Jobs Report

 

The June unemployment report was released this week and it raised eyebrows. The unemployment rate increased to 9.5%; that part was expected. The number of jobs lost was 467,000, compared to 322,000 for May. This was much higher than economists had expected casting doubt on an early end to this recession. The Dow Jones Industrial Average fell 223 points in response to this.

Deeper in the report is some more disquieting news. The average workweek fell to 33 hours, the lowest on record. This, of course, means that many workers continue to have their hours trimmed. But they still have jobs and so don't count as part of the 9.5% unemployment rate.

Although this is a setback, the recession still looks like it will technically end this year. But with consumers so battered by losses in wealth due to lower housing and stock market prices, it will be hard for the consumer to lead the charge to a strong economic expansion next year. Additionally, tight credit will make it hard for consumers to finance purchases of big ticket items and for businesses to finance capital goods to expand their businesses.

I apologize for the delay between postings. I didn't properly factor in that I teach 2 accelerated economics courses this summer. Hopefully I am good to go now!

Some Good News

The Treasury announced this morning that 10 of our largest banks will be allowed to repay $68 billion of TARP bailout money. These banks can put on their cap and gowns, graduate, and begin to focus more on the future. Former Treasury Secretary, Henry Paulson, said that this is the "beginning of the unwinding". This will lessen fears that the Federal government wants to own some banks. There are other programs to gradually unwind, but this is an encouraging step.

Secondly, U.S. Supreme Court Justice, Ruth Bader Ginsburg, issued a stay that, at least temporarily, stops Chrysler's sale to Fiat. Although the stay came in response to a group of Indiana pension funds, the court may also be responding to the strange usurpation of bond holders rights under bankruptcy laws.

Even if this doesn't proceed too far it is, at least, a high level statement that we are a nation of laws and must respect contracts.

Treasury Bond Yields Rise

Treasury bond yields have risen quite a bit over the last 2 weeks. It started when Standard & Poor's announced it may downgrade England's top level sovereign AAA credit rating. It does this by attaching a negative outlook to the credit rating, meaning a downgrade could come in the future. In anticipation, U.K.'s interest costs are rising. Moody's affirmed U.S.'s AAA rating. Our debt crisis is not as bad as theirs! Plus, the U.S. dollar is still the primary global central bank reserve asset, giving a unique source of international demand which is translated into demand for our Treasury bonds. This prop is lessening but still there.

The Fed is trying to put a good face on the rising yields by pointing out that tentative signs of a global recovery are lowering the perceived risk of further financial catastrophe. This view has investors moving out of safe-haven Treasuries into higher-risk corporate bonds, stocks (we've certainly seen that!) and even emerging market stocks and bonds.

The fly in the ointment is that mortgage rates are tied to the 10-year bond yield, and they too are rising. The Fed wants to keep mortgage rates low to support housing and thus the increase in 10-year yields is not helpful. The Fed could counter by increasing its purchases of Treasury bonds and mortgage-backed securities. This will quite possibly be the topic "du jour" at the next FOMC (the Fed's policy making arm) meeting scheduled for June 23-24.

This week German Chancellor, Angela Merkel, chimed in on this. She said that the Fed, Bank of England and, to a lesser extent, the ECB (European Central Bank) have been too aggressive with the printing press. She warns that central banks may be perceived as losing some of their independence if they are seen as too willing to finance big-time government deficits. That perception, if it becomes widespread, will likely cause bond yields and mortgage interest rates to rise further. It could conceivably derail the nascent economic recovery.

Fed Chairman, Ben Bernanke, responded to the rising rates and the Chancellor's comments by warning the Federal government to speed up its time table to lower the Federal deficit. This, unfortunately, may be jaw-boning as they hope to talk interest rates down. Many of the cows have already left the barn on rising Federal deficits!

We all hope his message will be heeded soon by Team Obama and Congress, but recent signs suggest we are still heading toward higher deficits as we broach huge new expenditures on health care.

The Economic Trauma of High Taxes

Occasionally an article comes along that is so good I agree with essentially everything in it. Two good economists, Arthur Laffer and Stephen Moore wrote a piece in the Wall Street Journal titled "Soak the Rich, Lose the Rich".

States are facing nearly $100 billion in budget deficits this year. They are required to balance their budgets. In the past, state governments have relied more on spending cut-backs. But now, they are trying to pursue the new paradigm: tax the rich, the top 1% -- 2% (or 5% in some cases) of earners in each state.

It will not work. One of the first laws of economics is extremely simple: people respond to incentives.

In their study Laffer and Moore show that Americans are more sensitive to higher taxes than ever before.
Tax differentials between low and high tax states is widening, meaning, for example, that a move from California to Nevada is increasingly more profitable. They found that between 1998--2007 1,100 people per day moved from the 9 highest income-tax states such as California and New York to the 9 tax haven states with no income tax. Also, incredibly, the no-income tax states created 89% more jobs and had 32% faster personal income growth than their high tax counterparts.

