Q&A: What is deflation?
Gary Duncan
What is deflation?
The dreaded “D” word, one of the most feared economic blights, refers to sustained falls in prices in the economy for goods and services.
Don't we already have falling prices for some products?
Yes. For goods such as many types of clothing, Britain has got used to steadily cheaper prices as a result of intense high street competition and cheap imports from Asia. But deflation is different, meaning falls in prices more or less across the board.
But that sounds good. What's the problem?
The trend can sound like a money-saving bonanza. A short-lived burst of deflation for only a few months might end up like that and need not be a disaster. Problems start when consumers collectively curb spending, constantly waiting for ever-cheaper prices. In turn, this sucks the lifeblood of demand from the economy. With spending falling sharply, businesses sell less and less and are forced to cut wages and lay off staff — leading to even less spending, lower demand and sharper falls in prices. A vicious, downward spiral takes hold that can spell deep and prolonged recession. Once deflation sets in, it can be tough to reverse it, as negative effects feed on themselves. For example, if interest rates have been cut sharply to try to rekindle spending, then once they fall to zero it is impossible to cut them further and, after factoring in falling prices, this means that real interest rates are still higher than zero.
Are there any other effects?
Unfortunately, yes. Debt is a headache. Where prices and incomes generally are falling in a bout of deflation, this means that the real value of people's debts, relative to falling incomes, is rising. So debts become an ever bigger burden, stretching the time that is needed to pay them off to longer periods. This is known as “debt deflation”. In an economy such as Britain's, where households have the highest burden of debt of any leading economy, it poses a particularly severe danger.
How can economies escape?
With great difficulty. Deflation is like quicksand. Once in it, it is very difficult to escape the mire. Solutions to “reflate” the economy are found in flooding the financial system with ultra-cheap money. This can be done by governments printing money to give away in tax cuts, although this risks irreversible damage to a country's finances, or by a central bank buying up assets from banks, effectively handing them extremely cheap cash.
Is deflation likely to take hold now?
There is a significant danger. Headline inflation in the United States could turn negative as soon as this week, after a huge reversal of last year's surge in fuel prices. In Britain, the Bank has said that it expects inflation on some measures to fall into negative territory for at least a few months. This may fall short of full-blown deflation, but will magnify the danger of it.
http://business.timesonline.co.uk/tol/business/economics/article5750994.ece
Tuesday 17 February 2009
The Age of Deflation
February 17, 2009
The Age of Deflation
A sustained fall in prices would cause immense economic disruption and hardship; policymakers are right to fear it and to focus all efforts on preventing it .
Figures released this week in the UK and the US are likely to confirm that the annual rate of inflation is decelerating. On some measures, inflation might even turn negative. Lower prices - not just weaker inflation - will sound like good news to households where incomes have been squeezed by tax rises and higher bills. But a sustained period of falling prices (deflation) would have huge economic costs.
While the risk that deflation will take hold of the Western economies is small, it is not trivial. The prospect is powerfully exercising the minds of central bankers and explains the urgency with which the Bank of England and the US Federal Reserve have cut interest rates. Their apprehension is justified: deflation would be the worst of outcomes for the global economy.
In Europe and America, the possibility of deflation goes against all postwar experience. During the Second World War, policymakers worried that the postwar economy would suffer prolonged falls in prices as troops were demobilised and capacity constraints were eased. Yet the enduring problem proved instead to be inflation. J.M. Keynes was the great intellectual influence on Western policy till the mid-1970s, yet his writings contained little on countering inflation beyond the view that expansionary policies should be relaxed before full employment had been achieved.
In practice, full employment, upward pressure on wages and earnings, and the willingness of governments to engage in deficit financing caused a build-up in inflationary pressures. Only with punishingly high interest rates and recession did central banks manage to tame inflation in the early 1980s. Since then, and especially since the mid-1990s, inflationary conditions have been broadly benign. Cheap imports from China helped to dampen inflation and allowed central banks to keep interest rates low.
Unfortunately, easy monetary policy also stimulated an unsustainable boom in asset prices and an irresponsible expansion of credit. The collapse of the housing market bubble and the credit crunch are now pulling the global economy down into recession. Inflation is decelerating sharply, helped by falls in commodity prices.
In the UK, the annual rate of consumer price inflation - the measure that the Government targets - declined a full point to 3.1 per cent in December. The Bank of England expects the figure to fall below 1 per cent this year. Annual inflation as measured by the retail price index, which includes mortgage repayments, has been falling even more rapidly and is approaching its lowest level since 1960.
A short period of falling prices would do little damage. Consumers are used to seeing the prices of some items fall consistently - particularly in electronic goods, as computing power has become much cheaper. But a long period of general price falls, as happened in Japan in the 1990s, would be damaging. Consumers would postpone purchases, as they would be able to buy goods more cheaply in a year or two. Employment and investment would collapse. Stock prices would fall as corporate earnings would contract. Most damaging, households with debt - either mortgage debt or unsecured loans - would suffer intense hardship. Adjusted for inflation, the value of their debt burden would rise. Deflation would cause hardship, eviction and widespread corporate and personal bankruptcy.
This is the risk, if not yet prospect, that central banks now contend with. Previous deflations are almost beyond living memory. The Great Depression was marked by hardship and hunger. The Long Depression of 1873-96 generated international friction, trade warfare and financial panic. These precedents are uniformly terrible; the stakes are extremely high.
http://www.timesonline.co.uk/tol/comment/leading_article/article5748227.ece
The Age of Deflation
A sustained fall in prices would cause immense economic disruption and hardship; policymakers are right to fear it and to focus all efforts on preventing it .
Figures released this week in the UK and the US are likely to confirm that the annual rate of inflation is decelerating. On some measures, inflation might even turn negative. Lower prices - not just weaker inflation - will sound like good news to households where incomes have been squeezed by tax rises and higher bills. But a sustained period of falling prices (deflation) would have huge economic costs.
While the risk that deflation will take hold of the Western economies is small, it is not trivial. The prospect is powerfully exercising the minds of central bankers and explains the urgency with which the Bank of England and the US Federal Reserve have cut interest rates. Their apprehension is justified: deflation would be the worst of outcomes for the global economy.
In Europe and America, the possibility of deflation goes against all postwar experience. During the Second World War, policymakers worried that the postwar economy would suffer prolonged falls in prices as troops were demobilised and capacity constraints were eased. Yet the enduring problem proved instead to be inflation. J.M. Keynes was the great intellectual influence on Western policy till the mid-1970s, yet his writings contained little on countering inflation beyond the view that expansionary policies should be relaxed before full employment had been achieved.
In practice, full employment, upward pressure on wages and earnings, and the willingness of governments to engage in deficit financing caused a build-up in inflationary pressures. Only with punishingly high interest rates and recession did central banks manage to tame inflation in the early 1980s. Since then, and especially since the mid-1990s, inflationary conditions have been broadly benign. Cheap imports from China helped to dampen inflation and allowed central banks to keep interest rates low.
Unfortunately, easy monetary policy also stimulated an unsustainable boom in asset prices and an irresponsible expansion of credit. The collapse of the housing market bubble and the credit crunch are now pulling the global economy down into recession. Inflation is decelerating sharply, helped by falls in commodity prices.
In the UK, the annual rate of consumer price inflation - the measure that the Government targets - declined a full point to 3.1 per cent in December. The Bank of England expects the figure to fall below 1 per cent this year. Annual inflation as measured by the retail price index, which includes mortgage repayments, has been falling even more rapidly and is approaching its lowest level since 1960.
A short period of falling prices would do little damage. Consumers are used to seeing the prices of some items fall consistently - particularly in electronic goods, as computing power has become much cheaper. But a long period of general price falls, as happened in Japan in the 1990s, would be damaging. Consumers would postpone purchases, as they would be able to buy goods more cheaply in a year or two. Employment and investment would collapse. Stock prices would fall as corporate earnings would contract. Most damaging, households with debt - either mortgage debt or unsecured loans - would suffer intense hardship. Adjusted for inflation, the value of their debt burden would rise. Deflation would cause hardship, eviction and widespread corporate and personal bankruptcy.
This is the risk, if not yet prospect, that central banks now contend with. Previous deflations are almost beyond living memory. The Great Depression was marked by hardship and hunger. The Long Depression of 1873-96 generated international friction, trade warfare and financial panic. These precedents are uniformly terrible; the stakes are extremely high.
http://www.timesonline.co.uk/tol/comment/leading_article/article5748227.ece
Roubini tells Geithner to nationalise US banks
Roubini tells Geithner to nationalise US banks
Tim Geithner must nationalise some of America's biggest banks and take the total toll of the US bail-out to around $2 trillion, according to one of the world's most prominent economists.
By James Quinn Wall Street Correspondent
Last Updated: 1:12AM GMT 16 Feb 2009
Nouriel Roubini – the man feted with having foreseen the financial crisis before almost any of his peers – has warned that the US Treasury Secretary must go significantly further than his detail-light bail-out plan delivered last week, and argues that the Obama administration should move swiftly to take public ownership of those major US banks which are failing.
Professor Roubini, who worked with Mr Geithner in the Clinton administration, told The Daily Telegraph: "Many US banks are insolvent, even the major ones." While nationalisation is "a politically- charged decision" which needs to handled carefully, he said it needs to take place "sooner rather than later" for the sake of the wider economy.
Professor Roubini calculated that, on top of the existing $700bn (£491bn) of American taxpayers' money allocated to solving the banking crisis, Mr Geithner may need to ask the US Congress for between $1,000bn and $1,250bn in extra funds. "Sooner rather than later, they'll need more money," he added.
Prof Roubini, professor of economics and international business at NYU Stern, New York University's business school, is highly critical of Mr Geithner's bail-out plan, which he unveiled to much market chagrin last Tuesday.
The New York-based academic believes that although his former boss (the two worked together when Mr Geithner was under-secretary of international affairs at the Treasury in the dying days of the Clinton era) is moving in the right direction, he is either unwilling or unable to be direct enough when it comes to taking the tough decisions.
Prof Roubini also has some stern advice for the British government, itself facing yet another banking crisis this week as it considers whether to increase its ownership of Lloyds Banking Group.
"In the UK, the government has taken over those banks in distress through a number of measures. But the question now is whether they want to go from de facto ownership to de jure?
"It's necessary and I think that's the way we're going in the UK," he continues, saying he would be "supportive" of such a decision. Politicians "might not want it," he adds "but it is strong in action," before going on to explain that it is better for markets that governments nationalise banks quickly, resolve problems whilst in public ownership, before returning them to the market.
Prof Roubini argues that the UK is very similar to the US in terms of its economic position due to its analogous problems – both suffered housing and consumer credit bubbles – but is even more concerned about Germany, which produced dismal gross domestic product figures at the end of last week.
"Germany did not have the same excesses as the UK, but even the German banks had significant exposure to other types of excesses in lending, and they're weak," he says.
http://www.telegraph.co.uk/finance/financetopics/financialcrisis/4634398/Roubini-tells-Geithner-to-nationalise-US-banks.html
Tim Geithner must nationalise some of America's biggest banks and take the total toll of the US bail-out to around $2 trillion, according to one of the world's most prominent economists.
By James Quinn Wall Street Correspondent
Last Updated: 1:12AM GMT 16 Feb 2009
Nouriel Roubini – the man feted with having foreseen the financial crisis before almost any of his peers – has warned that the US Treasury Secretary must go significantly further than his detail-light bail-out plan delivered last week, and argues that the Obama administration should move swiftly to take public ownership of those major US banks which are failing.
Professor Roubini, who worked with Mr Geithner in the Clinton administration, told The Daily Telegraph: "Many US banks are insolvent, even the major ones." While nationalisation is "a politically- charged decision" which needs to handled carefully, he said it needs to take place "sooner rather than later" for the sake of the wider economy.
Professor Roubini calculated that, on top of the existing $700bn (£491bn) of American taxpayers' money allocated to solving the banking crisis, Mr Geithner may need to ask the US Congress for between $1,000bn and $1,250bn in extra funds. "Sooner rather than later, they'll need more money," he added.
Prof Roubini, professor of economics and international business at NYU Stern, New York University's business school, is highly critical of Mr Geithner's bail-out plan, which he unveiled to much market chagrin last Tuesday.
The New York-based academic believes that although his former boss (the two worked together when Mr Geithner was under-secretary of international affairs at the Treasury in the dying days of the Clinton era) is moving in the right direction, he is either unwilling or unable to be direct enough when it comes to taking the tough decisions.
Prof Roubini also has some stern advice for the British government, itself facing yet another banking crisis this week as it considers whether to increase its ownership of Lloyds Banking Group.
"In the UK, the government has taken over those banks in distress through a number of measures. But the question now is whether they want to go from de facto ownership to de jure?
"It's necessary and I think that's the way we're going in the UK," he continues, saying he would be "supportive" of such a decision. Politicians "might not want it," he adds "but it is strong in action," before going on to explain that it is better for markets that governments nationalise banks quickly, resolve problems whilst in public ownership, before returning them to the market.
Prof Roubini argues that the UK is very similar to the US in terms of its economic position due to its analogous problems – both suffered housing and consumer credit bubbles – but is even more concerned about Germany, which produced dismal gross domestic product figures at the end of last week.
"Germany did not have the same excesses as the UK, but even the German banks had significant exposure to other types of excesses in lending, and they're weak," he says.
http://www.telegraph.co.uk/finance/financetopics/financialcrisis/4634398/Roubini-tells-Geithner-to-nationalise-US-banks.html
Nouriel Roubini trusts Timothy Geithner to get it right on US banks
Nouriel Roubini trusts Timothy Geithner to get it right on US banks
Nouriel Roubini can see that the 'N' word might be a little difficult for Western governments to swallow right now. But for him, it's the right – indeed, the only – route to follow.
By James Quinn, Wall Street Correspondent
Last Updated: 2:34PM GMT 16 Feb 2009
Nouriel Roubini predicted the current financial crisis and now argues that many US banks should be nationalised
The "N" word, of course, is nationalisation: nationalisation of failing banks which are continuing to wreak havoc on the world's economies.
