Budget ‘09: Make the next generation pay

Over at the American Interest editorial blog, economist Peter Heller looks at where the money from Bernard Madoff’s $50-billion ponzi scheme might have gone:

First, one must assume that some of the capital simply went to support Mr. Madoff and his life style of an apartment in Manhattan, fancy houses in Montauk and Palm Beach, and if I recollect from the news, a house or apartment in Europe. I also seem to recall yachts with the name of “Bull,” as well as country club memberships in Palm Beach and the Hamptons. All of this does not come cheap, and one may assume that Mr. Madoff pocketed and spent, after tax, at least $25 million a year—or $35 million pretax– (my ignorance of this standard of living may mean that I have underestimated what such a life style costs by a factor of two or three even). But there is also significant overhead to the production of Ponzi income of this magnitude. Add three floors of rent in the so-called Lipstick building of Manhattan, as well as the overhead costs of the employees and other running costs of his legitimate securities transactions business (presumably including at least two well-paid sons and other relatives), and we can potentially account for another $40 million in expenses (again, my numbers are completely arbitrary). So this would imply that Madoff would have had to have annual inflows of capital to his operation of at least $75 million to cover these costs.

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Finance minister Jim Flaherty has delivered what sounds suspiciously like an ultimatum to Canada’s banks, to lower lending rates and pump more consumer credit into the system.
It’s understandable enough, but it raises a couple of questions. What evidence does Ottawa have that the banks are refusing to make loans, at reasonable rates, to people who deserve them? And if the ultimatum is “lend or else…” the obvious question is “or else what?”

The banks are clearly approaching full-on rebellion at the Bank of Canada’s strategy to re-inflate the economy (refusing to pass on fthe full impact of interest rate cuts etc.), but it’s not clear how much leverage Ottawa has in this case. The banks are sitting back and refusing to do the things that got us into this mess in the first place. We’re going through a period in which credit is tight for very good reasons. We don’t want or need Ottawa pushing the banks to behave like Citigroup or worse, Wachovia.

Back in early August, before the market collapsed and the economy tumbled after it, I wrote a piece for Maclean’s called “There will be pain” that gravely forecast that Canada was in real danger of developing an inflation problem. Boy was I wrong. Now, of course, consumers have stopped buying and everyone is worried about the exact opposite, deflation, which would see prices spiralling down and taking corporate profits with them.

That raises a serious question: Am I an idiot?

I prefer to think not. And I’ll haul out that timeless punditry excuse in my defence: My prediction wasn’t wrong, I was just off on the timing.

I still think that the U.S. and Canada will develop an inflation problem, in fact I now think it will be much worse. It’s just that it’s going to take a year or so before we get there. And on Tuesday I got some backup from some heavy-duty artillery in the financial pundit world.

Martin Wolf, associate editor and chief economics commentator at the Financial Times of London, also thinks that today’s deflation problem could quickly turn into a huge inflation problem. As he points out in his latest column (registration may be required) the two are actually pretty closely related, as both are side effects of an unstable economy. I like to think of it this way: When everything is steady, you keep standing upright, but when you’re thrown off balance, you’re as likely to fall forward as backward.

Anyway, as he writes, deflation is easy to cure. You just keep the money presses rolling — which is exactly what the U.S. is doing now. The more there is of something, the less it’s worth, and that applies to the almighty American greenback too. The problem is, once you’re cured the deflation problem, “the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation…. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation.”

That’s why I’m dead set against all of the huge bailouts we’re seeing. They’re just prompting us to print more and more money, and we will pay the price for that, eventually. We’re not curing the problem, we’re just replacing one crisis with another. As Wolf writes, “the result will ultimately not be deflation but unexpectedly high inflation, though probably many years hence.”

What do you think?

Hundreds of thousands of jobs may or may not be at risk as the Detroit auto industry teeters on the brink of collapse. Talk of  a government bailout has been coming and going like transport trucks on the 401.  Surely, you ask, there’s some good news to be had somewhere?  Well, how about this: the Ford F-150 was named the 2009 Truck of the Year by Motor Trend magazine. Never mind that one of the trucks it was competing against was a Hummer H3T pickup, Detroit can still make a good vehicle.  What’s more, Ford executive Bill Ford Jr. said that sales in the first two weeks of December were actually “turning out relatively well” compared to November. Ford also announced that its market share in Europe was up last month. Can you handle all this good news?!

