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Current Account Woes

by TwoCentsEditor

Published on: 10/22/2010

Categories: Current Events, Economics, My Two Cents

Tags: andy sutton, business, current account, debt, finance, investments, money, My Two Cents, stocks, Tim Geithner

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Amid the recent rout of the USDollar, fears of an all-out trade war have been stoked globally. The G20 finance heads are currently struggling to find common ground on current account imbalances that will avert the inevitable. The point should not be lost on anyone that none of these leaders are really concerned about why these imbalances exist, but rather are only focusing on avoiding the negative consequences of poor fiscal behavior stacked up over the past several decades. It is for these reasons that any accords that are reached now will fail. The same forces that created the current dissatisfaction will create future dissatisfaction. As in many other arenas today, we appear content to kick the can down the road and try to keep the game going another month or year. This week we’ll take a look at the current account and some of the factors driving these imbalances.

Financial Responsibility DOES Matter

Using 2009 data, the United States ranked 181st out of 181 ranked nations in terms of current account at -$380.1 Billion. Anyone out there want to take a guess at some of the lowest ranking nations?

Current Account Deficit as % of GDP

You guessed it. Spain, Italy, France, and Greece are right behind the US at the bottom of the heap. If anyone still thinks that debt doesn’t matter, this fact should provide a compelling argument to the contrary. The ongoing problems in Europe as a result of debt and the increasing violence in the French strikes portends a bad ending for those nations that insist on running massive debts to the rest of the world. This is particularly true when that borrowed money is used to prop up otherwise unsustainable social programs. People will not be quick to vote to end their own gravy train, and as such, these things usually end badly.

Taking a look at the Eurozone both in totality and by its worst offenders, it becomes rather obvious that Germany is carrying the entire EU. While this is no surprise or great revelation, it should emphasize the inability of a few savers to make up for the gross negligence of the rest. Frankly, it should be a bigger surprise that Germany isn’t seeing the kind of civil unrest that France is. If nothing else, this should underscore an interesting characteristic of human nature. People who are having something (that for the most part unearned, at least in this example) taken away react much more violently than those who are being forced to pay for it.

Eurozone Current Account Woes

Why Support the Dollar?

Also by contrast, the same data that showed the US as being ranked 181/181 showed Germany as being ranked #3 behind only China (1) and Japan (2). It should be a curiosity then why Japan is stepping in to support the Dollar. This action started a few weeks ago, with rhetoric, and has been followed up by somewhat meaningful action. The obvious question is why would a nation who ranks #2 in a valid measure of economic strength step in to support a dying currency paradigm? Especially when doing so will only be to its own peril? It is pretty obvious that just on a current account basis that the US is leading the way down followed by the UK and most of Europe. There are other offenders as well.

The answer is found in the most massive of imbalances, and the root of the current account and debt problem, which is the imbalance of manufacturing. Japan does a great deal of its business abroad and as such desires a ‘weaker’ currency to make its exports more competitive. It must compete with China, and the other Asian manufacturing hubs in foreign markets, and therefore it is to Japan’s advantage to keep the Yen cheap just as it is to China to keep the Yuan suppressed. This is a direct result of globalization, and it is this author’s opinion that this reality was an intended consequence of the actions of the 1980s and 1990s. Economists, political analysts, and historians will undoubtedly argue about the causes of the eventual decline of the US/UK/Eurozone. Was it the nearly exponential explosion of social entitlement programs or was it the decay of manufacturing capability and production that triggered the demise? The two happened nearly simultaneously here in the US, so the debate is wide open or so it would seem.

What Came First?

I would opine that the diminished manufacturing activity and increase of ‘great society’ style entitlement programs go hand in hand. The transition from production to consumption creates a gap in the wealth function and that must be filled if societal paradigms are to be maintained. Governments, in their infinite wisdom, thought it wise to steal from tomorrow to create a paradoxical utopia in the present. First the national savings were spent and then when that was exhausted, the borrowing spree began. What used to be the third world was anxious to participate because those nations saw it as an opportunity for their own industrial revolutions and a means to create economic superpowers. The problem with superpowers is that not everyone can be one; otherwise there’d be nothing super about it.

Government Spending by Category

In summary, Treasury Secretary Tim Geithner is currently meeting with other finance ministers from the G20 to figure out a way to keep this mess going another year. Geithner’s plan is to create current account targets as a way of pushing China towards a revaluation of its currency.

“Setting numerical targets would be unrealistic,” said Japanese Finance Minister Yoshihiko Noda, while German Economy Minister Rainer Bruederle rejected a “command economy” approach. Indian Finance Minister Pranab Mukherjee said caps would be hard to quantify. In interviews with Bloomberg Television, Canadian Finance Minister Jim Flaherty said the idea was a “step in the right direction” and Australian Treasurer Wayne Swan called it “constructive.”

It is pretty obvious that the biggest offenders want help and the countries in positions of superiority don’t have a large affinity for further handouts in the form of currency revaluations. What is odd is Canada’s position. Canada ranked #22 in 2009 with a reasonable current account surplus and as such ought to be averse to such forms of charity. However, Canada’s position is being formulated by the creator of the tax plan that killed the Canadian Energy Trusts, so the common sense of his position could easily be called into question.

The central point of concern at this point is that the race to the bottom in the currency world is going to start a trade war. This race in currencies is caused by current account imbalances, which were in turn caused by an avalanche of social programs and a deindustrialization of much of the First World. While there are certainly other factors, the causality here should be rather clear.

Intended Consequences?

by TwoCentsEditor

Published on: 10/08/2010

Categories: Current Events, Economics, My Two Cents

Tags: debt, deficits, dollar, Federal Reserve, gold, justin bieber, lady gaga, Lindsay Lohan, money, stocks

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As was generally expected, this morning’s employment situation report gave another bundle of evidence to suggest that there is in fact no recovery, never was, and that several trillion dollars of ‘stimulus’ has disappeared down a rat hole of greed. In typical fashion, the mainstream press tried yet again to put a positive spin on a negative reality, pointing to the fact that we should rest easy; the Fed is going to buy government bonds to save the day. It is in total wonderment that I listen to these happy expectations and can only guess if these people know what they’re even wishing for. Let’s look at a few examples.

AP Business Writer Stephen Bernard writes:

“High unemployment remains a major hurdle as economic growth continues to be sluggish. The Labor Department’s report, considered the most important on the economic calendar, did little to alter anyone’s perception about the strength of the economy.

While the job growth remains scarce, there could be a silver lining. Expectations are growing that the Federal Reserve will try to stimulate the economy through the purchase of government bonds. The gloomy jobs report could give the Fed more incentive to act.”

While this is certainly true, do we really want the private, non-government Federal Reserve buying more bonds? It is bad enough that the Chinese already own massive portions of our future economic output in the form of Treasury Bond holdings. They own scads of mortgage bonds as well. Does anyone out there feel comfortable about the Chinese holding the note on your house? How about the Fed? Do we really want them owning the notes on any more of our homes? I asserted years ago that the housing bubble was nothing more than a property-grab and all indications are that it has been little more than just that.

