Paradox and uncertainties of US economy

OF late, the US market is acting weirdly. It is really a paradox. Though different macroeconomic indexes, e.g., rate of unemployment, consumption, manufacturing, consumer confidence index, Chief Executive Officer (CEO) confidence index etc., are showing some red flags about the US economy, some readings that represent market's expectation, e.g., VIX, TED spread etc., about future uncertainty are more optimistic about the economic future than it was in September 2008! In finance, we are always told that market is smarter than you. Market as a whole can predict things better than a trained individual. But it looks like that this time market is not guessing future uncertainty wisely, at least for near-term!

VIX, also used as the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, a popular measure of the market's expectation about implied volatility in S&P 500 index options over the next 30-days period. A high value corresponds to a more volatile market over the next one month. For new readers, this writer would like to mention that the S&P 500 is a value weighted index of 500 large cap common stocks traded in the USA. Almost all stocks included in the index are among the 500 American stocks with the largest market capitalizations. However, VIX is expressed in terms of percentage points in an annualized basis. For example, if the VIX is at 50, this represents that market expects an annualized change of 50 per cent over the next 30 days or there is 68 per cent likelihood, i.e., one standard deviation that the magnitude of the S&P 500's 30-day return will be about 14.43 per cent up or down. Though until October 2008, the average value of VIX was 19.04, on October 24, 2008, the VIX reached an intraday high of 89.53.

On the other side, the TED spread is the difference between the three-month Treasury (T)-bill interest rate and three-month London Inter-bank Offered Rate (LIBOR). A TED spread is in general a broad indicator of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. A rising TED spread often indicates that liquidity is being withdrawn and also shows concern about the solvency of the banking system. When the TED spread increases, lenders believe the default risk on inter-bank loans, i.e., counterparty risk is increasing. Inter-bank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. Accordingly, when the risk of bank defaults is considered to be decreasing, the TED spread decreases.

The TED spread fluctuates over time, but historically it has often remained within the range of 10 and 50 bps (0.1 per cent and 0.5 per cent), until 2007. The long term average of the TED has been 30 basis points with a maximum of 50 bps. However, during 2007, the sub-prime mortgage crisis, the TED spread skyrocketed to a region of 150-200 bps. On October 10, 2008, the TED spread reached another new high of 465 basis points.

September 2008 will be remembered in financial history of the USA. Why? On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection which is marked as the largest bankruptcy in US history. And, on September 14, 2008 Bank of America (BOA) announced its intention to acquire Merrill Lynch. On September 16, 2008, Bruce Wallis's money market fund, Reserve Primary, "broke the buck", i.e., its net asset value went below $1.0. There was so much uncertainty in September, 2008. And thus both TED spread and VIX were on their record high. Though there was enough uncertainty in last September, it was limited mainly in the banking sector which was lacking liquidity and, most importantly, trusts.

And, now economists are concerned about the whole macro-economic condition in the US rather than any particular sector or industry. The US economy lost 598,000 jobs in January, pushing the unemployment rate to a 16-year high of 7.6 per cent. Meanwhile, new home sales are 10.2 per cent below the revised December rate of 344,000 and 48.2 per cent down from a year earlier. Recent gross domestic product (GDP) report showed that the economy fell at a 6.2 per cent annual pace at the end of last year, a much faster than expected pace. Year-to-date (YTD), S&P 500 dropped 45 per cent and DJIA dropped 19 per cent. Prof. Dimson from London School of Business estimates that we'll have to wait nine more years before the Dow average, including dividends, has a 50 per cent chance of hitting its 2007 highs. Because of "flight to quality," yield on 10-year treasury is beaten down below 3.0 per cent. Again gold price per ounce already crossed 1,000 dollar. Moreover, there is also a fear that the US banking system might be nationalized at least for the short-term which will dilute or eradicate present shareholders position in the company. However, the good news for the US is that Consumer Price Index (CPI) for January rose by 0.3 per cent. Core CPI, i.e., CPI for all items excluding food and energy showed an increase of 0.2 per cent.

Thus, here is the paradox: though economists see much uncertainty right now than it was in September 2008, market perception about future uncertainty is relatively optimistic if we compare the situation with that of the last September. Market believes that future uncertainty is relatively lower than it was in September 2008! And, we need to wait for a while to see who is right.

Does Keynes fits well into today's economy?

The U.S. suffered a net loss of 2.6 million jobs in 2008, the most since 1945. Now, 7.2 per cent of the work force is unemployed. New factory orders, housing construction and retail sales have shrivelled. The Obama administration claims the stimulus bill will "create or save three or four million jobs over the next two years . . . with over 90 per cent of those jobs in the private sector." According to the "stimulus bill", House Democrats propose to spend $550 billion of their two-year, $825 billion "stimulus bill" (and the rest of it being tax cuts). Because of the "multiplier effect", Keynesians argue that massive deficit spending by the federal government is the right policy for deepening recession. Why do Keynesian economists think that multiplier effect is so relevant to address the current worldwide economic meltdown?

