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Tuesday, August 10, 2010

Transcript: 399 On the brink with European CDS's and US commercial real estate?

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One of the elements of the current economy, according to the Demand Side assessment, is the continuing fragility of the banking sector. We suggested in our forecast last January that new financial crises could be triggered by breakdowns in Europe's handling of its sovereign debt or in the non-too-big banks and their exposure to dropping commercial real estate values. Last week we even devoted a good part of the podcast to the possibility of a new Greek debt crisis starting the fall of a trail of dominoes through credit default swaps and ending in the fall of banks worldwide.

Today, we review and retrench on that. Also a critical review of the new paper by Alan Blinder and Mark Zandi and its hopeful title "How the Great Recession Was Brought to an End."

Since the first of the year, Demand Side has been concerned about a new financial crisis emanating from either the European sovereign debt mess or U.S. commercial real estate as it affects the not-too-big-too-fail banks.

On point one, we made a big deal last week of how the banking system is poised for defeat should it be required to digest the credit default swaps written on Greek bonds. We suspected, along with Carl Weinberg, that the IMF would come into Athens with its green eyeshades and find the Greek response wanting and trigger a restructuring, which is a default event.

Instead the IMF took only a few days to give Greece a high five on the “strong start” they’ve made in cutting their deficit and in reward for this “great progress” they will get the next tranche as scheduled in September.

Quoting a news account:

Greece makes 'strong start' on reforms
By Kerin Hope in Athens

Greece has won praise from the International Monetary Fund for making a “strong start” to implementing a three-year programme of fiscal and structural reforms aimed at overcoming its debt crisis.

Oh, wait, that was from July. Here's the one from after their visit.

Greece in "strong start" implementing austerity measures: IMF
Aug 5, 2010, 11:20 GMT

Athens/Brussels - Greece has made a 'strong start' in implementing austerity measures and structural reforms to cut its massive deficit but still faces many challenges, European and International Monetary Fund inspectors said Thursday.

The group of EU/IMF officials wrapped up a two-week review of Greece's austerity programme to determined whether it should qualify for a 9-billion euros installment of emergency loans.

The 'performance criteria have all been met, led by a vigorous implementation of the fiscal programme and important reforms are ahead of schedule,' the EU, IMF and European Central Bank officials said in a joint statement.

'Our overall assessment is that the programme has made a strong start.'

IMF official Poul Thomsen told journalists that he was confident Greece would receive the next installment of a three-year, 110 billion euro rescue package.

Athens hopes to receive the 9 billion euro installment by September 13. In exchange, Athens has been implementing a set of austerity measures that range from pension and pay cuts to increases in taxes.

The delegation applauded Greece's progress, saying the government was ahead if its targets in many areas but also warned that the country still faced 'important challenges and risks.'

In their review, the EU/IMF said that while Greek authorities have kept spending significantly below budget limits at the state level they still need to control expenditures at the sub-national level, namely local governments, hospitals and social security funds.

And so on with the austerity bleeding and leeches prescribed by these economic physicians


The commercial real estate market’s pricing has been a tale of two worlds with the largest metro markets attracting significant institutional capital and forcing prices upward over the first two quarters of 2010, while the broader market has continued to soften. This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets, says Calculated Risk.

The collapse of commercial real estate prices is real and will continue, but it may not trigger the kind of meltdown that residential property did, because there is more ability of the smaller banks to renegotiate the terms and write down the loans to keep those properties working. Commercial Mortgage Backed Securities may also be more amenable to unpacking and dealing with rationally.

We'll see. CR also notes, though we have lost the link:

Distress is becoming a bigger factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.


On the forecast segment this week, we take note of a hopeful title from the redoubtable duo of Mark Zandi and Alan Blinder. "How the Great Recession Was Brought to an End."

To our mind the Great Recession is not at an end, but is continuing and worsening. Zandi and Blinder may achieve a place in history alongside Irving Fisher and his "permanent high plateau." That said, and noting that Fisher contributed a great deal, including the concept of debt-deflation, there is much in the new paper to like and dislike.

It offers strong evidence that the economy was significantly helped by the ARRA.

Evidence for help from the financial sector bailout regime indicates it had a much stronger impact than the fiscal policy response. Here we object. A legitimate counterfactual is not included. The baseline is compared with a condition of "No policy response." The possibility of no policy response did not exist. The chief alternative was a nationalization of the banks.

Blinder and Zandi begin:
The U.S. government’s response to the financial crisis and ensuing Great Recession included some of the most aggressive fiscal and monetary policies in history. The response was multifaceted and bipartisan, involving the Federal Reserve, Congress, and two administrations. Yet almost every one of these policy initiatives remain controversial to this day, with critics calling them misguided, ineffective or both. The debate over these policies is crucial because, with the economy still weak, more government support may be needed, as seen recently in both the extension of unemployment benefits and the Fed’s consideration of further easing.