Let’s look at another news outlet and their thoughts. Greg Robb at Marketwatch writes:

“There is little in the data to suggest further easing measures aren’t up the Federal Reserve’s sleeve. Prior to the report, economists had said that a strong U.S. payrolls number would be needed to take pressure off the Fed to deliver a second round of quantitative easing.”

Essentially the same pabulum from another ‘independent’ media outlet. The fancy term quantitative easing (QE) must be explained to the masses. We’ll try to sum it up in a few sentences so everyone is clear. QE entails the printing of money. It is what happens when interest rates are already at zero. The Fed cannot reasonably pay people to borrow money (negative interest rates) and expect this charade to continue. So QE is the printing of money, which is then used to buy certain strategic assets such as stocks, bonds, etc in the hopes of goosing markets and giving the Treasury ill-gotten cash with which to continue ‘stimulating’ the economy. QE is, in essence, declaring a fire sale on America, then creating the money from nothing to take advantage of the sale.

To make an analogy, it is kind of like you and I lending a bunch of money to a store, getting the store hooked on easy credit, etc. etc. then when it breaks, walking into the store with a pile of Monopoly money and buying the entire inventory. This is robbery and needs to be called for what it is.

And now, perhaps my favorite, coming from Reuters:

“Expectations the Fed, which has already pumped $1.7 trillion into the economy by buying mortgage-related and government bonds, would announce a second phase of quantitative easing at its Nov. 2-3 meeting have buoyed U.S. stocks and prices for shorter-dated government debt and have undercut the dollar.”

There is QE again. Sounds mighty fancy to the untrained ear, doesn’t it? Notice that even Reuters gives the truth almost as an afterthought. QE, and/or the expectation thereof, has undercut the dollar. That affects Main Street. Wages are stagnant, jobs are very hard to come by, and the Fed is purposely undertaking a course of action that will further squeeze Main Street by driving up the cost of living. While the Fed might get a 9.5 for style points and the fancy terminology, it gets a big, red, F- in terms of stewardship of its two legal mandates: maximum employment and price stability. Round 1 of QE didn’t help and there is no reason to believe that more of the same will do any better.

And how about the recent rally in stocks? Are any of these gains real? Of course not. The dollar is tanking while stocks, Gold, and oil take off. The Fed is trying to rekindle inflationary expectations to artificially pump markets. If they are successful, it will most assuredly be at the expense of the American taxpayer-consumer.

This is the crossroads at which we now stand. The M3 contraction that has been occurring for the entirety of 2010 will either be allowed to continue, which would have a cleansing affect despite the many negative manifestations in the real economy, or the Fed will simply try to overwhelm market forces and fill a $200+ trillion fiscal gap with dumpsters of worthless paper dollars.

So far the Fed et al have proven to be completely unable to perfect the ‘kick the can down the road’ approach. The economy is sliding despite QE and other miscellaneous efforts to this point. Certainly things might be ‘worse’ had they done nothing, but we can certainly make the argument that in this case, the cure is worse than the disease.

Partial Equilibrium Analysis – Part 2

by TwoCentsEditor

Published on: 09/24/2010

Categories: Current Events, Economics, My Two Cents

Tags: andy sutton, bonds, Economics, gold, government, justin bieber, lady gaga, Lindsay Lohan, money, My Two Cents, Paris Hilton, politics, stock market, stocks, Sutton & Associates

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Andrew W. Sutton, MBA

In the first part of this series, we took at a look at Partial Equilibrium (PE) analysis in terms of analyzing a particular good or service rather than macroeconomic aggregates. What PE allows us to do as well is to both qualitatively and quantitatively assess the true effects of taxes and subsidies. We can also answer whether or not taxes and subsidies represent Pareto efficiencies. For our example we chose to look at the area of gasoline taxes. Many state governments are considering increasing gasoline taxes in the face of collapsing tax receipts. Intuitively, it would seem that such measures would be penny-wise and dollar foolish, but let’s use PE and see if that bears out conventional wisdom.

We’re going to also take it a step further and add an externality to our analysis: reserves depletion. Peak oil has been talked about in many forums, including military think tanks, World Bank whitepapers, and countless other places. We’ll take a look at efficiency and how it is affected by the lack of internalization by energy producers and consumers.

The first conclusion that we were able to arrive at last time is the fact that non-intervention (zero taxes / subsidies) market equilibrium are Pareto efficient, that is to say that Total Net Social Benefit (TNSB) is maximized. This fits the criteria for being Pareto efficient since any other combination would result in certain parties being made better off at the expense of other parties.

In the non-intervention equilibrium, there are only two types of surpluses – consumer and producer. There were no other parties involved. Certain economic agents produced the goods, while others consumed them. However, in the situation where there is a tax or subsidy (in this case a proposed tax), the government is now put into the mix and its impact on equilibrium must be studied. When the government collects a tax, it now has a surplus, which otherwise would have accrued to either producers or consumers. We’ll call the government’s new windfall GS.

The bottom line in any tax situation is that consumers are now short GS. In the most simplistic terms, GS could be returned to the consumers and a return to Pareto efficiency would be observed. Obviously GS has not disappeared; it is still available to society. This is where the rhetorical question of who spends your money better comes from.

In the following chart, note that equilibrium is present at P_m and Q_m. When the government imposes a tax (let’s insert our proposed gasoline taxes in here), the price of gasoline is shifted to P_c, with producers collecting P_p. The new quantity produced/traded is Q_d. This new reality reflects consumers’ lack of willingness to consume at the equilibrium quantity since they’re facing higher prices. It must be noted that elasticity of demand will determine exactly how much less they’re willing to consume, but for the purposes of this discussion, let’s assume that demand and supply are both linear functions.

PE: Total Net Social Benefits

In the situation where the tax is collected, consumers will lose surplus because they are paying more for what is consumed. Producers are losing surplus because they receive less for what they sell. The government generates a surplus because it collected the tax. Let’s take a look at the welfare calculations:

Total Welfare

It is obvious from the welfare analysis that the equilibrium was economically efficient while the new tax equilibrium is not because the total welfare is lower under the tax equilibrium than the market equilibrium. Put another way, the change in total welfare from the new tax is negative, indicating that the tax is not economically efficient. –(E+F) is often referred to as a welfare loss in general economics classes.

Conversely, let’s think about the affect of reducing a tax. Let’s say we reduced the tax by 40%. We’d now see equilibrium re-appear at new price level P_{(reduced tax)} and the new quantity at Q_{(reduced tax)}. The new –(E+F) or welfare loss would be considerably smaller than at the original tax level. In this case, the total welfare would have increased from the level of the original tax levy, but would still not be Pareto efficient since it would still be less than market equilibrium.

