Friday, January 28, 2011

Alfred Kahn - Prof Deregulation dies

You are always influenced by the teachers of your period of coming of age. My economic coming of as was during the period of deregulation which started with President Carter and reached its apex under President Reagan. Anyone who followed deregulation read Alfred Kahn's two volume series on the economics of regulation. In clear prose, Kahn outlined the economic impact of changing the rules. With graphs and case stories, he did a great job of providing deep insight into difficult problems. He was an influence, and we mourn his loss.

Margin increases push traders out of gold

The CME has increased margin again in the gold contract and it has been reported that this increase is a key reason for a large liquidation of open interest and may be responsible for the recent sell-off. Speculative margin for the 100 oz contract is 6751.35 per contract or about 5% of the contract value.

Margin setting is an art as well as a science. It should more than cover a one day price move in the market, but it is set on a dollar basis. If volatility which is quoted in percent stays the same but the price of the commodity increases, the dollar value of a volatility will increase. Margin in dollars as a percentage of contract value will fall with rising prices. Hence, there is little choice but an action to increase margin. Nevertheless, increasing margin will make it more expensive to hold any contract. There will be reason to look for other markets to trade even if futures trading is the lowest cost alternative to access the gold market. Liquidation will occur, and it is less likely that a marginal buyer or seller will enter the market. If the cost increase and the marginal buyer is less likely to be found, the price will decrease.

If there is no increase in margin, the risk for the exchange increases. Volatility has been higher over the last year from lows in early September (for 30-day periods) although 100-day volatility has been relatively stable. Given a 17% volatility a one standard deviation move is about $1400. Margin will cover an over 4 standard deviation move. The fear is that volatility will be higher.

The concerns for business have to be balanced against the risks to the exchange. Buyers may flee but the system is more important.

The three-speed global recovery

Zhu Min, advisor to the IMF, called the current economic environment the "three-speed" recovery at the Davos World Economic Forum. The three speeds are 6 percent for the emerging markets, 3 percent for the US and 2 percent for the EU. Many economists differ on the specifics of the so called three speeds, but no one has really offered an alternative to what may be seen in 2011.

Three speeds also applies to inflation with emerging markets seeing high price increases similar to their growth rates, the G3 still concerned about flat prices because of continued output gaps, and the G7 of the remaining developed world looking at prices in around their long-term targets or slightly higher.

Three speeds and no gear shifter available.

Thursday, January 27, 2011

Valued-added by a country not the same as goods traded

Pascal Lamy, the director-general of the WTO, provides some sanity to trade discussions in the Financial Times through his recent editorial, "Made in China" tells us little about global trade. The simple views of trade in goods does not fit the way trade in conducted in the 21st century.

Parts are made all over the world and may be assembled in one country. China may be the great assembler of the world. So what is the trade deficit? It could be the entire value of the good that is shipped or more rightfully, it should be the valued-added in production. In this second version, the trade valued-added by China is small. Profits are razor then and the deficit with China is not as large a problem as suggested. For example, we book the import of an i-phone for its entire value when the actually valued-added was small. Most of the value added came from design which was done locally. The trade numbers increase fear and makes many want to increase protectionism when trade should be further embraced.

Supply shocks come in all shapes - the cocoa problem

Cocoa production is dominated by the Ivory Coast. About 1/3 of all supply comes from this country. Weather has not been a problem. The issue has been the presidential election. A candidate won but the incumbent president is not willing to give up the office. Countries have recognized the election and the new president, yet the old president will not leave.

A solution is to squeeze cash to invoke a change. The new president has asked cocoa buyers to stop their purchases to help oust the old president. Many traders have agreed to go along with this scheme. The result has been a very significant increase in price. This will not last, but the shock is real and will cause disruption in the supply chain.

You can guess the reaction in some parts of the country. Smuggling is on the rise. A one month halt will not have a severe impact on price , but a continued political battle may send prices off to the races.

Commodity index confusion?

