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John Makin

JP Morgan fiasco demonstrates the ineffectiveness of Dodd-Frank

By John Makin

May 11, 2012, 10:40 am

Coming on top of renewed turmoil in Europe that has increased the selling of European bank shares, JP Morgan’s announcement of a $2 b. trading loss, with more to come, sharply raises the perceived risks of U.S. bank shares. This news will severely undercut JPM’s reputation as the best-run U.S. bank and pushes global markets to another encounter with systemic risk.

The Fed faces a difficult choice. The need to counter the impact of financial uncertainty on the economy has risen, while the opposition to doing so has also increased in view of JP Morgan’s apparent willingness to embrace risks that it does not understand and/ or cannot manage. In the short run, expect Bernanke’s assurance that the system is sound and that the Fed stands ready to meet any liquidity needs. Over the longer term, the Fed will want to put bankers on a shorter tether, that limits proprietary trading.

At the very least, the JP Morgan fiasco demonstrates the ineffectiveness of Dodd-Frank as a viable guardian of financial stability. The problem is structural. Depository institutions that enjoy protection afforded by deposit insurance and their absolute large size—too big to fail—should not be allowed to engage in proprietary trading. Time to implement the Volcker rule.

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John Makin

Global stock markets are looking fragile

By John Makin

April 5, 2012, 4:35 pm

While U.S. economic signals were broadly positive this week, U.S. and European stocks have been wobbly since Tuesday. Yes, there are the usual worries about Europe’s debt problems–it’s Spain this week–and slower European growth, but the real scare for stocks and gold has come from hints out of the Fed and the ECB that they may not be ready to undertake still further easing–QE3 by the Fed or still more bank loans by the ECB–at the first sign of any economic slowdown.

The minutes of the last Fed policy meeting in March were released Tuesday (April 3) and they contained little in the way of assurances that more Fed easing can be seen as a forgone conclusion–as many in markets had apparently been assuming. The next day at his press conference after the ECB meeting, ECB President Mario Draghi was less than forthcoming on whether further accommodation could be assured. While comments from both central banks were decidedly not hawkish, the fact that the mere absence of a proactive doveish stance was enough to cause stocks to sell off suggests two things: First, the first quarter rise in stocks at or above 12 percent is fragile–tied as it was largely to higher price-earning multiples instead of higher earnings. Second, should the Fed or the ECB have to talk more specifically about actually removing monetary ease, say due to higher inflation, the result would be a nasty sell off in stock markets. That possibility, along with weaker European and Chinese economic data, is making investors nervous enough to ignore better U.S. economic numbers.

Bottom line: the second quarter won’t be as good for stocks as the first quarter was.

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John Makin

Can Japan finally overcome its own burst housing bubble?

By John Makin

March 5, 2012, 3:01 pm

Americans who are feeling the extreme pain of a burst housing bubble are finding it hard to regain lost optimism and, more concretely, are facing the realities of lost wealth, less availability of credit, and less mobility given struggles related to selling a house that is “upside down”—with the mortgage greater than the value of the house. As painful as America’s burst housing bubble has been, Japan’s bubble was even larger (see chart) and its bursting in 1990 led to over two decades of economic weakness and persistent deflation.

The damage from Japan’s burst housing bubble and the difficulty of trying to repair it has influenced Fed Chairman Bernanke’s response to the American house price collapse. In fact, the Fed has pursued more aggressive reflationary policies in response to the 2008 American house price collapse than the Bank of Japan.

At least until now. Given the recent very weak report on Japan’s GDP, which is shrinking at a 2.3 percent annual rate along with continuing deflation, a sharp drop in exports, rising fears of a weaker global economy, and recent extra easing moves from the Fed and from Europe’s central bank, the Bank of Japan took the aggressive steps of announcing a sharp rise in the level of government bonds it would buy—effectively printing money to fund Japan’ s budget deficit—and setting an explicit inflation target of 1 percent.

