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Archive for August, 2011

My latest column at the Christian Science Monitor:

America’s fiscal challenges are often portrayed as a conflict between hawks and doves. The real battle, however, is between foxes and hedgehogs.

Unfortunately, fiscal hedgehogs still have the upper paw.

“The fox knows many things, but the hedgehog knows one big thing,” wrote the ancient Greek poet Archilochus. Both foxes and hedgehogs play important roles in the policy ecosystem in normal times. In times of great change, however, society needs more foxes and fewer hedgehogs. More citizens and leaders who can adapt to new conditions, and fewer who want to preserve the status quo.

That’s where we find ourselves today. Despite all the anguish over a debt limit deal, America’s fiscal outlook remains daunting. Little progress has been made on our largest budget challenges. Despite bipartisan efforts, prospects for a grand fiscal bargain remain dim.

One reason is that fiscal hedgehogs still have the upper paw on key issues.

Consider entitlements. Everyone knows that entitlement spending is our No. 1 long-term budget challenge. Because of an aging population and rising health-care costs, spending on Social Security and federal health programs will explode. The Congressional Budget Office estimates that over the next 25 years spending on these programs will rise from roughly 10 percent of the economy to almost 17 percent. Accommodating that growth would require substantial cuts in other government programs, much higher tax revenues, or unsustainable deficits and debt.

The challenge is to find ways to keep the core benefits of these programs while reining in costs. This is where entitlement hedgehogs and foxes part company.

The hedgehogs know one big thing: These programs provide major benefits. Social Security, for example, has dramatically reduced poverty among seniors and provides essential income to millions of retirees.

Inspired by that one big thing, hedgehogs oppose any benefit reductions, such as increasing the eligibility age or trimming benefits to reflect increased longevity.

Entitlement foxes have a more nuanced view. They recognize, like the hedgehogs, the value of the guaranteed retirement income that Social Security provides. But they also know that the number of retirees receiving benefits is growing faster than the number of workers paying payroll taxes. They know that Americans are living longer but retiring earlier. They know, in short, that the future will be different from the past and that the program needs to evolve to remain sustainable. Foxes are thus open to ideas like raising the eligibility age or changing the benefit formula.

A similar dichotomy exists with taxes. Revenue hedgehogs know one big thing: Taxes place a burden on taxpayers and the economy. Thus, they oppose all tax increases, even efforts to reduce the many tax breaks that complicate our tax code.

Revenue foxes see things differently. They recognize the burden that taxes place on taxpayers and the economy. But they also know that tax increases are not all created equal. Higher tax rates, for example, are usually worse for the economy than cutting back on tax breaks. Indeed, cutting tax breaks sometimes frees taxpayers to make decisions based on real economic considerations rather than taxes, thus strengthening the economy. That’s why revenue foxes support eliminating many tax breaks.

Fiscal hedgehogs will never embrace such changes. To make progress, we need more fiscal foxes.

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Which of the following nations recorded the strongest economic growth in the second quarter? France, Germany, Italy, Japan, or the United States?

This nice chart from today’s Wall Street Journal provides the answer (click for larger version):

The U.S. expanded at a tepid 1.3% annual pace in Q2, but that was still better than many other developed economies. Italy grew at a 1% pace, Germany at 0.5%, and France at 0.0%. And then there’s Japan, which contracted at a 1.3% pace.

The chart also nicely illustrates just how sharp the GDP declines were in late 2008 and early 2009.  Both Germany and Japan, for example, had quarters in which economic activity contracted at a 15% annual pace or more. By contrast, the worst U.S. quarter saw declines at “only” a 8.9% pace.

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Today’s housing data showed that the number of single-family homes under construction hit another record low in July:

Ten years ago, America’s home builders were in the midst of constructing 689,000 single-family homes. Five years ago, they were building 913,000 homes. Last year, they were building 278,000. And now that figure is down to a mere 243,000.

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Daily deal leader Groupon continues to grow its revenues at a jaw-dropping pace. According to its updated S-1 filing, the company sold $878 million in Groupons in the second quarter, ten times more than a year earlier:

However, costs have been exploding too. Groupon spent almost $1 billion in Q2:

Put it all together, and Groupon has been losing hundreds of millions of dollars:

Small compared to the billions and trillions of red ink the federal government confronts, but still a formidable problem. Particularly given all the other players in this space, including a certain search company whose $6 billion acquisition offer Groupon spurned last year. I would have taken the money and run. But perhaps I am not seeing the secret ingredient that will give Groupon a persistent competitive advantage in the face of vigorous competition.

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The S&P downgrade of U.S. credit has understandably dominated headlines, but S&P was by no means the first mover. At least three other rating agencies had already downgraded the United States.

Egan-Jones was the first Nationally Recognized Statistical Rating Organization (NRSRO) to downgrade. It lowered the U.S. rating from AAA to AA+ in mid-July. NRSROs are the companies that the SEC officially recognizes as credit rating agencies. They number ten in total, with Fitch, Moody’s, and Standard & Poors the most famous (or, in some circles, infamous).

