U. S. Businesses Shop Europe

“As Europe struggles with its debt crisis, American businesses and financial firms are swooping in amid the distress, making loans and snapping up assets owned by banks there—from the mortgage on a luxury hotel in Miami Beach to the tallest office building in Dublin.” (http://www.nytimes.com/2011/12/26/business/us-firms-see-europe-woes-as-opportunities.html?_r=1&scp=2&sq=nelson%20schwartz&st=cse)

Where in our current understanding of macroeconomics does it indicate that a sovereign debt crisis might end up with foreign interests owning large chunks of a country’s physical assets?  How much of Ireland will United States interests buy?  How much of Spain will Middle Eastern countries end up owning?  And, how much of Italy will China possess?

Macroeconomics just cannot pick up the complexity of real economies.  Too much of the reality of an economy takes place at the micro-level and cannot be comfortably incorporated into the simple structures of the aggregate models of the economy. 

Macro-models just cannot include all of the incentives that are created within the total economy that lead to results that can even produce contradictory outcomes to what the macro-economists had been predicting. 

One of the most egregious results of the past fifty years is the prediction of the macro-economist that inflation can help the working classes and the middle classes.  Yet fifty years of credit inflation in the United States produced exactly the opposite effect in that the income/wealth distribution in the U. S. became highly skewed toward the wealthier in the society.

For one, the economists used aggregate models to show that there was a favorable tradeoff between employment and inflation.  The policy implication: if a little more inflation can be created then more people will be hired and unemployment will decline.

These models did not pick up micro-behavior that indicated that the “less wealthy” could not protect themselves from credit inflation whereas the “more wealthy” could not only protect themselves from credit inflation but could actually benefit from it.

Furthermore, these models did not include the fact that the credit inflation would provide incentives for manufacturing companies to move more into financial services while shifting their focus away from their historically productive enterprises.  Who would have thought in the 1960s that General Electric and General Motors would, by the end of the century, be earning more profit from their financial wings than from their manufacturing capacities?

Another macroeconomic idea that I have repeatedly used in discussing international financial arrangements has been that of the “trilemma”.  The “trilemma” analysis concludes that a country can only achieve two of the following three policy objectives: a free international flow of capital; a fixed exchange rate; and the ability to follow an independent economic policy.

Since 1971 when the United States went off the gold standard, many countries floated the value of their currencies in foreign exchange markets.  This had to occur, the argument went, because in the 1960s, capital began to flow freely throughout the world. 

Therefore, if governments wanted to gain the favor of those that worked in manufacturing and the labor unions by conducting a policy of credit inflation to keep unemployment low and, in many countries, housed in their own home, they had to be able to conduct an independent economic policy.  Within this effort, popular pension programs were also expanded to encourage people to retire earlier and governments became a large supplier of jobs to the economy.   

Thus, the value of the currency could be allowed to decline as governments created massive amounts of debt often financed by foreign interests.  Governments were able to keep the pedal to the floor during this period by generating a relatively steady flow of credit to their economies.

And, what was the micro-impact that the “trilemma” models did not pick up?  It was the declines that occurred in labor productivity that made many nations uncompetitive in world product markets. 

Here we see Greece…and Spain…and Ireland…and Portugal…and Italy…and, others...

And, corporate interests in the United States…and elsewhere…have lots of cash available…either on their balance sheets…or through financial markets that have been generously supplied by the Federal Reserve.

“At Kohlberg Kravis (Roberts), Nathaniel M. Zilkha, co-head of the special situations group, is expanding his London team to eight, from two, and hoping to take advantage of opportunities in Europe.  The firm is even considering potential investments in the country where the crisis began, Greece, despite headlines warning of a default by Athens or the possibility that Greece may withdraw from the eurozone…

Besides Greece, Kohlberg Kravis bankers have also been looking for deals in Spain and Portugal, where private companies are having a similarly hard time winning new credit or extending existing loans.”

As we see over and over again, the excessively loose monetary policy of the Federal Reserve is not helping the “working people”, those 20- to 25-percent of the labor market that are under-employed.  The Fed’s largesse is going to those that can use the money to “do the deal”.  Now, it seems that the flow of funds is going into the acquisition of assets formerly owned by Europeans.  Earlier, we saw Fed injections creating bubbles in commodity prices and in the stocks of emerging markets.   Even earlier than that, we saw Fed injections creating bubbles in the U. S. housing market and in U. S. stocks. 

The macroeconomic models are becoming less and less useful because the world works at a more micro-economic level.  It is at this micro-economic level that we can really observe the complexity of human behavior and also see how markets can self-organize and emerge to take on a life of their own.  Until governments become more sophisticated in their analysis of economic problems, they will continue to create opportunities that the wealthy and the better connected can take advantage of.  And, a Fed guarantee that short-term interest rates will remain at levels that are close to zero only exacerbates the situation.      