Welfare Loss created by Pareto Inefficient Tax

Partial Equilibrium with Externalities

Obviously with peak oil on the mind of most people, it pays to take a look at partial equilibrium with a negative externality, namely overproduction, in this instance. In our prior example, we had several classes of surpluses: consumer, producer, and government. Now, we’ll add a fourth economic agent, albeit a non-acting agent, in the form of petroleum reserves. It is important to note up front that we are not in any way trying to estimate the degradation of any specific resources, but merely to show how efficiency towards reserves will be affected by other intransigent policy.

In our example, we’ll label our variables CS, PS, GS, and ES for consumer surplus, producer surplus, government surplus, and externality surplus. The total welfare or TNSB will be the sum of these four surpluses. We can then further deduce that the change in TNSB (?TNSB) will be the sum of the changes of the four surpluses. ?G will merely be (R-S) revenue minus subsidy or spending. ?E will be the change of petroleum reserves.

SD functions with externality

In the above chart MSC represents the marginal social cost, and MPC represents the marginal private cost. The difference here between the MSC and MPC represents the ?ES or depletion of reserves in this case. The case where MSC intersects MSB is the efficient outcome from the standpoint of the depletion externality, and the intersection of MPC and MSB is the market equilibrium. It is fairly obvious in this case that consuming at the market equilibrium entails inefficiency in terms of reserves depletion. Again, any consumption is obviously going to diminish reserves, however, we’re searching for the most efficient mix of production and consumption.

Let’s take a look at total welfare and see what we get in terms of adding this very important externality to the equation.

Welfare Analysis - With Externality

In the case of petroleum, taxes can actually serve to bring MSC and MPC (MC) into line, meaning that in effect, taxes can make actual production equal the optimal from both a cost and depletion perspective. However, too high of a tax will obviously be inefficient as well. In our case, graphically, the tax would need to be precisely the difference between MSC and MPC (MC) in the above chart. This would serve to reduce production and consumption to the point where utilization was optimal.
Let’s look at the total welfare analysis:

Surpluses in the presence of the tax:

Welfare Analysis - Tax Included

Surpluses at market equilibrium:

Welfare Analysis - Tax Removed

Welfare analysis (Sum of changes in all surpluses):

Welfare Analysis - Sum of Surpluses

With the externality in place, less oil is produced, less damage is done to reserves, and TNSB is maximized with a tax equal to the different between MSC and MPC in place.

Summary and Conclusions

Consumers and producers both generally prefer the market equilibrium and, minus externalities, the market equilibrium is the most efficient as measure in Pareto terms. Taxes in such a situation will cause immediate dislocations and will not be efficient. However, in cases where there are externalities, taxes can be useful for bringing the monetary costs and the net social costs into line. We can easily conclude that imposing a gasoline tax merely for the purposes of increasing revenue is inefficient because the intent is not to bring monetary and social costs in line, but rather is arbitrary and capricious in nature. Further analysis could easily glean whether or not the actual taxes collected were efficient or not. The example of using depletion of petroleum reserves is key since taxes can actually help to make our use of this wasting asset more efficient. However, simply applying additional revenue-generating taxes on the purchase, consumption, or the byproducts of oil are not economically efficient, and while they may prolong reserves a bit further, there will be other economic costs that will be greater than the benefits accrued.

References: Primer on PE: R. Wigle, Microeconomics: J. Perloff, Economics and Public Policy: J. Kearl.

Meet the New Goldilocks

by TwoCentsEditor

Published on: 09/10/2010

Categories: Current Events, Economics, Financial Markets, My Two Cents

Tags: Economics, economy, gold, Hindenburg Omen, justin bieber, lady gaga, politics, stocks, trade

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Back in the glory days of 2008, the mainstream press, political pundits, and various government officials talked about the idea of the Goldilocks economy. Not too hot, not too cold, but just right. Of course the analogy ended when the bears chased Goldilocks out of the cottage. While the same outlets aren’t trotting out the fairy tale this time around, it is clear that the US has hit phase two of the Goldilocks economy and it is my guess that most folks will like this one even less than the first.

And again, there are three major bears that are threatening to once again drive Goldilocks deep into the forest.

Bear #1 – A Jobless Economy

Month after month, the Bureau of Labor Statistics releases Employment Situation reports that continue to befuddle even the most casual of observers. They have become Newspeak in the truest sense of the word. Take last Friday’s report for example.

BLS reported that 54,000 jobs had been lost in August. The media immediately jumped on the fact that private sector payrolls were up by 67,000 and immediately blamed the entirety of the negative report on the fact that it was only bad because some census workers got laid off. Talk about having your cake and eating it too. Back in the spring when the census workers were being hired, it was the same press that counted those temporary jobs as if they were actually created by a recovering economy.

U6 Underutilization Aggregate

But it actually goes a lot deeper than just the 67,000 jobs gained in the private sector. Let’s analyze:

331,000 people became underemployed for economic reasons, meaning that they desired full time work, but were only able to find part time work. 331,000 full-time jobs lost. That takes out total up to 385,000. Left completely uncounted are those folks who lost one full time jobs and managed to find another, but at a much lower wage.

BLS’ CESBD Birth/Death adjustment assumed that 115,000 full-time jobs were created by new businesses in August. This ‘adjustment’ has been a source of great consternation by labor market analysts and real economists for some time now. In what turned out to be a vain attempt at getting a look at the methodology used to derive this number, I contacted BLS and had email communications with no less than a half dozen staff economists in its Continuing Employment Statistics group. Not a single one of them could or would give me any information on how this metric was arrived at other than to point me to the website. At this point, we are left to assume that the Birth/Death adjustment is probably more arbitrary than anything based in reality. So for argument’s sake, let’s back out half of those fictitious jobs. Our total is now at 442,500 full-time jobs lost.

CESDB Adjustments for 2010

Finally, in order to keep pace with demographics, the economy needs to create 150,000 full-time jobs each month just to break even. Creating that many will not result in a reduction in unemployment but is the working equivalent of treading water.

Taking all this into account, August saw a deficit of 592,500 full-time jobs. And this was carried as a ‘good’ report? Former Labor Secy. Robert Reich actually came out and declared the report in its totality to be ‘awful’.

Keep in mind that the mediocre (at best) and lately awful jobs reports are after nearly a trillion dollars in direct stimulus and over another trillion in palliatives by the Fed in the form of purchasing mortgage-backed securities to stimulate the housing/construction sector. This reality alone should serve to underscore how dire the situation is. Unfortunately, this will likely be the status quo moving forward. Meet the new Goldilocks.

Bear #2 – An Unending Bear Market

It has been a cruel twist that the bear market which has been firmly in place since 2007 came precisely as the baby boomers began having serious thoughts about retirement. There have been countless stories of folks who retired in late 2007 or early 2008, either by choice or because they lost jobs and decided to retire, then had their portfolios halved over the next 18 months.

Sure the markets have recovered somewhat, but so many individual investors bailed out at Dow 8000 to 6500 and never got back in for the upswing. This market certainly has many folks perplexed. This is one of the reasons we have focused nearly exclusively on income producing investments, opting to lock in returns in the present rather than gambling on an uncertain future.

