Financial Review

Stagnation versus Innovation

Sinclair Noe — April 7, 2015

 

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DOW – 5 = 17,875
SPX – 4 = 2076
NAS – 7 = 4910
10 YR YLD – .01 = 1.89%
OIL + .94 = 53.08
GOLD – 6.30 = 1208.70
SILV – .14 = 16.93

The stock market was in positive territory almost all day, right until the very end of the session; it just slipped away. And that coincided with an American Petroleum Institute report showing crude oil inventories increased by 12.2 million barrels in the last week, about triple estimates.

Not much economic news today. The Labor Department JOLT survey reports job openings rose to a 14-year high of 5.13 million in February from 4.97 million in January. There were 1.69 unemployed people for every opening in February. The quits rate slipped to 1.9% from 2%. This is good news; there are more jobs available, and people are quitting their current jobs because they have a level of confidence that they can find a new, better job.

Because this is a slow week for economic data, we will be hearing some opinions from the folks at the Federal Reserve. Minneapolis Fed President Narayana Kocherlakota laid out a case for waiting until the second half of 2016 to start raising rates, and to then raise them gradually so as to reach just 2 percent by the end of 2017. Some of the Fed’s more hawkish policymakers have even pressed for a rate rise as early as June, warning that waiting too long could force the Fed to hike borrowing costs sharply to head off a potential surge in unwanted inflation. Kocherlakota says it would be a mistake to raise rates this year, and the Fed “can be both late and slow in reducing the level of monetary accommodation.” Kocherlakota is one of the doves at the Fed, and as the Fed rotates voting among policymakers, it turns out he won’t be voting at FOMC meetings this year.

The Bank of England has asked British banks to put emergency plans in place to be able to absorb the potential shock from an escalation of the Greek debt crisis. Minutes from the Financial Policy Committee’s latest meeting show the central bank believes the current turmoil in Greece is one of the biggest external risks to the U.K’s financial stability. Because of this, it is already working closely with the Treasury and bank regulator the Financial Conduct Authority to make sure contingency plans are ready.

The Greeks are supposed to make a $500 million IMF loan repayment on Thursday. Prime Minister Alex Tsipras has gone to Moscow to beg for rubles. Putin is reportedly open to the idea of providing a line of credit, plus discounts on natural gas in exchange for… well, that’s the rub isn’t it. What will Putin demand? Greece has assets, including possible offshore oil. EU officials fear any Russian rescue loans or other sweeteners could persuade Athens to veto sanctions on the Kremlin over Ukraine; such sanctions require unanimity among EU members, so Greece could end sanctions on its own.

A deal with Russia might cause some irritation, and the Greeks seem ready to provoke; they keep demanding reparations from Germany for Nazi occupation and crimes. Meanwhile, the Greeks demand an investigation into the 2010 Greek bailout, which they are still paying for and which they believe might have been somewhat corrupted. And so we know Greece is ready to ruffle feathers.

We’ve been waiting for a list of reforms from Greece. We never really got that. The Troika has glossed over that omission. It would be more difficult to gloss over a loan payment. What would happen if Greece doesn’t make its loan payment on Thursday? That would shake things up; even if they are a day or two late in making the payment; it would change the entire dynamics of negotiations moving forward. One thing is becoming obvious, the Greeks are not timid and they don’t have much to lose.

Even if Greece makes the loan repayment on Thursday, it will have to make payroll the following week; about $1.7 billion in wages and pension payments. Then there are more IMF payments due in May and June. And the problem is that the Greek economy is not getting better, so at some point there must be a deal or there will be a default.

The IMF and the World Bank hold their annual spring meeting next week; ahead of the meeting the IMF has issued a report on the world economy, entitled “Lower Potential Growth: A New Reality”, and the outlook is grim. The IMF says living standards may only rise slowly due to an aging population and lower capital and productivity growth. The IMF says the rapid pace of productivity growth in the late 1990s and early 2000s is unlikely to be restored in advanced countries. In emerging economies, the returns from education and innovation are unlikely to be as large as they were initially. The IMF expects potential growth in advanced economies to rise slightly, from an average of 1.3% during the period of 2008 to 2014, to 1.6% between 2015 and 2020. That’s well below pre-crisis rates of around 2.25%.