The Bank of Japan’s extra-aggressive measures are testimony to two things. First, Japan’s housing bubble was bigger than America’s and its aftermath was at least as painful as the aftermath to America’s bubble has been, and considerably longer lasting. And second, the Bank of Japan has come to realize, perhaps with some impatient prodding from Japan’s beleaguered government, that the time for drastic measures is at hand.

So far, Japan’s stock market has jumped by about 10 percent this year, with much of the uptick coming after the extra stimulus measures from the Bank of Japan. The yen has weakened as well. While some will complain that Japan is trying to foster faster growth at the expense of its trading partners by pushing down the yen, if Japan, the world’s third-largest economy, can grow faster and exit deflation as a result of more aggressive monetary stimulus, it probably makes sense for other countries to withhold objections. It would be unwise to fight over the division of a bigger global output pie.

With the U.S. recovery still tepid, Europe slipping into a recession, and China trying, with varying degrees of success, to achieve a soft landing, it would surely come as a pleasant surprise to see a robust recovery in Japan.

For much more on the Japanese economy, see my new AEI Outlook.

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John Makin

What if the Fed had done nothing when the U.S. economy tanked?

By John Makin

February 15, 2012, 9:25 am

The Fed has been accused of risking higher inflation for having undertaken repeated rounds of rate cuts and quantitative easing since the 2008 Lehman crisis. The stimulus has been likened to a drug that will lead to a nasty inflation hangover with no benefits for the economy. Before jumping to the conclusion that the Fed has performed poorly after the financial crisis, it is important to consider alternative scenarios that might have followed from Fed inaction:

The Austrian school would say that if the Fed had remained inert after the Lehman crisis, prices would have fallen sharply at first, but expectations of a subsequent rise in prices (higher future expected inflation) would have pushed down real interest rates enough to stimulate investment. The higher investments and subsequent growth would lead to a self-sustaining recovery.

That experiment [waiting for prices to stop falling] went badly in the Great Depression [during 1931-32] and has gone badly in Japan over the past twenty years. Little empirical evidence exists for the Austrian counterfactual assumption that deflation leads to expected inflation. In any case, the economy and investors now heavily depend on low real interest rates, and abruptly withdrawing them could lead to financial collapse and deflation. This might be called cleansing the system, but unless prices somehow started to rise in the midst of an equity, housing, and economic collapse, a very doubtful outcome, we would face another Great Depression and some nasty bank failures. For better or worse, the Fed is stuck holding interest rates low and steady for at least another year, and probably longer.

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John Makin

AEI Debate Prep: Can China avoid a hard landing?

By John Makin

November 10, 2011, 4:33 pm

This post is part of an ongoing series preparing for the AEI/CNN/Heritage National Security & Foreign Policy GOP presidential debate on November 22. See the rest of the posts here.

China is heading for a hard landing in 2012 or 2013 for three reasons: Excess capacity tied to overstimulation of investment in export industries and weak domestic demand growth, a bursting speculative bubble in its real estate sector, and a sharp slowdown in global growth.

After the Lehman crisis, China engineered a massive—14 percent of GDP over two years—stimulus package aimed at boosting investment in export industries. Chinese households haven’t done much to boost demand for higher output because they continue to save a large portion of their incomes to cover health care, retirement, and education costs that are not provided for by the government. Consequently, China has more excess capacity in its export sector today than it had a few years ago.

The easy credit included in China’s stimulus package spilled over into the real estate sector, creating a real estate bubble. Inflation also began to rise, particularly for food and energy. Recently, China’s authorities have tightened credit to slow inflation. This has led to a sharp slowdown and some falling prices in China’s volatile property markets. The combination of excess capacity in its export sector and a bursting property market bubble has made Chinese growth vulnerable to a global slowdown.

