President Obama Largely Inherited Today’s Huge Deficits

Lost in Washington’s current fascination with “the deficit” is how we got into this mess in the first place:

via President Obama Largely Inherited Today’s Huge Deficits — Center on Budget and Policy Priorities.

Some critics charge that the new policies pursued by President Obama and the 111th Congress generated the huge federal budget deficits that the nation now faces. In fact, the tax cuts enacted under President George W. Bush, the wars in Afghanistan and Iraq, and the economic downturn together explain virtually the entire deficit over the next ten years (see Figure 1).

The deficit for fiscal 2009 was $1.4 trillion and, at an estimated 10 percent of Gross Domestic Product (GDP), was the largest deficit relative to the size of the economy since the end of World War II. Under current policies, deficits will likely exceed $1 trillion in 2010 and 2011 and remain near that figure thereafter.

The events and policies that have pushed deficits to astronomical levels in the near term, however, were largely outside the new Administration’s control. If not for the tax cuts enacted during the Presidency of George W. Bush that Congress did not pay for, the cost of the wars in Iraq and Afghanistan that began during that period, and the effects of the worst economic slump since the Great Depression (including the cost of steps necessary to combat it), we would not be facing these huge deficits in the near term.

While President Obama inherited a bad fiscal legacy, that does not diminish his responsibility to propose policies to address our fiscal imbalance and put the weight of his office behind them. Although policymakers should not tighten fiscal policy in the near term while the economy remains fragile, they and the nation at large must come to grips with the nation’s deficit problem. But we should all recognize how we got where we are today.

Recession Caused Sharp Deterioration in the Budget Outlook

Whoever won the Presidency in 2008 faced a grim fiscal legacy, a fact already well known as the Presidential campaign got underway. The Congressional Budget Office (CBO) presented a sobering outlook in its 2008 summer update,[1] and during the autumn, the news got relentlessly worse. Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that became embroiled in the housing meltdown, failed in early September; two big financial firms — AIG and Lehman Brothers — collapsed soon thereafter; and others teetered. In December 2008, the National Bureau of Economic Research confirmed that the nation was in recession and pegged the starting date as December 2007. By the time CBO issued its new projections on January 7, 2009 — two weeks before Inauguration Day — it had already put the 2009 deficit at well over $1 trillion .[2]

Will your big-screen Super Bowl party violate copyright law?

Nate Anderson of Ars Technica relates a timely example of just how absurd and outrageous the concept of copyright has gotten.

An offhand comment the other day by a friend caught my attention—”Did you know that you can’t watch the Super Bowl on a TV screen larger than 55 inches? Yeah, it’s right there in the law.”

With the Colts and Saints set to do battle in Super Bowl XLIV, this seemed worth looking into as a public service. Could it be that some of those giant flat panel TV sets now finding their way into US living rooms are actually violating copyright law?

Yes, it’s in the law—sort of….

via Will your big-screen Super Bowl party violate copyright law?.

5.7% Q4 2009 Real GDP Growth: Not What It Seems, Don’t Get Excited

The first estimate (‘flash’ estimate) of 4th quarter 2009 Real GDP growth came out Friday.  The headline number, a 5.7% annual growth rate certainly looks good and has gotten a fair amount of attention.  Unfortunately, the number is highly deceptive.

First, this is only the flash estimate.  It will be revised next month and the month after that.  Remember at the end of October 2009 the flash estimate for 3rd Qtr real GDP was 3.7%!   Everybody declared it proof the recession was over, time to move on to cut spending, etc.  Then in November the number was revised down to 2.7% and eventually just before Christmas we got the more accurate number of 2.4%, of which 1.4 points were cash for clunkers, a  discontinued program.  I fully expect this 5.7% estimate to be revised downward in Feb and March.  It may not be cut as much as the 3rd qtr number was, but nonetheless.