January is the month for revisions of commodity indices market weights. Everyone does it although it is not clear exactly how those changes are derived. Commodity indices has turned into a $200 billion business and when the weights change there will be a significant amount of money flowing between commodities.

Now, most of the indices say they have some production and or supply component to the changes in weights as well as liquidity criteria but it is hard to determine what will be the actually adjustments. We have presented just one index for review, the largest, DJUBS commodity index. Here gold is the biggest winner with a one percent increase in weight. Natural gas got cut while saw a bump up. If you looked at the GSCI weights there would have been some more significant changes. The Roger's index added some new commodity markets such as milling wheat.

Adaptation is important but these fluctuation in weights have a feel of arbitrariness. There is no one index that dominates and there is no one standard. There is a line between passive and "active" management. Changing weights, adding and subtract markets, can all be viewed as forms of semi-active management.

DJUBS commodity index change
Commodity 2010 2011 Diff
Natural Gas 11.55% 11.22% -0.33%
Crude Oil 14.34% 14.71% 0.37%
Unleaded Gasoline 3.53% 3.50% -0.03%
Heating Oil 3.58% 3.58% -0.01%
Live Cattle 3.55% 3.36% -0.19%
Lean 2.10% 2.00% -0.10%
Wheat 4.70% 4.61% -0.10%
Corn 7.09% 6.98% -0.11%
Soybeans 7.91% 7.86% -0.06%
Soybean Oil 3.00% 2.94% -0.06%
Aluminum 5.75% 5.20% -0.55%
Copper 7.64% 7.54% -0.10%
Zinc 3.02% 2.85% -0.17%
Nickel 2.37% 2.25% -0.12%
Lead 0.00% 0.00% 0.00%
Tin 0.00% 0.00% 0.00%
Gold 9.12% 10.45% 1.33%
Silver 3.29% 3.29% 0.00%
Platinum 0.00% 0.00% 0.00%
Sugar 2.89% 3.33% 0.43%
Cotton 2.00% 2.00% 0.00%
Coffee 2.56% 2.36% -0.21%
Cocoa 0.00% 0.00% 0.00%

What makes commodities different from equities

"When you buy commodities, you're selling human ingenuity"Dylan Grice SG analyst

This is great quote for all of the commodity bulls to take to heart. We are not in a a Malthusian world of shortages and excess demand form growing population. There will be innovations to offset the shortages and the spike in prices. For example, rare earth which ave been restricted for export by China have seen huge price increases. The result is that there will be innovation to find substitutes. Buying commodity equities is based on the idea that they will be able to innovate and find a cheaper way to gain commodities. You are long innovation and economies of scale.

If you believe this story, you have to think of commodity investing as opportunistic. When there are supply shortages, be long. When the shortages are eliminated be short. Holding long-only commodities under the idea that there will be a long-term positive risk premium does not make sense.

Macroprudential regulation - Are we making any headway?

Macroprudential regulation is all of the buzz word these days, but stepping back I have a sense that this is moving more towards the critical issues with allocations in a planned economy. Do we have enough information to allocate risk capital in the right direction or is it the role of markets to price risk and help with the allocation of risk. Granted the markets did a poor job of allocating risk capital. The sub-prime mess should not have occurred, but some of these allocation problems occurred because the government allowed the price of risk to be too cheap. The risk weighting for triple-A securities and governments was zero. Of course, the market will find a way to create these securities.

Can the IMF and the new FSB or Financial Stability Board provide the right guidance? There seems to be some clear priorities with governments and regulators on where there focus will be:

  • Maturity mismatches - the bread and butter of banks. Lend long and borrow short. If you change how this is done, the channels of monetary policy will change.
  • The links between big banks and other financial institutions. This will effect all financial innovation because many of the advances in finance have come outside the traditional banking model.
  • The shadow banking system. Financial intermediation grew because banks were not able to service clients needs. This area should be under closer observation but not dominated by the vested interest of established banks.
The problem is always three-fold. What information is collected? How is it interpreted? How is it used to implement policy?