This study and many others provide powerful evidence that high state and local taxes repel jobs and businesses. The authors found a study that looked at 3 tax-the-rich states that increased taxes between 2000 and 2005 (Connecticut, New York, and New Jersey). All were rewarded by a significant reduction in the number of rich filers. "Amazingly, these 3 states ranked 46th, 49th, and 50th among all states in percentage increase in wealthy tax filers in the years after they tried to soak the rich."

Laffer and Moore then pointed out that Governor Rick Perry told them, "Our state is competing with Germany, France, Japan and China for business. We'd better have a pro-growth tax system or those American jobs will be out-sourced." They conclude that Texas has the jobs and prosperity model right. Texas created more new jobs in 2008 than all other 49 states combined!

My last thought is that the Texas message needs to be spread across America. Instead the Obama Nation is imposing greater bureaucratic costs on business, while contemplating its own tax-the-rich schemes. This can't be good for Texas or, indeed, the other 49 states.

Some Threats to the Economic Recovery

 

There is some light at the end of the proverbial tunnel on the economy. Some economic measures are showing modest improvements while others are still decreasing, but at a lessened rate. Forecasters are becoming more confident that the recession will end in the second half of this year followed by at least a modest recovery in 2010. Unemployment will continue to rise and may stay stubbornly high in the first half of 2010 (maybe around 10%). This forecast is consistent with Fed thinking as expressed by Fed Chairman, Ben Bernanke, on several occasions.

I believe this scenario is all but assured. Monetary and fiscal policies are more aggressive than in any period of U.S. history. Assuming there are no more hidden financial icebergs out there, this historic stimulus will jump-start the economy.

Monetary policy has lowered the overnight Federal Funds rate to essentially 0%. The Fed has pumped so many reserves into the system (leading to excess money creation) that the Fed's own balance sheet has more than doubled, and is still growing

Fiscal policy (government tax and spending policies) is also unusually aggressive. Last year's deficit was $458 billion. The projection so far this year is for a deficit of $1.8 trillion.

The problem with this much stimulus is the potential deleterious side effects starting in 2010 (hopefully not this year). Because of huge deficits and money creation we probably face high interest rates and inflation not too far down the road.

The challenge for policy-makers will be to unwind the stimulus so that the expected recovery will lead to a sustained economic recovery that does not peter-out into another recession, unusually soon after this one ends. I will be monitoring this over the next several years.

Today"s Topic: Divergent Economic Forecasts
The stock market has staged one of the most impressive short-term rallies (starting early March), since The Great Depression. A rule of thumb is that if the March lows hold, the economy should touch bottom (GDP wise) in this year's 3rd or 4th quarter. The stock market is watched by many more people than the bond market.

Watching the bond market is more tricky. An analyst can't just look at the yield on the 10-year Treasury bond (the bench-mark for the bond market). Treasury bonds have no, or very low, default risk (but that could change after 2009). Corporate bonds have higher yields than do comparable (in maturity) treasuries, ranging from relatively low spreads, for a company like IBM, and much higher spreads for a company like GM.

Three economists are publishing a paper on bond spreads. The essence of the study is that the wide spreads between corporate bonds and treasury bonds suggest this down-turn still has a way to go. Another economist pointed out that the gap between BBB-rated corporate debt (just a notch above junk bonds) and 10-year Treasuries remains high and has not improved due to the stock market rally. He claims that when the two markets diverge, in his opinion, frequently the bond market is proven correct. As a bond analyst, I concur.

Going forward then, stocks are flashing green lights and bonds are flashing red lights. Until this is resolved, the economic outlook is unusually uncertain. For the economy to do much better, bond spreads need to narrow. Then, companies will begin to increase investment in plants and equipment and re-employ workers.

Today"s Topic: The Fed and the Inflation Genie
One of the most powerful relationships in economics is the relationship between the amount of money in circulation and the price level. Classical economists (primarily those from the 17th--19th centuries) understood this and, for example, argued that a one-time increase in money of say 50%, would eventually lead to a roughly 50% rise in prices. This phenomenon is not that surprising and is still true in our time.

To combat this recession the Fed has added more liquidity (money) per time period than at any other time in its history. Fed chairman, Ben Bernanke, is an expert on the Great Depression. He argues that had the Fed pushed the money lever in the 1930's, as today, they could have limited one major cause of the recession and avoided deflation. This could have shortened the depression and perhaps it would have just been a really bad recession.

To stimulate the economy the Fed has more than doubled its balance sheet (printed money) and is expected to do that again in 2009--2010. Ultimately, this will lead to a major inflation if not checked. This is not likely to occur in 2009, with the unemployment rate expected to reach 10%. The money is out there, but with sentiment so low, consumers don't want to invest in capital goods and so on (it's like everyone is putting money under their mattress).

Once a recovery starts (late this year or early next year is the consensus), spending will increase and then we could have a serious inflation problem. The Fed says it will start taking money out of the system. However, it is not that easy as coming out of a long recession there will be enormous pressure on the Fed to delay to be sure that the economy gains traction. If they miss their timing, which has happened before, the inflation genie could get out of the bottle.

This issue will be definite concern over the next few years.