The weakness of the U.S. economy in 2011 and, more important, the intensification of the European sovereign debt crisis since summer have sharply increased the risk of a Chinese hard landing. China’s response has been to mitigate its credit tightening policy. Meanwhile, Chinese resistance to further currency appreciation that continues to threaten export growth will grow. That said, the longer Europe’s debt crisis drags on with its depressing effect on growth, the greater the risk that collateral damage will spread to China. If China has been too slow in reversing its credit tightening, the weakness in domestic demand combined with falling demand for Chinese exports could mean that China’s inflation rapidly drops and deflation appears. The antidote—a weaker Chinese currency—could surprise everyone.

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John Makin

What’s the Fed supposed to do?

By John Makin

November 3, 2011, 9:56 am

The first question for Fed Chairman Bernanke at his post-FOMC press conference was about the rising criticism of Fed policy from congressional leaders and presidential candidates. He largely sidestepped the question by saying simply that “politics is politics” and remarking on the Fed’s need for independence on specific policy conducted within the framework of broad congressional oversight.

In fact, the Fed is in a bind given the rising tensions over the direction its policy should take in coming months. On the one hand, most of the criticism coming from Congress and Republican presidential candidates asserts that the Fed is risking runaway inflation and a dollar collapse following QE2 and Operation Twist—its latest easing steps. On the other hand, as the Fed noted in its latest FOMC policy statement, “there are significant downside risks to the economic outlook, including strains in global financial markets”—the intensifying European sovereign debt crisis and the bankruptcy filing this week of MF Global. Meanwhile, year-over-year core inflation has stabilized at 2 percent, right where the Fed has consistently said it wanted to see it. Core inflation has begun to slow, with the latest month’s annualized rate at below 1 percent. (See chart.) Long run market measures of expected inflation have dropped sharply since summer.

At some point, Chairman Bernanke will have to confront his critics by asking what they would have him do in the face of significant downside risks to the economy, persistent high unemployment, and an absence of runaway inflation or a dollar collapse. What would markets have done today if the Fed had announced plans for some form of tightening—higher interest rate targets or reserve draining? It’s a pretty safe bet that we would have seen a sharp collapse in stock prices and a stronger dollar. Is that what the politicians want?

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John Makin

AEI Debate Prep: Contain the crisis

By John Makin

October 31, 2011, 1:03 pm

This post is part of an ongoing series preparing for the AEI/CNN/Heritage National Security & Foreign Policy GOP presidential debate on November 22nd. See the rest of the posts here.

Europe’s financial crisis has raised uncertainty in financial markets globally. The result has been to slow growth even in Germany, Europe’s strongest economy. The longer the financial crisis in Europe drags on, the greater the risk of a European economic collapse with substantial additional negative spillover effects on the United States and the rest of the global economy.

The financial crisis in Europe has resulted from the attempt to impose a single money on such disparate economies as Germany and Greece. Europe’s single currency regime has meant that Greece—along with some other European countries—has borrowed more than it can repay. With European banks and even the European central banks holding large amounts of risky sovereign debt, financial sector risks have risen to a point where they are harming economic growth.

So far the approach to Europe’s debt crisis has been to have richer countries—essentially Germany—lend more to Greece so it can continue to service its debt. However, the condition for such aid has been sharp fiscal retrenchment in Greece, which has caused the economy to collapse and created the riots being seen in news media. Better to recognize that Greece is insolvent, write down its debt, and contain the crisis there than to keep supplying Greece with the funds to service an ever-increasing level of debt. While not a pleasant outcome, such decisive steps could help to keep Greece’s debt crisis from spreading even further—to Portugal, Spain, and Italy—and thereby threatening to precipitate a European economic collapse.

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John Makin

Learning From Employment Surprises

By John Makin

October 7, 2011, 1:15 pm

The September employment report was better than expected and substantially better than my own forecast for zero employment growth. September job growth was reported at 103,000, a level 43,000 above the consensus forecast. Employment increases for July and August were revised up by a total of 97,000. As a result, average per month employment growth over the most recent three months rose from 35,000 per month in August to 96,000 in September.