As stated by Claudio Borio of the BIS, "The main reason why crises occur is not lack of statistics but the failure to interpret them correctly and to take remedial action".

Global consumerism and the commodity super cycle

There has been continued talk of a commodity super cycle which is hard to argue against since 10-20 year cycles by their very nature are few and far between. Any extended commodity rally could be considered a super cycle; nevertheless, there is something going on that is different with his rally. Most important, the rally is not just a response to supply shocks. Certainly there have been some significant supply shocks in the last year. Many have been weather related. These supply shocks will cause price increases but to get an extended rally you need two other conditions. One, there has to be a decline or low inventory levels. If there is less inventory, the buffer stocks of commodities cannot be used to smooth prices. Second, there has to be strong demand.

In the first case, we are seeing lower inventory levels relative to consumption or use. The level of inventories are low relative to historical numbers. This is not the case for all markets and many markets still show contango which suggest that inventories are plentiful. But the key markets seeing the highest gains seem to be having backwardation in contracts. Second, there is a strong demand shocks which will not be just a temporary shift. The demand shock which is the real driver for the super cycle is coming from the increase in the middle class for emerging markets.

The story of stronger commodity demand is a play on emerging markets. The super cycle is that this demand will not go away quickly because it represents the explosion of a growing middle class which is unlikely to move back to poverty. From the Euromonitor and Morgan Stanley, households with disposable income over $10,000 in the BRIC's now outnumber those in the US, over 100 million. These middle class households will now outnumber those in the EU by the end of this year. Middle class households in China will exceed the number in Japan and will exceed the US by 2014. Middle class is defined as household disposable income above $10,000.

Auto sales in BRIC countries exceeded the US in 2008. The gap is only getting larger with annual sales over 20 million unit versus between 10-12 million in the US. PC unit sales in China increased 13.1% in 2009 versus 2.2% in the US. Income distribution is changing from low income to something more balanced across different income groups. In less than 5 years P&G sales to developed countries have increased from 23% to 32% of the firm total, an increase from $13 billion to $25 billion. Household debt to GDP in many of these countries is below the average for developed countries. The purchases of goods is for cash. If there is more consumer credit, product demand will show further increases.

If you want to call this a super cycle, go ahead. The tailwinds to higher commodity prices are strong.

Wednesday, January 26, 2011

The rising long rates - what is the right explanation

There are several explanations for the increase in interest rates over the last few months. All of them make sense, but all have flaws when compared with theory and with past analysis. There has to be a new view or framework to help explain the rate rise or at least provide some breakdown on the source of the rise.

  • Increasing US debt /GDP - The average debt/GDP for '60-'07 was 36%; in 2010 the debt/GDP reached 62%. The numbers should hit above 100% before 2020. The key level of 90% debt/GDP has been used by some economists as the threshold where there is a significant drag on growth, (See work by Rogoff and Reinhart). The debt burden is rising, but savings is also increasing in the US. Nevertheless, the size of the rise in debt is unprecedented so past studies on the sensitivity of debt to GDP may not seem relevant. Analysis of other countries which have had deficit problems seem more appropriate and this suggests that there is a higher risk premium in long Treasuries.
  • There is an increase in inflationary expectations. Forward rates for 5-year inflation has increased from 2% which was the long-term core inflation target to 2.90%, a 90 bps rise in just a few short months. The increase in longer-term inflation may be key reason for he steepening of the yield curve.
  • There has been reduced Treasury demand by foreign buyers. Foreign investors were buying 55% of Treasuries during the fourth quarter of 2008 and have moved to 34% in the most recent numbers. Of course, the strong buying was during the period of flight to the dollar based on safety but the size of the deficit has continued to go up and the demand for safety has passed. Investors are looking to diversify but the link between buying and rate changes is unclear.
  • The dollar index have declined to pre-crisis levels. There has not be a strong fall in the dollar and recently there has actually been a rally, but there is a greater potential for dollar decline given the continued savings and debt imbalance. Rates will have to go up to attract capital and allow for a stable dollar.