What many still have not realized is that the investing paradigm changed in a big way back in the year 2000. Stocks had seen an 18 year Supercycle of solid gains. One could quite literally pin the Sunday business section up on a wall, throw darts blindfolded and have a better than average chance of picking a winning portfolio. Precious metals languished for nearly two decades. That all changed in 2000 and as we entered a new century, we entered a new paradigm. Gold has surged fourfold and change and stocks have gone absolutely nowhere.

10-Year Gold Chart

These Supercycles are generally 16, 18, or 20 years, so at a minimum, the current paradigm has another 6 years to go. Given all the distress in the economy from both a macro and fiscal perspective, it is entirely possible that we’re only halfway through this cycle. That means another 6-10 years of the stock market bear and another 6-10 years of strength in precious metals. At least in this case, there is a silver lining – pun intended.

Bear #3 – Leverage in All the Wrong Places

Perhaps the most ferocious of all the bears set to battle this new, unimproved Goldilocks is leverage or lack thereof. We have heard plenty about the leverage in the banking system and how it has been used to enhance bank and brokerage profits over the past few years. We’ve also talked plenty about how leverage has helped destroy the consumer, which is absolutely true. What is not being talked about, however, is the lack of leverage that we have as a nation in terms of righting the ship.

There have been many calls for the US to reassert itself as the premier manufacturing nation in the world. This would serve the dual purpose of diminishing our reliance on foreign goods as well as helping the unemployment situation by bringing jobs home. While I am a huge advocate of doing exactly this, there are several major problems that need to be dealt with along the way should we as a nation decide to pursue this path.

2010 Trade Deficit

First and foremost is the fact that many American goods are not price competitive with their foreign counterparts simply because of the cost of labor. Placing tariffs on imported goods is an obvious solution proposed by many, but keep in mind the role that just the Chinese have played in keeping our economy afloat over the past decade in particular through vendor financing – the purchase of US debt.

Secondly, shifting manufacturing back to the US would require the rebuilding of the manufacturing infrastructure including the railroads and likely the power distribution grids in many areas as well. This is a huge capital investment and isn’t even on the radar of most policymakers. The mindset isn’t there at this time. For the most part we are content to convert old railways into biking paths instead of trying to figure out how to revive them.

A third area where the US lacks the leverage to reassert herself is in the area of energy. With peak oil on the immediate horizon, we are doing precious little other than burning a lot of corn to prepare for yet another paradigm shift. As long as we’re dependent on foreigners for one of the most important staples of economic growth, we will not be able to affect meaningful changes.

There are other areas as well, but I think the point has been made. A stagnant labor market, lack of individual wealth growth, and a lack of economic and tactical leverage to change key areas are conspiring to create this new Goldilocks economy which will plod along as long as trillions of new dollars are pumped in on a regular basis. Can anyone say unsustainable?

Next week we’ll finish up our analysis of proposed new gasoline taxes from a partial equilibrium perspective.

Partial Equilibrium Analysis – Part I

by TwoCentsEditor

Published on: 08/30/2010

Categories: Economics, My Two Cents

Tags: Economics, partial equilibrium, stocks, subsidies, taxes

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One of the many tools available to economists and analysts in determining the suitability of fiscal or economic policy is partial equilibrium (PE) analysis. However, many scoff at the notion of using partial equilibrium simply because many of its assumptions are deemed to be too unrealistic. However, for taking a look at the potential benefits (or costs) of a policy such as a tax on a single good, PE is a very valid construct. One of the biggest hot button topics these days in nearly every state is how to raise revenue (rather than cutting costs). One of the traditional cash cows for states is in the form of gasoline taxes. The same goes for the Federal government in this regard. However, as we all know, simply arbitrarily and capriciously taxing a product is not necessarily efficient. In fact it usually isn’t.

Proponents of supplemental gasoline taxes have pointed out that the additional revenue gives the taxing authority resources, which it can use to benefit citizens, increase spending, and generate economic activity. This argument is centered on the belief that government can most efficiently allocate economic resources. Opponents claim that the taxes create an unnecessary and unfair drag on those economic agents (people) who tend to create the most in the way of economic activity. Their argument is based on the belief that the economic agents can allocate resources more efficiently than government.

The goal of this exercise is to assess the efficiency of this go-to, knee-jerk taxing mechanism, and also take a look at the equitability of such taxes. It must be noted before we begin that gasoline is not a true final good since it is used in some instances in the production or provisioning of other final goods and/or services.

Scope of PE Analysis and Assumptions

As a general rule, PE analysis works much better for more specific instances. For example, our exercise of a tax on a single product (a gallon of gasoline) lends itself to PE much better than the government’s proposal of adding a VAT to all products. In the case of the VAT, general equilibrium analysis would be more appropriate.

The following assumptions are used in PE analysis:

• The market under scrutiny is that of a private good. There are no externalities such as imports and/or exports.

• All product and factor markets are perfectly competitive.

• Production shows non-increasing returns of scale (scale economies)

• There is no government intervention

What these assumptions mean is that we can look at the demand curve for gasoline as being equal to the Marginal Social Benefit (MSB) and the supply curve as being equal to the Marginal Social Cost (MSC). By aggregating the individual curves of all economic agents, we can derive the total demand and total supply curves (shown below).

Summing Demand Curves

From this, we can derive the total social benefit (TSB) and total social cost (TSC) for a market by summing the marginal benefits and costs for all units purchase/produced according to the following:

TSB =?MSB(1?Q_purchased)

TSC =?MSC(1?Q_produced)

Before anyone gets too excited about the government intervention and externalities assumptions, these can be backed out of the analysis or mitigated once a baseline has been established.

Interpretation and Pareto Efficiency

For now, it is important to connect supply and demand for a product to the concept of Net Social Benefit/Cost. Really, when you think about it, the validity of any tax or subsidy is whether its benefits outweigh its costs. If we can answer ‘yes’ to that question, then from a strictly economic perspective, it is a valid policy.

One of the measuring sticks used to interpret the results of PE analysis is the concept of Pareto efficiency, which states simply that efficiency exists when all factors are such that one party cannot be made better off without making another party worse off. In other words, our gas tax would be Pareto efficient if it were structured so that its net benefits to government and individuals were equal to or greater than its net costs to other individuals.

It is crucial to note that just because something makes sense economically and is Pareto efficient does NOT make it equitable. There are many instances of taxes and levies that may pass the Pareto efficiency criteria, but you’ll be hard pressed to convince the payers of the tax that it is equitable.

Supply, Demand and Total Net Social Benefits

With the earlier assumptions in place, it is now possible to take a look at the demand function for a particular product, in this case, gasoline, and interpret it as a social benefit. This is important since one of the goals of PE analysis is to create a cost-benefit scenario then make judgments from there. That said if we know each individual’s demand function, it is simple to derive the total demand for that particular good, or in our case, the total social benefit. We can aggregate the supply curves in similar fashion, and derive total social cost. Once we have these two, finding net social benefit is done by:

TNSB = TSB – TSC

where TNSB is total net social benefit, TSB is total social benefit, and TSC is total social cost.