Absent from this treatment and any other we have seen is an appreciation of the stability provided by the policy regime surviving from the New Deal. That is, demand has a floor from social security and unemployment insurance, and the bit of financial regulation that survived deregulation, most notably the FDIC, has been a major tool of financial sector stability. Absent these programs, Great Depression 2.0 might be much closer.

That said, the ultimate cost and the worst case downside described by Blinder and Zandi assumes, we believe incorrectly, a natural force toward equilibrium. Absent ANY policy response, they suggest, output and employment would return to an upward slope. Irving Fisher would not agree. Nor do we. Absent policy action, even in the current situation, there will be no return to a positive economic trajectory.

Let's leave it to you to analyze the paper for yourself, link on line, while we pick out some of the more interesting of the findings:

"The effort to end the recession and jump-start the recovery was built around a series of fiscal stimulus measures," they say. "Tax rebate checks were mailed to lower- and middle-income households in the spring of 2008; the American Redevelopment and Recovery Act (ARRA) was passed in early 2009; and several smaller stimulus measures became law in late 2009 and early 2010. In all, close to $1 trillion, roughly 7 percent of GDP, will be spent on fiscal stimulus. The stimulus has done what it was supposed to do: end the Great Recession and spur recovery. We do not believe it a coincidence that the turnaround from recession to recovery occurred last summer, just as the ARRA was providing its maximum economic benefit."

This is a good point. We have said that stimulus spending is had its maximum effect in Q2 2010. Blinder and Zandi say summer of 2009. We might compromise with the biggest bang for the buck occurred in 2010, while the biggest number of bucks flew out in 2009.

Absent a policy response, Blinder and Zandi describe a GDP that would have been negative through 2010. In fact, GDP returned to positive territory in Q3 of 2009. Absent a policy response, they say, more than eight million more jobs would have been lost by the end of 2010, roughly twice the actual loss, and the unemployment rate would peak at 16.3 percent in 2011, compared to their projection of 9.8 percent. Plus deflation would have continued into 2011.

More than half of the positive effect is attributed by Zandi and Blinder to the financial policy response. This suffers, as we said, from the supposition that there would have been no response absent the full-scale bailout of banks, when in fact, the likely alternative was a more effective policy. But that said, it is not the scale of its effect, but its costs -- both past and going forward -- that we most disagree with. In particular, we question whether the Federal Reserve's massive purchases of securities and its guarantees of credit, its zero interest rate and a too big to fail insurance policy that remains for the biggest banks that is neither efficient nor costless. Blinder and Zandi estimate total cost at $15 billion.

We look forward to the audit of the Fed, mandated in the recent Financial Regulation Bill, to come up with a more sensible estimate.

To us, some of the most intersting stuff comes buried here at the end. An estimate of the multipliers for various programs and functions. Sometimes referred to as "the bang for the buck," we use it to gauge the outcomes of all kinds of economic events. Blinder and Zandi look at two categories -- tax cuts and direct government spending.

With regard to tax cuts, estimates of the multiplier range from 1.30 to 0.32. Best was judged to be a job Tax Credit at 1.30, followed closely by the payroll tax holiday and refundable lump-sum tax rebates. Coming in at or below 1.0, that is, you could buy hamburgers and do as well, are across the board tax cuts and the housing tax credit. Way down there, below 0.50, that is, benefitting the recipient at a net cost to the economy, are the tax cuts for the rich and the business subsidies. These include extention to the alternative minimum tax patch, making the Bush tax cuts permanent, making dividend and capital gains tax cuts permanent, cuts in the corporate tax rate and -- at 0.22 and 0.25 respectively -- the business friendly tax cuts of loss carryback and accelereated depreciation.

Bottom line: All tax cuts are not equal

Contrast the bang for the buck from actual spending. Work share programs, unemployment insurance extensions, infrastrucutre spending and food stamps all contribute above 1.57 per one dollar. General aid to state governments is estimated at only 1.41. We assume this has to do with states gaming the system, because this ought to be at the top if all aid were passed through without reducing anticipated spending from other sources.

This demonstrates, to us, at least, the effective way out, because the multipliers work in reverse as well. Curtailing costly tax benefits to the rich and to business and transferring the revenue to spending and to middle class tax benefits is a revenue neutral way of generating more economic activity. Specifically, creating jobs directly, building infrastructure, supporting states and municipalities, and strengthening the social safety net work. Middle income tax benefits kind of work. High end and business tax cuts do not work.

Next week, the light of common sense comes to Rogoff and Reinhardt's popular, superficial and alarmist analysis in "This Time It's Different," the book that brought you a straight line from government debt to economic collapse and default. The straight line may be there, but the head of the arrow is on the opposite end.

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