Paul Krugman: Debt and Denial

Paul Krugman is worried that Ben Bernanke has inherited a difficult set of economic conditions due to ballooning trade and budget deficits, housing bubble zones, and denial among economic agents creating these conditions. Because of this, Krugman is worried about a hard-landing outcome for the U.S. economy. I have more faith in the soft landing scenario than he does, but perhaps that's wishful thinking or denial on my part. In any case, this time I hope Krugman is wrong:

Debt and Denial, Commentary, by Paul Krugman, NY Times: Last year America spent 57 percent more than it earned on world markets. That is, our imports were 57 percent larger than our exports. How did we manage to live so far beyond our means? By running up debts to Japan, China and Middle Eastern oil producers. ... Sometimes large-scale foreign borrowing makes sense. ... But this time our overseas borrowing isn't financing an investment boom: ... business investment is actually low by historical standards. Instead, we're using borrowed money to build houses, buy consumer goods and, of course, finance the federal budget deficit.

In 2005 spending on home construction as a percentage of G.D.P. reached its highest level in more than 50 years. People who already own houses are treating them like A.T.M.'s, converting home equity into spending money: last year the personal savings rate fell below zero for the first time since 1933. And it's a sign of our degraded fiscal state that the Bush administration actually boasted about a 2005 budget deficit of more than $300 billion, because it was a bit lower than the 2004 deficit.

It all sounds unsustainable. And it is. Some people insist that the U.S. economy has hidden savings that official statistics fail to capture. I won't go into the technical debate about these claims ... except to say that the more closely one looks at the facts, the less plausible the "don't worry, be happy" hypothesis looks.

Denial takes a more systematic form within the federal government... Last week Mr. Cheney announced that a newly created division within the Treasury Department would show that tax cuts increase, not reduce, federal revenue. That's the Bush-Cheney way: decide on your conclusions first, then demand that analysts produce evidence supporting those conclusions.

But serious analysts know that America's borrowing binge is unsustainable. ... So how bad will it be? It depends on how the binge ends. If it tapers off gradually, the U.S. economy will be able to shift workers out of sectors that have benefited from the housing boom and ... into sectors that produce exports or replace imports. Given time, we could bring the trade deficit down and bring housing back to earth without a net loss in jobs.

In practice, however, a "soft landing" looks unlikely, because too many economic players have unrealistic expectations. This is true of international investors, who are still snapping up U.S. bonds ... seemingly oblivious both to the budget deficit and to the consensus view ... that the dollar will eventually have to fall 30 percent or more to eliminate the trade deficit.

It's equally true of American home buyers. Most Americans live in regions where housing remains affordable. But ... most of the rise in housing values has taken place in a "bubble zone" along the coasts, where housing prices have risen far more than the economic fundamentals warrant. ... houses in the bubble zone are overvalued by between 35 and 40 percent, creating trillions of dollars of illusory wealth.

So it seems all too likely that America's borrowing binge will end with a bang, not a whimper, that spending will suddenly drop off as both the bond market and the housing market experience rude awakenings. If that happens, the economic consequences will be ugly. All in all, Alan Greenspan, who helped create this situation, can consider himself lucky that he's safely out of office, giving briefings to hedge fund managers at $250,000 a pop. And his successor may be in for a rough ride. Best wishes and good luck, Ben; you may need it.

Previous (2/10) column: Paul Krugman:  The Vanishing Future
Next (2/20) Column: Paul Krugman: The Mensch Gap

Comments

[dryfly]

I have more faith in the soft landing scenario than he does, but perhaps that's wishful thinking or denial on my part. In any case, this time I hope Krugman is wrong

Every time I hear somebody mention 'hard' or 'soft' landings I want ask them what they mean by 'hard' and 'soft'... is Hard like 30s? Late 70s? Early 90s? What is easy like? Mid-90s? Mid-80s?

If we had that agreed to then we could better discuss whether it would be hard or soft...