Weiss Ratings was the first U.S.-based rating agency to rate the U.S. below AAA. It initiated official coverage in April at the equivalent of BBB and lowered to the equivalent of BBB- in mid-July, just one notch above junk. Back in May 2010, Weiss challenged the three major agencies to downgrade the United States, but hadn’t yet rated the U.S. itself. Weiss is not an NRSRO.

And then there’s Dagong, the Chinese rating agency. It initiated coverage with a AA rating in July 2010. It then cut the U.S. to A+ in November and to A last week.

So who was first?

Weiss if you count its May 2010 announcement that the U.S. ought to be downgraded. Dagong if you go by the first published rating below AAA. And Egan-Jones if you focus on the NRSROs.

Anyway you slice it, though, S&P wasn’t first.

S&P may want to make that point during the inevitable congressional hearings in September. And committee staffers should consider inviting Weiss or Egan-Jones as well.

ht: Dan D. and David M.

P.S. Apologies for the lack of links; I am writing on an iPad today, and it’s a nuisance to add them.

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In the final hours before Friday’s historic downgrade, Standard & Poors gave Treasury an advance copy of its report. Amazingly, that report contained a $2 trillion error in its calculations of U.S. deficits and debt over the next decade. Here are four things you should know about it.

1. Treasury hoped that S&P would change its decision in light of the error, but S&P shrugged it off as not material. 

In a blog post, Acting Assistant Secretary for Economic Policy John Bellows described what happened when the error was discovered:

After Treasury pointed out this error – a basic math error of significant consequence – S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one.
On Saturday morning, S&P issued a clarification / rebuttal acknowledging the error, but downplaying its importance:

The primary focus [of our analysis] remained on the current level of debt, the trajectory of debt as a share of the economy, and the lack of apparent willingness of elected officials as a group to deal with the U.S. medium term fiscal outlook. None of these key factors was meaningfully affected by the assumption revisions to the assumed growth of discretionary outlays and thus had no impact on the rating decision.

2. Despite S&P’s claim, $2 trillion would “meaningfully affect” “the trajectory of debt as a share of the economy.”

It’s own revised calculations show net general government debt hitting 85% of gross domestic product in 2021 instead of 93%. That’s a big difference.

The 85% figure is still uncomfortably high and may well not deserve a AAA rating. But S&P was too dismissive in its clarification.

3. The error is understandable but remarkably sloppy for such an important analysis. 

The source of the error is painfully familiar to anyone who deals with U.S. budget projections. S&P’s analysts didn’t use the right measuring stick — i.e., the right budget baseline — when analyzing the effects of the recently-enacted Budget Control Act.

In one sense, it’s easy to see how this error happened. Budget discussions are now hopelessly confused by a profusion of different baseline projections of what spending and revenues will look like in the future. Indeed, I have devoted multiple posts to clarifying how different revenue baselines fit together (e.g., here and here). I’ve even used Johnny Depp to highlight the challenge.

A similar challenge exists with discretionary spending. Official budget baselines assume that annual appropriations (the defense and non-defense spending Congress fights over every year) grow with inflation unless subject to an explicit cap. That was the basis, for example, for the official baseline that the Congressional Budget Office used in evaluating the impacts of the Budget Control Act.

Before the BCA, there were no discretionary spending caps, so annual budget authority was assumed to grow with inflation from the most recent appropriated levels. The BCA then generated $917 billion in budget savings by setting annual spending caps below those levels.

S&P messed up because it based its analysis on another baseline. That “alternative fiscal scenario” assumes that discretionary spending grows at the same pace as the overall economy, not just with inflation. That baseline implies much more spending and debt over the next decade — $2 trillion more, in fact — than the official baseline.

So, again, it’s easy to see mechanically how this error happened. But it’s still remarkably sloppy. Budget experts are well-aware of the problem of multiple baselines. Indeed, we all pepper our conversations and analysis with the question “what baseline are you using?” It’s stunning that S&P didn’t have multiple analysts asking the same question to make sure their original numbers were right.

4. S&P’s response to the error further demonstrates that its primary concern about the United States is political not numerical. 

As S&P said in Friday’s report:

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers. In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging.

In short, S&P worries that America won’t get its act together in time.

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On Friday night, Standard and Poors announced that it was downgrading U.S. long-term sovereign debt from AAA to AA+, the first such downgrade in U.S. history.

Here are five things you should know about the downgrade — four important, one trivia.

1. S&P downgraded U.S. debt not only because of the deteriorating fiscal outlook, but also because of concerns about America’s ability to govern itself. It said:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

2. Moody’s and Fitch recently reaffirmed their AAA ratings on U.S. sovereign debt. On Tuesday, Moody’s reaffirmed its Aaa rating, but assigned a negative outlook given the risk that the U.S. might flinch from further fiscal tightening, borrowing costs might rise, and the economy might weaken. Fitch similarly reiterated its AAA rating on Tuesday, but noted that it would have a fuller reassessment by the end of August. Fitch also emphasized the need for further fiscal adjustments.