The U.S. Federal Reserve cut its target interest rate to a never-before seen low of between zero and  0.25 percent.  The move was widely seen as a signal that the central bank will act very aggressively to boost the economy as it moves into unchartered waters. It is also, perhaps, a sign that it’s even more worried about the state of things than it has let on. So, interest rates have been cut as low as they can go. What next?

The Fed stated that it still has other “available tools to promote the resumption of sustainable economic growth.” That will involve pumping money directly into struggling financial companies. For instance, it plans to buy hundreds of billions of dollars worth of mortgage-backed securities from the government-sponsored Fannie Mae and Freddie Mac.  It may  also lend money against securities backed by things  like student and car loans. Presumably, this will help ease credit markets and get money flowing again. How well that will work is anyone’s guess. 

As Princeton economist Alan Blinder tells the Wall Street Journal, “The Fed gets an ‘A’ or ‘A-minus’ for effort and not very good marks for results.” The story from the New York Times  also ends with a critical note from  Blinder: “Right now, the crisis is created by the huge demand by banks for hoarding cash. The Fed is providing cash, and the banks want to hoard it. When things start returning to normal, the banks will want to start lending it out. If that much money is left in the monetary base, it would be extremely inflationary.”

When the dot-com bubble burst in 2001 and the economy entered a recession, it wasn’t long before a new bubble started to grow and fill the void—money started pouring into the housing sector. That, somewhat predictably, burst even more spectacularly than the Internet one. So, what’s next?  There’s a pretty strong argument that yet another bubble is being primed. What it will be is still unclear (could it be infrastructure or alternative energies?). But like it or not, the bubble cycle could well be finding a permanent place in our economy—a kind of vicious cycle.  The most complete, and interesting, argument appeared in Harper’s earlier this year (it is worth reading in its entirety).

There’s also research that suggests this is simply human nature. In a controlled study, outlined here, people were given money and shares to trade, and 90 percent of the time, ended up creating bubbles. “Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then… it crashes,” explains the Atlantic article.  So, are we set to repeat the same mistakes? Or will this downturn be deep and long enough to convince us of the error of our ways?

Update: more on bubbles in the latest Atlantic (the Henry Blodget piece that Sisyphus points out)

The Congressional plan to bail out the Detroit auto industry died a swift death last night, but the White House may yet swoop in with a unilateral bailout of its own. Reports surfaced this morning to suggest that the Treasury Department, on the authority of the President (and presumably the U.S. Fed) would tap the $700 billion fund to bail out Wall Street in order to get enough cash to Detroit to keep the companies afloat until next year.

That, of course, would finally destroy any notion that the U.S. Government is actually operating with a coherent plan. I know, I know…nobody really believed that anymore anyway. But the Trouble Asset Recovery Plan (TARP) was first supposed to buy up bad mortgage assets, then got converted into a giant bank account to buy bank stocks, and now, apparently, it might also branch out into the car business. This, dear friends, is what’s known as making it up as you go along.

Unlike my friend Andrew Coyne, I’m a little more sympathetic to the idea that governments can lend a helping hand to industry in times of trouble. That said, these bailout plans are disasters in the making. The best explanation of why can be found here (a column from a month ago in the Wall Street Journal by Michael Levine.) Continue…

The Bank of Canada says that’s a very real possibility. In its Financial System Review today, the Bank warns there’s a growing risk many Canadians could lose their homes if the financial crisis worsens further.

With household balance sheets under pressure from weak equity markets, softening house prices, slowing income growth, and a record-high debt-to-income ratio, a severe economic downturn could result in a substantial increase in default rates on household debt

The fact is foreclosures are already on the rise. Continue…

Starting in 1998 if an American family had socked away $100 a month for retirement or savings, which investment strategy would have produced the best returns as of now left you better off as of now—stocks, bonds, a balanced portfolio, or simply stuffing the cash under a mattress? As this short video from the Economist shows, Sealy and Serta beat out equities and ETFs in the end. While this type of analysis is fun, it obviously overlook the power of compounding as well as the corrosive effects of inflation. Even so, this simple clip sums up the gargantuan task the financial planning industry is going to face as it tries to win back peoples’ trust.