Below, we take a look at a chart with three quantity levels, Q₀, Q₁, and Q₂.Using PE, we will then analyze TNSB at each point.

Marginal Social Cost/Benefit

In traditional general equilibrium analysis, Q₁ represents what we would consider equilibrium at P1 (unlabelled). However, using PE, we’re going to take a look at TNSB at each level of Q.

Total Net Social Benefit

Let’s take a look at Q₀. The area under the Demand Curve (MSB) is A+B. This represents the TSB for gasoline. The area under the supply curve (MSC) is B. Subtracting TSC from TSB leaves us with a TNSB of A. Following the methodology for Q1, we get a TNSB of A+C, which is obviously more optimal than that of Q₀. In this case, the highest TNSB occurs at the market equilibrium Q₁.

Another Look at Market Efficiency

For comparative purposes, let’s take a look at another example and examine the various surpluses that arise and what that means for equilibrium:

Market Equilibrium

It is also relatively easy to see how we can look at the surpluses generated at the different levels of Q and assign these surpluses to either producers or consumers. Looking at the above market equilibrium chart, we can see that the consumer’s surplus in this case is the value of purchases to consumers (total benefits) minus the cost paid. Consumers received value of ABC, and paid BC, leaving the consumer surplus of A. The producer surplus equals total payments received (B+C) minus the opportunity cost of the production of the goods (C), leaving the producer surplus at B. The TNSB of this situation is the sum of the producer and consumer surpluses (A+B). It is important to note that:

• Market equilibrium requires MSB=MSC,

• Supply equals Demand, and

• Assuming no externalities, market equilibrium represents a Pareto optimum (as illustrated above).

In the next installment we’ll apply the concept of PE analysis to the notion of an additional tax on each gallon of gasoline sold and determine if in fact this would represent market efficiency.

References: Primer on PE: R. Wigle, Microeconomics: J. Perloff.

Only It Didn’t

by TwoCentsEditor

Published on: 08/13/2010

Categories: Current Events, Economics, My Two Cents

Tags: Federal Reserve, quantitative easing, recession, stocks, unemployment

Comments: No Comments

The powers that be are now starting to be shown what should be a very important lesson in the old saying: “You can fool all of the people some of the time and you can fool some of the people all of the time, but you can’t fool all of the people all of the time”. For a year and a half now, starting at a rather well defined point in time during early March 2009, the govermedia switched gears and pronounced that the shattered American economy was in recovery.

The perceptive ears on Wall Street picked up on this rather quickly and the markets reversed and headed higher. Consumers bought it not only because they’d bought almost anything that moved for nearly a decade and a half, but frankly, because they wanted to. The doomsday talk was really putting a damper on the consumption party, and well hey, let’s pass out the credit cards and get it rolling again. It would have seemed as if the powers that be had created another blowout, profited from it, bailed themselves out at taxpayer expense, then with a few crafty words and graphics on the telescreen kick start the next phase. It was all set up to happen perfectly.

Consumer Credit

Only it didn’t.

The consumer bit for a while, but never fully embraced the idea of the jobless recovery. Many times over the past year, these pages were filled with wonderment at the unmitigated gall of an establishment that would think that a man without a means to make a living, unable to support his family, would hike out his credit card and march off to the store and forget about it all. It defied logic. Yet that was what was supposed to happen.

Only it didn’t.

In early 2009, the federal government handed out cash to consumers and instead of spending it, consumers saved it, paid down debt, bought Gold or any number of a hundred things other than doing what they were ‘supposed’ to do with it, namely spending it. I joked at the time that because of non-compliance, the next stimulus would be store gift cards. While we haven’t gotten there yet, there has been zero talk of another round of checks.

This should send a very clear signal that our government, a miserable failure in doing anything to help our economy, STILL thinks it can spend your money better than you can. Look at recent actions this week as our government decided to pull the ultimate robbing of Peter to pay Paul when it swiped $12 Billion from the food stamps program to give bailouts to the teachers’ union and other state and local employees.

And even this will not last. States are still broke. What happens when this money is spent? The same thing as when the last stimulus money was exhausted. We’re right back where we started with nothing to show except more kicking of the can down the road and a hefty bill for our children and grandchildren. Larry Kotlikoff’s article on Bloomberg this week nailed it – We’re broke and we don’t even know it. The fiscal gap, now at $202 trillion, is up roughly $17 trillion in the last 6 months.

The debt function is going parabolic and yet there are still people on TV on a daily basis screaming that America has the strongest economy in the world. If a fiscal gap that represents almost 15 years of GDP is considered the strongest, then I’d hate to see what the weakest looks like. It is repeated like Newspeak in the hopes that some of it will stick.

Yet there truly is a dichotomy going on in America. Take a trip to the local shopping mall and you’ll see people snapping up the latest iGadgets, consumer electronics, and other ‘necessities’. Yet retail sales are flat. Granted, much of the spending is being done on deeply discounted items, but there is something worth mentioning here. There is a silver lining in all this. If you are one of those people who have been responsible (and fortunate) and have savings and some extra cash for discretionary spending, there has never been a better time. America is on sale – literally, and in more ways than one. Don’t get too excited though; the silver linings pretty much end right there.

In recent weeks, almost on perfect cue, the mainstream press started playing up the ‘Double Dip’ card. They even trotted out the relic Alan Greenspan for a few sound bytes. The buzzword is now deflation. M3 is contracting (albeit bouncing somewhat in the past few weeks). M1 growth is falling, and M2 is hovering very close to the zero-growth area. The banks are being blamed for hoarding bailout dollars and not lending to consumers and businesses. Funny thing though, it is the Fed who is incentivizing this behavior by paying the banks to keep their money there and it is the same Fed who is working on a ‘bank CD’ system to pay the banks an even higher return for not lending.

Monetary Aggregates

Something ought to ring patently false then when Ben Bernanke gets up on his soapbox and talks about the need for lending by banks. Yet no one in Congress has the fortitude to ask these tough questions save for Ron Paul and perhaps one or two others. The Fed knows our economy is built on inflation, credit, and increasing money supply, yet in similar fashion to the 1930’s, the Fed is actually encouraging deflation through a number of its policies while talking about overall easing through its pursed lips and crossed fingers.

I realize that this is heresy to the many people who talk about quantitative easing and hyperinflation as being a certainty. The truth is that the banking system creates much more inflation than the Fed, and right now the banking system isn’t doing it. Granted, the Fed is doing QE through a variety of channels – if it were not, we’d have crashed a long time ago. But to be fair, most of that QE has been for the purposes of saving banks and related institutions rather than helping consumers and the economy. I think everyone can agree on that point.