One issue (on which I haven’t seen much discussion) is how the impact of a downgrade would increase if it spreads from just one rating agency to two or three.

3. In the past thirty years, five nations — Australia, Canada, Denmark, Finland, and Sweden– have regained a AAA rating after losing it. See, for example, this nice chart from BusinessWeek:

America still has much to learn from other nations that fixed their economies and budgets after financial crises. Sweden, for example, did a remarkable job addressing the fiscal challenges that followed its financial crisis in the early 1990s.

4. This downgrade may set off a cascade of further downgrades for other U.S. debt. The federal government provides an implicit or explicit backstop for many other debt securities. For example, the federal government stands behind trillions of dollars of debt and guarantees issued by Fannie Mae and Freddie Mac, GNMA securities, and securities backed by guaranteed student loans. It implicitly stands behind systemically important financial institutions. And it provides substantial support to state and local governments. S&P did not specifically address these other credits in Friday’s report, but did say that:

On Monday, we will issue separate releases concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.

S&P did reaffirm its highest, A-1+ rating on U.S. short-term debt, which should limit impacts on money market funds and other short-term lending markets.

5. S&P was not the first rating agency to downgrade U.S. sovereign debt. In the category of trivia, China’s Dagong credit rating agency downgraded U.S. credit to A with a negative outlook earlier this week. Dagong had initiated U.S. coverage with a AA rating about a year ago, which was lowered to A+ last November. Dagong apparently views the United States as a greater risk than China. Despite all of America’s problems, that seems a stretch.

Update: In addition, Egan-Jones, a U.S. rating agency, cut the U.S. to AA+ in mid-July. Egan-Jones thus wins the prize as first U.S.-based agency to downgrade. Writing in the Financial Times, Michael Mackenzie noted:

Egan-Jones was officially recognised in 2008 by the Securities and Exchange Commission and, unlike its larger rivals, generates revenue from institutional investors and not from issuers of debt. During the past decade it downgraded US carmakers and structured credit products before similar decisions by the big rating agencies.

Thanks to reader Dan Diamond for pointing out the Egan-Jones downgrade.

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America’s job market has been down so long, today’s mediocre report looked like up.

The headline figures — payrolls up 117,000, unemployment rate down a tic to 9.1% — were better than most forecasters anticipated. That’s a relief.

And many details moved in the right direction as well. Revisions to May and June added another 56,000 jobs, the U-6 measure of underemployment ticked down to 16.1%, and hourly earnings were up 0.4%.

But we still need much stronger job growth if we are ever going to get America back to work. Both unemployment and underemployment remain stubbornly high:

(The U-6 measures includes the officially unemployed, marginally attached workers, and those who are working part-time but want full-time work.)

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If all goes according to plan, the hoopla over the debt limit will soon recede. Policymakers and analysts will move on to the next new thing. And, sadly, some fascinating questions will forever go unanswered. For example, which president would appear on the trillion-dollar coin?

 But if you are up for one last article about default, yesterday’s piece by Christophe Chamley at Bloomberg is a good one (ht: Donald M.). Chamley recounts Spain’s intentional bond default way back in 1575:

Spain, at the time, was the world’s sole superpower. Contemporaries described it as an empire “over which the sun never sets.” Yet the king needed the cities’ consent to borrow at a reasonable rate. And he needed it for a reason: The cities collected the taxes.

Each of the 18 main cities of Castile levied a special tax earmarked for long-term debt service. The level of this tax was set every six years through negotiation with the king. Tax collections were used first to pay off local long-term bondholders, with the rest sent to the central government. The local long-term bondholders were, in large part, the elderly living in the area. So local taxpayers realized that if they didn’t pay, their parents would be hurt. Thus, this precursor to Social Security had an effective enforcement mechanism — the ire of the elders.

But the king could only exploit this confluence of interests so far. The Cortes set the earmarked tax rate by majority rule, and that limited the king’s issuance of what were, in effect, his AAA securities. The king also issued other bonds secured by other, non-earmarked revenue. These securities were of a lower grade and sold at lower price.

Thanks to Philip’s expensive military adventures in the Netherlands and the Mediterranean, Spain’s debt had reached half of gross domestic product by 1573. At that point, the cities balked at paying higher taxes. For the next two years, they refused to budge in their confrontation with the king.

Finally, in September 1575, Philip took a circuitous route to outmaneuver the Cortes. He suspended payments not on the long-term debt, but on the short-term debt, which was owed primarily to Genoese bankers. The people cheered. Resentment against bankers ran as high then as now — perhaps higher, because the bankers were foreigners. The upshot, however, was default and a full-blown credit crisis.

 And then what? Well, as Chamley recounts, it wasn’t pretty.

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