Government Incentives Do Matter--Part II: US Home Ownership

Just saw another example of the role that government incentives play within an economy. 

On Friday, I took off on the interesting essay by Financial Times columnist Gillian Tett about the impacts that the regulatory declaration that European sovereign debt was “risk free” had on the European sovereign debt crisis. (http://seekingalpha.com/article/305431-government-incentives-do-matter-the-european-case)

The conclusion presented by Ms. Tett was that declaring the debt of a government as “risk free” results in too much government debt being issued because it is so cheap to issue it.  Continuing to maintain the “risk free” tag after it becomes obvious that the debt is no longer “risk free” just exacerbates the situation.  Too much sovereign debt gets issued and a financial crisis can result.

Within that post I pointed to another situation in which government incentives produce a result that inconsistent with the original goal of the economy.  I argued that the credit inflation policies followed by many western governments over the past fifty years to keep people employed and provide a buoyant economy so that the income/wealth distribution of the country can stay more balanced or at least not deteriorate has had the exact opposite effect of making the income/wealth distribution more skewed toward the wealthy end of the spectrum.

Today in the Financial Times there is a major article on the United States housing market. (http://www.ft.com/intl/cms/s/0/a05d2a58-0565-11e1-a429-00144feabdc0.html#axzz1d1bsytCm)

Included within this article is more evidence of how government incentives, created with the best intentions, have produced results that are inconsistent with the original goals and objectives of the government’s policy. 

The specific programs at issue in this article are those US government programs intended to bring home ownership to more and more Americans.  These governmental efforts were an integral part of the credit inflation program of the United States government over the past fifty years, in both Republican and Democratic administrations.

The housing programs of the American government appeared to be very successful for a long period of time and with the underlying credit inflation policies in place, it seemed as if this success would continue on unabated.  Not only could people own their own home, home ownership seemed to be the “piggy bank” that accounted most of the wealth increases being experienced by the middle class. 

This was income/wealth re-distribution at its best because it was achieved without any overt or explicit governmental policies aimed a achieving such a re-distribution!

The numbers: in 1960, approximately 62.0 percent of Americans owned their own home; in 2004 69.4 of all Americans owed their own homes.  And, it looked like this number would continue to rise for the foreseeable future. 

The government programs worked!

Unfortunately, the current number is slightly more than 66.0 percent. 

And, analysts at Morgan Stanley argue that the true number is around 60.0 percent because many delinquent borrowers who say they are “merely renting” homes will soon be forced to give these homes up.  Hence, the number of actual homeowners in the country is substantially over-estimated. 

Behind this argument is the fact that about 20.0 percent of homeowners are either unable or unwilling to make their mortgage payments. This is consistent with those analysts who predict that one in five borrowers will default in the near future.  This problem only places more pressure on the prices of homes to continue to fall. 

The actual rate of home ownership in the United States could drop below 61.0 percent in the next three- to five-years.  This estimate is attributed to Karen Weaver at Seer Capital Management.  The shrinking of the American middle class will only add to this decline.

Thus, the picture of the United States as “a nation of renters.”

Who would have thought?

The structure of the United States housing industry, as we know it at the start of the twenty-first century, was built on the foundation of the continuation of credit inflation as the basis of the government’s fiscal policy.  This credit inflation and the ease with which someone could become a home builder helped to account, not only for the number of builders that existed within the industry, but also the size of many construction companies that were able to achieve substantial scale in home-building.

This structure is changing and will continue to change in the near future. 

But, all the firms and businesses that supported this structure will also have to change.  Business, especially if America becomes that “nation of renters”, will have to change and this will include real estate agents, mortgage brokers, security bundlers, and so forth. 

This is not a philosophical question, it is a reality for hundreds, even thousands, of people who have worked in the real estate area.  What is going to happen in this area and how will this impact investment opportunity in the “housing” space?

But, perhaps even more important is the question about how will this situation impact the federal government and the federal programs and the incentives that they create?  Fannie Mae and Freddie Mac are insolvent and costing the American taxpayer billions of dollars.  Who is going to finance mortgages in the future?  Security bundling and packaging is under scrutiny and is going to change.  And, who is going to buy these mortgage securities in the future?  The Federal Reserve? The rating agencies have been under attack and there is a movement for government to oversee or control them.  And, how about the subsidy of construction... and the construction of low-income units…that the government has played such a large role it?

The governmental incentives related to home ownership are changing as it the behavior of the American public with respect to whether or not people want own their own home.  As individuals continue to de-leverage, home ownership does not seems to be such a desirable allocation of their income/wealth. 