Again, one must ask serious questions about the Fed and its true purposes. The latest talk is that the Fed is worried about the recovery. The last time I checked, the Fed’s ONLY two mandates were price stability and maximum employment, not micromanaging the economy. They’ve done a lousy job on both counts, but have painted a picture of a slow, but steady recovery that would get fuel from borrowed money, stimulus, and the last of the age of consumer largesse. It was all supposed to happen just like that.

Only it didn’t.

The Manufacturing Myth

by TwoCentsEditor

Published on: 08/04/2010

Categories: Current Events, Economics, My Two Cents

Tags: bonds, employment, government, manufacturing, stocks

Comments: No Comments

They still don’t get it – or perhaps they do and just won’t admit it. Either way, it doesn’t matter much as the jesters, namely Msrs. Bernanke and Greenspan, continue to chirp their assigned lines, playing good cop/bad cop with the USEconomy. Right now, Bernanke is the good cop, pointing to increasing wages and the likelihood that the consumer will once again step up and rescue us from the grips of the double dip. On the other side of the room is Greenspan, talking about how that double-dip is still possible, although extremely unlikely. Today the mainstream press jumped on the bandwagon and trumpeted the smashing success of the ISM’s manufacturing index for June as an indicator that all is and will be well. Stocks soared, bonds shed a point, and oil jumped over $80/barrel for the first time since May.

July ISM Index

So what gives with manufacturing anyway? For years now we’ve heard stories about the deindustrialization of America and have seen countless pictures of decaying factories and manufacturing infrastructure. Yet at the same time the economic masterminds of this nation are telling us that manufacturing is going to pull us out of this horrible recession, and in fact, prevent any and all future recessions. If ever there was a dichotomy in perception, it is now. It would appear as if suddenly everyone is realizing that we must produce in order to consume. While this is a notable departure from conventional Keynesian theory, are we seeing a true sea change or just lip service to the common sense of the matter?

Inventories

Manufacturing currently accounts for about 28% of GDP at just a tad over $400 billion annually (based on final value of shipments) at our current clip, but total goods-producing employment accounts for just 13 million jobs – less than 14% of total US non-farm employment. By contrast, service sector jobs account for a whopping 85.5% of US non-farm employment and provisioning of services accounts for over 70% of GDP.

The Myth of the Manufacturing-Led Recovery

A closer look at the manufacturing activity over the past year jives with direct observation and many conversations with management level staff of several firms. The bump up has been anecdotally nothing more than a period of inventory rebuilding after inventories were run down during the recession. The biggest difference between the recession of the early 1990’s (see chart above) and the last two recessions is the wide acceptance of JIT (just-in-time) inventory management, CRM, ERP, and similar systems as firms broke away from accepting carrying costs as a cost of doing business and made an attempt to streamline operations to compete globally.

The net result of these fundamental changes in the way business is conducted is that inventories are now run down much faster than previously, and the rebuilding phase begins earlier – often while the recession is still in progress. If we had a true manufacturing economy, all else being equal, we might have a reasonable chance of being rescued to some extent by inventory building. However, ultimately, in the absence of an increase in aggregate demand, manufacturing will begin to stagnate again once the rebuild is complete. It should also be noted that the value of inventories is only marginally adjusted for changes in price, hence the increasingly higher dollar amount of goods.

Goods-Producing Jobs

Even though the ISM index made a slightly better showing than what was expected, this was clearly another case of ‘less bad’ being good. New orders continued to slump, down to 53.5 from 57, indicating very sluggish growth and contributing to the idea that the inventory rebuild is nearly complete. The 53.5 reading on the new orders index was the lowest since the same month last year according to the ISM. The backlog index fell by 2.5 points to 54.5 and that, combined with the new orders data, belied the small blip up in manufacturing unemployment and gives considerable credence to the temporary nature of such a move. Of course with the Labor Department solidly fudging the jobs numbers every month it is rather difficult to get a solid reading on anything at this point.

Overall, the composite manufacturing index put in its lowest reading of the year at 55.5. Anything over 50 signals growth with values less than 50 signaling contraction. Even the MSM is now admitting that manufacturing’s role in the continuing ‘recovery’ is becoming suspect. Small wonder.

Bernanke had quite a bit of cold water thrown on his argument as well on Wednesday as auto sales were rather tepid in July, especially when the massive incentives offered by manufacturers were thrown in. The 6% gain in sales will be almost totally wiped out in dollar terms by the slashed prices. Bernanke’s thesis took another blow just an hour later when personal income and outlays were released and neither moved an inch in July. Non-durables and services were particularly weak. Given the contribution to GDP that services represent, this is an unsettling trend.

The bottom line is that services alone will not be able to remove us from our economic and fiscal duress mainly because so many cannot be exported and therefore are of little help to the current account. A strong manufacturing presence would do wonders, however, it is very difficult to ask a struggling consumestocracy to purchase domestic goods at a steep premium to their foreign counterparts. National pride will certainly help some make the leap, but in many cases, the price gaps are just too large.

Tariffs could be used to close the gap, but widespread use could very well put an end to the Chinese (and others) vendor financing of the American economy. The same can be said for import quotas. For all the talk of energy independence, that would only be a microscopic piece of recapturing true national sovereignty. And yes, we have lost a good deal of that by virtue of being dependent on other nations to fill our shelves with everything from soap dispensers to many food items.

As for the current economic malaise? As the chart above shows, the tiny blip in manufacturing jobs represents so small a portion of our labor market that it is nearly laughable that anyone would assert that such a performance will lead this economy anywhere. Yet the spin-doctors continue to do exactly that.

Income in a Zero-Rate World – Revisited

by TwoCentsEditor

Published on: 07/09/2010

Categories: Current Events, Financial Markets, My Two Cents

Tags: dividends, energy stocks, income investing, oil, stocks

Comments: No Comments

It has been 18 months now since the original piece of the same name. Quite a lot has happened in those 18 months, but we still have the zero-rate world and along with it all of the accompanying problems. One positive side for fixed-income style investors has been the ability to make nice capital gains on bonds. But how about those who are interested in monthly or quarterly income and don’t wish to trade in and out of traditional fixed income instruments? In this essay, we’ll take a look at the portfolio model that was created 18 months ago and see how it has performed.

One important thing to note is that one of the Canadian Trusts (Harvest Energy) no longer does business by that name. It was purchased by Korean National Oil Corporation (KNOC) at the end of last year. It was perhaps the first casualty of Canada’s ill-fated decision to change the taxing structure for Trusts and it was a big one. Harvest was one of very few vertically integrated Oil & Gas operations, meaning that it owned refinery operations in addition to its exploration and production program. It was viciously attacked by short-sellers during the months leading up to the acquisition and when shareholders were offered a roughly 40% premium over the then $6 and change trading price, they jumped and Harvest was lost.