"Many US banks are insolvent, even the major ones," argues Roubini, professor of economics and international business at NYU Stern, New York University's business school, without naming names. "Call it nationalisation, or if you don't like the dirty N-word, use 'receivership' or whatever is palatable."
Call it what you want, says Roubini, but without nationalisation of some of the major banks in both the US and the UK, the banking crisis will get worse and the current recession deepen.
"If the problem of banks is one of liquidity, you can do anything you like, which seems to me what the US Treasury wants to do," he says, with reference to US Treasury Secretary Tim Geithner's slightly-fumbled banking bail-out plan launched last week to much disregard from Wall Street.
"But if the banks are insolvent, none of these will work," says Roubini of Geithner's three-part plan which includes stress-testing major banks to see if they need more public capital.
"To see which banks are insolvent, a stress test is a step to making these tough decisions," he says, tough decisions which are so politically charged that they need to be "done right" due to the number of stakeholders involved who face being wiped out if nationalisation were to occur.
"Triage the banks that are solvent but illiquid, and those that are beyond redemption need to be nationalised. But it's urgent to do it sooner rather than later. Let's not wait another 12 months."
Roubini, one of the world's foremost experts on the current banking crisis, argues that until now, the US government, like many of its European counterparts, has been busy "trying to provide manna to everyone" without actually working out who needs what.
So why, given that Geithner appears to know some of what is needed, does Roubini think he didn't go the whole hog last Tuesday?
"The benevolent view of what they've done is realise the problem, but maybe not go as far as they might like to. A month into the [Obama] administration, saying "we're going to take over most of the US banks" because they're insolvent - that might lead to being accused of being Bolshevik," he surmises.
The second reason Geithner may have held back, Roubini adds, is that perhaps he and the rest of Obama's economic team – including senior adviser Larry Summers and chairman of the White House Council of Economic Advisers Christina Romer – were banking on the economy recovering somewhat later in the year, which might lead to less stress being placed on bank assets. "A sense of cautiousness, perhaps?" he says.
Based on Roubini's forecast for the US economy, such caution is perhaps a little unwise.
He estimates that a "broad recession" – will continue well into next year, with some form of recovery into 2011. But even that is not certain, he argues, saying there is a "risk" that the current recession does not create a U-shaped curve as the majority do, but that the US ends up like Japan of the 1990's with "nasty L-shape stagnation."
"In a banking crisis, some banks are so under-capitalised that they might as well just take them over," he argues, pointing out that often it is better from a capitalist-friendly perspective to take them over, clean them up in public ownership, and sell them off again, than it is to leave them flailing for help on the open market.
Roubini, who turns 50 in March, makes his comments with a degree of inside knowledge. Although he is no way connected to the Obama administration – and is an independent economist whose only commercial tie is as chairman of economic analysis firm RGE Monitor – he did work with Geithner at the tail-end of the Clinton administration.
When Geithner was promoted to under-secretary for international affairs, Roubini became his adviser, working together for just under a year.
"I trust him," he says, despite acknowledging that he may not quite have got his ducks in a row yet. "He's someone I know well and I have great respect for him."
Why then did Geithner get it so wrong, with his ill-timed and ill-structured banking bail-out which was in many ways smothered by the ongoing debate on the now-passed $787bn fiscal stimulus package?
"You cannot blame him," says Roubini, pointing out that he's facing the "worst economic crisis since the Great Depression" and also that he is just one of a number of high-level economic advisers working under Obama. Although he does concede that his old boss could have waited for a few weeks to "get it right."
Getting it right, in Roubini's eyes of course, means nationalisation, which will invariably involve Geithner returning to the US Congress for additional funds on top of the existing $700bn bail-out fund. "Sooner rather than later, they'll need more money," estimating that $1 trillion to $1.25 trillion of extra money needs to be injected in to the US financial system to revive it, having previously warned that credit losses from US institutions will total $3.6 trillion by the time the crisis is over.
"If you do it fast, you will get private money. But if you take time, and mix good apples with bad apples, then private investors won't want to get involved," he warns.
Aware that going back to the US Congress for an extra $1 trillion of taxpayer's money will be a hard sell for Geithner, Roubini stresses that sum would not necessarily be the final cost. "That's not necessarily the total loss for the taxpayer, as the net costs are less than the headline number due to interest payments and the hope that most of the capital will be repaid."
"They'll get to that point, it's just a matter of when," shrugs Roubini, who, nationalisation or not, will no doubt be watching the actions of his former boss with keen interest.
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4639504/Nouriel-Roubini-trusts-Timothy-Geithner-to-get-it-right-on-US-banks.html
Nouriel Roubini can see that the 'N' word might be a little difficult for Western governments to swallow right now. But for him, it's the right – indeed, the only – route to follow.
By James Quinn, Wall Street Correspondent
Last Updated: 2:34PM GMT 16 Feb 2009
Nouriel Roubini predicted the current financial crisis and now argues that many US banks should be nationalised
The "N" word, of course, is nationalisation: nationalisation of failing banks which are continuing to wreak havoc on the world's economies.
"Many US banks are insolvent, even the major ones," argues Roubini, professor of economics and international business at NYU Stern, New York University's business school, without naming names. "Call it nationalisation, or if you don't like the dirty N-word, use 'receivership' or whatever is palatable."
Call it what you want, says Roubini, but without nationalisation of some of the major banks in both the US and the UK, the banking crisis will get worse and the current recession deepen.
"If the problem of banks is one of liquidity, you can do anything you like, which seems to me what the US Treasury wants to do," he says, with reference to US Treasury Secretary Tim Geithner's slightly-fumbled banking bail-out plan launched last week to much disregard from Wall Street.
"But if the banks are insolvent, none of these will work," says Roubini of Geithner's three-part plan which includes stress-testing major banks to see if they need more public capital.
"To see which banks are insolvent, a stress test is a step to making these tough decisions," he says, tough decisions which are so politically charged that they need to be "done right" due to the number of stakeholders involved who face being wiped out if nationalisation were to occur.
"Triage the banks that are solvent but illiquid, and those that are beyond redemption need to be nationalised. But it's urgent to do it sooner rather than later. Let's not wait another 12 months."
Roubini, one of the world's foremost experts on the current banking crisis, argues that until now, the US government, like many of its European counterparts, has been busy "trying to provide manna to everyone" without actually working out who needs what.
So why, given that Geithner appears to know some of what is needed, does Roubini think he didn't go the whole hog last Tuesday?
"The benevolent view of what they've done is realise the problem, but maybe not go as far as they might like to. A month into the [Obama] administration, saying "we're going to take over most of the US banks" because they're insolvent - that might lead to being accused of being Bolshevik," he surmises.
The second reason Geithner may have held back, Roubini adds, is that perhaps he and the rest of Obama's economic team – including senior adviser Larry Summers and chairman of the White House Council of Economic Advisers Christina Romer – were banking on the economy recovering somewhat later in the year, which might lead to less stress being placed on bank assets. "A sense of cautiousness, perhaps?" he says.
Based on Roubini's forecast for the US economy, such caution is perhaps a little unwise.
He estimates that a "broad recession" – will continue well into next year, with some form of recovery into 2011. But even that is not certain, he argues, saying there is a "risk" that the current recession does not create a U-shaped curve as the majority do, but that the US ends up like Japan of the 1990's with "nasty L-shape stagnation."
"In a banking crisis, some banks are so under-capitalised that they might as well just take them over," he argues, pointing out that often it is better from a capitalist-friendly perspective to take them over, clean them up in public ownership, and sell them off again, than it is to leave them flailing for help on the open market.
Roubini, who turns 50 in March, makes his comments with a degree of inside knowledge. Although he is no way connected to the Obama administration – and is an independent economist whose only commercial tie is as chairman of economic analysis firm RGE Monitor – he did work with Geithner at the tail-end of the Clinton administration.
When Geithner was promoted to under-secretary for international affairs, Roubini became his adviser, working together for just under a year.
"I trust him," he says, despite acknowledging that he may not quite have got his ducks in a row yet. "He's someone I know well and I have great respect for him."
Why then did Geithner get it so wrong, with his ill-timed and ill-structured banking bail-out which was in many ways smothered by the ongoing debate on the now-passed $787bn fiscal stimulus package?
"You cannot blame him," says Roubini, pointing out that he's facing the "worst economic crisis since the Great Depression" and also that he is just one of a number of high-level economic advisers working under Obama. Although he does concede that his old boss could have waited for a few weeks to "get it right."
Getting it right, in Roubini's eyes of course, means nationalisation, which will invariably involve Geithner returning to the US Congress for additional funds on top of the existing $700bn bail-out fund. "Sooner rather than later, they'll need more money," estimating that $1 trillion to $1.25 trillion of extra money needs to be injected in to the US financial system to revive it, having previously warned that credit losses from US institutions will total $3.6 trillion by the time the crisis is over.
"If you do it fast, you will get private money. But if you take time, and mix good apples with bad apples, then private investors won't want to get involved," he warns.
Aware that going back to the US Congress for an extra $1 trillion of taxpayer's money will be a hard sell for Geithner, Roubini stresses that sum would not necessarily be the final cost. "That's not necessarily the total loss for the taxpayer, as the net costs are less than the headline number due to interest payments and the hope that most of the capital will be repaid."
"They'll get to that point, it's just a matter of when," shrugs Roubini, who, nationalisation or not, will no doubt be watching the actions of his former boss with keen interest.
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4639504/Nouriel-Roubini-trusts-Timothy-Geithner-to-get-it-right-on-US-banks.html
China is right to have doubts about who will buy all America's debt
China is right to have doubts about who will buy all America's debt
Chinese doubts about the value of US Treasury bonds highlight a crucial question: who will buy the estimated $2.7 trillion (£1.9 trillion) to $4.2 trillion of debt expected to be issued over the next two years?
By Martin Hutchinson
Last Updated: 12:14PM GMT 13 Feb 2009
With annual foreign purchases accounting for less than a tenth of the low end of that range, and domestic investors unable to bridge the gap, the Chinese are right to worry.
Yu Yongding, former adviser to the People’s Bank of China, recently demanded guarantees for the value of China’s $682bn of Treasury securities. Then Luo Ping, director of the China Banking Regulatory Commission, said that China had misgivings about the US economy, but despite this it would continue to buy Treasuries. The two statements appear designed to raise the issue non-confrontationally before new chief US diplomat Hillary Clinton’s visit to Beijing on February 20.
China worries about the dollar’s value against other currencies, particularly the yuan. With US interest rates so low, the dollar’s value may slide. However, President Barack Obama has repeatedly said he wants a strong dollar, and indeed its trade-weighted value rose 13.9pc between April and December 2008.
The other area of concern for China is the value of its Treasuries. Given the US borrowing requirement and its lax monetary policy, Treasury bond yields could well rise sharply, causing a corresponding price decline. If China’s holdings match Treasuries’ average 48-month duration, then a 5pc rise in yields, from 1.72pc on the 5-year note to 6.72pc, would lose China 17.5pc of its holdings’ value, or $119bn.
Foreign buyers have absorbed a little over $200bn of Treasuries annually, a useful contribution to financing the $459bn 2008 deficit, but only a modest help towards the $1.35 trillion minimum average deficit forecast for 2009 and 2010.
Unless that changes substantially, there will be $1trillion annually to be raised by the Treasury from domestic sources, more than double the previous record from domestic and foreign sources together, plus whatever is needed to bail out the banks.
Even if the US savings rate were to rise from zero to its long-term average of 8pc of disposable personal income, that would create only an additional $830bn of savings -- not enough to fund the domestic share of the deficit. Interest rates would probably have to rise substantially to pull in more foreign investors.
Yu is right to worry.
For more agenda-setting financial insight, visit www.breakingviews.com
http://www.telegraph.co.uk/finance/breakingviewscom/4611408/China-is-right-to-have-doubts-about-who-will-buy-all-Americas-debt.html
Chinese doubts about the value of US Treasury bonds highlight a crucial question: who will buy the estimated $2.7 trillion (£1.9 trillion) to $4.2 trillion of debt expected to be issued over the next two years?
By Martin Hutchinson
Last Updated: 12:14PM GMT 13 Feb 2009
With annual foreign purchases accounting for less than a tenth of the low end of that range, and domestic investors unable to bridge the gap, the Chinese are right to worry.
Yu Yongding, former adviser to the People’s Bank of China, recently demanded guarantees for the value of China’s $682bn of Treasury securities. Then Luo Ping, director of the China Banking Regulatory Commission, said that China had misgivings about the US economy, but despite this it would continue to buy Treasuries. The two statements appear designed to raise the issue non-confrontationally before new chief US diplomat Hillary Clinton’s visit to Beijing on February 20.
China worries about the dollar’s value against other currencies, particularly the yuan. With US interest rates so low, the dollar’s value may slide. However, President Barack Obama has repeatedly said he wants a strong dollar, and indeed its trade-weighted value rose 13.9pc between April and December 2008.
The other area of concern for China is the value of its Treasuries. Given the US borrowing requirement and its lax monetary policy, Treasury bond yields could well rise sharply, causing a corresponding price decline. If China’s holdings match Treasuries’ average 48-month duration, then a 5pc rise in yields, from 1.72pc on the 5-year note to 6.72pc, would lose China 17.5pc of its holdings’ value, or $119bn.
Foreign buyers have absorbed a little over $200bn of Treasuries annually, a useful contribution to financing the $459bn 2008 deficit, but only a modest help towards the $1.35 trillion minimum average deficit forecast for 2009 and 2010.
Unless that changes substantially, there will be $1trillion annually to be raised by the Treasury from domestic sources, more than double the previous record from domestic and foreign sources together, plus whatever is needed to bail out the banks.
Even if the US savings rate were to rise from zero to its long-term average of 8pc of disposable personal income, that would create only an additional $830bn of savings -- not enough to fund the domestic share of the deficit. Interest rates would probably have to rise substantially to pull in more foreign investors.
Yu is right to worry.