The term 'animal spirits,' popularized by John Maynard Keynes in his book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence. When animal spirits evaporate, consumers do not want to spend and businesses do not want to make capital expenditures or hire new employees. When interest rates are close to zero, and thus, conventional monetary policy is ineffective, Keynesian theory would argue that the government should have a fiscal target. If spending would otherwise be less than full employment GDP, the government should put more green bills into people's pockets. China has already announced to do so.

What's wrong with the Keynesian macroeconomic model? Keynes assumed that unemployed labour and capital can be utilized at essentially zero social cost, but the private market is somehow unable to do so. In other words, there is something wrong with the price system. John Maynard Keynes thought that the problem lay with wages and prices that were trapped at excessive levels. But this problem could be readily fixed by expansionary monetary policy so that wages and prices do not have to fall. However, real-life complex economy does not comply with simple Keynesian model. In addition, a simple Keynesian macroeconomic model implicitly assumes that the government is better than the private sector at marshalling unoccupied resources!

In addition, another substantial downside with the Keynes's model is that the money for government spending boom has to come from somewhere, which means it is removed from the private sector as higher taxes or debt. For every $1.0 the government 'injects,' it must take $1.0 away from someone else - either in the form of taxes or by issuing T-bills. In either case this leaves $1.0 less available for investment by the private sector or consumption. Moreover, the 'leaky bucket principle,' originally coined by Arthur Okun, is another reason which states that when government transfers income or wealth from rich to poor a lot leaks out and is wasted because of corruption, lack of monitoring, and planning.

For instance, a 2002 study of U.S. data by Roberto Perotti found that the effect of debt-financed spending increases was somewhat positive, but the multiplier effect was much less than one. A 2004 IMF study on recessions in advanced economies also found that "multipliers are unlikely to exceed unity." A 2006 study of U.S. data by IMF economist Magda Kandil found that the effect of fiscal expansion is insignificant on aggregate demand and economic activity. In December 2008, the National Bureau of Economic Research (NBER) published "What are the Effects of Fiscal Policy Shocks?" by Andrew Mountford and Harald Uhlig, and says, "The best fiscal policy to stimulate the economy is a deficit-financed tax cut," and "the long term costs of fiscal expansion through government spending are probably greater than the short term gains."

Thus, contrary to Keynesian followers, some economists suggest eliminating the federal corporate income tax rather than throwing money to the people. To be really stimulating, tax cuts need to be immediate, permanent and must be on the margin, and this was the principle behind the Kennedy tax cuts of 1964, as well as the Reagan tax cuts of 1981. The revenue cost of eliminating the corporate tax wouldn't be any more than their proposed $355 billion in new spending, but its 'multiplier' effects on growth would be far greater. Research by Mr. Obama's own White House chief economist, Christina Romer, has already shown that every $1.0 in tax cuts can increase output by as much as $3.0.

The "New Deal" is widely recognized as to have ended the Great Depression, and this has led many policy makers to support a 'new' New Deal to address the current crisis. For our new readers, the New Deal is the name that United States President Franklin D. Roosevelt gave to a sequence of central economic planning programmes with the goal of ensuring employment, reform of business and financial practices to ensure recovery of the economy during The Great Depression in 1930s. And, the lesson we have already learned from the New Deal is that government intervention can - and does - prolong a recession and might lead to severe depression. This was true in the 1930s, when artificially high wages and prices kept the U.S. economy depressed for more than a decade, it was true in the 1970s when price controls were used to combat inflation but just produced shortages. It is true also today, when poorly designed regulation produced a financial system that bears too much risk. If the multiplier effect were true, the government should spend $10 trillion and we'd all live in paradise.

However, Noble Lauret Paul Krugman (2008) has asserted that the Great Depression in 1930s lasted 10 years because the New Deal didn't spend enough. But if we take a close look at an other attempt by Japan, we will observe that it tried to spend its way out of its post-bubble economic disorder in the 1990s but ended up with a pile of debt and a 'lost decade' of no economic growth.

So, to address the current economic meltdown, government must ensure incentives for people and businesses to invest, produce and work. But the government spending will be a net stimulus only if its $1.0 goes to more productive purposes than those to which private investors would have put that same $1.0. So, if the government does not want to prolong the current recession, it should stimulate business activities through providing different incentives to businesses, e.g., tax-cut on corporate income and eliminating trade barriers, rather than following Keynes's vague multiplier in this multifaceted world.