Trimming your Hedges

The hedging tool used in this particular Portfolio Model was the UltraShort Oil & Gas ETF since it correlated fairly well with the mix of assets represented. However, one of the drawbacks of these ETFs is their propensity to leave gains on the table based on the objectives they pursue. This reality has become somewhat better understood by investors, but let’s go over it again if for no other purpose than to reinforce the point.

From the ProShares website:

“This ETF seeks a return of -200% of the return of an index (target) for a single day. (Emphasis theirs) Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.“

What they’re saying is if you purchase this type of fund and it moves 2X the inverse of the correlated index or security, that if the underlying issue moves down 20%, you would expect the price of the 2X inverse fund to go up 40%. It doesn’t always work that way. Depending on the price action, you could actually end up with a much lower gain, especially if the price action is volatile and choppy.

Again, this is not meant to be an indictment of these types of funds, but rather to point out that no hedge is going to be perfect and you’d better keep your eye on the ball if you want to be successful.

The Sample Portfolio Model

Let’s see how our components have faired over the past 18 months:

Sample Portfolio Model

For the 18 months ended June 2010, the portfolio model is up substantially not counting dividends. Assuming the purchase of the same 100 shares each and 250 shares of DUG as in the original article, our portfolio on 11/20/2008 would have cost us $31,969. As of 7/8/2010, it would be worth $47,964 for an increase of 50%. During the same time, the portfolio threw off $2,634 in dividends making the effective yield of the portfolio 8.24% and bringing in $146.33/month in dividend/distribution income. $146 doesn’t sound like a lot of money, but when you consider deploying a $100,000 or $200,000 portfolio in this fashion, suddenly you’re talking about some very nice cash flow – certainly in excess of what can be found at the local bank. The performance metrics stated above assumed that the positions were all started on 11/20/2008; a significant market bottom. Waiting until 3/6/2009 to begin them would have resulted in slightly higher gains. We put a few of these positions to work in our newsletter portfolio on 3/13/09 and they have performed in spectacular fashion.

Model Performance

During the same period of time, the Dow Jones Industrials are up just 34%, with well under one-half the yield of this model. The S&P500 is up only 33% with just over one quarter the yield of the model.

Conclusions

One thing that has worked extremely well for me in practice is the strategic placement and removal of hedging devices. I am not talking about trading hedges; that is a completely different animal. What I am talking about is searching for multi-month trends and then placing or removing hedges based on the results of that research. For the average investor who has neither the time nor the inclination to get involved at this level, selecting a solid hedge, putting it in place, and monitoring once a week should suffice.

Still other investors who don’t mind potential wild fluctuations in their core holdings, but are interested merely in yield, will construct a similar portfolio and put 100% of their capital to work earning dividends. We could have pumped the yield of our sample model up considerably by doing that, but decided on a more conservative approach and were willing to leave a point or two of yield on the table in favor of more stable performance.

One thing to note is that many of these components have had their dividends cut since 11/20/2008. Several have been cut significantly. A few were cut, and are now beginning to increase again. One of the lesser-known ramifications of the ongoing credit crisis is that many small and midsize companies have had a difficult time raising capital at reasonable rates. This resulted in a more protective position taken on by management as they’ve sought to preserve cash for operations. This has led to dividend cuts in many cases. Falling share prices in 2008 and 2009 made it easy to do so since they could cut the dividend and still maintain a similar yield for new investors. The argument could certainly made that this is irrelevant since 8% is 8% no matter what the price/distribution levels, but I think it needs to be mentioned to maintain a spirit of objectivity.

Disclosures: Long PWE, PGH, KMP

No Surprise in Housing’s Dive

by TwoCentsEditor

Published on: 06/23/2010

Categories: Current Events, Economics, My Two Cents

Tags: depression, Economics, housing, recession, stocks

Comments: 1 Comment

Wall Street doubled over in anguish today as the latest numbers on existing home sales hit the news wires. I must say that I am totally confused as to why the decline was any kind of surprise, however. The mainstream press dutifully expressed every emotion from grief to even outrage as the number was reported and analyzed.

Most people have quickly forgotten that the biggest reason there were so many sales to begin with was due to the fact that Congress had waded into yet another market and propped it up with cash on the barrelhead for anyone willing to take the leap. When they lured all the first time buyers they could, they took the next logical step and offered the cash to pretty much everyone else. Couple those actions with the Fed’s active (and now passive) buying of mortgage backed securities and it was bubble mania all over again. Until it wasn’t. That point came at the end of April, when the tax cuts were mercifully allowed to expire, saving our children and grandchildren untold billions.

At that point, I began to have serious doubts as to whether this beaten market could even avoid another crash. I studied the Mortgage Bankers Association reports each Wednesday and watched applications for new purchases fall off a cliff. My contacts in that particular industry said their phones have never been so quiet regarding new purchases. The refinance business kept them busy, but nobody seemed interested in buying a house after April 30. At that point, I wondered how bad May’s numbers would be. It was pretty obvious that the end of the tax credit had pulled at least most of May’s agreements back into April; and quite likely some of June’s as well. Where demand would settle after that was anyone’s guess.

Exiting Home Sales

One of the problems with the report on existing homes released today is that the report is based on actual closings. So any one who was hurrying to get locked in during March and perhaps even the early part of April would have had their closing count in May’s number provided it happened before the end of the month. May’s actual purchases for existing homes (or lack thereof) will not hit the statistics until at least June and perhaps July. So the 2.2% drop, while not a surprise, does not reflect base demand for existing housing ex-stimulus. Unfortunately, this was the spin being applied by at least some folks in the MSM. They posited that housing can indeed survive and even thrive without further stimulus and declared the tax credits a smashing success and a fine example of the benefits of government intervention.

30-Year Rates

However, stimulus in the housing arena has taken on three forms; one fairly transparent; the other two much less so. The transparent stimulus was the tax credits. Many are in fact clamoring for a reinstatement of the credits. Unfortunately, this is an election year, and right now it just isn’t cool to be a big spender – at least not openly. Congress will actually forego having a budget for FY2011. If there is no budget, I guess there can be no budget deficit. Are we really that far along in this charade? We could go a long way down that road without ever finishing this point, however. The second type of stimulus with regard to housing is the ultra-low interest rates that have been created by the Federal Reserve and it’s illicit (and often illegal) actions. These actions have kept 30-year mortgage rates under 5% and that alone has been enticing many people into taking the plunge. In truth, the total amount repaid on a $200,000 mortgage will be over $20,000 less if you can get a 4.8% rate as opposed to 5.25%. The bottom line is that low rates trump tax credits any day of the week. The third type of stimulus – and one that is setting an alarming trend is the number of mortgages being essentially underwritten by the US Government. This number has been hovering somewhere around 50% on average depending on the week.

What must be asked, however, is how much lower mortgage rates can reasonably be expected to go? At the same time rates have been near historic lows, it is more difficult than any time during the last 20 years to actually obtain financing. Many lenders, still ringing from 2007 and 2008’s losses are demanding better financial situations lending in many areas. It is not odd to hear lenders requesting 20% down, which was virtually unheard of just a few years ago. The rest have pretty much been following suit despite the fact that they were made whole by the US Taxpayer.