For more agenda-setting financial insight, visit www.breakingviews.com
http://www.telegraph.co.uk/finance/breakingviewscom/4611408/China-is-right-to-have-doubts-about-who-will-buy-all-Americas-debt.html
The buy/sell ratio in Lloyds Banking Group was 7:1 on Friday
Private investors pile into Lloyds shares
Private investors who bought shares in Lloyds Banking Group outnumbered sellers by seven to one at one London stockbroker as the shares plunged following news of huge losses at HBOS.
By Richard Evans
Last Updated: 6:11PM GMT 16 Feb 2009
"The buy/sell ratio in Lloyds Banking Group was 7:1 on Friday," said TD Waterhouse, a broker that specialises in "execution only" trades – those where investors make their own decisions.
Strong demand for the bank's shares continued on Monday – the ratio was two to one in favour of buyers, after Lloyds shares fell by 20pc on the opening of the market in London. By midafternoon, the shares were trading at 57p.
Investor interest was first triggered on Friday when Lloyds' share price fell by 32pc, closing at 61.4p as institutional investors sold the shares following news of losses of almost £11bn at HBOS, the troubled bank that Lloyds bought last year.
TD Waterhouse said: "Lloyds Banking Group accounted for 40pc of the top 10 trades by our customers on Friday. On Monday Lloyds again was the most traded stock."
It added: "The data indicates that our frequent traders are looking to turn a quick profit on the volatility of banking stocks, and Lloyds in particular."
Tom Diavolitsis, a director of TD Waterhouse, said: "Lloyds was the number one traded stock by our customers on Friday last week and in the first two hours of trading today [Monday].
"It is clear that our investors are hoping to take advantage of the recent volatility in the Lloyds share price. Some will be looking to make a short-term profit, others may be looking to gain by holding the stock for the longer term."
It was a similar story at Stocktrade, the execution-only division of Brewin Dolphin, another stockbroker. Lloyds accounted for 25pc of the division's trades on Monday morning; 56pc of the Lloyds orders were buys and 44pc were sells.
Royal Bank of Scotland accounted for 7pc of trades – 63pc of them buys and 37pc sells. Buy orders for Barclays shares outnumbered sales by three to one.
Brewin Dolphin said its view for investment management clients was that the Government would nationalise Lloyds only as a very last resort. "We are not that close to a last-ditch scenario just yet, though very much aware of the strong economic head winds.
"The current Lloyds share price is acting like a warrant; if they can survive we believe there is significant longer-term upside."
http://www.telegraph.co.uk/finance/personalfinance/investing/shares/4640868/Private-investors-pile-into-Lloyds-shares.html
Private investors who bought shares in Lloyds Banking Group outnumbered sellers by seven to one at one London stockbroker as the shares plunged following news of huge losses at HBOS.
By Richard Evans
Last Updated: 6:11PM GMT 16 Feb 2009
"The buy/sell ratio in Lloyds Banking Group was 7:1 on Friday," said TD Waterhouse, a broker that specialises in "execution only" trades – those where investors make their own decisions.
Strong demand for the bank's shares continued on Monday – the ratio was two to one in favour of buyers, after Lloyds shares fell by 20pc on the opening of the market in London. By midafternoon, the shares were trading at 57p.
Investor interest was first triggered on Friday when Lloyds' share price fell by 32pc, closing at 61.4p as institutional investors sold the shares following news of losses of almost £11bn at HBOS, the troubled bank that Lloyds bought last year.
TD Waterhouse said: "Lloyds Banking Group accounted for 40pc of the top 10 trades by our customers on Friday. On Monday Lloyds again was the most traded stock."
It added: "The data indicates that our frequent traders are looking to turn a quick profit on the volatility of banking stocks, and Lloyds in particular."
Tom Diavolitsis, a director of TD Waterhouse, said: "Lloyds was the number one traded stock by our customers on Friday last week and in the first two hours of trading today [Monday].
"It is clear that our investors are hoping to take advantage of the recent volatility in the Lloyds share price. Some will be looking to make a short-term profit, others may be looking to gain by holding the stock for the longer term."
It was a similar story at Stocktrade, the execution-only division of Brewin Dolphin, another stockbroker. Lloyds accounted for 25pc of the division's trades on Monday morning; 56pc of the Lloyds orders were buys and 44pc were sells.
Royal Bank of Scotland accounted for 7pc of trades – 63pc of them buys and 37pc sells. Buy orders for Barclays shares outnumbered sales by three to one.
Brewin Dolphin said its view for investment management clients was that the Government would nationalise Lloyds only as a very last resort. "We are not that close to a last-ditch scenario just yet, though very much aware of the strong economic head winds.
"The current Lloyds share price is acting like a warrant; if they can survive we believe there is significant longer-term upside."
http://www.telegraph.co.uk/finance/personalfinance/investing/shares/4640868/Private-investors-pile-into-Lloyds-shares.html
Europe has reached acute danger point.
Failure to save East Europe will lead to worldwide meltdown
The unfolding debt drama in Russia, Ukraine, and the EU states of Eastern Europe has reached acute danger point.
By Ambrose Evans-Pritchard
Last Updated: 2:05AM GMT 15 Feb 2009
Comments 91 Comment on this article
If mishandled by the world policy establishment, this debacle is big enough to shatter the fragile banking systems of Western Europe and set off round two of our financial Götterdämmerung.
Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.
"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.
The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East.
Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said. We'll see about that.
Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut.
Not even Russia can easily cover the $500bn dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36pc of its foreign reserves since August defending the rouble.
"This is the largest run on a currency in history," said Mr Jen.
In Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly – by lenders and borrowers – it matches America's sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.
Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74pc of the entire $4.9 trillion portfolio of loans to emerging markets.
They are five times more exposed to this latest bust than American or Japanese banks, and they are 50pc more leveraged (IMF data).
Spain is up to its neck in Latin America, which has belatedly joined the slump (Mexico's car output fell 51pc in January, and Brazil lost 650,000 jobs in one month). Britain and Switzerland are up to their necks in Asia.
Whether it takes months, or just weeks, the world is going to discover that Europe's financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus.
Under a "Taylor Rule" analysis, the European Central Bank already needs to cut rates to zero and then purchase bonds and Pfandbriefe on a huge scale. It is constrained by geopolitics – a German-Dutch veto – and the Maastricht Treaty.
But I digress. It is East Europe that is blowing up right now. Erik Berglof, EBRD's chief economist, told me the region may need €400bn in help to cover loans and prop up the credit system.
Europe's governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.
The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan – and Turkey next – and is fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.
Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia's central bank governor has declared his economy "clinically dead" after it shrank 10.5pc in the fourth quarter. Protesters have smashed the treasury and stormed parliament.
"This is much worse than the East Asia crisis in the 1990s," said Lars Christensen, at Danske Bank.
"There are accidents waiting to happen across the region, but the EU institutions don't have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU."
Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4pc in the fourth quarter.
If Deutsche Bank is correct, the economy will have shrunk by nearly 9pc before the end of this year. This is the sort of level that stokes popular revolt.
The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU "union bonds" should the debt markets take fright at the rocketing trajectory of Italy's public debt (hitting 112pc of GDP next year, just revised up from 101pc – big change), or rescue Austria from its Habsburg adventurism.
So we watch and wait as the lethal brush fires move closer.
If one spark jumps across the eurozone line, we will have global systemic crisis within days. Are the firemen ready?
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4623525/Failure-to-save-East-Europe-will-lead-to-worldwide-meltdown.html
The unfolding debt drama in Russia, Ukraine, and the EU states of Eastern Europe has reached acute danger point.
By Ambrose Evans-Pritchard
Last Updated: 2:05AM GMT 15 Feb 2009
Comments 91 Comment on this article
If mishandled by the world policy establishment, this debacle is big enough to shatter the fragile banking systems of Western Europe and set off round two of our financial Götterdämmerung.
Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.
"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.
The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East.
Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said. We'll see about that.
Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut.
Not even Russia can easily cover the $500bn dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36pc of its foreign reserves since August defending the rouble.
"This is the largest run on a currency in history," said Mr Jen.
In Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly – by lenders and borrowers – it matches America's sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.
Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74pc of the entire $4.9 trillion portfolio of loans to emerging markets.
They are five times more exposed to this latest bust than American or Japanese banks, and they are 50pc more leveraged (IMF data).
Spain is up to its neck in Latin America, which has belatedly joined the slump (Mexico's car output fell 51pc in January, and Brazil lost 650,000 jobs in one month). Britain and Switzerland are up to their necks in Asia.
Whether it takes months, or just weeks, the world is going to discover that Europe's financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus.
Under a "Taylor Rule" analysis, the European Central Bank already needs to cut rates to zero and then purchase bonds and Pfandbriefe on a huge scale. It is constrained by geopolitics – a German-Dutch veto – and the Maastricht Treaty.
But I digress. It is East Europe that is blowing up right now. Erik Berglof, EBRD's chief economist, told me the region may need €400bn in help to cover loans and prop up the credit system.
Europe's governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.
The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan – and Turkey next – and is fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.
Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia's central bank governor has declared his economy "clinically dead" after it shrank 10.5pc in the fourth quarter. Protesters have smashed the treasury and stormed parliament.
"This is much worse than the East Asia crisis in the 1990s," said Lars Christensen, at Danske Bank.
"There are accidents waiting to happen across the region, but the EU institutions don't have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU."
Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4pc in the fourth quarter.
If Deutsche Bank is correct, the economy will have shrunk by nearly 9pc before the end of this year. This is the sort of level that stokes popular revolt.
The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU "union bonds" should the debt markets take fright at the rocketing trajectory of Italy's public debt (hitting 112pc of GDP next year, just revised up from 101pc – big change), or rescue Austria from its Habsburg adventurism.
So we watch and wait as the lethal brush fires move closer.
If one spark jumps across the eurozone line, we will have global systemic crisis within days. Are the firemen ready?
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4623525/Failure-to-save-East-Europe-will-lead-to-worldwide-meltdown.html
Monday 16 February 2009
Classic Question: Annuities or Bonds?
Classic Question: Annuities or Bonds?
Sponsored by by Don Taylor
Saturday, February 14, 2009
provided by
Dear Dr. Don,
I have been considering an immediate annuity, but was wondering what the benefit is over buying a long-term corporate bond or bonds with a similar yield.
Assuming I seek 30 years of income, it seems the annuity is implying something like a 4.5 percent to 5 percent yield. Wouldn't I be better off buying a corporate bond that yields a similar amount? That way, I'd still have the principal to spend at maturity in case I lived longer than planned.
Am I not taking the same default risk with either investment since the insurance company could go out of business just like any other company? And finally, are there tax reasons that would make an immediate annuity better?
-- Laurence Longevity
Dear Laurence,
Yours is a classic question in retirement planning. To restate: "If you can invest at the same yield and the same risk as the immediate annuity, aren't you better off investing in the bonds versus buying the immediate annuity?"
For many the answer will be "no," but making it an apples-to-apples comparison is more difficult than just comparing the interest income from the bonds with the income from the annuity.
In addition, getting the risk levels equal is nigh impossible. State insurance commissions have reserve and other requirements that make an investment in an annuity from a highly rated insurance company safer than an investment in a highly rated corporate bond.
You purchase an immediate annuity with a lump sum and buy an income stream that lasts for your lifetime. The immediate annuity allows you to achieve a higher income stream than you could earn from living off the interest income paid by the bonds. That's because a straight life immediate annuity doesn't return principal when you die, and the annuity only lasts for your lifetime.
There are a multitude of options in how you structure the annuity. You can have it pay over your lifetime, over a joint lifetime or over a set time horizon. The payment can be indexed to inflation. There may or may not be a death benefit to a beneficiary. There may be a guarantee that you or your beneficiaries will at least receive in distributions the amount of money you have invested.
As soon as you start adding options, however, the value of the annuity payment declines because you have spent part of the purchase price to buy that option.
I used the annuity quote function on ImmediateAnnuities.com and assumed a $1 million investment for a 66-year-old male. (The annuity calculator on Vanguard.com is also recommended.) You can do your own calculation based on your age and the money you have available to purchase the annuity. The site will return almost two dozen different monthly payments based on typical annuity options.
I'm going to focus on the straight life annuity, which is the type of annuity that ensures a fixed income for the rest of the purchaser's life. The $1 million purchase secures a monthly income stream of $7,397. If you assume a 30-year life, it equates to a yield of roughly 8.4 percent (assuming the 66-year-old lives to 96). The longer you live, the higher the implied yield on the annuity.
A portfolio of 30-year, single-A rated corporate bonds isn't currently yielding in that ballpark. However, even if the two products were yielding a similar rate, the bonds are riskier than the annuities (for the reasons stated earlier).
I'm going to beg off on the tax discussion between the two investments and leave that to you and a tax professional. However, there's more to consider here than just taxes. Two other considerations are how the choice of an annuity versus the bond portfolio could impact your eligibility for Medicaid and potential estate-planning issues.
The bottom line is that the law of large numbers should allow an insurance company to pay a higher income stream on a single life annuity than you can earn off a similar amount invested in a high-quality bond portfolio.
This is true because the insurance company doesn't have to return your principal if you die sooner than expected, and dealing with a large pool of annuity owners means it can use mortality figures to estimate the average life of that pool to price the annuity.
Annuities are going to make the most sense for people who are worried about outliving their income and don't have a large retirement nest egg as a backstop.
Before signing an annuity contract, get a second opinion on the decision from a fee-only financial adviser. The National Association of Personal Financial Advisors maintains a listing of fee-only advisers.
Copyrighted, Bankrate.com. All rights reserved.
http://finance.yahoo.com/focus-retirement/article/106589/Classic-Question:-Annuities-or-Bonds?mod=retirement-post-spending
Sponsored by by Don Taylor
Saturday, February 14, 2009
provided by
Dear Dr. Don,
I have been considering an immediate annuity, but was wondering what the benefit is over buying a long-term corporate bond or bonds with a similar yield.
Assuming I seek 30 years of income, it seems the annuity is implying something like a 4.5 percent to 5 percent yield. Wouldn't I be better off buying a corporate bond that yields a similar amount? That way, I'd still have the principal to spend at maturity in case I lived longer than planned.