More importantly, it’s always important to look at where the growth or increase comes from and then ask whether it’s sustainable.  In this case, the growth overwhelmingly came from changes in private inventories.   Students in my classes should remember that GDP = C + I + G + (X-M).  In other words, GDP is the sum of consumer, investment, and government spending and net exports.  Further, we can “explode” the I component, investment spending, into other sub-categories such as:  spending on new equipment, business software, residential investment (RI) in new housing,  new commercial buildings, and changes in inventories.  When I grows significantly, it is always critical to see what is driving the increase in I spending.  If it’s new plant, equipment, or software then it probably portends expansion of businesses.  Businesses are expecting the economy to grow and are investing for the future – good.  This isn’t what happened this quarter.  Similarly, increases in RI are usually good since RI actually represents a part-investment, part-consumer good:  new housing.  Increases in RI have historically been indicators of future growth in GDP.  In this case, we had a very modest increase in RI, but it doesn’t look sustainable since we still have a huge inventory of unsold houses nationwide – more houses than we need (at current prices).

As Calculated Risk notes below in this post, changes in inventory accounted for 3.4 of the 5.7% of growth this past quarter. What happened?  Well, essentially it reflects three things happening.  First, businesses in general overreacted a bit in the 1st, 2nd, and 3rd qtrs of 2009 and cut inventories a bit too far in anticipation of an even worse recession.  This partly happened because financing (banking crisis) wasn’t available for inventory.  To the extent the recession did not prove as disastrous as anticipated (we stopped falling in the summer), businesses began to rebuild inventory in 4th qtr.  Not likely to repeat in 1st qtr 2010.  Second, cash for clunkers program seriously depleted inventories of new cars, auto makers cranked up to replenish inventory in 4th qtr .  Again, not likely to repeat in 1st qtr.   Finally, it appears that businesses may have cranked up inventories a bit too high hoping for a good Christmas selling season.  Christmas wasn’t a disaster, but it wasn’t real strong, either.  This actually bodes poorly for 1st qtr.

So overall, while 5.7% is better than a lower number, I don’t think it indicates good times returning.  If good times were truly returning, we should see more than 6% growth AND it should be driven by large increases in C (personal consumption) and the RI and plant & equipment portions of Investment.  We just aren’t seeing that yet.  This means that the economy is still on life support (also known as G).  Unfortunately, the deceptive headline growth numbers have too many in Washington talking about prematurely ending the life support.

As expected, GDP growth in Q4 was driven by changes in private inventories, adding 3.39% to GDP.

From the BEA:

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 5.7 percent in the fourth quarter of 2009, (that is, from the third quarter to the fourth quarter), according to the “advance” estimate released by the Bureau of Economic Analysis.

The increase in real GDP in the fourth quarter primarily reflected positive contributions from private inventory investment, exports, and personal consumption expenditures (PCE). Imports, which are a subtraction in the calculation of GDP, increased.

via Calculated Risk: BEA: GDP Increases at 5.7% Annual Rate in Q4.

Moral Hazard and How to Reform Our Financial System – NYTimes.com

Former Chair of Federal Reserve, Paul Volcker notes both the need for banking industry regulatory reform and that one of the needs to address the “moral hazard” that currently exists in the system.  Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk” according to Wikipedia.  In the case of banks, it is the phenomenon of “heads the bank wins, tails somebody else loses”.  Since widespread bank failures have economy-wide effects (see Great Depression), society, through the government, has an interest in making sure banks don’t fail.  But, knowing that failure is effectively “insured” against, banks will typically take on more risk than they otherwise would.  Figuring out how to insure depositors against loss and widespread bank failures without creating excessive moral hazard is one of the goals of any financial regulatory reform program.

PRESIDENT OBAMA 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international.

Aggressive action by governments and central banks — really unprecedented in both magnitude and scope — has been necessary to revive and maintain market functions. Some of that support has continued to this day. Here in the United States as elsewhere, some of the largest and proudest financial institutions — including both investment and commercial banks — have been rescued or merged with the help of massive official funds. Those actions were taken out of well-justified concern that their outright failure would irreparably impair market functioning and further damage the real economy already in recession.

A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established “safety net” undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world’s largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected.

via Op-Ed Contributor – How to Reform Our Financial System – NYTimes.com.

More On Banking Regulation: How To Do It Right

If we are to avoid another crisis and melt-down of the banking/financial sector such as we had in 2008, then we must change the rules of the game.  There must be institutional change.  Canada avoided much of the financial crisis.  Why?  Well, part of it is regulation (something Canadians are more comfortable with than Americans) and part of it is just plain culture.  For more see:

Paul Krugman via Op-Ed Columnist – Good and Boring – NYTimes.com.