[cm]

dryfly: Soft as in "you jump from the 3rd floor and I watch it".

[anne]

Whether soft or hard will be important, but more important still is how to structure a portfolio to account for either.

[rob]

One thing that worries me is that the US not only spends more than it earns, but spends it on things that do not create future foreign returns: housing, military, consumer goods.
Building up debt to invest will keep your bankers more confident than building up debt to consume.
And a soft landing will depend on the confidence of the lenders.

[ziz]

Senator Byrd said that Congress is not an ATM.

Looks like nobody is listening ... the capacity of this administration to spend and build debt is without limit... in my view reckless.

But what do I know?

[Charlie]

I can't argue the facts. The dollars future isn't looking too good. I think the best case for a soft landing scenario is it's in everyone's best interest. Our major creditors need us more than we need them; so I don't see them foreclosing on us.

[Bruce Webb]

Not to beat a dead horse, but hard or soft is going to be determined in large part by actual financing needs in the years between 2011 and 2023, all btw within the window of the newly reissued 30 year bond. Your views on the viability of continued foreign borrowing will vary substantially depending on which path you expect the Trust Fund to take: cash cow or looming disaster.

I didn't link much to this piece when I wrote it last April but it might interest one or two of you given this context Solvency and the Long Bond: Economic Life after Crisis

[anne]

Interestingly, the international value of the dollar over the last 10 years has remarkably stable. An international basket of stocks has increased in value 6.9% a year in domestic currency terms and 6.5% in dollars, so actually the value of the dollar is a little higher now than 10 years ago. The dollar rises and falls in value, so why should we be all that concerned?

[anne]

There is no foreclosing on bonds. A bond holder can always choose to buy no more or even sell bonds, and that will effect interest rates at least for a while, but there is the Federal Reserve to compensate and while I am not at all pleased with the terrible Republican budgets we have had and will continue to have, I do not finds signs of a near term problem and besides a point of portfolio managing is to protect against pronounced economic changes and that can be done.

[Elaine Meinel Supkis]

The dollar is "stable" because the Japanese and Chinese squirrel it all away so they won't have their own currencies rise! GEEZE.

This is deadly!

They then loan the dollars back to us so we can destroy our industrial base buying stuff from both of them that is cheaper than in reality thanks to them squirreling away our dollars and giving us loans. This circular conspiracy is killing America and the Fed is happily, along with Congress and Bush, doing this because the loans are cheaper than inflation, ie, the rate we grind out paper dollars!

So we appear to be getting "richer" when we ain't. And this will show up in due time when China drops their end of the deal which they plan on doing when it will cause the greatest damage to our power.

Already, our power is fading, we don't control events except when we attack countries and even then, it fails!

[Emmanuel]

I'm kind of glad that Krugman has done something focused on international economics instead of his usual fare. After all, he did write the book (now in its seventh edition) on the topic with Maurice Obstfeld. If PK says it's going to be a hard landing, then I am inclined to think that it will be so.

[d]

If you want a soft landing, be out of debt and pay cash for things for a while. If you want a hard landing, just keep borrowing and spending. I think hard and soft are going to be very individual things this time around.

[dryfly]

Whether soft or hard will be important, but more important still is how to structure a portfolio to account for either.

Most of my neighbors won't have 'portfolios' a month or two into it if the landing is 'hard' by almost anyone's classification.

While portfolio management might be a worthy concern for those with assets... most folks have so little that if the equity in their home evaporates the LAST thing they will be thinking about is their portfolio... they will be far too concerned about where they scratch together the coins for tonights dinner.

I've seen it up close - it isn't pretty.

[Yartrebo]

"If you want a soft landing, be out of debt and pay cash for things for a while. If you want a hard landing, just keep borrowing and spending. I think hard and soft are going to be very individual things this time around."
- d

The US is already deeper in debt (relative to GDP) than it was in the summer of 1929 and I believe that even if we tried very hard to turn around our dissavings and deficits today, we cannot avoid another depression much like the 1930's one.