Am I not taking the same default risk with either investment since the insurance company could go out of business just like any other company? And finally, are there tax reasons that would make an immediate annuity better?
-- Laurence Longevity
Dear Laurence,
Yours is a classic question in retirement planning. To restate: "If you can invest at the same yield and the same risk as the immediate annuity, aren't you better off investing in the bonds versus buying the immediate annuity?"
For many the answer will be "no," but making it an apples-to-apples comparison is more difficult than just comparing the interest income from the bonds with the income from the annuity.
In addition, getting the risk levels equal is nigh impossible. State insurance commissions have reserve and other requirements that make an investment in an annuity from a highly rated insurance company safer than an investment in a highly rated corporate bond.
You purchase an immediate annuity with a lump sum and buy an income stream that lasts for your lifetime. The immediate annuity allows you to achieve a higher income stream than you could earn from living off the interest income paid by the bonds. That's because a straight life immediate annuity doesn't return principal when you die, and the annuity only lasts for your lifetime.
There are a multitude of options in how you structure the annuity. You can have it pay over your lifetime, over a joint lifetime or over a set time horizon. The payment can be indexed to inflation. There may or may not be a death benefit to a beneficiary. There may be a guarantee that you or your beneficiaries will at least receive in distributions the amount of money you have invested.
As soon as you start adding options, however, the value of the annuity payment declines because you have spent part of the purchase price to buy that option.
I used the annuity quote function on ImmediateAnnuities.com and assumed a $1 million investment for a 66-year-old male. (The annuity calculator on Vanguard.com is also recommended.) You can do your own calculation based on your age and the money you have available to purchase the annuity. The site will return almost two dozen different monthly payments based on typical annuity options.
I'm going to focus on the straight life annuity, which is the type of annuity that ensures a fixed income for the rest of the purchaser's life. The $1 million purchase secures a monthly income stream of $7,397. If you assume a 30-year life, it equates to a yield of roughly 8.4 percent (assuming the 66-year-old lives to 96). The longer you live, the higher the implied yield on the annuity.
A portfolio of 30-year, single-A rated corporate bonds isn't currently yielding in that ballpark. However, even if the two products were yielding a similar rate, the bonds are riskier than the annuities (for the reasons stated earlier).
I'm going to beg off on the tax discussion between the two investments and leave that to you and a tax professional. However, there's more to consider here than just taxes. Two other considerations are how the choice of an annuity versus the bond portfolio could impact your eligibility for Medicaid and potential estate-planning issues.
The bottom line is that the law of large numbers should allow an insurance company to pay a higher income stream on a single life annuity than you can earn off a similar amount invested in a high-quality bond portfolio.
This is true because the insurance company doesn't have to return your principal if you die sooner than expected, and dealing with a large pool of annuity owners means it can use mortality figures to estimate the average life of that pool to price the annuity.
Annuities are going to make the most sense for people who are worried about outliving their income and don't have a large retirement nest egg as a backstop.
Before signing an annuity contract, get a second opinion on the decision from a fee-only financial adviser. The National Association of Personal Financial Advisors maintains a listing of fee-only advisers.
Copyrighted, Bankrate.com. All rights reserved.
http://finance.yahoo.com/focus-retirement/article/106589/Classic-Question:-Annuities-or-Bonds?mod=retirement-post-spending
Sunday 15 February 2009
Paradox of thrift
Go ahead and save. Let the government spend.
By Robert H. Frank
Sunday, February 15, 2009
A psychotherapist friend says that several of her patients are fretting about whether they have an obligation to help the nation spend its way out of the current downturn. Some of them are having a hard time making ends meet, she said, yet are reluctant to cut back for fear they would cause the economy to slide further.
The role of consumers has had considerable attention in the press because the economy desperately needs additional spending right now. But it is not — and should not be — the responsibility of middle-income families to provide that spending. If financially comfortable families want to support their favorite restaurants during hard times by eating out more often, who could object? But if others are inclined to pay down their bills or save a little more, concerns about the economy shouldn't stop them.
Government is in a far better position to provide immediate economic stimulus. It is in fact the only player that can significantly alter the economy's short-run trajectory. In a recession, as in ordinary times, a family's first economic priority should be to spend its income prudently.
The "paradox of thrift," a celebrated chestnut first described by John Maynard Keynes in the 1930s, has been the source of much confusion about how saving affects the health of the economy. Intuition suggests, correctly, that if any one family saves an extra $100 this year, its bank balance at year's end will be higher by that amount. According to the paradox of thrift, however, if everyone tries to save more at once, total savings will actually fall.
How could that happen? The explanation begins with the observation that, to save more, a family must spend less. Because consumption spending is part of national income, which in turn is the total amount spent by everyone in the economy, more saving causes national income to fall. Income will actually fall by more than the initial decline in consumption, because when one family spends less, other families earn less and respond by cutting their own consumption. When the dust settles, the story concludes, each family ends up saving less than before.
But that doesn't mean that people should stop saving for retirement or their children's education. If we're going to ask people to make sacrifices, it should be for something that will actually make a difference. (My colleague David Leonhardt wrote a column on Wednesday suggesting that by making certain kinds of investments — like making their homes more energy efficient — families could boost current spending while also increasing their long-run savings, despite the paradox of thrift.)
But even by mortgaging itself to the hilt (as many families have indeed already done during the recent national spending spree), no family could spend enough to affect the current downturn.
Nor is it reasonable to demand that individual businesses pick up the slack, since most of them already have more capacity than they currently need. At moments like these, government is the only actor with both the motivation and the ability to jump-start the economy.
Passage of a robust stimulus bill has rightly been the Obama administration's highest priority since taking office last month. As Keynes explained during the Great Depression, increased public spending would help end the downturn even if it were for useless activities like digging holes and filling them back up. It would obviously be better if the extra spending went for something useful. And as it happens, decades of infrastructure neglect, combined with huge state and local government budget shortfalls, provide more than enough valuable projects to put everyone back to work.
Bizarrely, however, some congressional critics have denounced the administration's stimulus proposals as "mere spending programs." Of course they're spending programs! More spending is exactly what we need. The imperative is to get this legislation passed and get the spending started right away.
The paradox of thrift has been a pernicious idea. By casting saving in such a negative light, it has encouraged people to think that thrift no longer matters. And most Americans have been only too happy to spend more freely. Household savings rates have fallen sharply for several decades. For two of the past three years, they have actually been negative, meaning that spending has exceeded income.
By fueling the housing bubble, this spending not only helped cause the current crisis, but also led to substantially increased borrowing from abroad. We're poorer each year by the hundreds of billions of dollars that we must pay in interest on these loans.
The "paradox of thrift" applies only during economic downturns, and even then only when government fails to stimulate spending. Most of the time, however, the economy operates near full employment. Before long, it will again. Under those circumstances, if every family saved a little more, extra money would flow into the capital market, causing interest rates to fall and investment spending to rise.
Because the fall in consumption from increased savings would be exactly offset by the rise in investment, total demand would still be sufficient to maintain full employment. The extra investment would boost productivity, causing national income to grow faster in the long run. As a result of the spending spree of recent decades, however, our growth rate has fallen sharply. Much of the nation's credit-card debt is now carried at annual interest rates of 20 percent or more. In just five years, each dollar invested in paying down such debt would support more than $2.50 of additional consumption; in just 10 years, more than $6. It is unreasonable to ask families to spend more when government can stimulate the economy so much more efficiently.
THE financial health of the nation and the financial health of individual families are not conflicting goals. A family that wants to help put the economy back on its feet while increasing its own future standard of living should consider saving a little more or paying down debt. Those who want a tangible symbol of their patriotism can buy additional government bonds, which will help repair an extra bridge or hire an extra math teacher.
--------------------------------------------------------------------------------
Copyright © 2009 The International Herald Tribune www.iht.com
http://www.iht.com/articles/2009/02/15/business/15view.php
By Robert H. Frank
Sunday, February 15, 2009
A psychotherapist friend says that several of her patients are fretting about whether they have an obligation to help the nation spend its way out of the current downturn. Some of them are having a hard time making ends meet, she said, yet are reluctant to cut back for fear they would cause the economy to slide further.
The role of consumers has had considerable attention in the press because the economy desperately needs additional spending right now. But it is not — and should not be — the responsibility of middle-income families to provide that spending. If financially comfortable families want to support their favorite restaurants during hard times by eating out more often, who could object? But if others are inclined to pay down their bills or save a little more, concerns about the economy shouldn't stop them.
Government is in a far better position to provide immediate economic stimulus. It is in fact the only player that can significantly alter the economy's short-run trajectory. In a recession, as in ordinary times, a family's first economic priority should be to spend its income prudently.
The "paradox of thrift," a celebrated chestnut first described by John Maynard Keynes in the 1930s, has been the source of much confusion about how saving affects the health of the economy. Intuition suggests, correctly, that if any one family saves an extra $100 this year, its bank balance at year's end will be higher by that amount. According to the paradox of thrift, however, if everyone tries to save more at once, total savings will actually fall.
How could that happen? The explanation begins with the observation that, to save more, a family must spend less. Because consumption spending is part of national income, which in turn is the total amount spent by everyone in the economy, more saving causes national income to fall. Income will actually fall by more than the initial decline in consumption, because when one family spends less, other families earn less and respond by cutting their own consumption. When the dust settles, the story concludes, each family ends up saving less than before.
But that doesn't mean that people should stop saving for retirement or their children's education. If we're going to ask people to make sacrifices, it should be for something that will actually make a difference. (My colleague David Leonhardt wrote a column on Wednesday suggesting that by making certain kinds of investments — like making their homes more energy efficient — families could boost current spending while also increasing their long-run savings, despite the paradox of thrift.)
But even by mortgaging itself to the hilt (as many families have indeed already done during the recent national spending spree), no family could spend enough to affect the current downturn.
Nor is it reasonable to demand that individual businesses pick up the slack, since most of them already have more capacity than they currently need. At moments like these, government is the only actor with both the motivation and the ability to jump-start the economy.
Passage of a robust stimulus bill has rightly been the Obama administration's highest priority since taking office last month. As Keynes explained during the Great Depression, increased public spending would help end the downturn even if it were for useless activities like digging holes and filling them back up. It would obviously be better if the extra spending went for something useful. And as it happens, decades of infrastructure neglect, combined with huge state and local government budget shortfalls, provide more than enough valuable projects to put everyone back to work.
Bizarrely, however, some congressional critics have denounced the administration's stimulus proposals as "mere spending programs." Of course they're spending programs! More spending is exactly what we need. The imperative is to get this legislation passed and get the spending started right away.
The paradox of thrift has been a pernicious idea. By casting saving in such a negative light, it has encouraged people to think that thrift no longer matters. And most Americans have been only too happy to spend more freely. Household savings rates have fallen sharply for several decades. For two of the past three years, they have actually been negative, meaning that spending has exceeded income.
By fueling the housing bubble, this spending not only helped cause the current crisis, but also led to substantially increased borrowing from abroad. We're poorer each year by the hundreds of billions of dollars that we must pay in interest on these loans.
The "paradox of thrift" applies only during economic downturns, and even then only when government fails to stimulate spending. Most of the time, however, the economy operates near full employment. Before long, it will again. Under those circumstances, if every family saved a little more, extra money would flow into the capital market, causing interest rates to fall and investment spending to rise.
Because the fall in consumption from increased savings would be exactly offset by the rise in investment, total demand would still be sufficient to maintain full employment. The extra investment would boost productivity, causing national income to grow faster in the long run. As a result of the spending spree of recent decades, however, our growth rate has fallen sharply. Much of the nation's credit-card debt is now carried at annual interest rates of 20 percent or more. In just five years, each dollar invested in paying down such debt would support more than $2.50 of additional consumption; in just 10 years, more than $6. It is unreasonable to ask families to spend more when government can stimulate the economy so much more efficiently.
THE financial health of the nation and the financial health of individual families are not conflicting goals. A family that wants to help put the economy back on its feet while increasing its own future standard of living should consider saving a little more or paying down debt. Those who want a tangible symbol of their patriotism can buy additional government bonds, which will help repair an extra bridge or hire an extra math teacher.
--------------------------------------------------------------------------------
Copyright © 2009 The International Herald Tribune www.iht.com
http://www.iht.com/articles/2009/02/15/business/15view.php
A generation shy of risk?
A generation shy of risk?
FEB 15 – You did what you were supposed to do. College. Graduate school, maybe. Bought a home. Invested in mutual funds. Bought a house.
And now? You have student loan debt. Your degree has not shielded you from unemployment (or the fear of it). The house is worth 20 per cent less than two years ago, and your retirement portfolio is down 40 per cent from its peak.
So at this moment, can you blame people in their 20s and 30s for giving up altogether on risk of any sort? It’s one of the bigger questions preoccupying those who think about money management all day.
Are we in the process of minting a new generation of adults who are averse to taking chances, whether it’s buying real estate or investing in stocks?
“We trained people that if you took risk and diversified and played by the rules that you’d have a great life for yourself,” said Howard L. Simons of the bond specialist Bianco Research. “But all of that can disappear in a hurry. And most of us can look in the mirror and say, ‘What did I do to cause this?’ And nothing springs to mind.”
I’m not sure we can say for sure whether there has been some permanent change in attitudes toward risk. It’s easy to overestimate the extent to which the world – and our perception of it – has changed in the middle of a crisis. But this one has not lasted long. And its duration does not come close to matching the period in the 1930s that left a permanent imprint on so many people’s financial habits.
Even before the downturn, younger adults were not necessarily enthusiastic about riskier forms of investing, even though they are far from retirement.
A joint study by the Investment Company Institute and the Securities Industry and Financial Markets Association noted that just 45 per cent of households headed by people under 40 held 51 per cent or more of their portfolios in stocks, mutual funds and other, similar investments last spring. That is less than what households headed by those 40 to 64 owned. Fifty per cent of them invested more than half their money in equities.