Government incentives obviously are important.  But, as with most incentives, one has to separate the impacts of the incentives in the short-run from the consequences of the incentives in the longer-run.    

The Case Against the Obama Taxes

Yesterday, President Obama proposed a tax plan.  George Shultz has replied: “rich people and large companies like General Electric Co. are the beneficiaries of a complicated tax system.”

“It’s wealthy people and the GEs of the world that know how to manipulate these preferences and get their tax rates down,” said George Shultz, an economist and former dean of the University of Chicago’s business school. “The average Joe doesn’t have access to those lawyers.”

George Shultz, also former United States Secretary of the Treasury and Secretary of State, made this statement in an interview with Bloomberg press when arguing for a complete change in the tax code to reflect the realities of the 2010s. (http://www.bloomberg.com/news/2011-09-20/shultz-says-it-s-time-to-clean-house-with-u-s-tax-code-to-boost-economy.html)

One could also say the same thing when referring to the ability of “wealthy people and the GEs of the world” to handle the inflationary environment created by governments that are aiming to sustain “high levels of employment” as designated by the full employment objectives of the United States and many other western nations. 

The wealthy and the large corporations can protect themselves or even benefit from inflation.  The “average Joe” cannot do this.  In fact, the “average Joe” ultimately “gets screwed” from inflationary policies aimed at keeping him employed.  Having under-employment rates in the 20 percent plus range is not what was planned as policies of credit inflation dominated the past 50 years. 

Furthermore, credit inflation creates a wonderful stage for financial innovation, shifting jobs from manufacturing and production to financial services and other support industries…like the legal profession.  We can only look at the shift in jobs in the United States over the past fifty years to see the consequences of this development.

The financial innovation of the last fifty years points to another change in the world that not only allowed the financial innovation to take place but provides insight into the world of the future.  The change I am writing about is the advent of the Age of Information.  Financial innovation thrived upon the new technology and the new technology was underwritten by the growth of the financial innovation. 

“Wealthy people and the GEs of the world” (along with the JPMorgan’s, Goldman-Sachs, and others) are able to use this technology “to manipulate” things so as to benefit themselves as much as possible.  They have the tools.  Why did GE come to earn two-thirds of its profits from its finance wing?  And, the same can be said for General Motors and many other “manufacturing” companies. 

And, people are concerned about the fact that over the past fifty years the income/wealth distribution of the United States became so skewed toward the rich.  The credit inflation and social policies of the past fifty years created the conditions for those that could “manipulate” things and get their tax rates down and profit from the inflationary environment that was created by the politicians. 

The “average Joe”? 

The “average Joe” could do little or nothing.  If he “stayed employed”, kept the job at which he was already working, he fell behind.  The “average Joe” needed to become educated, needed to become more technologically savvy, needed to find the “lawyers” and financial advisors to “manipulate” the system.  But, that was not the way the incentives were aligned!

Unfortunately, the objective of the politician does not mesh with that of “the average Joe.”  The objective of the politician is to get elected and then to get re-elected.  Consequently, laws and regulations aimed at keeping “Joe” fully employed in his current job have been crucial.  Empathy with “Joe” was good politics.  The fact that “Joe” was constantly falling behind was not the issue.

The world has changed.  Yet, we can’t seem to get away from the same election strategies that have been followed over the past fifty years.  In my mind, we are going through a cultural shift that is painful and disturbing.  It is a shift that is going to take place, one way or another, and just pursuing the same goals over and over will only exacerbate the pain and the disturbance over time.  And, the constant advancements of information technology will just add to this.  

Shultz is arguing that the “Tax Reform Act of 1986” needs to be revised and reformed, not extended and made more complex.  He argues that “a simplification of the code would allow Congress to lower rates on a ‘revenue-neutral’ basis, while economic expansion would boost tax receipts.

“You’ll get a gusher,” Shultz said. “If you get this kind of stimulative tax policy and other things into effect, there will be a response and revenue will come in.”

 It seems as if “wealthy people and the GEs of the world” will play ball with you when they feel that they are not being singled out and picked on.  Otherwise, out will come the lawyers and the financial advisors and we get results similar to the ones described above.  The problem is that in proposing these changes in the tax codes as Obama has done or creating an environment of inflation, things just don’t stay the same. 

The politician is subject to the same fallacy that is faced by the economist conducting his deductive reasoning.  It is the problem of “ceteris paribus”, the assumption that “all else stays the same.”   When you change the tax code or the inflationary environment, all else does not remain the same.  As a result, you often find yourself facing the problem of “unintended consequences.”  You get results that you didn’t intend to get.  In the case of the economic policy over the past fifty years, you get higher levels of employment and under-employment than you wanted and greater inequality in the distribution of income/wealth. 

The current Obama tax plan is a journey into the past.