Keynes - Hayek debate - Did Keynes actually win?

A great video on the comparison of Keynes and Hayek has hit the internet for over a year but is still very refreshing. It is called "Fear the Boom and Bust", a rap anthem. In a humorous fashion, it contrasts the macroeconomic views of Keynes and Hayek. Keynes and his idea of "animal spirits" won the day, but Hayek and his ideas surrounding excess credit expansion as the driver of swings in business cycles has received a revival.

No one could compete with the debating skills of Keynes. He was a master of language . Hayek, a non-native English speaker with a German thought process, could not win he popular debate. Low interest rates coupled with excessive credit will lead to the misallocation of resources which, in turn will lead to bad decisions and economic failure.

The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.

We should listen more to Hayek but unfortunately the key decision-makers are at the very place that controls credit, the Fed. It is unlikely that the fed will be willing to give up their control of the process.

QE2 - a serious cartoon tells the story

It is amazing how a simple meme can take hold of the economic imagination. In this case, a cartoon video on quantitative easing 2 (QE2) called Quantitative Easing Explained. Chairman is referred to as "The Bernank". The Bernank could have made this policy a lot easier if he just said we are just going to create a lot of money and up that inflation expectations would go up which will cause consumers and investors to be buyers. There is no fancy policy just dropping "helicopter money" from the sky.

Tuesday, January 25, 2011

What direction for long rates?

Looking at the yield curve may tell us that the bond market sell-off has gone too far. Taking mid-August as the starting point. The long-bond has increased by 85 bps from 3.71 to 4.57. The spread versus three-month bills is 440 bps. Even the 2-year - 30-year yields have a differential of over 400 bps. Fed policy is keeping the short-rates artificially low so the yield spread may not have the same information value, but the numbers are very wide.

Looking at the simple 2% inflation rule suggests that long-term growth will be about 2% with some room for a risk premium. By this measure the current yields seem to be reasonable. If growth or inflation come in higher, there is actually room for this spread to get wider and for long rates to increase even more. Any flattening may come from the front-end moving higher. If you are in the high growth camp with controlled inflation, there is more bad news ahead for the bond market.

The new paradigm of slower growth and the potential for soft price increases suggests that a rally is ahead. Inflation coming in below 25 with soft growth will mean lower yields.

This is the bond world of two extremes and is one reason for the high volatility. Any change in the marginal investors to one camp or the other will lead to a wild bond price swing.

The tie breaker is the pull of fiscal supply. If the economy does better, here will be a increase in demand for private funding. Pressure will build in the interest rate markets if there is not a decline in government spending. On the other hand, if growth is slow, there will be continued high budget deficits which will provide a headwind from allowing rates to move lower. In all cases, a loanable funds story suggests rates are going higher. Certainly higher growth will mean a decline in savings which again will place pressure on rates.

Though the battle of the two extremes will continue, we still argue that there will be longer-term bias toward higher rates.

Saturday, January 22, 2011

Iceland - Ireland: an interesting comparison

Iceland serves as an interesting comparison with Ireland. Both had severe banking collapse but each was handled in a very different way. This a good experiment of policy differences. Bail-out in Ireland versus no bail-out in Iceland. Devaluation in Iceland versus deflation in Ireland.

In the case of Iceland, the banks were allowed to fail, the currency depreciated, and the economy took a major hit. Debt-holders of Iceland banks were left with nothing as expected in a bankruptcy. Ireland, on the other hand, decided to enlist help and bail-out the banks so that debt was shifted to the taxpayers. The debt burden was not decreased. Hence savings would have to be increased and growth would be cut in order to pay-down debt. The results has been a debt deflation spiral in Ireland versus a devaluation and cleaning of the balance sheet in Iceland.