Data from Vanguard, however, suggests that its investors under 45 who use target-date mutual funds, which allocate assets among stocks and bonds for the investor, tend to have significantly more money in stocks than those who do not use these mutual funds.
As more employers automatically sign up younger workers for 401(k) plans and use fairly aggressive target-date funds as a default investment, those employees’ exposure to stocks will grow.
So perhaps a better question to ask is not whether people in the first half of their working lives are becoming more risk-averse, but whether they should be.
On Thursday night, Kevin Brosious, a financial planner in Allentown, Pa., polled the students in his financial management class at DeSales University on the percentage of their portfolios they would allocate to stocks right now. The majority would put less than half in stocks; among their reasons were fear of job loss, lack of accountability on Wall
Street and economic fears amplified by the news media.
The problem with their approach, according to Brosious, is that by investing conservatively they are probably guaranteeing themselves a smaller return and a more meagre standard of living in retirement.
Or, as Robert N. Siegmann, chief operating officer and senior adviser of the Financial Management Group in Cincinnati, wrote to me in an e-mail message, “Why would you consider taking less risk NOW after most of the risk has already been paid for in the market over the past 12 months?”
If investing still seems too risky to you right now, you’re not alone. At Charles Schwab, according to a spokesman, younger 401(k) participants are not making many big investment moves. But there is a sense that at least some younger investors may divert 401(k) contributions to other uses, especially as more companies reduce or suspend their 401(k) matches.
In that case, one sensible way to reduce overall risk is to pay down high-interest debt, like credit cards or private student loans. That, at least, offers a guaranteed return, since every extra dollar you pay now keeps you from having to pay more interest later. Also, the sooner you rid yourself of debt payments, the less you would need in your monthly budget if you lost your job.
“I think the only thing younger people should be more risk-averse about is the leverage they take on,” said Jeffrey G. Cribbs, president of Chicago Wealth Management in Oak Park, Ill.
In particular, he suggested they buy real estate and cars at levels below what they can actually afford.
So what kind of risk should you take on with the savings you have left over? To Moshe A. Milevsky, the author of “Are You a Stock or a Bond?,” risk should have less to do with the era in which you live and more to do with what you do for a living.
If you are a tenured professor, a teacher, a firefighter or other government employee, you have better job security than most other people. Your income stream is stable, like a bond. Certain service providers, like plumbers and doctors, have similar security.
Investment bankers and many technology and media workers, however, have more volatility in their career paths. A chart of their income might bounce around like one showing a stock’s price.
“The idea is that we should focus on our human capital and invest in places where our human capital is not,” Milevsky said. “It’s not about risk tolerance or time horizon but about what you do for a living.”
As a tenured professor, he invests entirely in equities. Other people with bond-like characteristics who are far from retirement could take similar risks, and withstand 2008-level losses, because their incomes are fairly stable. Those who have more stock-like careers, however, probably ought to invest a bit more conservatively, in both their retirement accounts and in their primary residences.
For most young people, however, their biggest asset is not a 401(k) account or a home but the trajectory of their career and the value of 20 or 30 or 40 years of future earnings. It makes nearly everyone a millionaire on paper.
So whether you are taking on too much risk right now or not, all of that money will provide many more chances to fix any mistakes you have already made.
Has your risk tolerance changed forever? – NYT
FEB 15 – You did what you were supposed to do. College. Graduate school, maybe. Bought a home. Invested in mutual funds. Bought a house.
And now? You have student loan debt. Your degree has not shielded you from unemployment (or the fear of it). The house is worth 20 per cent less than two years ago, and your retirement portfolio is down 40 per cent from its peak.
So at this moment, can you blame people in their 20s and 30s for giving up altogether on risk of any sort? It’s one of the bigger questions preoccupying those who think about money management all day.
Are we in the process of minting a new generation of adults who are averse to taking chances, whether it’s buying real estate or investing in stocks?
“We trained people that if you took risk and diversified and played by the rules that you’d have a great life for yourself,” said Howard L. Simons of the bond specialist Bianco Research. “But all of that can disappear in a hurry. And most of us can look in the mirror and say, ‘What did I do to cause this?’ And nothing springs to mind.”
I’m not sure we can say for sure whether there has been some permanent change in attitudes toward risk. It’s easy to overestimate the extent to which the world – and our perception of it – has changed in the middle of a crisis. But this one has not lasted long. And its duration does not come close to matching the period in the 1930s that left a permanent imprint on so many people’s financial habits.
Even before the downturn, younger adults were not necessarily enthusiastic about riskier forms of investing, even though they are far from retirement.
A joint study by the Investment Company Institute and the Securities Industry and Financial Markets Association noted that just 45 per cent of households headed by people under 40 held 51 per cent or more of their portfolios in stocks, mutual funds and other, similar investments last spring. That is less than what households headed by those 40 to 64 owned. Fifty per cent of them invested more than half their money in equities.
Data from Vanguard, however, suggests that its investors under 45 who use target-date mutual funds, which allocate assets among stocks and bonds for the investor, tend to have significantly more money in stocks than those who do not use these mutual funds.
As more employers automatically sign up younger workers for 401(k) plans and use fairly aggressive target-date funds as a default investment, those employees’ exposure to stocks will grow.
So perhaps a better question to ask is not whether people in the first half of their working lives are becoming more risk-averse, but whether they should be.
On Thursday night, Kevin Brosious, a financial planner in Allentown, Pa., polled the students in his financial management class at DeSales University on the percentage of their portfolios they would allocate to stocks right now. The majority would put less than half in stocks; among their reasons were fear of job loss, lack of accountability on Wall
Street and economic fears amplified by the news media.
The problem with their approach, according to Brosious, is that by investing conservatively they are probably guaranteeing themselves a smaller return and a more meagre standard of living in retirement.
Or, as Robert N. Siegmann, chief operating officer and senior adviser of the Financial Management Group in Cincinnati, wrote to me in an e-mail message, “Why would you consider taking less risk NOW after most of the risk has already been paid for in the market over the past 12 months?”
If investing still seems too risky to you right now, you’re not alone. At Charles Schwab, according to a spokesman, younger 401(k) participants are not making many big investment moves. But there is a sense that at least some younger investors may divert 401(k) contributions to other uses, especially as more companies reduce or suspend their 401(k) matches.
In that case, one sensible way to reduce overall risk is to pay down high-interest debt, like credit cards or private student loans. That, at least, offers a guaranteed return, since every extra dollar you pay now keeps you from having to pay more interest later. Also, the sooner you rid yourself of debt payments, the less you would need in your monthly budget if you lost your job.
“I think the only thing younger people should be more risk-averse about is the leverage they take on,” said Jeffrey G. Cribbs, president of Chicago Wealth Management in Oak Park, Ill.
In particular, he suggested they buy real estate and cars at levels below what they can actually afford.
So what kind of risk should you take on with the savings you have left over? To Moshe A. Milevsky, the author of “Are You a Stock or a Bond?,” risk should have less to do with the era in which you live and more to do with what you do for a living.
If you are a tenured professor, a teacher, a firefighter or other government employee, you have better job security than most other people. Your income stream is stable, like a bond. Certain service providers, like plumbers and doctors, have similar security.
Investment bankers and many technology and media workers, however, have more volatility in their career paths. A chart of their income might bounce around like one showing a stock’s price.
“The idea is that we should focus on our human capital and invest in places where our human capital is not,” Milevsky said. “It’s not about risk tolerance or time horizon but about what you do for a living.”
As a tenured professor, he invests entirely in equities. Other people with bond-like characteristics who are far from retirement could take similar risks, and withstand 2008-level losses, because their incomes are fairly stable. Those who have more stock-like careers, however, probably ought to invest a bit more conservatively, in both their retirement accounts and in their primary residences.
For most young people, however, their biggest asset is not a 401(k) account or a home but the trajectory of their career and the value of 20 or 30 or 40 years of future earnings. It makes nearly everyone a millionaire on paper.
So whether you are taking on too much risk right now or not, all of that money will provide many more chances to fix any mistakes you have already made.
Has your risk tolerance changed forever? – NYT
Without a cure for toxic assets, credit crisis will persist
Without a cure for toxic assets, credit crisis will persist
By Steve Lohr
Friday, February 13, 2009
NEW YORK: Many of the large U.S. banks, according to economists and other finance experts, are like dead men walking.
A sober assessment of the growing mountain of losses from bad bets, measured in today's marketplace, would overwhelm the value of the banks' assets, they explain. The banks, in their view, are insolvent.
None of the experts' research focuses on individual banks, and there are certainly exceptions among the 50 largest banks in the country. Nor do consumers and businesses need to fret about their deposits, which are federally insured. And even banks that might technically be insolvent can continue operating for a long time, and could recover their financial health when the economy improves.
But without a cure for the bad-asset problem, the credit crisis that is dragging down the economy will linger, as banks cannot resume the ample lending needed to restart the wheels of commerce. The answer, the economists and experts say, is a larger, more direct government role than in the Treasury Department's plan outlined this week.
The Treasury program leans heavily on a sketchy public-private investment fund to buy up the toxic, mortgage-backed securities held by the banks. Instead, the experts say, the government needs to plunge in, weed out the weakest banks, pour capital into the surviving banks and sell off the bad assets.
It is the basic blueprint that has proved successful, they say, in resolving major financial crises in recent years. Such forceful action was belatedly adopted by the Japanese government from 2001 to 2003, by the Swedish government in 1992 and by Washington in 1987 to 1989 to overcome the savings and loan meltdown.
"The historical record shows that you have to do it eventually," said Adam Posen, a senior fellow at the Peterson Institute for International Economics. "Putting it off only brings more troubles and higher costs in the long run."
Of course, the stimulus plan put forward by the administration of President Barack Obama could help to spur economic recovery in a timely manner and the value of the banks' assets could begin to rise.
Absent that, the prescription would not be easy or cheap. Estimates of the capital injection needed in the United States range to $1 trillion and beyond. By contrast, the commitment of taxpayer money is the $350 billion remaining in the financial bailout approved by Congress last fall.
Meanwhile, the loss estimates keep mounting.
Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, has been both pessimistic and prescient about the gathering credit problems. In a new report, Roubini estimates that total losses on loans by American financial companies and the fall in the market value of the assets they hold will reach $3.6 trillion, up from his previous estimate of $2trillion. Of the total, he calculates that American banks face half that risk, or $1.8 trillion, with the rest borne by other financial institutions in the United States and abroad.
"The United States banking system is effectively insolvent," Roubini said.
For its part, the banking industry bridles at such broad-brush analysis. The industry defines solvency bank by bank and uses the value of a bank's assets as they are carried on its books, rather than the market prices calculated by economists. "Our analysis shows that the banks have varying degrees of solvency and does not reveal that any institution is insolvent," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, a trade group whose members include the largest banks.
Roubini's numbers may be the highest, but many others share his rising sense of alarm. Simon Johnson, a former chief economist at the International Monetary Fund, estimates that the U.S. banks have a capital shortage of $500 billion. "In a more severe recession, it will take $1 trillion or so to properly capitalize the banks," said Johnson, an economist at the Massachusetts Institute of Technology.
At the end of January, the IMF raised its estimate of the potential losses from loans and other credit securities originated in the United States to $2.2 trillion, up from $1.4 trillion in October. Over the next two years, the IMF estimated, U.S. and European banks would need at least $500 billion in new capital, an estimate more conservative than those of many economists.
Still, those numbers are all based on estimates of the value of complex mortgage-backed securities in a very uncertain economy. "At this moment, the liabilities they have far exceed their assets," said Posen of the Peterson Institute. "They are insolvent."
Yet, as Posen and other economists note, there are crucial issues of timing and market psychology that surround the discussion of bank solvency. If one assumes that current conditions reflect a temporary panic, then the value of the banks' distressed assets could well recover over time. If not, many banks may be permanently impaired.
"We won't know what the losses are on these mortgage-backed securities, and we won't until the housing market stabilizes," said Richard Portes, an economist at the London Business School.
Raghuram Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between "liquidation values" and those of calmer times, or "going concern values." In a troubled time for banks, Rajan noted, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.
"If they had to sell these securities today, the losses would be far beyond their capital at this point," he said. "But if the prices of these assets will recover over the next year or so, if they don't have to sell at distress prices, the banks could have a new lease on life by giving them some time."
That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before. In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a meltdown of the banking system.
In the current crisis, experts warn, banks need to get rid of bad assets quickly. The Treasury's public-private investment fund is an effort to do that.
But many economists and other finance experts say that the government may soon have to move in and take on troubled assets itself to resolve the credit crisis. Then, they say, the government could have the patience to wait for the economy to improve.
Initially, that would put more taxpayer money on the line, but it might reduce overall losses if the government-controlled entity were a shrewd seller. That is what happened during the savings and loan crisis, when the troubled assets, mostly real estate, were seized by the Resolution Trust Corp., a government-owned asset manager, and sold over a few years.
The eventual losses, an estimated $130 billion, were far less than if the hotels, office buildings and residential developments had been sold immediately.
"At the end of the day, the taxpayer money would be used to acquire assets, and behind most of those securities are mortgages, houses, and we know they are not worthless," said Portes, the London Business School economist, who is president of the Center for Economic Policy Research.
"So the taxpayers would not be out anything like the back-of-the-envelope, headline numbers people toss around."
--------------------------------------------------------------------------------
Copyright © 2009 The International Herald Tribune www.iht.com
http://www.iht.com/articles/2009/02/13/business/insolvent.php
By Steve Lohr
Friday, February 13, 2009
NEW YORK: Many of the large U.S. banks, according to economists and other finance experts, are like dead men walking.
A sober assessment of the growing mountain of losses from bad bets, measured in today's marketplace, would overwhelm the value of the banks' assets, they explain. The banks, in their view, are insolvent.
None of the experts' research focuses on individual banks, and there are certainly exceptions among the 50 largest banks in the country. Nor do consumers and businesses need to fret about their deposits, which are federally insured. And even banks that might technically be insolvent can continue operating for a long time, and could recover their financial health when the economy improves.