New Home Sales

With so many economists and policymakers hanging their hats on the return of the housing bull to fuel the next economic binge, it would seem that today’s number was maybe a small jolt. If today was a jolt, tomorrow’s new home purchases report is likely to act as a thunderbolt. Contrary to the manner in which existing sales are reported, new home numbers are tabulated based on when a contract is actually signed. In other words, tomorrow morning’s report will give us the first glimpse at the post stimulus housing market. Economists are expecting quite a drop – roughly 20%.

One point that is often overlooked is the fact that there are now so many publicly traded homebuilders. They even have their own index. Inventories have been a problem since the middle of 2006, but never once has anyone seriously mentioned a cessation to building. Sure, permits fluctuate, but most experts will readily agree that the quickest resolution to this crisis would have been to put a moratorium on homebuilding for a few months and let them inventory get worked down. However, how many public company CEO’s would be able to hold their job if they took a quarter off? How would a homebuilder’s stock fare if they hung up the shovels for 3 or 6 months? Answer: it wouldn’t. This is why the housing problem won’t get better, and in fact will probably get worse. Prices will adjust until it simply ceases to be profitable to build a house. Once that happens, the building will stop and the market can start to address its inventory problem.

Contributing to that inventory problem are foreclosures, which are still running at all-time highs, tax sales, which are close to all-time highs in many locales, and the continued loss of quality jobs, which are driving people out of certain areas while not bringing anyone back in to replace them.

With so much of our economic prospects tied into housing, it will be very important to see how well this market stands on its own – if it can do so at all. Should the numbers start to falter, will the Congress race back in with more incentives? Are potential buyers expecting more tax credits? Will the Fed continue to keep rates in the cellar? My guess at this point is that, like so many other areas, it’ll go until it doesn’t. And then once again we’ll have to be reactive as opposed to proactive.

Life After Government Stimulus

by TwoCentsEditor

Published on: 06/11/2010

Categories: Current Events, Economics, My Two Cents

Tags: budget deficits, Economics, government, stimulus, stocks

Comments: No Comments

There is perhaps no better example of the destructive nature of government intervention than the current housing and retail goods markets. For the past three years a spend-happy Congress lavished these areas with stimulus spending, tax credits, and other palliatives all aimed at papering over the structural defects in these markets. In the case of housing, the problem was years of easy money, sky-high prices, and zero-standards lending. In the case of retail goods, it was years of abuse of various types of credit to expand a spending bubble and increased reliance on foreign products. However, Congress has now buttoned up – in fear for their political existence in many cases. The public is aware and fearful of debt for the first time in recent memory. Living in a post-stimulus world; even if it is only until the next Congress is seated will be interesting to say the least.

The Housing Market’s Freefall

While the actual damage to the housing market in the near term cannot be totally assessed until later this month, there are some hints in the rate at which purchase applications for mortgages have plunged. The following data is compiled weekly and presented by the Mortgage Bankers Association:

MBA Indices

During the past 4 weeks, purchase applications are down a whopping 35%. It is easy to see the spike at the end of April as the end of the tax credit lured May’s (and perhaps June’s too) sales back a month. The downward trend of new purchase applications has continued into June despite very low relative interest rates for home loans. These low rates boosted the Refinance portion of the index during May and remain low, the national average currently at 4.88% according to bankrate.com.

With an upcoming election, we will now likely get the first glimpse at the true state of the housing market. Granted there are still many programs in place at the Fannie/Freddie/FHA level that are encouraging purchases to varying degrees, but it is not likely that direct stimulus through tax credits will be used for at least the next few months. What is very disconcerting is that more than half of the purchasing blitz during March and April was done on the back of government mortgages. Much in the way the government nationalized the student loan business it is now similarly giving the heave ho to private lenders in the mortgage market. These actions virtually guarantee the perpetuation of the distortions currently seen in this critical area.

30-Year Mortgage Rates

I had commented, perhaps cynically, to some friends back in 2005 that the housing bubble seemed to be little more than a giant property grab. With government now owning or guaranteeing the majority of mortgages (69 percent), it seems that very well could be the case. Unemployment is still high, decent paying jobs are difficult to come by, and people are still being laid off. Consumer debt burdens are causing the financial hardships endured by many to continue. Repossessions of houses just hit another all-time record high last month. When the government owns the mortgage and someone defaults, who gets the house? Some food for thought on a Friday afternoon.

Retail’s May Swoon

This morning’s retail sales report gave much more cause for concern than any of the recent month’s reports in this area. I’ve dissected these reports on several occasions for our paid subscribers to reveal the biases. Put simply the numbers are not what they seem and haven’t been for quite some time now. The biases, statistical and/or hedonic, tend to overstate retail sales.

Retail Sales

Even those biases could not conceal last month’s drop. It is quite likely that the 1.2% decrease in sales was caused in no small part by the ‘Here we go again’ mindset when global stock markets began another round of liquidation. The media had been blaming a late Memorial Day for the potential downdraft in sales well in advance of the release of this morning’s report, which really makes no sense. The drop in sales speaks volumes about the delicate nature of consumer confidence. It is easily shaken these days, and it doesn’t take much. Granted the European (and spreading) debt crisis is a huge problem and will affect us eventually, however, that is not the impression the average person has thanks to the largely absentee media in this country. The crash of 2008, however, is still on people’s minds, and there is a general fear of a recurrence of those conditions. So when the markets act up, people slow spending and increase savings. It is one of the few things we’ve seen in recent memory that actually makes sense. Ironically, the University of Michigan’s consumer sentiment index is telling us that confidence is at the highest level since 2008. So much for our brief trip back to sanity.

The retail sector has not been without its share in the government stimulus binge of the past three years either. Most of the stimulus other than the checks sent out in early 2008 has been indirect, however, the benefits from foreclosure prevention tactics, strategic defaults, and hyper-extended unemployment benefits have perpetuated the spending bubble much in the same way the housing bubble has been prodded along. However, with more and more states such as Colorado and California having to borrow money to pay unemployment benefits and record repos of homes, it would seems likely as though the fuel for this leg of the spending bubble might be petering out somewhat.

Another weight on the consumer is the comparatively higher interest rates on credit cards. According to creditcards.com, the national average for credit cards in May 2010 was 14.31%, up from 12.75% just 6 months ago. So even as banks have been able to borrow from the Fed for essentially nothing, they’ve repaid the consumer for the hefty bailouts by jacking interest rates. Of course the selling line here is that so many consumer loans are in default. Small wonder. Maybe if the underwriting department hadn’t taken 5 years off this wouldn’t have happened.

In summary, the pressures on these two critical markets are increasing as the government’s ability to intervene is hampered by a broadening awareness of its own insolvent state. Granted, one or two months does not a trend make, but we need to be aware of the possible paradigm shift that is occurring – the end of the age of perpetual stimulus.

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