However, the longer we continue down the borrow and spend route, the worse the eventual depression will be. The Great Depression was bad, but it is no cieling to how badly things may go if pushed hard enough. Given our reliance on crucial oil and semiconductor imports, a dollar crash (which will happen if we try to inflate our way out of our mess) will force us quite quickly to 3rd world status. Nearly our entire economy is services, which cannot be traded for hard imports.

[dryfly]

Nearly our entire economy is services, which cannot be traded for hard imports.

Exactly.

And even though we have plenty of land to grow food, without oil it gets tough. The good news is there are domestic substitutions for 'oil energy inputs'... people. Labor substitutes for fuel. Composted manure substitutes for oil based ferilizers.

So no matter how bad things get if we work at it correctly we won't starve... but it will be hell. I read once that it took a young fit man about 6 weeks working dawn to dusk, 6 days a week to plow & plant a quarter section on the prairie prior to mechanization. I believe that was with the assistance of a mule too. That's about a days work with modern machinery (and favorable weather).

I don't know if that's true but when I was in high school we would do 'day labor' and 'walk beans'... meaning talk the rows of soybean fields & hoe out weeds. That was before Round Up Ready GM variaties so back then pesticides couldn't be sprayed after the plants had emerged so far (kill both the crop & the weeds). Anyway the farmer we worked for had a couple full sections (way more land than the pioneer example) and we didn't work anything like dawn to dusk... but then there would be a half dozen of us and all we had to do was walk & occasionally hoe, not plow... and it still would take weeks to complete the whole field.

I know it is silly of me to imply that the future will completely revert to the past and well all go back to being pioneers - we know that won't happen. But the point is many of the routine things we do today will change forever - stuff will still have to get done but a lot of it won't be very pleasent - IF the landing is hard enough. Multiply this across the whole economic spectrum and we can get an idea of how serious this could be.

[ilsm]

Dryfly,

Agree with your Ford/GM post. Very important for economists to get a little micro and understand lean, and pull.

We may see a return of victory gardens. Grow more local, reinvigorate the local dairy industry in Northeast, more truck farms in New Jersey, etc.

Get a little less concerned about what to do with reactor waste and get natural gas into making fertilizer.

Look to oil sands and oil shale. Look into gasifying some of the 300 years worth of coal we have between WV, Mont and Pa.

Lots of options and if OPEC and the Gulf oil sellers start going market on us like in the 80's and lower prices to eliminate long term shifts away from petroleum, we should roll out tariffs.

[slink]

polonian honor roll:

anne:

"Whether soft or hard will be important, but more important still is how to structure a portfolio to account for either"

" a point of portfolio managing
is to protect against pronounced economic changes
and that can be done"

dry fly:

"no matter how bad things get if we work at it correctly we won't starve"

d:

"If you want a soft landing, be out of debt
and pay cash "

[dd]

Anne asks about portfolio diversification. My question is whether institutional diversification is equally important. Investment banks and their mutual funds are not federally insured (brokerage is SPIC but no overall FDIC or PGBC). If we were to have a 1929 repeat liquidity could be an issue for those funds and institutions. I believe they are also repositories for the vast majority of retirement accounts (401k/IRA/Roth). For example Capital Group is having outflow problems and Refco has devolved into an issue of whether brokerage clients of the unregulated unit are mere unsecured creditors. There are many complicated issues surrounding the intersection of retirement accounts and institutional liquidity that are not well understood by account holders. Any thoughts?

[dryfly]

If we were to have a 1929 repeat liquidity could be an issue for those funds and institutions.

Diversification in that case means put some in the tomato can burried in the backyard... some under the mattress... a little more in the hollow tree... etc.

[anne]

The question of liquidity would seem to involve whether a parent company can borrow against client assets. Can Merrill Lynch, which is going to partially sell its management component, borrow against assets invested? Interersting question, about which I have no immediate answer but will ask. I am struck by the partial sale of the Merrill unit, and the cost of involved to investors to make the purchase profitable, for I am not the least pleased by the "for profit" mutual fund industry.

