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Belmont Club

The Crystal Ball

May 25th, 2010 - 7:15 am

Niall Ferguson in an article for Economic History Review asked why the bond market failed to anticipate World War 1 any better than anyone else. “The main question addressed [in the paper] is why political events appeared to affect the … the London bond market, much less between 1881 and 1914 than they had between 1843 and 1880. In particular, I ask why the outbreak of the First World War … was not apparently anticipated … To investors, the First World War truly came as a bolt from the blue.”

Nor was World War 2 any more obvious, except in some markets. Moreover Bruno Frey and Daniel Waldenstrom argue that with the possible exception of the Nordic countries it was unclear whether the bond markets were able to anticipate World War 2 despite the obvious impact such an event would have on sovereign debt.

But once the surprise was past, Frey and Waldenstrom showed that the markets were capable of drawing the obvious conclusions. Studying markets which stayed open for the duration of the war the professors found that major events in the conflict affected the prices of both German and Belgian bonds in obvious ways. Hitler’s offensive in 1940 raised the German bonds but depressed the Belgian while the defeat at Stanlingrad raised the Belgian but depressed the German. It is tempting to conjecture that the markets are no better at anticipating a ‘phase change’ than anyone else. But once the discontinuity has been crossed investors proved themselves fairly astute analysts of events across the more linear parts of the trajectory.

What can be said about the predictive power of markets today? The Wall Street Journal reports that a “combination of Korean tensions, Spanish bank health worries and inter-bank lending woes slammed U.S. stock futures”. Is the rising LIBOR rate predicting anything? Such as a second financial crisis? Maybe. But one complicating factor is that market signals have the ability to change the future by warning politicians of possible catastrophe. They send back an echo from the unseeable future that may alter present policies and thereby change the future.

James Pethokoukis, writing for Reuters says the “Greek debt crisis could save America” because the sad example of Greece may cause enough American politicians to have second thoughts about the wisdom of welfare states and rising deficits. Here the markets acting like a Crystal Ball, may yet keep America from that meeting in Samarra; or mayhap it may help ensure it in other ways. Yet if financial responsibility were wisdom it is sagacity compelled on politicians by the voters. Left to themselves they wouldn’t give it a damn. Pethokoukis is certain that American politicians would gladly ignore the even the prospect of the collapse of US bonds but for the certainty that the voters would resist more heedless spending.

Americans intuitively understand that there is something deeply wrong about running trillion-dollar budget deficits as far as the eye can see. Maybe deficits didn’t politically matter in the 1980s, but debt as a share of GDP was only 50 percent. Now it is 60 percent only its way to 100 percent in a decade.

This is why we didn’t see a second trillion-dollar stimulus. Although plenty of liberal economists though it was needed, even congressional Democrats understood that Stimulus 2.0 would not fly with voters freaked by all the red ink.

Second, America doesn’t need a domestic debt crisis. Voters can easily track the one happening with Greece and the EU. Runaway spending. Overpaid civil servants. A loss of confidence. Trillion-dollar bailouts. Falling standards of living. National decline.

Ultimately it is fear for their political hides and not a string of figures on a piece of paper that can make them see the sums. In this scenario the politicians are completely irrational but are saved from utter folly by reactions of the public, who in a strange way keep their betters in check, the way butlers kept wayward aristocrats from doing anything too stupid in the PG Wodehouse universe.  The voters take their cues from the somewhat rational markets and the dwindling state of their bank accounts and tell the politicians about the bad things ahead. Certainly the danger to the global economy is become obvious even from the summit.  CNBC reports that despite assurances from the US, China is worried about Europe. “The United States suggested Europe’s debt crisis would have minimal impact on global growth, but China took a more pessimistic view, warning it would impact demand for its exports and other regions would suffer too.” That would not be news to the general public. That the thought would occur to the exalted ones — that is news. The catastrophe is no longer unthinkable and paradoxically, therein lies the hope. A real sense of danger may avert the headlong race for the cliff.

The problem is whether the negative feedback will be strong enough to arrest the momentum. USA Today reported that private paychecks in America have fallen to historic lows while the government payroll has risen to unprecedented heights.

Paychecks from private business shrank to their smallest share of personal income in U.S. history during the first quarter of this year, a USA TODAY analysis of government data finds.

At the same time, government-provided benefits — from Social Security, unemployment insurance, food stamps and other programs — rose to a record high during the first three months of 2010.

Those records reflect a long-term trend accelerated by the recession and the federal stimulus program to counteract the downturn. The result is a major shift in the source of personal income from private wages to government programs.

The trend is not sustainable, says University of Michigan economist Donald Grimes. Reason: The federal government depends on private wages to generate income taxes to pay for its ever-more-expensive programs. Government-generated income is taxed at lower rates or not at all, he says. “This is really important,” Grimes says.

Especially to those who know how to take advantage of a growing government role. For some, the expanding size of government is a once-in-a-lifetime opportunity. The willingness of government to intervene creates a moral hazard that may be irresistible. For example, Robert Reich argues that the so-called financial reform bill still leaves the banking industry concentrated in a few large firms.  “That makes them too big to fail almost by definition, because if one or two get into trouble — as they did in 2008 — their demise would shake the foundations of the financial system, even if there were an “orderly” way to liquidate them. Because traders and investors know they are too big to fail, these banks have a huge competitive advantage over smaller banks.” That same dynamic has allowed Spain, California, Illinois and whoever else to trip carelessly through the financial fields, secure in the knowledge that the government will step in and rescue them — like the banks — from their own folly. The taxpayer’s always there for the ‘sake of stability’ or for the ‘sake of the children’.

All those government jobs come at an eventual price. Consider the pensions. The Financial Times reports that “state pensions are becoming a federal issue”. “Illinois used to have a plan to pay off the gaping shortfall in the pension funds that pay retired teachers, university employees, state workers, judges and politicians … But Illinois could not stick to the plan.”

Illinois is the poster child of unfunded pensions in the US. But state retirement systems could become a national concern, new research shows.

Joshua Rauh, associate professor of finance at the Kellogg School of Management at Northwestern University said that, without reform, some state pensions might run out within the decade. By 2030, as many as 31 states may not have the money to pay pensions. And, if these funds exhaust their assets, the size of payments for the benefits they have promised will be too large to cover through taxes, putting pressure on the federal government for a bail-out that could potentially cost more than $1,000bn, he says.

“It is more than a local problem,” Mr Rauh said. “The federal government could be on the hook.” Estimates put the unfunded liabilities at between $1,000bn and $3,000bn after years of states promising benefits but not contributing enough in both good times and bad to cover them.

The pensions are too big to fail to the tune of 1 to 3 trillion dollars.  Which means they won’t stop mailing the checks, at least, not while a stone remains upon a stone. Will a day come when everything comes tumbling down? Maybe. But we may not be able to rely on the markets for proximate warning. Yet despite their inability to clearly predict the crash of 2008, once past the discontinuity they have proved fairly good at tracking the linear parts of the trend. And while the politicians remain utterly blind they are not insensible to the voters, who with their greater reserves of common sense, can read the tea leaves better. But the future is still a blank. Does a second discontinuity lies ahead and when? What will happen in Europe? Will some ‘damn fool thing’ on the Korean peninsula or the Middle East create an unanticipated bend in the road? Nobody can say for sure. But it’s a good bet that politicians will keep their blindfolds on until the very last second. No crystal ball is any better than the willingness to look into it.


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