Tuesday, October 21, 2008

Why I'm optimistic

For the benefit of new visitors, let me recap why I am optimistic.

To begin with, it's not hard to be optimistic when everyone is pessimistic and there is no shortage of bad news to worry about (e.g., Obama is likely to win, he wants to raise taxes and expand government; housing prices are plunging; financial markets are frozen; banks aren't lending; stock prices have collapsed; the great majority of economists are now saying we're in a recession, and the only areas of disagreement are over how deep and how long the recession will be). I think that the market has priced in all the bad news by now, and is fully expecting the news to get worse, which is why corporate bonds and stocks are so incredibly cheap.

All this would be reason alone to be optimistic, but here's the good news the pessimists are overlooking: 1) the Fed, along with other major central banks, has launched a massive effort to pump money into the banking system and backstop the credit worthiness and credibility of major financial institutions and money funds, and there are plenty of signs that these efforts are gaining traction—swap spreads and the TED spread have plunged, and implied option volatility is down; 2) there is plenty of money in the system, with all measures of money supply currently at all-time highs; 3) the credit squeeze is a myth—bank lending is at all-time highs and nonfinancial commercial paper is expanding—the problem is not a shortage of money but a shortage of buyers; 4) the credit default swap market has so far managed to settle and liquidate many hundreds of billions of contracts without so much as a hiccup, and without a shred of assistance or oversight from the federal government; 5) housing prices have plunged and this has resulted in a surge of home sales, to the point where buyers are competing with each other to grab foreclosed properties; 6) capital spending by corporations has been rising for the past year, laying the foundation for future productivity gains, 7) the labor market is weak but not collapsing—corporate layoffs according to Challenger Gray & Christmas have risen only modestly, the Monster Index appears to have leveled off, and weekly unemployment claims are flat for the past four weeks; and 8) speculative excesses have been wrung out of the commodity markets, leaving most prices (especially energy prices) at levels that pose little or no threat to future growth.

In short, we're seeing evidence that unprecedented action by central banks is restoring confidence, and there are lots of signs that the market is busy fixing itself. Rather than pulling the rug out from under the economy, the financial market has functioned as an ideal shock absorber for the real economy. This means that the recovery from this crisis could come much quicker than most would expect.

I've talked about all of this in previous posts. I called for a bottom in the equity market a few days too early, it seems, but the action of the past week or so, especially the improvement in key financial indicators such as swap spreads and the TED spread, has significantly increased my confidence that we've seen the worst of this financial crisis.


Mark Gerber said...

Hi Scott,
I just heard about your blog on Kudlow & Company. It sure would be great if the equity correlation with the two year swap spread carries forth.

I always enjoyed your comments on Our Piazza, and I'm enjoying your blog. You make so many interesting and informative points, I hesitate to critically focus on those I disagree with. But, such disagreements have often proved illuminating, so here goes three:

1) The unregulated free market for credit default swaps has NOT proven a success. At the very least, AIG blew up costing the taxpayers a bundle. We may never know if other blow-ups were covered with tax payer money behind closed doors.

2) The deregulation of our financial system from 1999 - 2004 has proven to be a disaster that has required substantial taxpayer dollars to stabilize. Without the taxpayer dollars, we would almost certainly enter into a depression. The free market failed.

3) On OP, I argued many times that reckless deficit spending by the Bush administration put our system of free market capitalism at risk. Now, we are about to witness the consequences with the election of a socialist president (Obama) who will probably enjoy a congress with a socialist majority. Rugged individualism in America is about to further ebb away, and I doubt the tide will come back in for at least a generation, if ever. With around $40 Trillion (present dollars) in unfunded Social Security and Medicare programs plus $10 Trillion in National Debt, the game is over.

Mark Gerber

Scott Grannis said...

Hi Mark, and welcome back.

1) I'm not an expert on AIG's failure, but I would be very surprised if it were due to unregulated CDS contracts. It could have been due to any number of things. The important thing about swap contracts is that they are very carefully constructed so that no one has any surprises at the time of settlement. Futures work pretty much the same way. And someone in AIG's position would not likely have been taking massive positions with swaps; the vast majority of their positions would likely have been offset with other parties. Unfortunately it is all so complex that it lends itself to misinformation and demagoguing by politicians. Don't believe everything they tell you, that's my advice.

2) Check back on some of my earlier posts and you will see one that details why this crisis has nothing to do with deregulation. Quite a few people have written about this. It's not widely known, however, and the Democrats have managed to demagogue the issue flagrantly. Again, this was NOT a failure of the free market. If anything, it was a failure of Congress to exercise its regulatory authority!

3) Deficits are tragic, yes, but Bush didn't break the bank. There is nothing about our current deficit or national debt that is of urgent consequence. The numbers are still VERY manageable.

Art Laffer noted recently that the one good thing about the fact that the deficit has increased this year is that it will make it much harder for the next administration to pursue stupid stimulus policies. Thank goodness for small favors!

Social security and Medicare deficits are another matter, of course, but those are not cast in stone like Treasury debt is. The government can always renege on those promises, or increase the retirement age, or modify medicare benefits, or streamline the workings of the healthcare system, etc. No reason to despair yet.

Rick Neaton said...

Hi Scott and Mark,

I got the link to your blog from David Gordon's blog.

As I understand it, AIG did not hedge its CDS risk. They viewed the contracts like any other insurance policy except that they forgot to reinsure them. Thus, they were the end counterparty to many of the swap contracts as opposed to most other parties who spread their risk.

By deregulation, the Dems mean the repeal of Glass-Steagall. Without that repeal, BAC could not own MER and JPM could not own Bear Stearns. That repeal occurred long after the securitization of mortgages commenced.

I agree with Scott on this one. The regulators failed. Banks and insurance companies have been regulated for decades. Inverstment banks were/are regulated at the federal level. Some derivatives are regulated.

But I agree with Mark's third point. I think the current progressive income tax system poses a systemic risk to the federal government's solvency. In 2006, 25% of the federal budget depended upon personal income revenues from 4 million tax returns. Obama's workers' credit plus tax rate changes shift at least another 10% of that budget burden on to those same 4 million tax returns.

What happens when those 4 million tax returns say, "No mas"? What happens when those 4 million tax returns fail to generate as much income as they did in 2006? Would you buy the debt of a corporation at AAA interest rates when 75% of its revenue came from 3 percent of the total market?

That's the federal income tax system. In 2006, 4 million tax returns out of 138 million filed accounted for 57% of the total revenue. That's real systemic risk.

Just Julie said...

Hello Scott,

I found your blog from Larry Kudlow and wanted to thank you for your commentary regarding our current financial situation. I recently received my MBA with a Financial emphasis and, while I am still grappling with understanding much of your analysis, I appreciate the concise and intelligent analysis you offer.

All I have to say regarding most of what our Government does is from Ronald Reagan, "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'"

Scott Grannis said...

Thanks Julie. It really is a shame that politicians are trying to pin the blame for this crisis on deregulation. The problem is really one of too much government.

Scott Grannis said...

I think Rick makes a good point about how the bulk of taxes come from a relative handful of taxpayers. We now have a tyranny of the majority, and Obama has exploited that to the max, promising to take money from a few and give it to the majority. Pure Robin Hood politics.

There is a lot to be said for simplying our tax system with a flat tax and very few or no deductions. We need everyone to pay at least something in tax, if only to have some skin in the game.