[anne]

http://www.nytimes.com/2006/02/13/business/13deal.html?ex=1297486800&en=63d4f73c1484a8bb&ei=5090&partner=rssuserland&emc=rss

February 13, 2006

Merrill and BlackRock Are Said to Be Near Deal
By LANDON THOMAS Jr.

Merrill Lynch is nearing a deal to sell its asset management division to BlackRock, a fast-growing fund manager, in exchange for a large stake in the company, according to people close to the discussions.

The deal, which could be completed this week, would be a coup for Merrill Lynch and a disappointment for John J. Mack, the chief executive of Morgan Stanley, who just weeks ago had pursued a similar agreement with BlackRock and its chief executive, Laurence D. Fink.

The transaction would quickly elevate BlackRock into the upper echelon of asset management companies, giving it an asset base approaching $1 trillion, the most of any publicly traded fund company....

[anne]

David Swensen is highly critical of the investor costs of money management companies, and I completely agree. Then, for Merrill Lynch investors who already pay absurd fees for management, how will Black Rock make up the cost of the purchase of Merrill, of your, assets? Investment cost is a most serious matter here and internationally, and is the reason indexing and Vanguard offers such a boon to investors. Imagine paying a 2% to 5% fee, before management costs, simply to invest in a bond fund, with interest rates not much higher if higher at all.

[anne]

Who wins, who loses....

http://www.nytimes.com/2006/02/14/business/14place.html?ex=1297573200&en=bafd3d6fa9813878&ei=5090&partner=rssuserland&emc=rss

February 14, 2006

Merrill and BlackRock Deal Draws Cheers on Wall St.
By LANDON THOMAS Jr.

For most big deals on Wall Street, the market picks a winner and a loser. Yesterday, however, investors and analysts declared both Merrill Lynch and BlackRock victorious on word that the two companies were nearing a deal to combine their fund operations.

Shares of BlackRock, the fast-growing asset management firm, soared 8 percent, to $141.99, as investors embraced the firm's emergence as the largest publicly traded fund company. The stock has risen nearly 34 percent so far this year.

Merrill's stock increased 1.4 percent, closing at $73.83. Merrill's advance, more muted than BlackRock's, was still indicative of a growing acceptance on Wall Street that large investment banks will continue to move away from the financial supermarket model and focus on areas of core expertise instead....

In the transaction, Merrill would sell its $539 billion in fund assets to BlackRock in exchange for a minority stake of just under 50 percent, people involved in the talks said. BlackRock's asset base would increase to almost $1 trillion, while Merrill would secure for itself a stake in a larger, more valuable fund entity and gain access to a variety of new mutual funds to sell to clients.

"I don't see any losers," said Richard X. Bove, an analyst with Punk, Ziegel & Company. "Merrill takes a division that had little value and creates value by selling it to BlackRock," he said. "And BlackRock now has a currency to buy other firms." ...

[dd]

Anne, my concern is that borrowing takes on many guises. Derivatives are a betting cum leveraging tool that put assets at risk with little disclosure, obscure bad judgment, and encourage short term profit for long term risk. Derivatives are now a mainstay of financial management; but like securities in the 1920's, they are unregulated. So we have in place an eerily familiar scenario: an unregulated financial instrument with unlimited leveraging power; vast pools of available uninsured capital (mutual/money market funds); a trusting public; and no regulations governing how the instruments are created or traded.

[anne]

Here, on derivatives, I anticipated where you were going, and will be treated to a lunch :) in hopeful partial explanation of your question. As such derivatives are credit extensions, and derivative use by money management companies is massive and complex and costly.

[dd]

I'm glad my musings have produced a positive result. Have a great lunch! I look forward to any insights gained.