What should market participants and policy makers take away from this positive surprise? First, keep it in perspective. The average monthly employment increase over the past year has been 124,000, so employment growth certainly isn’t taking off. It takes persistent monthly employment increases of 150,000 or better to bring down the unemployment rate that is of so much concern to policy makers in Washington, not to mention struggling households across the United States. September’s employment report, provided it is not substantially revised, tells us that the pace of weakening in the labor market is lower than what was thought a month ago. That said, we still need credible tax reform, deficit reduction, and relief from new regulatory burdens and Europe’s debt crisis.

The need for continued improvement on the policy front was signaled by the market response to the employment report. Interest rates on safe haven Treasury bonds rose as investors’ concerns about a possible U.S. recession eased. But the stock market was flat to down, at least through midday as I write this post.

A little less fear about acute problems for the U.S. economy alongside continued concerns about underlying policy problems is perhaps a fair characterization of the market’s take on the latest employment data. Such a modest improvement in sentiment will evaporate if Europe’s sovereign debt crisis continues to upset financial markets as it has done for the last year and a half.

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John Makin

Zero Option: New Jobs Report Likely to Show Little Growth

By John Makin

October 6, 2011, 11:07 am

Tomorrow’s employment report will help to settle the debate about whether the United States is going to join Europe as a major economy slipping into recession as we head into the last months of 2011. The US stock market is on the cusp of entering bear market territory, having dipped briefly to a level below 20 percent off of its 2011 high earlier this week. European markets have already entered bear market territory, as have some Asian markets. Some constructive news on the US employment front would surely help to stabilize shaky global markets.

What can we expect from tomorrow’s report on September employment? Probably not much. The August report showed zero employment growth and a drop in total hours worked. Taking account of most of the indicators that help to predict employment growth, we’ll probably see an increase close to zero, even allowing for a 47,000 bump from returning Verizon strikers. The unemployment rate may rise from 9.1 percent to 9.2 percent. Numbers like these aren’t going to reassure anyone and the fears of an outright US recession by year-end will rise.

Now for the hard part. There isn’t a lot that can be done to improve the US employment picture at present. The Fed’s operation twist has given a boost to the bond market and pushed down interest rates, but that’s not going to do much to increase hiring because there is plenty of productive capacity around to satisfy waning demand growth. The president’s jobs package—don’t call it stimulus—won’t help because everyone knows it’s temporary and has to be paid for with unstimulus starting a year from now. Call it macro economic “cash for clunkers” that would offer up a brief boost followed by contraction.

Restoring employment growth requires at least three things. One, more certainty that would come from an improved financial environment and less regulatory burdens. Dodd Frank and healthcare legislation are increasing uncertainty. Second, we need tax reform—lower marginal tax rates financed by loophole closing—and credible long-term reductions in outlays on Social Security and entitlements. And, finally, Europe needs to contain its financial crisis. These are pretty tall orders, so for now I’d fasten my seat belt and hope that the continued slow growth and financial turbulence that has resulted from not addressing these problems will finally push governments to start doing things that help the economy instead of hurting it.

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John Makin

Taxes May Go Up This Year for Higher-Income Households and Businesses

By John Makin

January 21, 2011, 10:17 am

Many in the top U.S. tax bracket may think they dodged a tax increase with the recent extension of the so-called Bush tax cuts. But look at the front page of today’s New York Times and hang onto your wallets—and your chairs. State government officials, recently deprived of the huge transfers to their coffers under the first Obama stimulus plan, are now exploring legislative changes to permit them to declare bankruptcy, which they are now prohibited from doing. That would allow renegotiation of pension obligations as well as, possibly, some write-downs on their municipal bond obligations. That would amount to a tax on the upper-income households and small businesses that are the primary investors in munis, since the value of the tax exemption on muni bond interest is greatest for those with the highest tax rates. With an estimated $2.7 trillion in muni obligations outstanding, a haircut of, say, 20 percent would save those state governments nearly half a trillion dollars in the spending cuts they ought to be making in their bloated budgets, including their very generous pension plans for state retirees. That’s almost equal to the (over-)estimated $700 billion cost of a 10-year extension of Bush tax cuts for upper-income households and small businesses.