But without a cure for the bad-asset problem, the credit crisis that is dragging down the economy will linger, as banks cannot resume the ample lending needed to restart the wheels of commerce. The answer, the economists and experts say, is a larger, more direct government role than in the Treasury Department's plan outlined this week.
The Treasury program leans heavily on a sketchy public-private investment fund to buy up the toxic, mortgage-backed securities held by the banks. Instead, the experts say, the government needs to plunge in, weed out the weakest banks, pour capital into the surviving banks and sell off the bad assets.
It is the basic blueprint that has proved successful, they say, in resolving major financial crises in recent years. Such forceful action was belatedly adopted by the Japanese government from 2001 to 2003, by the Swedish government in 1992 and by Washington in 1987 to 1989 to overcome the savings and loan meltdown.
"The historical record shows that you have to do it eventually," said Adam Posen, a senior fellow at the Peterson Institute for International Economics. "Putting it off only brings more troubles and higher costs in the long run."
Of course, the stimulus plan put forward by the administration of President Barack Obama could help to spur economic recovery in a timely manner and the value of the banks' assets could begin to rise.
Absent that, the prescription would not be easy or cheap. Estimates of the capital injection needed in the United States range to $1 trillion and beyond. By contrast, the commitment of taxpayer money is the $350 billion remaining in the financial bailout approved by Congress last fall.
Meanwhile, the loss estimates keep mounting.
Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, has been both pessimistic and prescient about the gathering credit problems. In a new report, Roubini estimates that total losses on loans by American financial companies and the fall in the market value of the assets they hold will reach $3.6 trillion, up from his previous estimate of $2trillion. Of the total, he calculates that American banks face half that risk, or $1.8 trillion, with the rest borne by other financial institutions in the United States and abroad.
"The United States banking system is effectively insolvent," Roubini said.
For its part, the banking industry bridles at such broad-brush analysis. The industry defines solvency bank by bank and uses the value of a bank's assets as they are carried on its books, rather than the market prices calculated by economists. "Our analysis shows that the banks have varying degrees of solvency and does not reveal that any institution is insolvent," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, a trade group whose members include the largest banks.
Roubini's numbers may be the highest, but many others share his rising sense of alarm. Simon Johnson, a former chief economist at the International Monetary Fund, estimates that the U.S. banks have a capital shortage of $500 billion. "In a more severe recession, it will take $1 trillion or so to properly capitalize the banks," said Johnson, an economist at the Massachusetts Institute of Technology.
At the end of January, the IMF raised its estimate of the potential losses from loans and other credit securities originated in the United States to $2.2 trillion, up from $1.4 trillion in October. Over the next two years, the IMF estimated, U.S. and European banks would need at least $500 billion in new capital, an estimate more conservative than those of many economists.
Still, those numbers are all based on estimates of the value of complex mortgage-backed securities in a very uncertain economy. "At this moment, the liabilities they have far exceed their assets," said Posen of the Peterson Institute. "They are insolvent."
Yet, as Posen and other economists note, there are crucial issues of timing and market psychology that surround the discussion of bank solvency. If one assumes that current conditions reflect a temporary panic, then the value of the banks' distressed assets could well recover over time. If not, many banks may be permanently impaired.
"We won't know what the losses are on these mortgage-backed securities, and we won't until the housing market stabilizes," said Richard Portes, an economist at the London Business School.
Raghuram Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between "liquidation values" and those of calmer times, or "going concern values." In a troubled time for banks, Rajan noted, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.
"If they had to sell these securities today, the losses would be far beyond their capital at this point," he said. "But if the prices of these assets will recover over the next year or so, if they don't have to sell at distress prices, the banks could have a new lease on life by giving them some time."
That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before. In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a meltdown of the banking system.
In the current crisis, experts warn, banks need to get rid of bad assets quickly. The Treasury's public-private investment fund is an effort to do that.
But many economists and other finance experts say that the government may soon have to move in and take on troubled assets itself to resolve the credit crisis. Then, they say, the government could have the patience to wait for the economy to improve.
Initially, that would put more taxpayer money on the line, but it might reduce overall losses if the government-controlled entity were a shrewd seller. That is what happened during the savings and loan crisis, when the troubled assets, mostly real estate, were seized by the Resolution Trust Corp., a government-owned asset manager, and sold over a few years.
The eventual losses, an estimated $130 billion, were far less than if the hotels, office buildings and residential developments had been sold immediately.
"At the end of the day, the taxpayer money would be used to acquire assets, and behind most of those securities are mortgages, houses, and we know they are not worthless," said Portes, the London Business School economist, who is president of the Center for Economic Policy Research.
"So the taxpayers would not be out anything like the back-of-the-envelope, headline numbers people toss around."
--------------------------------------------------------------------------------
Copyright © 2009 The International Herald Tribune www.iht.com
http://www.iht.com/articles/2009/02/13/business/insolvent.php
How To Tell When The Economy's Getting Better
How To Tell When The Economy's Getting Better
Rick Newman
Friday February 13, 2009, 8:19 am EST
The stimulus package is finally finished. President Obama is promising a tough new bank-rescue plan to boost lending and limit outrageous pay. Troubled homeowners may even get some relief. All told, the government could spend more than $3 trillion to help end the recession.
So now all we have to do is sit back and watch the economy grow like a beanstalk, right?
If only. One risk of the unprecedented government intervention is that it won't do all that much to hasten the end of the recession. Another risk is that consumers, expecting a magic-bullet fix, could fail to prepare for tough times that still lie ahead. "This is going to be a difficult year," Obama himself said at his first press conference. "If we get things right, then starting next year we can start seeing some significant improvement."
[Read 4 myths about Obama's bank-rescue plan.]
Next year? Afraid so. Most economists agree that it will take that long, at least, before the biggest problems - mounting layoffs, the housing bust, the banking crisis, and plunging confidence - start to turn around. Here's what to watch for to tell whether the stimulus package is actually working, and when the economy might start to mend.
An improvement in the unemployment rate.
Of all the economic indicators, this is probably the single most important. But you might want to avert your eyes for awhile.
Obama has talked about creating 3 to 4 million new jobs, and if the stimulus plan works, it might come close to that - over several years, combined. But it's almost certain that through this summer and into the fall, there will be a net job loss, not a gain. Most economists expect the unemployment rate, now 7.6 percent, to hit at least 9 percent by the end of this year. That represents up to 2 million more lost jobs. Many of those cuts are already in the works - just follow the recent layoff announcements from companies like Caterpillar (20,000), Boeing (10,000), SprintNextel (8,000) and Home Depot (7,000). But the pink slips haven't all gone out yet, so the layoffs haven't shows up in the official numbers.
[See 15 companies that might not survive 2009.]
The first sign of an improvement will be...corporate silence. As in no more draconian job-cut announcements. Once that happens (or doesn't), the unemployment rate will plateau. Then, companies might start hiring again, and a couple of months after that, the unemployment rate will start to fall. Three straight monthly declines would be a good sign that the economy is really on the rebound. That probably won't happen until 2010.
If you're wondering what's the point of the stimulus package if it won't do much to help workers in 2009, look to 2010. And 2011. That's where the plan will make a bigger difference. Moody's Economy.com estimates that by the middle of 2010, the unemployment rate will start to drift back toward 8.5 percent. But without any stimulus plan, it would have hit 11 percent. Viva la government.
More stable home prices.
The real estate boom and bust is what torpedoed the economy in the first place, and the economy won't start to recover until the housing bubble fully deflates. The good news is that housing prices have already been falling for more than two years, with prices down more than 20 percent nationwide. And we might be more than halfway toward the bottom: Moody's Economy.com predicts that housing prices should stop falling nationwide by the second half of 2009. Overall, the forecasting firm predicts a 30 percent drop in home values from the peak values of 2006.
[See why the feds rescue banks, not homeowners.]
Others think it will take longer, but whenever it happens, an end to the housing slide will mark an important turning point. Hardly anybody thinks that prices will shoot back up or there will be another buying binge. But a boomlet, maybe. Once prices stabilize, buyers will stop worrying that they could be purchasing a costly asset that's falling in value. As they buy, other kinds of consumer activity - like shopping for furniture and kitchen upgrades - will follow. Slowly.
A consumer confidence rebound.
Since consumer confidence closely tracks the job market, the dismal numbers of the last few months probably won't improve by much until late in 2009, or 2010. Homeowners have lost more than $3 trillion worth of value in their homes over the last three years, and investors have seen their stock portfolios shredded. So even people who feel secure in their jobs are dour.
[See how Wall Street continues to doom itself.]
A turnaround in the housing or stock markets would break the gloom and help some people feel better off. So would easier lending by banks, which would help solvent consumers buy a few more cars, appliances, and other goods. But consumer confidence won't really start to improve until workers start to feel more secure about their jobs and income. Think 2010.
A less volatile stock market.
Every investor hopes that beleaguered stocks will come roaring back in 2009 and regain some of the ground lost since the peak in 2007 - when the S&P 500 stock index was nearly 50 percent higher than it is today. But a better indicator of economic health would be a steady recovery - without the manic swings that seem to come from every hint of undisclosed trouble at some big bank or rumor of new government intervention.
The stock market is harder to predict than most other parts of the economy, since it's deeply dependent on psychology and other intangibles. The market could bounce back by mid-summer. Or it could remain stagnant for years, like it did for most of the 1970s. The experts can't be any more sure than you or I.
[See why "Wall Street talent" is an oxymoron.]
One hopeful sign would be less market sensitivity to events in Washington. The biggest market mover these days is the federal government, since fortunes stand to be won or lost - mostly lost - depending on how deeply the government intervenes in the activities of megabanks like Citigroup and Bank of America, and how much federal spending will be available to stand in for plunging consumer spending. The markets will be back to their old selves when earnings reports, IPO announcements, and M&A deals are what send stocks up or down, and utterings from Washington amount to little more than an echo. Since the government seems to be the only institution spending money so far in 2009, it could be awhile before Wall Street returns to form.
Economic growth turns positive.
By economic standards, the current downturn has already lasted longer than the typical post-World War II recession. Yet there's still a lot more pain to endure. A recent survey of economists by the Wall Street Journal found that the majority think the economy will continue to contract for the first half of 2009, with growth turning positive in the second half of the year. That outlook is much worse than a few months ago, and even when growth turns positive the economy could sputter along without many new jobs or bold moves in the private sector.
[See why lousy unemployment numbers are no surprise.]
It's always possible that impatient consumers will get sick of holding back, and start running up their credit card balances once again (if the banks let them). The bank-rescue plan might spur more lending than expected, goosing businesses and consumers alike. Or the stimulus plan might spread goodwill and optimism throughout the land. If you get the urge to spend, that might be the strongest indicator of all. Call the economists.
http://finance.yahoo.com/news/How-To-Tell-When-The-Economys-usnews-14351762.html
Also read:
Best of Flowchart
How to Tell if You're Rich
Greenspan vs. Buffett
4 Myths About Free Markets—and Their Demise
The Need for Greed
5 Upsides of $4 Gas
Economic Recession, Consumer Depression
Why More Saudi Oil Could Harm American Consumers
Economic Upswing? Ask Again in a Year
What Springsteen Can Teach CEOs
6 Myths About Oil Speculators
Rick Newman
Friday February 13, 2009, 8:19 am EST
The stimulus package is finally finished. President Obama is promising a tough new bank-rescue plan to boost lending and limit outrageous pay. Troubled homeowners may even get some relief. All told, the government could spend more than $3 trillion to help end the recession.
So now all we have to do is sit back and watch the economy grow like a beanstalk, right?
If only. One risk of the unprecedented government intervention is that it won't do all that much to hasten the end of the recession. Another risk is that consumers, expecting a magic-bullet fix, could fail to prepare for tough times that still lie ahead. "This is going to be a difficult year," Obama himself said at his first press conference. "If we get things right, then starting next year we can start seeing some significant improvement."
[Read 4 myths about Obama's bank-rescue plan.]
Next year? Afraid so. Most economists agree that it will take that long, at least, before the biggest problems - mounting layoffs, the housing bust, the banking crisis, and plunging confidence - start to turn around. Here's what to watch for to tell whether the stimulus package is actually working, and when the economy might start to mend.
An improvement in the unemployment rate.
Of all the economic indicators, this is probably the single most important. But you might want to avert your eyes for awhile.
Obama has talked about creating 3 to 4 million new jobs, and if the stimulus plan works, it might come close to that - over several years, combined. But it's almost certain that through this summer and into the fall, there will be a net job loss, not a gain. Most economists expect the unemployment rate, now 7.6 percent, to hit at least 9 percent by the end of this year. That represents up to 2 million more lost jobs. Many of those cuts are already in the works - just follow the recent layoff announcements from companies like Caterpillar (20,000), Boeing (10,000), SprintNextel (8,000) and Home Depot (7,000). But the pink slips haven't all gone out yet, so the layoffs haven't shows up in the official numbers.
[See 15 companies that might not survive 2009.]
The first sign of an improvement will be...corporate silence. As in no more draconian job-cut announcements. Once that happens (or doesn't), the unemployment rate will plateau. Then, companies might start hiring again, and a couple of months after that, the unemployment rate will start to fall. Three straight monthly declines would be a good sign that the economy is really on the rebound. That probably won't happen until 2010.
If you're wondering what's the point of the stimulus package if it won't do much to help workers in 2009, look to 2010. And 2011. That's where the plan will make a bigger difference. Moody's Economy.com estimates that by the middle of 2010, the unemployment rate will start to drift back toward 8.5 percent. But without any stimulus plan, it would have hit 11 percent. Viva la government.
More stable home prices.
The real estate boom and bust is what torpedoed the economy in the first place, and the economy won't start to recover until the housing bubble fully deflates. The good news is that housing prices have already been falling for more than two years, with prices down more than 20 percent nationwide. And we might be more than halfway toward the bottom: Moody's Economy.com predicts that housing prices should stop falling nationwide by the second half of 2009. Overall, the forecasting firm predicts a 30 percent drop in home values from the peak values of 2006.
[See why the feds rescue banks, not homeowners.]