Now, move beyond the numbers and the IMF is saying the global economy is slowing down and it will stay down; this is a fundamental break from historic patterns.  For financial markets, this likely means that interest rates could settle in for an extended stay around the zero lower bounds; this also means that equity markets have likely moved higher despite a big decline in business investment since 2008. While we have seen more and more stock buybacks and M&A activity, there has been a chronic lack of spending on equipment and technology that drives gains in competitiveness and increases productivity. The IMF report says: “weak business investment has contrasted with the ebullience of stock markets, suggesting a possible disconnect between financial and economic risk taking.”

The great hope is that booming asset prices will trigger a surge of investment, allowing economic fundamentals to catch up with markets; that thinking is a variation on the theme of trickle-down economics; that hordes of corporate cash will rain down on the economy in a deluge of spending on research and infrastructure. The IMF report says it isn’t happening and it won’t happen. The productivity gains of the internet revolution have run their course; the world’s demographics are also changing and we are getting older and grayer and slower; the decline has begun. Economic growth as we have known it is a thing of the past. Get over it, get used to it.

It’s not all doom and gloom. The IMF suggests that there is still room for optimism—the future trajectory of potential output is not set in stone. And then they trot out some stale ideas for improving innovation; their big idea is to strengthen patent laws. And worker productivity could get a boost by improving education quality. True enough I suppose, but it lacks a sense of urgency. And the IMF analysis strikes me as superficial and shallow.

Economists sometimes forget what drives an economy, and so they can’t imagine what would drive change. Much of the world struggles to scrape out a day to day living, and that will become an even bigger challenge in the coming years. Innovation is not born of patent laws, just the opposite; innovation is born of necessity. Innovation comes from scientists and science fiction writers and tired workers looking for a break and daydreamers and shade tree mechanics and kitchen table tinkerers. And innovation answers questions. Right now the biggest questions for the coming years seems to be how we can provide food, water, housing, transportation, and health care to a global population that will soon top 9 billion; all without destroying the planet in the process.

The answer is likely to come from new sources of energy; at least that is my best guess. With enough energy we can clean fouled water, we can grow enough food, we can build enough housing, and we can move whatever needs to be moved. And it is my estimation that the next great advances in innovation must need be in energy.

Think about the innovations in technology that we’ve seen for computing and communication. One hundred years ago you could not have imagined the computing power you now have in your laptop or even your smartphone. Fiber optics and satellite communications were beyond the imaginations of the science fiction writers. Yet the car motor of 100 years ago is essentially unchanged; an internal combustion engine burning gasoline; carburation is improved and now it pounds out more horsepower but the principle hasn’t changed. Mr. Edison’s electric motor is essentially the same, slightly more efficient and bigger, but the same at its core. Nuclear power offered the prospect of tapping previously unseen sources of power, but we have never figured out how to do it without making an even bigger mess. Harnessing the power of the sun is an ancient idea but in 100 years it is likely that solar power will seem as quaint as the telegraph seems to someone using the internet. Morse code works to relay a message but Skyping someone halfway around the world is much better.

Whether the world really is nearing the end of its growth potential has been an ongoing economic theme for a long time. Ben Bernanke, the former chairman of the US Federal Reserve turned blogger for the Brookings Institution reminds us in his debut blog of another economist, Alvin Hansen, who coined the term “secular stagnation” back in 1938, arguing even then that population growth was slowing and the big advances in technology were mostly finished. Hansen might be forgiven his pessimistic outlook; in 1938 the economy was still a mess, the Dust Bowl was an ecological disaster, and World War was right around the corner. And it was out of crisis that innovation occurred. Of course, in the decades that followed Hansen’s argument, the postwar population boomed, there was rapid technological advancement, and the economy did not stagnate.

Bernanke believes that the US economy will right itself naturally, as so often before, if we only pay attention to the three most important objectives for economic policy: achieving full employment, keeping inflation low and stable, and maintaining financial stability. But I doubt secular stagnation can be beaten by low inflation. Innovation is born of necessity and forged in crisis. Only then do we open our minds to the unimaginable and determine that something is only impossible until it is done.