Of course, the decline in Iceland was severe and painful, but it seems that they have been able to get on with its economic life with a better balance sheet and a trade surplus. Iceland GDP fell by 15% while Ireland fell by 14%; however, Iceland has seen interest rates fall from 18 to 4.5% but the exchange rate has fall by 50%. The inflation rate is falling and unemployment is declining so the misery index of inflation plus unemployment is actually declining and less than Ireland.

Devaluation is tough medicine but has advantages going forward versus switching private debt to public debt and fixing the exchange rate.

Thursday, January 13, 2011

Chinese currency trading - will be improving

Yuan trading developments this month have accelerated with the Bank of China now allowing customers to trade yuan outside mainland China. Starting last July trading was allowed in Hong Kong.This is another step to convertibility.

From WSJ: Chinese regulators last month increased the number of exporters that can use the yuan to settle international transactions from a few hundred to nearly 70,000. Some analysts have predicted that it will be only a few years before 20% to 30% of China's $2.3 trillion in imports could be conducted in yuan rather than dollars.

There is a long way to go before we reach convertibility, but the Chinese government is taking all of the right steps to make the yuan a major currency. Convertibility with size makes for a foreign exchange powerhouse, but it should be noted that Japan was never able to gain trading dominance from its export power. Capital flows have to be free and there has to be a willingness to allow for open trade. We have a way to go before this is allowed with the yuan.

Wednesday, January 12, 2011

Brazil sovereign wealth fund another tool of currency management

Brazil will allow its sovereign wealth to trade currency derivatives which will further the tools available to the government to stop the real appreciation. Remember that Brazil was the country which coined the phrase "currency wars" to describe the current environment in the FX markets. The trading of currency derivatives could allow for intervention through reverse currency swaps by buying dollars and selling real.

The central bank last offered reverse currency swaps, a contract equivalent to buying dollars in the futures market, in May 5, 2009, helping spark a 1 percent slide in the real that day. Under these contracts, the central bank pays investors the Brazilian overnight interbank rate, now at 10.75 percent, in reals and receives a fixed interest rate in dollars.

How or when exactly currency derivatives will be used to stabilize the real is unclear, but a normal course of action is to punish speculators at times when the government can have the maximum impact on rates. The central bank on Jan. 6 also set reserve requirements on short dollar positions held by local banks. Finance Minister Mantega wants to stop the dollar from, as he put it, "melting". He is sure "the real will not strengthen".

Scenario risk for oil - the growing role of Iran as a regional power

We are strong followers of George Freidman and the folks at Stratfor global intelligence. There views are always insightful and can be used as a jumping off point for discussions on scenario risks for commodity and other asset markets. One of their latest pieces "The Turkish Role in Negotiations with Iran" is very helpful with looking at geopolitical risks in the Middle East. That is always going to effect the price of oil.

The risk for Iran has always centered with most news pundits on the nuclear threat. That threat has declined after serving as a focal point for Middle East geopolitical risk. Negotiations are being held. Threats will be made. Peace will be achieved, but the bigger issue is still very conventional. Who will control the Middle East region?

The control of the Middle East will not but just about pure military power although we are seeing Saudi Arabia rearm in order to restore or offset the coming power imbalance. What is more important is the political influence that occurs when there is a dominant regional power. To that end, Iran will fill the void in Iraq from the withdrawal of the US. The US is focused in Afghanistan which is regional just not that important. Iran is going to have an extremely strong influence in Iraq which will effectively extend its borders to Saudi Arabia. When you include its influence with the Palestinians, their influence extends across the region slicing the region into Turkey in the north, Saudi Arabia in the south, and Iran in the middle.

The conventional power of Iran will be strong without nuclear weapons. The influence will start to grow in the oil markets because it will enhance its influence with all other oil players. Both Europe and China will want to accommodate the desires of Iran because nay spikes in oil will come through the actions to unduly influence Iran.

This issue is more likely to increase in the minds of policy-makers if we start to see a tightening of oil markets in 2011. This was not a problem when inventories were high but should start to boil over as the US withdraws from the region.