[Lucy]

I've been working my way through impossibly worded releases and balance sheets from the BEA, IMF and treasury since July; now I think I have it figured out and 'Dark Matter' appears. To someone economically illiterate, it can be daunting. The US is selling off toll roads to the Eurpoeans, is it the intention of the government to wait until we lose soveriegnty to do something beside move numbers around and doubletalk about this?

[anne]

Lucy :)

http://www.nytimes.com/2006/01/20/business/20bank.html?ex=1295413200&en=4a76deb75973919d&ei=5090&partner=rssuserland&emc=rss

January 20, 2006

Turning Asphalt to Gold
By JENNY ANDERSON

In late 2004, Goldman Sachs advised the city of Chicago on the $1.83 billion sale of a 99-year concession for its Skyway toll road. For its work, the firm received a nice $9 million fee. More important, Goldman also got inspiration.

Across the negotiating table was an Australian bank that until recently was little known outside its home country: Macquarie Bank. In recent years, Macquarie has become the envy of Wall Street by buying the rights to operate infrastructure projects including ports, tunnels and airports, as well as toll roads, packaging them in funds and reselling the stock in those funds to the public, minting money at each stage along the way.

Now Goldman is raising a $3 billion fund to invest in similar public infrastructure deals. Another unit of the bank recently bid on a public-private partnership to run the Dulles Toll Road outside Washington. Mark B. Florian, the municipal finance banker who advised Chicago on the Skyway deal, has moved to New York to oversee the bank's efforts to advise on, invest in and better understand infrastructure assets.

And Goldman is not alone. If imitation is the sincerest form of flattery, the best and brightest of Wall Street are for once not complimenting each other, but an outsider on the rise. Credit Suisse, Merrill Lynch, Morgan Stanley and UBS are all in different stages of exploring how to make money on public infrastructure, both as an adviser to others and as a principal in investing in the deals.

Credit Suisse is looking at how to leverage its expertise in buying real estate and advising on the sale of airports; both UBS and Credit Suisse are trying to gauge whether their big private banking clients would be interested in the assets.

"Before anyone else, Macquarie saw the potential of the U.S. market," said Robert W. Poole Jr., the director of transportation studies at the Reason Foundation, a libertarian research group. "They have the most robust model of highways as a new utility that can be an investor-owned utility like gas and electric utilities."

With local and state governments in the United States in search of ways to increase revenue without raising taxes or issuing bonds, public-private partnerships have recently become a hot-ticket investment idea....

[anne]

http://www.calvorn.com/gallery/photo.php?photo=5340&offset_finder=1&u=24039

Worm-eating Warbler Singing
New York City--Central Park, North Woods.

Thanks, DD :)

[Ran]

"Diversification in that case means put some in the tomato can burried in the backyard... some under the mattress... a little more in the hollow tree... etc."

ummm...not if the dollar goes down in value. I would say that would be gold or other precious metals.

[R. Philippsborn]

While I generally agree with the opinions of Krugman and Sloan questioning the likelihood of a "soft landing" in housing and raising the possibility of recession, a factor that everyone seems to be overlooking is the widespread extent of questionable, not to mention outright fraudulant, practices in the mortgage and real estate industries. If you've ever wondered how so many people can afford such expensive houses, the answer is simple: They can't. But every realtor knows a mortgage broker who will qualify just about anyone, because (1) they, in turn, know an appraiser who will provide whatever valuation is required, and (2) they're going to pocket their commission and resell the loan anyway. Let's add it all up: A lot of people are living in houses they can barely afford and extremely vulnerable to mortgage rate hikes, investers who make up a significant percentage of the "froth" (many of who are realtors and real estate brokers and not above bending the rules themselves) are leaving a flattening market, and banks (and Fannie Mae) are going to be saddled with large numbers of non-performing loans and will have to auction off the foreclosures. Supply could quickly overwhelm demand, further driving down home valuations. So what happens to all the families that have borrowed against their equity? Didn't we learn ANYTHING from the Savings & Loan scandal??