Wednesday, August 20, 2014 - Sunlight is the Best of Disinfectants

Financial Review with Sinclair Noe

DOW + 59 = 16979
SPX + 4 = 1986
NAS – 1 = 4526
10 YR YLD + .02 = 2.42%
OIL + .63 = 93.49
GOLD – 3.80 = 1292.40
SILV + .04 = 19.55

No economic reports today, but the Federal Reserve released the minutes of the July 29-30 FOMC meeting. You will recall that the Fed left interest rates unchanged and continued the taper by reducing large scale asset purchases by $10 billion a month, with the plan to end purchases by October. The Fed had said in its policy statement following the July meeting that there was "significant" labor market slack, but the minutes showed many members of its policy-setting panel thought this characterization "might have to change before long."

Most Fed officials wanted further evidence the labor market and the economy were showing significant improvement before changing their view on raising rates, but they said, "Labor market conditions had moved noticeably closer to those viewed as normal in the longer run," and policymakers "generally agreed" the job market was healing faster than they had expected.

Most Fed policymakers felt any change in their view on when to start raising rates "would depend on further information on the trajectories of economic activity, the labor market and inflation." Well, we got more data yesterday showing that inflation is not a problem yet; so that leaves economic activity and the labor market. The economic trajectory has remained sluggish since the beginning of the recovery; GDP turned negative in the first quarter of this year and then showed a very strong bounce in the second quarter. Is the second quarter bounce sustainable? It seems most Fed officials think it could be. And the Fed minutes almost seem to gloss over this long-term sluggishness, or what the Center for Economic Policy Research callssecular stagnation. What is secular stagnation?

A persistent gap between actual and potential output. Because of an imbalance between saving and investment, the nominal interest rate required to maintain full employment falls to less than zero -- not just briefly, but persistently. Since the rate can't be cut to less than zero, monetary policy (as currently conceived) can't keep the economy running at full potential.

A slowdown in growth of potential output. This may happen because of demographic changes, or because innovation isn't what it used to be, or for other reasons.

An irreversible drop in the level of potential output. Even if the full-employment rate of interest is still positive and the growth in potential output hasn't slowed, the recession may have permanently cut its level -- for instance, by causing workers to leave the labor force and not come back. Even if the economy now grows as fast as it did before, it's on a lower track and won't ever converge with the path it was on pre-crash.

This all means that the Fed’s long awaited economic liftoff might not happen, at least for another 20 years or so. But the Fed doesn’t seem to be concerned with this problem, which means that if the US economy experiences secular stagnation, the condition will be self-inflicted.

That leaves the Fed with the question of the recovery in the labor market. So, it really boils down to jobs. More jobs, and specifically, the quality of the jobs. So far, the average wage is stuck at $24.25 an hour; too many jobs are part-time or temporary. If we start to see some movement on wages, and more full-time positions, that might be a sign for rate increases. One area of remaining slack is the low participation rate, the percentage of working age population that is still in the labor pool; many people got out of the pool. Last month the economy added 209,000 net new jobs. The unemployment rate moved up to 6.2% from 6.1%. The jobless rate can rise for both good reasons (more people looking for work) and bad reasons (fewer people having a job).  Even though the economy added jobs, more people joined the labor force, and that is why the unemployment rate moved higher.

There are many things that could derail the recovery in the labor market, but for now the Fed thinks things are on track, and that means a probable rate increase in the first half of 2015. Any rate increase is likely to be incremental. Right now the fed funds target rate is between zero and 0.25%. It would likely be increased by 25 basis points, with the lower range representing the rate on overnight reverse repurchase operations. In reverse repos, the Fed borrows funds overnight from banks to mop up excess cash in the financial system.

Market reaction to a slightly more hawkish Fed stance: well, the dollar index continued higher, Treasuries dropped but then settled down, precious metals were a little lower, oil was higher, stocks initially threw a little tantrum and then recovered. After all, there were no real surprises.

