treasury market. Now put the two together. By reducing its holdings of MBS and increasing its holdings of Treasurys, the Fed de-emphasizes shrinking risk spreads and emphasizes flattening the yield curve. That strikes me as a bad deal for the economy because the real problem has been high risk spreads, not high Treasury bond rates.

Mish Reply:

Once again, the question at hand is: Did Bernanke succeed and if so by how much?

Clearly yields are lower, but why? The answer is the economy is weakening rapidly in spite of heroic efforts by both the Fed and Congress. In simple terms, the Fed failed to stimulate either lending or the economy. Thus yields fell.

The goal was not to lower rates, the goal was to stimulate lending. Pray tell, how can a policy that failed to meet its objectives be construed a success?

Alan Blinder:

If the FOMC is serious about re-entry into quantitative easing, it should buy private assets, not Treasurys. Which assets? The reflexive answer is: more MBS. But with mortgage rates already so low, how much further can they fall? And would slightly lower rates revive the lifeless housing market?

To give quantitative easing more punch, the Fed may have to devise imaginative ways to purchase diversified bundles of assets like corporate bonds, syndicated loans, small business loans and credit-card receivables. Serious technical difficulties beset any efforts to do so without favoring some private interests over others. And the political difficulties may be even more severe. So the Fed will go there only with great reluctance.

Mish Reply:

The last damn thing we need is for the Fed to get creative. Can the already distorted economy possibly take any more Fed creativity? Look at the failures of all the stimulus programs. Are we any better off? Are banks lending? Are consumers in any better shape?

In order, the answers are: No, No, No, No (not that the order makes any difference).

Alan Blinder:

The FOMC has been telling us repeatedly since March 2009 that the federal-funds rate will remain between zero and 25 basis points "for an extended period." This phrase is intended to nudge long rates lower by convincing markets that short rates will remain near zero for quite some time.

The Fed's second option for easing is to adopt new language that implies an even longer-lasting commitment to a near-zero funds rate.

Frankly, I'm dubious there is much mileage here. What would the new language be? Hyperextended? Mr. Bernanke is a clever man; perhaps he can turn a better phrase. But market participants already interpret the "extended period" as lasting deep into 2011 or beyond. How much longer could any new language stretch that belief?

Mish Reply:

Blinder finally implied something that I totally agree with: jawboning by the Fed is virtually useless.

Alan Blinder:

Interest on reserves. In October 2008, the Fed acquired the power to pay interest on the balances that banks hold on reserve at the Fed. It has been using that power ever since, with the interest rate on reserves now at 25 basis points. Puny, yes, but not compared to the yields on Treasury bills, federal funds, or checking accounts. And at that puny interest rate, banks are voluntarily holding about $1 trillion of excess reserves.

So the third easing option is to cut the interest rate on reserves in order to induce bankers to disgorge some of them. Unfortunately, going from 25 basis points to zero is not much. But why stop there? How about minus 25 basis points? That may sound crazy, but central bank balances can pay negative rates of interest. It's happened.

Charging 25 basis points for storage should get banks sending money elsewhere. The question is where. If they just move money from their accounts at the Fed to the federal funds market, the funds rate will fall—but it can't fall far. After all, it has averaged only 16 basis points since December 2008. If banks move the money into Treasury bills instead, the T-bill rate will fall. But even if it drops all the way to zero, that's not a big change from its 12-month average of 11 basis points (for three-month bills). So charging 25 basis points is no panacea.

But suppose some fraction of the $1 trillion in excess reserves was to find its way into lending. Even if it's only 10%, that would boost bank lending by 3%-4%. Better than nothing.

Mish Reply:

Blinder is correct to assume paying negative interest on reserves will not stimulate much lending. Moreover, it would be stupid to try, because forced lending will increase bank losses. How much additional pain can the FDIC take?

Blinder is also correct in stating the money will go somewhere. The "where" should be easy to spot although Blinder failed to mention it: longer dated treasuries. Should that indeed be the target, it would further suppress yields, which as Blinder says "strikes me as a bad deal for the economy because the real problem has been high risk spreads, not high Treasury bond rates"

The second place money might go is gold. That would not do the economy much good either.