This letter was sent to U.S. President Franklin D.  Roosevelt in 1933 by John Maynard Keynes.  Much of it (advice on ‘recovery and reform’) reads as if it could have been written last month. “Individuals must be induced to spend more out of their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees,” he urges. 

I enjoyed this curious passage, from a second private letter sent to Roosevelt in 1938. Some advice on handling businessmen: “Businessmen have a different set of delusions from politicians, and need, therefore, different handling. They are, however, much milder than politicians, at the same time allured and terrified by the glare of publicity, easily persuaded to be ‘patriots’, perplexed, bemused, indeed terrified, yet only too anxious to take a cheerful view, vain perhaps but very unsure of themselves, pathetically responsive to a kind word. You could do anything you liked with them, if you would treat them (even the big ones), not as wolves or tigers, but as domestic animals by nature, even though they have been badly brought up and not trained as you would wish.”

More of Keynes writing is online here.

The Bank of Canada slashed its interest rate by 0.75 per cent today. The new lending rate, 1.50 percent, is the lowest in 50 years. The move came with dire warning that the Canadian economy “is now entering a recession as a result of the weakness in global economic activity.” Interestingly, for the second time in two months, Canada’s big banks, like TD and CIBC, have so far refused to fall in line, cutting their rates only half a percentage point. Canada’s bank have been reluctant to follow-through with the rate cuts, given the high costs of financing in these troubled times. The last time this happened, in October, the commercial banks received a gentle scolding from the prime minister, who said he was “disappointed” the commercial banks weren’t passing on the rate cut. Can we expect stronger language this time around from a PM who’s in a much more delicate position politically?

Update: Bank of Montreal, Royal Bank and National Bank are also refusing to play along, and opting for a 0.50 per cent cut.

This morning marks a watershed moment in the history of GM: It has decided to dispense with spin and throw itself on the mercy of the North American People. Continue…

Sometimes all you can really say is “ouch.” Over half a million jobs lost in November in the U.S., bringing the total jobs cuts this year to 1.9 million. A couple of weeks ago when David Rosenberg said he thought there would be 3 million U.S. job losses before this crisis is over, that sounded excessive. Not anymore. I am making a personal rule to stop doubting David’s forecasts about how bad this could get.

What does this mean to Canada? It means there’s a broad-based consumer recession happening in the United States
and that will have serious implications across almost every sector of the Canadian economy. that doesn’t mean we’re going to have a million job losses, but it certainly mean we’re going to take a hit. In fact, those losses are just beginning to roll in – with 71,000 cut in November, a terrible number, especially bad in Ontario.

Our economy has a few things going for it, but the stock market’s deep recent losses tell you that the market is still expecting things to get sigificantly worse before they get better. On the brightside: if you’re in a secure job, with a manageable debt load and some savings, the next year is going to be a fantastic year to get amazing bargains. Houses, cars, electronics…you name it.

Driving on the 401 yesterday I noticed a big bumper sticker that read “Buy American”. Based on the car it was pasted on—a mid-90’s green Pontiac—I was inclinded to think, no thanks. But for the first time in a long time, the message made a lot of sense.

While the heads of the Detroit automakers try to hammer out a last-second bailout in Washington, dealerships across the continent are desperately trying to sell cars. The industry is paralyzed, but for car shoppers, there has never been a better time in automotive history to buy a car, especially an American one. According to the CAW, the Detroit auto makers are offering anywhere from $3,000 to $7,000 in incentives on most models. In the U.S., Ford is offering as much as $4,000 cash back on its Edge crossover/SUV. In Canada, the Edge comes with zero percent financing, with the first two payments free. Today, Ford is advertising “$12,000 price adjustments on selected 2008 models.” And it’s not just the Detroit Three slashing prices. Double digit declines in sales have all automakers scrambling to move inventory. And ‘zero percent’ financing has become the industry’s new rally cry. Toyota’s “Saved By Zero” TV ad, for instance, has become infamous.

But more importantly, the American automakers are quite suddenly offering some very well-built and (dare I say) stylish cars. The Pontiac G8 was dubbed the new BMW by one influential auto blog (see below). Motor Trend named GM’s Cadillac CTS the 2008 Car of the Year. And along with the Chevy Malibu and Corvette, it was also in Car and Driver’s 10 Best Cars ranking. It would be a great loss (and an economic disaster) if even one of the Detroit companies fell. But if you’re thinking of buying a car, now’s the time.