Elsewhere, we’ve been waiting for the Department of Justice announcement on a settlement with Bank of America. Bank of America has reportedly reached a record $17 billion settlement to resolve an investigation into its role in the sale of mortgage-backed securities before the 2008 financial crisis. The official announcement will come tomorrow. The deal works out to $10 billion in cash, and $7 billion in soft dollar consumer relief - which is really a gift to the bank involving credits for various forms of consumer aid that the bank would or should be doing anyway. So, if you have a BofA mortgage and you’ve been having trouble with a loan mod or a refinance – try again. And by the way, the bank will make money on consumer aid.

The deal requires Bank of America to acknowledge making serious misrepresentations about the quality of its residential mortgage-backed securities issued by itself and by Countrywide Financial and Merrill Lynch. In exchange, BofA will probably not have to actually admit wrongdoing, and they get a free “get out of jail” card.  

Usually these settlements include a statement of facts which is most notable for its absence of facts and details. That silence means the Department of Justice is essentially protecting the banks from private lawsuits by deliberately withholding evidence which could result in even further disclosure of really bad behavior and even bigger damages and other unexpected outcomes. The biggest unexpected outcome would be that the public finally says to hell with the bankster criminals and we all see through the flimsy apologists in the media and the cronies in politics.

Most people know the banksters got away with murder; and I use the word literally, not figuratively. Most people want to see bankster executives prosecuted. Most people understand that the fines in these settlements are just a slap on the wrist, cost of business paid by shareholders, and taxpayers. Yep, the fines are typically considered tax deductible.

Tomorrow, the DOJ will announce the biggest settlement ever against a bank: $17 billion. But we know, it’s really a little under $10 billion in cash, with all kinds of little gifts to the banksters to soften the blow. And we know this will do nothing to deter future wrongdoing. You can place a huge derivative bet that they’re still committing those same crimes and new ones (such as subprime auto), so the prosecution clock resets daily.

And the crazy part is that the Department of Justice and BofA think we’re all too stupid to understand the cronyism. They will portray the settlement as a get tough stance on the bankers. Hogwash, I know it, you know it.

About 100 years ago, Supreme Court Justice Louis Brandeis wrote his famous statement that "sunlight is said to be the best of disinfectants" in a 1913 Harper's Weekly article. He went on to say that transparency is “justly commended as a remedy for social and industrial diseases.” Brandeis actually wrote privately about the idea of transparency 20 years earlier, writing, “about the wickedness of people shielding wrongdoers and passing them off (or at least allowing them to pass themselves off) as honest men."

About 100 years ago, the country was struggling with what was known as the Money Trust, the rough equivalent of today’s systemically important financial institutions, or too big to fail banks. Brandeis asked how the great wealth of his day had been accumulated, and he concluded: “power breeds wealth as wealth breeds power. But a main cause of these large fortunes is the huge tolls taken by those who control the avenues to capital and to investors. There has been exacted as toll literally ‘all that the traffic will bear.’”

Just a reminder, some of the mortgage problems of Bank of America date back to their acquisition of Countrywide; BofA had their own illegal mortgage problems. The guy who started Countrywide and nearly ran it into the ground is Angelo Mozillo. Until now, the harshest penalty imposed on Mozilo has been a $67 million settlement with the SEC from 2010 to resolve allegations that he misled Countrywide investors. Actually, Mozilo was forced to disgorge about $45 million from the sale of stocks, some of which may have been based on insider information; and then Bank of America paid for most of the other penalties; which is to say shareholders and consumers paid for Mozilo’s penalties.

The US attorney’s office in Los Angeles is now preparing a civil lawsuit against Mozilo and as many as 10 other former Countrywide employees. Government attorneys plan to sue Mozilo, Countrywide’s former chairman and chief executive officer, and other individuals using the Financial Institutions Reform, Recovery and Enforcement Act. The law, approved by Congress in 1989 in response to savings-and-loan scandals, gives prosecutors 10 years to bring cases and has less stringent liability requirements than criminal charges.

Prosecutors dropped a criminal probe of Mozilo in early 2011. The Citizens for Responsibility and Ethics in Washington, a watchdog group, sued the Justice Department in June to try to obtain its records detailing investigations of Mozilo and Countrywide. The group faulted the government for failing to prosecute either Mozilo or the company “despite substantial evidence of wrongdoing.”