Alan Blinder:

There is a fourth weapon, which the Fed chairman has not mentioned: easing up on healthy banks that are willing to make loans. Given bank examiners' record of prior laxity, it is understandable that they have now turned into stern disciplinarians, scowling at any banker who makes a loan that might lose a nickel. That tough attitude keeps the banks safe, but it also starves the economy of credit.

Well, quite a few of those bank examiners happen to work for the Fed. It would probably do some good, maybe even a lot, if word came down from on high that some modest loan losses are not sinful, but rather a normal part of the lending business.

So that's the menu. The Fed had better study it carefully, for if the economy doesn't perk up, it will soon be time to fire the weak ammunition.

By not making risky loans, banks are acting responsibly for the first time in a decade.

Now Blinder proposes more of what got us into this mess in the first place.

Assets at Banks whose ALLL Exceeds their Nonperforming Loans

The ALLL is a bank's best estimate of the amount it will not be able to collect on its loans and leases based on current information and events. To fund the ALLL, the bank takes a periodic charge against earnings. Such a charge is called a provision for loan and lease losses.

One look at the above chart in light of an economy headed back into recession and a housing market already back in the toilet should be enough to convince anyone that banks already have insufficient loan loss provisions.

That is one of the reasons banks are reluctant to lend. Lack of creditworthy customers is a second. Quite frankly would be idiotic to force more lending in such an environment.

Useless Jawboning

The one thing I completely agreed with Blinder about is that jawboning is useless. However that has not stopped others from recommending the tactic.

Jeannine Aversa, AP Economics Writer, claims Bernanke's top tool now may be power of persuasion.

The economy appears to be stalling. Yet the Federal Reserve has run out of simple steps it can take to revive it. Short-term interest rates near zero have yet to rejuvenate the economy. The benefits of federal stimulus programs are fading, and Congress has declined to pass any major new economic aid. That puts increasing weight on Bernanke's words.

But as Fed watchers like Alan Blinder, a former Fed vice chairman, have noted, the Fed has used up its most potent tools. And low rates, normally an elixir for a sluggish economy, have yet to stimulate much growth this time.

Ethan Harris, an economist at Bank of America Merrill Lynch, notes that several Fed bank presidents have sparked public uncertainty by pushing in conflicting directions. Some have expressed concerns about inflation, others about deflation -- a prolonged drop in the prices of wages, goods and assets like homes and stocks.

"They're hurting rather than helping confidence with their noisy public debate," Harris says.

Bernanke needs "to give a sense of confidence there is someone with a steady hand on the tiller," Harris says. "One decisive speech can quiet the noise."

A speech from Bernanke would not quiet the noise, rather it would be noise, and nothing but noise.

"The challenge is for Bernanke to communicate to the world at large -- to financial markets and the public -- that monetary policy is currently contributing to the economic expansion, and we need to be patient, says William Poole, former president of the Federal Reserve Bank of St. Louis.

The Real Challenge

The real challenge for the Fed and President Obama is to admit neither the Fed's policies nor Congressional policies are working, that there are no short-term cures or fixes, and that it is time to share the pain more equitably including huge concessions from public unions, a haircut by Fannie and Freddie bondholders, and a reduction in unsustainable spending, especially military spending.

Unfortunately, neither Bernanke, nor Obama is capable of saying what needs to be said, or doing what needs to be done. Unless and until they are, all the yapping by Obama and Bernanke will be as productive as giving a bullhorn to a bullfrog.

For demagogues and fools, It's Not Practical To Tell The Truth.
I wrote that column on August 1, 2008.

Nothing has changed except banks and bondholders are better off at an enormous expense to ordinary taxpayers. Simply put, thanks to Obama and the Fed, the poor are bailing out the wealthy. No amount of bullhorn blowing can change that fact, and fortunately the public is starting to catch on.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

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Mish's Global Economic Trend Analysis

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