In times of crisis, good news is no news. Iceland’s meltdown made headlines; the remarkable stability of Canada’s banks, not so much.

Yet as the world’s attention shifts from financial rescue to financial reform, the quiet success stories deserve at least as much attention as the spectacular failures. We need to learn from those countries that evidently did it right. And leading that list is our neighbor to the north. Right now, Canada is a very important role model.

Or see Christia Freeland in the Financial Times:

This tendency to react to the mere mention of Canada with either yawns or guffaws may be why, as the world struggles to figure out what went wrong in 2007 and 2008, not much international attention is being devoted to figuring out what went right in Canada. Canada is the only G7 country to survive the financial crisis without a state bail-out for its financial sector. Two of the world’s 15 most highly valued financial institutions – a list dominated by China – are Canadian and a recent World Economic Forum report rated the Canadian banking system the world’s soundest. Even Barack Obama, on the eve of a visit last year to Ottawa, the Canadian ­capital, admitted: “In the midst of the enormous economic crisis, I think Canada has shown itself to be a pretty good manager of the financial system and the economy in ways that we haven’t always been.”

One of the most important policy debates today – particularly in countries hardest hit by the crash, such as the US and UK – is what caused the crisis and what should be done to prevent a repetition. Inevitably, the discussion is hypothetical: even if we could agree on exactly what went wrong, no one can prove that any recommended policy changes would have averted the meltdown. That’s where Canada comes in. It is a real-world, real-time example of a banking system in a medium-sized, advanced capitalist economy that worked. Understanding why the Canadian system survived could be a key to making the rest of the west equally robust.

The first argument you are likely to hear when you start asking what made Canada different is cultural. Depending on your degree of fondness for Canucks, this thesis comes down to the notion that Canadians are either too nice or too dull to indulge in the no-holds-barred, plundering capitalism that created such a spectacular boom, and eventual bust, in more aggressive societies. A senior official in Ottawa likes to say that Canadian bankers are “boring, but in a good way. They are more interested in balance sheets than in high society. They don’t go to the opera.”

Canadian facts and figures

• 6 big banks, approximately 73 banking institutions in total

• The big banks are all universal – offering retail, commercial and investment banking services. Some boutique investment and commercial banks exist but they are relatively small

• Banks have minimal off-balance-sheet holdings

• Banks’ return on equity generally 13% to 20%

• Home ownership rate: 68.4% of the population

• Subprime less than 5% of the mortgage market

• Relatively low penetration of derivatives and securitisation
(27% of mortgages repackaged and sold as bonds)

• Mortgage default rate less than 1%

Source: McKinsey
Dates: 2008 & 2009, except Canadian home ownership figures, which come from the 2006 census.

Canadian facts and figures

• 6 big banks, approximately 73 banking institutions in total

• The big banks are all universal – offering retail, commercial and investment banking services. Some boutique investment and commercial banks exist but they are relatively small

• Banks have minimal off-balance-sheet holdings

• Banks’ return on equity generally 13% to 20%

• Home ownership rate: 68.4% of the population

• Subprime less than 5% of the mortgage market

• Relatively low penetration of derivatives and securitisation
(27% of mortgages repackaged and sold as bonds)

• Mortgage default rate less than 1%

Source: McKinsey
Dates: 2008 & 2009, except Canadian home ownership figures, which come from the 2006 census.

Watchdog: Bailouts created more risk in system | detnews.com | The Detroit News

We are learning from our mistakes.  The financial/banking crisis of late 2008 (which turned a recession into The Great Recession) could will repeat unless we enact stricter banking & financial industry regulations.

The government’s response to the financial meltdown has made it more likely the United States will face a deeper crisis in the future, an independent watchdog at the Treasury Department warned.

The problems that led to the last crisis have not yet been addressed, and in some cases have grown worse, says Neil Barofsky, the special inspector general for the trouble asset relief program, or TARP. The quarterly report to Congress was released Sunday.

“Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car,” Barofsky wrote.

Since Congress passed $700 billion financial bailout, the remaining institutions considered “too big to fail” have grown larger and failed to restrain the lavish pay for their executives, Barofsky wrote. He said the banks still have an incentive to take on risk because they know the government will save them rather than bring down the financial system.

via Watchdog: Bailouts created more risk in system | detnews.com | The Detroit News.