Others think it will take longer, but whenever it happens, an end to the housing slide will mark an important turning point. Hardly anybody thinks that prices will shoot back up or there will be another buying binge. But a boomlet, maybe. Once prices stabilize, buyers will stop worrying that they could be purchasing a costly asset that's falling in value. As they buy, other kinds of consumer activity - like shopping for furniture and kitchen upgrades - will follow. Slowly.
A consumer confidence rebound.
Since consumer confidence closely tracks the job market, the dismal numbers of the last few months probably won't improve by much until late in 2009, or 2010. Homeowners have lost more than $3 trillion worth of value in their homes over the last three years, and investors have seen their stock portfolios shredded. So even people who feel secure in their jobs are dour.
[See how Wall Street continues to doom itself.]
A turnaround in the housing or stock markets would break the gloom and help some people feel better off. So would easier lending by banks, which would help solvent consumers buy a few more cars, appliances, and other goods. But consumer confidence won't really start to improve until workers start to feel more secure about their jobs and income. Think 2010.
A less volatile stock market.
Every investor hopes that beleaguered stocks will come roaring back in 2009 and regain some of the ground lost since the peak in 2007 - when the S&P 500 stock index was nearly 50 percent higher than it is today. But a better indicator of economic health would be a steady recovery - without the manic swings that seem to come from every hint of undisclosed trouble at some big bank or rumor of new government intervention.
The stock market is harder to predict than most other parts of the economy, since it's deeply dependent on psychology and other intangibles. The market could bounce back by mid-summer. Or it could remain stagnant for years, like it did for most of the 1970s. The experts can't be any more sure than you or I.
[See why "Wall Street talent" is an oxymoron.]
One hopeful sign would be less market sensitivity to events in Washington. The biggest market mover these days is the federal government, since fortunes stand to be won or lost - mostly lost - depending on how deeply the government intervenes in the activities of megabanks like Citigroup and Bank of America, and how much federal spending will be available to stand in for plunging consumer spending. The markets will be back to their old selves when earnings reports, IPO announcements, and M&A deals are what send stocks up or down, and utterings from Washington amount to little more than an echo. Since the government seems to be the only institution spending money so far in 2009, it could be awhile before Wall Street returns to form.
Economic growth turns positive.
By economic standards, the current downturn has already lasted longer than the typical post-World War II recession. Yet there's still a lot more pain to endure. A recent survey of economists by the Wall Street Journal found that the majority think the economy will continue to contract for the first half of 2009, with growth turning positive in the second half of the year. That outlook is much worse than a few months ago, and even when growth turns positive the economy could sputter along without many new jobs or bold moves in the private sector.
[See why lousy unemployment numbers are no surprise.]
It's always possible that impatient consumers will get sick of holding back, and start running up their credit card balances once again (if the banks let them). The bank-rescue plan might spur more lending than expected, goosing businesses and consumers alike. Or the stimulus plan might spread goodwill and optimism throughout the land. If you get the urge to spend, that might be the strongest indicator of all. Call the economists.
http://finance.yahoo.com/news/How-To-Tell-When-The-Economys-usnews-14351762.html
Also read:
Best of Flowchart
How to Tell if You're Rich
Greenspan vs. Buffett
4 Myths About Free Markets—and Their Demise
The Need for Greed
5 Upsides of $4 Gas
Economic Recession, Consumer Depression
Why More Saudi Oil Could Harm American Consumers
Economic Upswing? Ask Again in a Year
What Springsteen Can Teach CEOs
6 Myths About Oil Speculators
Saturday 14 February 2009
Adam Smith: The Father Of Economics
Adam Smith: The Father Of Economics
by Lisa Smith (Contact Author Biography)
Adam Smith is often touted as the world's first free-market capitalist. While that designation is probably a bit overstated, Smith's place in history as the father of modern economics and a major proponent of laissez-faire economic policies is quite secure. Read on to learn about how this Scottish philosopher argued against mercantilism to become the father of modern free trade.
Early Life
The recorded history of Smith's life begins on June 16, 1723, at his baptism in Scotland. His birthday is undocumented. Smith attended the University of Glasgow at age 14, later transferring to Balliol College in Oxford, England. He spent years teaching and tutoring, publishing some of his lectures in "The Theory of Moral Sentiments" in 1759. The material was well received and laid the foundation for the publication of "An Inquiry Into the Nature and Causes of the Wealth of Nations" (1776), which would cement his place in history.
Invisible Hand Theory
"An Inquiry Into the Nature and Causes of the Wealth of Nations" documented the industrial and development in Europe. While critics note that Smith didn't invent many of the ideas that he wrote about, he was the first person to compile and publish them in a format designed to explain them to the average reader of the day. As a result, he is responsible for popularizing many of the ideas that underpin the school of thought that became known as classical economics. (Learn economics principles such as supply and demand, elasticity, utility and more in our tutorial, Economics Basics.)
Other economists built on Smith's work to solidify classical economic theory, which would become the dominant school of economic thoughtthrough the Great Depression. (Learn more about the causes of this global economic crisis in What Caused The Great Depression?)
Laissez-faire philosophies, such as minimizing the role of government intervention and taxation in the free markets, and the idea that an "invisible hand" guides supply and demand are among the key ideas Smith's writing is responsible for promoting. These ideas reflect the concept that each person, by looking out for him- or herself, inadvertently helps to create the best outcome for all. "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest," Smith wrote. (Read about one implementation of Smith's "invisible hand" in The Rise Of The Modern Investment Bank.)
By selling products that people want to buy, the butcher, brewer and baker hope to make money. If they are effective in meeting the needs of their customers, they will enjoy the financial rewards. While they are engaging in their enterprises for the purpose of earning money, they are also providing products that people want. Such a system, Smith argued, creates wealth not just for the butcher, brewer and baker, but for the nation as whole when that nation is populated with citizens working productively to better themselves and address their financial needs. Similarly, Smith noted that a man would invest his wealth in the enterprise most likely to help him earn the highest return for a given level of risk. (Read more in Risk And Diversification: The Risk-Reward Tradeoff.)
Published Philosophy
"The Wealth of Nations" is a massive work consisting of two volumes divided into five books. The ideas it promoted generated international attention and helped to drive the move from land-based wealth to wealth created by assembly-line production methods driven by division of labor. One example Smith cited involved the labor required to make a pin. One man undertaking the 18 steps required to complete the tasks could make but a handful of pins each week, but if the 18 tasks were completed in assembly-line fashion by 10 men, production would jump to thousands of pins per week. (Read more about this concept in What Are Economies Of Scale?)
He applied a similar logic regarding wealth generation and efficiency to British rule over the American colonies. According to his calculations, the cost of maintaining the colonies was simply not worth the return on investment. Interestingly, while much of the philosophy behind Smith's work is based on self-interest and maximizing return, his first published work, "The Theory of Moral Sentiments", was a treatise about how human communication relies on sympathy. While this may seem to be at odds with his economic views of individuals working to better themselves with no regard for the common good, the idea of an invisible hand that helps everyone through the labor of self-centered individuals offsets this seeming contradiction.
Today, the invisible hand theory is often presented in terms of a natural phenomenon that guides free markets and capitalism in the direction of efficiency, through supply and demand and competition for scarce resources, rather than as something that results in the well-being of individuals. (Read more about the evolution of our current economic system in History Of Capitalism.)
Still Relevant
The ideas that became associated with Smith not only became the foundation of the classical school of economics, but also gained him a place in history as the father of economics. His work served as the basis for other lines of inquiry into the field of economics, including ideas that built on his work and those that differed. Smith died on July 19, 1790, but the ideas he promoted live on. In 2007, the Bank of England even placed his image on the £20 note.
For further reading see, How Influential Economists Changed Our History and The History Of Economic Thought.
by Lisa Smith, (Contact Author Biography)
http://www.investopedia.com/articles/economics/08/adam-smith-economics.asp
Related Links
Tablets To 1040s: How Taxes Began - Ever dream of a world without tax? It existed - 3,000 years ago.
How Influential Economists Changed Our History - Find out how these five groundbreaking thinkers laid our financial foundations.
History Of Capitalism - Find out how the economic system we now use was created.
The History Of Economic Thought - Discover the theories that shaped the way we've come to understand economics.
What Is International Trade? - Everyone's talking about globalization, but what is it and why do some oppose it?
What Is The World Trade Organization? - The WTO sets the global rules of trade. But what exactly does it do and why do so many oppose it?
Macroeconomic Analysis - From unemployment and inflation to government policy, learn what macroeconomics measures and how it affects everyone.
What is the candle maker's petition?
by Lisa Smith (Contact Author Biography)
Adam Smith is often touted as the world's first free-market capitalist. While that designation is probably a bit overstated, Smith's place in history as the father of modern economics and a major proponent of laissez-faire economic policies is quite secure. Read on to learn about how this Scottish philosopher argued against mercantilism to become the father of modern free trade.
Early Life
The recorded history of Smith's life begins on June 16, 1723, at his baptism in Scotland. His birthday is undocumented. Smith attended the University of Glasgow at age 14, later transferring to Balliol College in Oxford, England. He spent years teaching and tutoring, publishing some of his lectures in "The Theory of Moral Sentiments" in 1759. The material was well received and laid the foundation for the publication of "An Inquiry Into the Nature and Causes of the Wealth of Nations" (1776), which would cement his place in history.
Invisible Hand Theory
"An Inquiry Into the Nature and Causes of the Wealth of Nations" documented the industrial and development in Europe. While critics note that Smith didn't invent many of the ideas that he wrote about, he was the first person to compile and publish them in a format designed to explain them to the average reader of the day. As a result, he is responsible for popularizing many of the ideas that underpin the school of thought that became known as classical economics. (Learn economics principles such as supply and demand, elasticity, utility and more in our tutorial, Economics Basics.)
Other economists built on Smith's work to solidify classical economic theory, which would become the dominant school of economic thoughtthrough the Great Depression. (Learn more about the causes of this global economic crisis in What Caused The Great Depression?)
Laissez-faire philosophies, such as minimizing the role of government intervention and taxation in the free markets, and the idea that an "invisible hand" guides supply and demand are among the key ideas Smith's writing is responsible for promoting. These ideas reflect the concept that each person, by looking out for him- or herself, inadvertently helps to create the best outcome for all. "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest," Smith wrote. (Read about one implementation of Smith's "invisible hand" in The Rise Of The Modern Investment Bank.)
By selling products that people want to buy, the butcher, brewer and baker hope to make money. If they are effective in meeting the needs of their customers, they will enjoy the financial rewards. While they are engaging in their enterprises for the purpose of earning money, they are also providing products that people want. Such a system, Smith argued, creates wealth not just for the butcher, brewer and baker, but for the nation as whole when that nation is populated with citizens working productively to better themselves and address their financial needs. Similarly, Smith noted that a man would invest his wealth in the enterprise most likely to help him earn the highest return for a given level of risk. (Read more in Risk And Diversification: The Risk-Reward Tradeoff.)
Published Philosophy
"The Wealth of Nations" is a massive work consisting of two volumes divided into five books. The ideas it promoted generated international attention and helped to drive the move from land-based wealth to wealth created by assembly-line production methods driven by division of labor. One example Smith cited involved the labor required to make a pin. One man undertaking the 18 steps required to complete the tasks could make but a handful of pins each week, but if the 18 tasks were completed in assembly-line fashion by 10 men, production would jump to thousands of pins per week. (Read more about this concept in What Are Economies Of Scale?)
He applied a similar logic regarding wealth generation and efficiency to British rule over the American colonies. According to his calculations, the cost of maintaining the colonies was simply not worth the return on investment. Interestingly, while much of the philosophy behind Smith's work is based on self-interest and maximizing return, his first published work, "The Theory of Moral Sentiments", was a treatise about how human communication relies on sympathy. While this may seem to be at odds with his economic views of individuals working to better themselves with no regard for the common good, the idea of an invisible hand that helps everyone through the labor of self-centered individuals offsets this seeming contradiction.
Today, the invisible hand theory is often presented in terms of a natural phenomenon that guides free markets and capitalism in the direction of efficiency, through supply and demand and competition for scarce resources, rather than as something that results in the well-being of individuals. (Read more about the evolution of our current economic system in History Of Capitalism.)
Still Relevant
The ideas that became associated with Smith not only became the foundation of the classical school of economics, but also gained him a place in history as the father of economics. His work served as the basis for other lines of inquiry into the field of economics, including ideas that built on his work and those that differed. Smith died on July 19, 1790, but the ideas he promoted live on. In 2007, the Bank of England even placed his image on the £20 note.
For further reading see, How Influential Economists Changed Our History and The History Of Economic Thought.
by Lisa Smith, (Contact Author Biography)
http://www.investopedia.com/articles/economics/08/adam-smith-economics.asp
Related Links
Tablets To 1040s: How Taxes Began - Ever dream of a world without tax? It existed - 3,000 years ago.
How Influential Economists Changed Our History - Find out how these five groundbreaking thinkers laid our financial foundations.
History Of Capitalism - Find out how the economic system we now use was created.
The History Of Economic Thought - Discover the theories that shaped the way we've come to understand economics.
What Is International Trade? - Everyone's talking about globalization, but what is it and why do some oppose it?
What Is The World Trade Organization? - The WTO sets the global rules of trade. But what exactly does it do and why do so many oppose it?
Macroeconomic Analysis - From unemployment and inflation to government policy, learn what macroeconomics measures and how it affects everyone.
What is the candle maker's petition?
Giants Of Finance: John Maynard Keynes
Giants Of Finance: John Maynard Keynes
by Andrew Beattie (Contact Author Biography)
If ever there was a rock star of economics, it would be John Maynard Keynes. Keynes shares his birthday, June 5th, with Adam Smith and he was born in 1883, the year communist founder Karl Marx died. With these auspicious signs, Keynes seemed to be destined to become a powerful free market force when the world was facing a serious choice between communism or capitalism. Instead, he offered a third way, which turned the world of economics upside down. In this article, we'll examine Keynes' doctrine and its impact. (To read about Adam Smith, be sure to check out Adam Smith: The Father Of Economics.)