Watching the flows in commodities

the traditional way of looking at flow indicators in commodity futures markets has been through the commitment of traders. The net positions for non-commercial and commercial traders are used as an indicator of market extremes and what is having with smart money. Small speculators are viewed as a counter-indicator. They generally lose money. Hedgers are viewed as smart traders and the large speculators are viewed as momentum traders whose positions peak at market tops and bottoms. The actual forecasting ability of the commitment of traders (COT) is suspect. For every extreme that is indicated with COT there are just as many periods of failure. The data has been looked at as percentiles, as a function of open interest, and as outright size. There is no true method for looking at the data.

Now, there is a new focus on ETF flows as a new indicator of market momentum and direction. The flow data especially for gold has matched the increase in prices over the last few years. Part of this flow has been catch-up for a new product, so it has been hard to determine forecasting skill. Still, we think the flows in ETF will become an increasingly important tool even if it reinforces price momentum.

We have noticed a new research product form JP Morgan called the commodity investment flow indicator which may be useful for watching what is happening in the commodity ETF market. Their recent research piece from January 10 offers some useful insights.

Open interest in a set of 43 commodity futures markets has surpassed the 2008 peak in the market. More participants are active in the commodity markets.

The changes in market cap for long-side and short-side commodity exchange traded products (ETP's) is starting to express differences in opinions about the movement in commodities. Precious metals have exploded in the last year but we are starting to see a slowdown in growth that is consistent with the more range-bound price behavior. Energy exposures have come down with the decline in natural gas prices and the more range-bound oil behavior. Agricultural and industrial metals demand has not seen the same growth. The short-side for many of these commodity products have also seen explosive growth. In fact, there has been more growth in the short-side products in the agricultural ETP products than from the long-side albeit from a much smaller base.

The ETP flows may become the new commitment of traders report over the next few years. It certainly should be used as an adjunct to the commitment reports.

The debt ceiling battle - no solution but a bad debt meme

One of the reasons for the sell-off in Treasuries over the last two weeks is the uncertainty concerning the statutory debt ceiling not being raised. Of course, it will be raised. The US government will not be shutdown, but there is a risk premium in the markets concerning what will be the cost of raising the ceiling. Clearly, if the ceiling is raised the amount of debt will continue to increase. There is no link between the deficits produced and the ceiling in place.

The real cost is what will be called the debt risk meme that is placed in the heads of investors. First, the US has a large debt problem. Second, the problem is getting bigger. Third, there is no solution. Fourth, there is no part of government that is willing to present a reasonable plan to get to a sustainable equilibrium. The bipartisan debt committee has met and offered some very reasonable first steps. The government and Congress have dismissed many solutions and said the issues will be studied which is code for no action.

What is important in risk management?

Three of the most important pieces on risk:
1. the peso problem
2. fat-tailed distributions
3. Knightian uncertainty

The hat-tip belongs to falkenblog for bringing up three very important risk management issues in the context of finance and statistical theory. One of the current problems with risk management has been the focus on "black swans' without a good framework for discussion. It is also odd that the idea of "black swans" has been viewed as novel. Yes, the emphasis is important but we have seen much of this work before.

First, the peso problem has been well-documented across many asset classes. There is a risk premium associated with low probability large negative events. They exist and many market anomalies can be explained through these events. Using rolling histories of data may not include past negative events in our memory set. Bad things do happen even if they have not happened recently or have not happened in a given market.

Fat-tails are present. I have always viewed this as surprise risk. Surprises away from the normal can occur both on the up-side as well as the down-side. Investors have to be ready for both.

Knightian uncertainty exists. There are risk which are not easy measure. They are not countable, but they are present. Any investor has to be aware that risks which are not in the known distribution are possible.

These three themes are fundamental to a true understanding of risk.

Tuesday, January 4, 2011

Farmland tells the commodity story

Latest data on farmland says that investors are buying. The price increases are not near the increases seen ingrain prices, but it looks like investors see a bright future with prices for grains sustainable at current levels. Some of the biggest gains are in the corn and soybean belt which corresponds with the higher commodity prices.