Muni bond write-downs would amount to “tax the rich” to pay for generous pensions for state employees. Those employees are better represented in Congress than are the “wealthy,” so the rhetoric could get pretty scary. However, if states want to continue to have access to funding in the muni market, someone had better step up and say that existing law—payments to muni holders come first—will not be changed. American states are not Greece. Their fiscal responsibilities can be managed through spending cuts and modification of absurdly generous pension plans. Now that states are faced with the spending cuts they ought to have made years ago, they are first going to try to get by with a familiar ploy of expropriating wealth from those who own their contractual obligations.

The Obama administration has been eager to point to the catastrophic consequences of a default on federal debt. What will they have to say about possible defaults on state government debt?

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John Makin

A Win-Win Solution to China’s Inflation Problem

By John Makin

January 19, 2011, 7:29 am

China’s President Hu Jintao, responding to questions posed by the Wall Street Journal and the Washington Post prior to his January 18–20 U.S. visit, broadly emphasized the need for cooperation with the United States, but called for changes in the international currency system, proclaiming it “the product of the past.” With $2.85 trillion of foreign exchange reserves, much of it in dollars, China is said to fear that loose U.S. monetary policy could lead to inflation. In truth, a win-win solution to China’s inflation problem that also enhances the global role of China’s currency is within its grasp.

Currently, the U.S. Federal Reserve is pursuing an expansionary monetary policy designed to combat a near-deflation situation in the United States, where the annualized core inflation rate over the last 3 months is a mere 0.3 percent. Meanwhile, China’s annualized inflation rate over the last three months is over 10 percent. The reason? China is importing U.S. easy-money policy—a policy that is appropriate for the United States but inappropriate for China—by virtue of its currency peg to the U.S. dollar. That peg essentially means that the U.S. Fed is acting as China’s central bank. China’s prohibition on capital outflows in the face of its large current account surplus and substantial capital inflows creates a huge net inflow of funds that boosts money and credit growth and thereby boosts inflation.

China could help control its inflation while moving toward its stated goal of enhancing the international role of its currency, the yuan, by moving to full currency convertibility. That would mean that China’s skillful private investors could move more funds abroad, thereby diversifying their holdings while reducing inflationary money flows into China. With freer flows of international goods and capital, China could move toward a freely flexible currency—a step that would insulate it from U.S. monetary policy while simultaneously allowing its domestic investors to diversify holdings into more productive uses than speculative purchases of empty apartments.

A floating yuan with free international flows of goods, services, and capital would provide China with better resource allocation between traded and non-traded goods sectors, as well as much-needed international diversification for Chinese investors. Under the current arrangement, China allocates too many resources to its traded goods sector (exports and imports) and, by preventing capital outflows, forces too much saving at home. Better to let Chinese investors diversify globally. The resulting capital outflows will benefit China by reducing inflation while increasing China’s stake in the global economy.

The necessary conditions for China to achieve its goal of fully internationalizing its currency include the free flows of goods and capital that full yuan convertibility would entail. The model that worked for the United Kingdom as mentor of the pound sterling’s role as a global currency prior to World War II and for the United States and the dollar since World War II could work for China.

China is the world’s second-largest economy. It is time for it to develop a world-class currency and financial system. Allowing free capital flows and currency pricing would be a huge step in that direction. So the question really is this: is President Hu Jintao ready to leap to a currency and financial system that is not a “product of the past?”

Note: Look for more on China’s currency option in the February Economic Outlook.

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