The Cambridge Seer
Keynes grew up in a privileged home in England. He was the son of a Cambridge economics professor and studied math at university. After two years in the civil service, Keynes joined the staff at Cambridge in 1909. He was never formally trained in economics, but over the following decades he quickly became a central figure. His fame initially grew from accurately predicting the effects of political and economic events. His first prediction was a critique of the reparation payments that were levied against the defeated Germany after WWI. Keynes rightly pointed out that having to pay out the cost of the entire war would force Germany into hyperinflation and have negative consequences all over Europe. He followed this up by predicting that a return to the prewar fixed exchange rate sought by the chancellor of the exchequer, Winston Churchill, would choke off economic growth and reduce real wages. The prewar exchange rate was overvalued in the postwar damage of 1925, and the attempt to lock it in did more damage than good. On both counts, Keynes was proved right. (For related reading, see War's Influence On Wall Street.)
A Big Miss, But a Great Rebound
Keynes was not a theoretical economist: he was an active trader in stocks and futures. He benefited hugely from the Roaring '20s and was well on his way to becoming the richest economist in history when the crash of 1929 wiped out three-quarters of his wealth. Keynes hadn't predicted this crash, and was among those who believed a negative economic event was impossible with the Federal Reserve watching over the U.S. economy. Although blindsided by the crash, the adaptable Keynes did manage to rebuild his fortune by buying up stocks in the fire sale following the crash. His contrarian investing left him with a fortune of around $30 million at his death, making him the second richest economist in history. (For more on this period in economic history, check out What Caused The Great Depression? and Crashes: The Great Depression.)
The General Theory
Many others fared far worse in the crash and the resulting depression, however, and this is where Keynes' economic contributions began. Keynes believed that free market capitalism was inherently unstable and that it needed to be reformulated both to fight off Marxism and the Great Depression. His ideas were summed up in his 1936 book, "The General Theory of Employment, Interest and Money". Among other things, Keynes claimed that classical economics - the invisible hand of Adam Smith - only applied in cases of full employment. In all other cases, his "General Theory" held sway. (Read Can Keynesian Economics Reduce Boom-Bust Cycles? to learn more.)
Inside the General Theory
Keynes' "General Theory" will forever be remembered for giving governments a central role in economics. Although ostensibly written to save capitalism from sliding into the central planning of Marxism, Keynes opened the door for government to become the principal agent in the economy. Simply put, Keynes saw deficit financing, public expenditures, taxation and consumption as more important than saving, private investment, balanced government budgets and low taxes (classical economic virtues). Keynes believed that an interventionist government could fix a depression by spending its way out and forcing its citizens to do the same, while smoothing futures cycles with various macroeconomic techniques.
Holes in the Ground
Keynes backed up his theory by adding government expenditures to the overall national output. This was controversial from the start because the government doesn't actually save or invest as business and private business do, but raises money through mandatory taxes or debt issues (that are paid back by tax revenues). Still, by adding government to the equation, Keynes showed that government spending - even digging holes and filling them in - would stimulate the economy when businesses and individual were tightening budgets. His ideas heavily influenced the New Deal and the welfare state that grew up in the postwar era. (To learn the differences between supply-side and Keynesian economics, read Understanding Supply-Side Economics.)
The War on Saving and Private Investing
Keynes believed that consumption was the key to recovery and savings were the chains holding the economy down. In his models, private savings are subtracted from the private investment part of the national output equation, making government investment appear to be the better solution. Only a big government that was spending on behalf of the people would be able to guarantee full employment and economic prosperity. Even when forced to rework his model to allow for some private investment, he argued that it wasn't as efficient as government spending because private investors would be less likely to undertake/overpay for unnecessary works in hard economic times.
Macroeconomics: Magnifying and Simplifying
It is easy to see why governments were so quick to adopt Keynesian thinking. It gave politicians unlimited funds for pet projects and deficit spending that was very useful in buying votes. Government contracts quickly became synonymous with free money for any company that landed it, regardless of whether the project was brought in on time and on budget. The problem was that Keynesian thinking made huge assumptions that weren't backed by any real world evidence. For example, Keynes assumed interest rates would be constant no matter how much or how little capital was available for private lending. This allowed him to show that savings hurt economic growth - even though empirical evidence pointed to the opposite effect. To make this more obvious, he applied a multiplier to government spending but neglected to add a similar one to private savings. Oversimplification can be a useful tool in economics, but the more simplifying assumptions are used, the less real-world application a theory will have.
The Theory Hits a Rut
Keynes died in 1946. In addition to "The General Theory", he was part of a panel that worked on the Bretton Woods Agreement and the International Monetary Fund (IMF). His theory continued to grow in popularity and caught on with the public. After his death, however, critics began attacking both the macroeconomic view and the short-term aims of Keynesian thinking. Forcing spending, they argued, might keep a worker employed for another week, but what happens after that? Eventually the money runs out and the government must print more, leading to inflation. This is exactly what happened in the stagflation of the 1970s. Stagflation was impossible within Keynes' theory, but it happened nonetheless. With government spending crowding out private investment and inflation reducing real wages, Keynes' critics gained more ears. It ultimately fell upon Milton Friedman to reverse the Keynesian formulation of capitalism and reestablish free market principles in the U.S. (Find out what factors contribute to a slowing economy, in Examining Stagflation and Stagflation, 1970s Style.)
Keynes for the Ages
Although no longer held in the esteem that it once was, Keynesian economics is far from dead. When you see consumer spending or confidence figures, you are seeing an outgrowth of Keynesian economics. The stimulus checks the U.S. government handed out to citizens in 2008 also represent the idea that consumers can buy flat-screen TVs or otherwise spend the economy out of trouble. Keynesian thinking will never completely leave the media or the government. For the media, many of the simplifications are easy to grasp and work into a short segment. For the government, the Keynesian assertion that it knows how to spend taxpayer money better than the taxpayers is a bonus. (To learn more about the stimulus checks, read How do government issued stimulus checks improve the economy?)
Conclusion
Despite these undesirable consequences, Keynes' work is useful. It helps strengthen the free market theory by opposition, as we can see in the work of Milton Friedman and the Chicago School economists that followed Keynes. Blind adherence to the gospel of Adam Smith is dangerous in its own way. The Keynesian formulation forced free market economics to become a more comprehensive theory, and the persistent and popular echoes of Keynesian thinking in every economic crisis caused free market economics to develop in response. Friedman once said, "We are all Keynesians now." But the full quote was, "In one sense we are all Keynesians now; in another, no one is a Keynesian any longer. We all use the Keynesian language and apparatus; none of us any longer accepts the initial Keynesian conclusions."
by Andrew Beattie, (Contact Author Biography)
Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.
http://www.investopedia.com/articles/economics/09/john-maynard-keynes-keynesian.asp?partner=basics2
by Andrew Beattie (Contact Author Biography)
If ever there was a rock star of economics, it would be John Maynard Keynes. Keynes shares his birthday, June 5th, with Adam Smith and he was born in 1883, the year communist founder Karl Marx died. With these auspicious signs, Keynes seemed to be destined to become a powerful free market force when the world was facing a serious choice between communism or capitalism. Instead, he offered a third way, which turned the world of economics upside down. In this article, we'll examine Keynes' doctrine and its impact. (To read about Adam Smith, be sure to check out Adam Smith: The Father Of Economics.)
The Cambridge Seer
Keynes grew up in a privileged home in England. He was the son of a Cambridge economics professor and studied math at university. After two years in the civil service, Keynes joined the staff at Cambridge in 1909. He was never formally trained in economics, but over the following decades he quickly became a central figure. His fame initially grew from accurately predicting the effects of political and economic events. His first prediction was a critique of the reparation payments that were levied against the defeated Germany after WWI. Keynes rightly pointed out that having to pay out the cost of the entire war would force Germany into hyperinflation and have negative consequences all over Europe. He followed this up by predicting that a return to the prewar fixed exchange rate sought by the chancellor of the exchequer, Winston Churchill, would choke off economic growth and reduce real wages. The prewar exchange rate was overvalued in the postwar damage of 1925, and the attempt to lock it in did more damage than good. On both counts, Keynes was proved right. (For related reading, see War's Influence On Wall Street.)
A Big Miss, But a Great Rebound
Keynes was not a theoretical economist: he was an active trader in stocks and futures. He benefited hugely from the Roaring '20s and was well on his way to becoming the richest economist in history when the crash of 1929 wiped out three-quarters of his wealth. Keynes hadn't predicted this crash, and was among those who believed a negative economic event was impossible with the Federal Reserve watching over the U.S. economy. Although blindsided by the crash, the adaptable Keynes did manage to rebuild his fortune by buying up stocks in the fire sale following the crash. His contrarian investing left him with a fortune of around $30 million at his death, making him the second richest economist in history. (For more on this period in economic history, check out What Caused The Great Depression? and Crashes: The Great Depression.)
The General Theory
Many others fared far worse in the crash and the resulting depression, however, and this is where Keynes' economic contributions began. Keynes believed that free market capitalism was inherently unstable and that it needed to be reformulated both to fight off Marxism and the Great Depression. His ideas were summed up in his 1936 book, "The General Theory of Employment, Interest and Money". Among other things, Keynes claimed that classical economics - the invisible hand of Adam Smith - only applied in cases of full employment. In all other cases, his "General Theory" held sway. (Read Can Keynesian Economics Reduce Boom-Bust Cycles? to learn more.)
Inside the General Theory
Keynes' "General Theory" will forever be remembered for giving governments a central role in economics. Although ostensibly written to save capitalism from sliding into the central planning of Marxism, Keynes opened the door for government to become the principal agent in the economy. Simply put, Keynes saw deficit financing, public expenditures, taxation and consumption as more important than saving, private investment, balanced government budgets and low taxes (classical economic virtues). Keynes believed that an interventionist government could fix a depression by spending its way out and forcing its citizens to do the same, while smoothing futures cycles with various macroeconomic techniques.
Holes in the Ground
Keynes backed up his theory by adding government expenditures to the overall national output. This was controversial from the start because the government doesn't actually save or invest as business and private business do, but raises money through mandatory taxes or debt issues (that are paid back by tax revenues). Still, by adding government to the equation, Keynes showed that government spending - even digging holes and filling them in - would stimulate the economy when businesses and individual were tightening budgets. His ideas heavily influenced the New Deal and the welfare state that grew up in the postwar era. (To learn the differences between supply-side and Keynesian economics, read Understanding Supply-Side Economics.)
The War on Saving and Private Investing
Keynes believed that consumption was the key to recovery and savings were the chains holding the economy down. In his models, private savings are subtracted from the private investment part of the national output equation, making government investment appear to be the better solution. Only a big government that was spending on behalf of the people would be able to guarantee full employment and economic prosperity. Even when forced to rework his model to allow for some private investment, he argued that it wasn't as efficient as government spending because private investors would be less likely to undertake/overpay for unnecessary works in hard economic times.
Macroeconomics: Magnifying and Simplifying
It is easy to see why governments were so quick to adopt Keynesian thinking. It gave politicians unlimited funds for pet projects and deficit spending that was very useful in buying votes. Government contracts quickly became synonymous with free money for any company that landed it, regardless of whether the project was brought in on time and on budget. The problem was that Keynesian thinking made huge assumptions that weren't backed by any real world evidence. For example, Keynes assumed interest rates would be constant no matter how much or how little capital was available for private lending. This allowed him to show that savings hurt economic growth - even though empirical evidence pointed to the opposite effect. To make this more obvious, he applied a multiplier to government spending but neglected to add a similar one to private savings. Oversimplification can be a useful tool in economics, but the more simplifying assumptions are used, the less real-world application a theory will have.
The Theory Hits a Rut
Keynes died in 1946. In addition to "The General Theory", he was part of a panel that worked on the Bretton Woods Agreement and the International Monetary Fund (IMF). His theory continued to grow in popularity and caught on with the public. After his death, however, critics began attacking both the macroeconomic view and the short-term aims of Keynesian thinking. Forcing spending, they argued, might keep a worker employed for another week, but what happens after that? Eventually the money runs out and the government must print more, leading to inflation. This is exactly what happened in the stagflation of the 1970s. Stagflation was impossible within Keynes' theory, but it happened nonetheless. With government spending crowding out private investment and inflation reducing real wages, Keynes' critics gained more ears. It ultimately fell upon Milton Friedman to reverse the Keynesian formulation of capitalism and reestablish free market principles in the U.S. (Find out what factors contribute to a slowing economy, in Examining Stagflation and Stagflation, 1970s Style.)
Keynes for the Ages
Although no longer held in the esteem that it once was, Keynesian economics is far from dead. When you see consumer spending or confidence figures, you are seeing an outgrowth of Keynesian economics. The stimulus checks the U.S. government handed out to citizens in 2008 also represent the idea that consumers can buy flat-screen TVs or otherwise spend the economy out of trouble. Keynesian thinking will never completely leave the media or the government. For the media, many of the simplifications are easy to grasp and work into a short segment. For the government, the Keynesian assertion that it knows how to spend taxpayer money better than the taxpayers is a bonus. (To learn more about the stimulus checks, read How do government issued stimulus checks improve the economy?)
Conclusion
Despite these undesirable consequences, Keynes' work is useful. It helps strengthen the free market theory by opposition, as we can see in the work of Milton Friedman and the Chicago School economists that followed Keynes. Blind adherence to the gospel of Adam Smith is dangerous in its own way. The Keynesian formulation forced free market economics to become a more comprehensive theory, and the persistent and popular echoes of Keynesian thinking in every economic crisis caused free market economics to develop in response. Friedman once said, "We are all Keynesians now." But the full quote was, "In one sense we are all Keynesians now; in another, no one is a Keynesian any longer. We all use the Keynesian language and apparatus; none of us any longer accepts the initial Keynesian conclusions."
by Andrew Beattie, (Contact Author Biography)
Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.
http://www.investopedia.com/articles/economics/09/john-maynard-keynes-keynesian.asp?partner=basics2
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