FOMC will ride the asset purchase horse

While the economic outlook was seen as improving, members generally felt that the change in the outlook was not sufficient to warrant any adjustments to the asset-purchase program, and some noted that more time was needed to accumulate information on the economy before considering any adjustment. Members emphasized that the pace and overall size of the purchase program would be contingent on economic and financial developments; however, some indicated that they had a fairly high threshold for making changes to the program.

FOMC comments.

The Fed is not willing to change their asset purchase program. They do not see enough signs of growth. This is in contrast with many economists who view that US growth will be stronger in 2011.

The monetary policy issue of 2011 will be the timing of any end to asset purchases. The Fed will have to find a glide-path for cutting purchases at the exact moment when the economy ill be able to stand on its own and not return to recession. The current view is that economic growth is not sustainable or at best growth cannot be at a pace that will significantly reduce unemployment. The output gap cannot be closed in a manner that will help employment.

The Taylor Rule does not show any signs that tightening should occur so the economy will continue to depend on asset purchases.

Treasury debt ceiling - the big issue for the first quarter

Why should we have a debt ceiling if every time we come close to it, the cap is raised?

Appearing on ABC’s This Week, Austan Goolsbee spent the hour noting the implications of a failure to pass a raising of the debt ceiling.

“Well, look, it pains me that we would even be talking about this,” Mr. Goolsbee told co-host Jake Tapper. “This is not a game. You know, the debt ceiling is not something to toy with.”

Mr. Goolsbee explained that any chance of failure to pass an increase would amount to a default. “If we hit the debt ceiling, that’s essentially defaulting on our obligations, which is totally unprecedented in American history, ” the chairman said.

The idea that it would pain someone from the government to talk about hitting the debt ceiling is an interesting choice of words. Is the pain coming from too much deficit spending or the fact that we have a debt ceiling? (It has been making the political rounds that Senator Obama voted against raising the ceiling in 2006.

The debt ceiling issue can become one of the key sovereign debt concern for the US. It is supposed o provide some constraint on debt spending because Congress is unwilling to constrain itself. But like many self-imposed constraints it is not binding. "I promise not to eat cake as a new year's resolution until someone gives me a piece of cake."

If government resources are considered common property, special interests can finance expenditures on preferred items. The overall debt will be higher will net transfer payments which will ultimately ed to higher taxes. A debt ceiling an be used to break this fragmented fiscal policy. (Described by A Valasco of NYU and the NBER.)

Special interests, of course, will argue that you cannot play chicken with a binding constraint. The special interests may also include all taxpayers. The issue is whether this is a special situation given the recession. The large deficits were, in part, counter-cyclical policies to minimize the cost of the down-turn. Under this case, a rise in the ceiling may be warranted; however, the recovery has been going on since June 2009 so how much longer should we expect debt increases? If the ceiling is raised then the issue is just pushed forward to another date.

How long should this go on?

Housing - moving along the bottom

Caroline Baum provides a sobering Bloomberg commentary on the housing market to start the new year. Simply put, there is no housing recovery in the US. When government subsidies were available through housing tax credit, buyers responded in 2009 and early 2010. Now that there are no tax credits, buyers have disappeared. The laws of supply and demand take over. Prices will have to fall to clear the excess inventory. This excess is not just want is on the market but the hidden inventory of those who want to move but cannot afford the financial hit of a sale. New construction will not occur until the existing home inventory is brought under control. Housing sentiment, sales, and starts are all flat and not rising enough to provide a gain for the economy. Prices have stabilized but are also flat. There is no wealth effect from the housing market.

There is little that can be done about this. New tax credits will only shift the loses to taxpayers. Rates are rising so cheap mortgages are not likely to help. Inflation would be helpful for homeowners but not at 2%.

This housing market is what we have seen in other countries when there is a balance sheet or financial recession. A recovery takes time.