Two Economists, Two Different Views

Two different economists and two different views are out there in today’s New York Times and Washington Post. Economists disagreeing with each other! Well, that will shock no one, of course. What is more noteworthy is the simplicity of one argument and the sophistication of the other. And the best argument doesn’t come from the Nobel Prize winner.

Paul Krugman’s stance in the NYT is again all about the need for another Fed stimulus. But over at the Post Mohamed El-Erian, the CEO of Pimco, the investment management company, has a far greater grasp, I think, that the crisis we are in is as much a structural one as cyclical.

Nobel Prize winner Krugman places most of the political blame for the non-recovery recovery on Republican obstructionism and Democratic timidity. El-Erian sees the political dimension of the crisis in less partisan terms – the whole political elite is failing to understand what is happening, is his take.

Here’s El-Erian: “What is critical to keep in mind is that this situation is part of a broad, multiyear process driven by national and global realignments. It’s a secular phenomenon that needs to be better understood and navigated — by recognizing its structural dimensions and by urgently broadening the excessively cyclical policy mindsets that abound…

Policymakers must break this active inertia by implementing a structural vision to accompany their current cyclical focus. Measures are needed to address key issues, which include the change in drivers of growth and employment creation; the high risk of skill erosion and lost labor productivity; financial deleveraging in the private sector; debt overhangs; the uncertain regulatory environment; and the unacceptably high risks facing the most vulnerable segments of society.

Specific measures would include pro-growth tax reform, housing finance reform, increased infrastructure investments, greater support for education and research, job retraining programs, removal of outdated interstate competition barriers and stronger social safety nets.”

And Krugman? “The Fed has a number of options. It can buy more long-term and private debt; it can push down long-term interest rates by announcing its intention to keep short-term rates low; it can raise its medium-term target for inflation, making it less attractive for businesses to simply sit on their cash. Nobody can be sure how well these measures would work, but it’s better to try something that might not work than to make excuses while workers suffer.” Although for Krugman a stimulus would be the thing. Damn those Republicans!

El-Erian, it strikes me, is right.

The New Normal — What’s To Be Done?

I had an interesting discussion today with the excellent libertarian blogger David Friedman prompted by a USA Today interview with Mohamed El-Erian, the CEO of Pimco. El-Erian was stressing his idea of the New Normal, “which predicts a post-financial-crisis world of lower investment returns, slower economic growth and higher odds of another out-of-the-blue financial shock. In short, a world in which the range of financial outcomes — and risk — is much wider than normal.”

David on Facebook commented: “Pimco’s CEO echoes what I have been saying for a while now: (1) cash is king; (2) asset returns will be negligible for the foreseeable future. You’ve been listening to me, right? You’ve liquidated your real estate holdings and are now renting, right? Right?”

And the edited exchange between us went thus:

Jamie Dettmer: “Actually, David, my old Cambridge contemporary doesn’t say anything of the sort. He does say there is too much home bias but it makes no sense to sell your property now in the troughs of the markets. Sure if you had investment property you should have sold long ago. Otherwise you sit tight — you have to live somewhere. Or rent your property out, if you are in a high-rent area and can go to a low-rent area for your needs. One thing that ordinary people make a mistake on is taking the advice of gurus like Mohamed. His clients are big corporations and high net-worth individuals. But I think he is right about the New Normal and that ordinary investors in particular should be careful of equities and look to emerging markets and foreign currency holdings. But should they sit on a lot of cash — more than, say, a year’s need? I am not so sure. In savings accounts and fixed bonds they are losing money when inflation and tax is taken into account — it maybe better, depending on personal circumstances, to pay the mortgage off or down. They would secure a better return.”

David Friedman: “Admittedly, his phrase “a lot of home bias” is ambiguous. I can see it being interpreted either as meaning too much money in one’s home or too much money invested in one’s home country. Which, in essence, is a distinction without a difference. So, I don’t see why you say he doesn’t say anything about home ownership.

But, generally, yes, the more equity one has in one’s home the more able one is to ride out rough economic storms. But, many people don’t have sufficient equity in their homes and so are teetering on the edge of bankruptcy. Better to liquidate one’s expensive, illiquid, and leveraged “investment” than to suffer the caprices of economic growth.

Finally, it’s not true that housing is a hedge against inflation.”

Jamie Dettmer: “No, my point about paying off or down on the mortgage wasn’t as a hedge against inflation as such. It was more that they are paying interest on their mortgage and by keeping lots of cash they are not getting a return on their savings to match or compensate what they are paying for their mortgage — at least over the long or even medium term. I agree that if someone is struggling and is over-leveraged on their home and they can get a sale, them they are better advised to escape. His comment about home bias is highly ambiguous — does he mean investing at home or being invested in a home? Even if it is the latter, then personal circumstances kick in. Last, it also comes down to where your property is. The US has a national housing market but with significant variations. I am reasonably content with having property in the DC-Baltimore metro area — but I would not be sitting comfortably if my property was in Enid,OK, say. But as I get older there are two things I am fairly sure about — taxes and death! Wow, that’s a bit depressing — think I need another espresso.”

David Friedman: “But, if we assume that he means US investors are over-invested in their home country, and we further make the assumption that most people’s largest investment is in their house, then it follows that most people would be better off liquidating their real estate investment and investing that cash abroad….”

Jamie Dettmer: “That might be. But he also notes that you should avoid big risks with equities and that things are going to be topsy-turvy and that people should invest in what they know. Further, I do have most of my cash in foreign currencies but I can find no really worthwhile fixed bond or savings account that would not have me losing when tax is taken into account. Standard Chartered offers an offshore fixed bond of 4.5 percent over a year. Others at the 4 percent mark require the bond to run for three to five years.”

David Friedman: ‘Well, it seems to me that what he’s really talking about here is that one should diversify across asset classes, and make that diversification international. Which is fine, as far as it goes, but as you say, that’s not practical for the average investor. So, the average investor, who more likely than not, has most of his net worth concentrated in his house, is sort of screwed.

On the other hand, when financial crises hit, all correlations go to 1, as we saw in 2009.

I think the lesson here is that volatility is inherent to financial markets, and that no government can mitigate that volatility. Better, then, to make peace with volatility, than to try to defeat it. Admittedly, that’s a fatalistic view of finance, but there you have it.”

Jamie Dettmer: “Yea, I think that’s right. We are mere corks floating on the water.”

David Friedman: “The first person who figures out how to properly hedge portfolios 100% of the time is going to make trillions.”

Jamie Dettmer: “Well, several big investment banks thought they were doing just that — great while it lasted, for them. And they were encouraged by Brown (the end of boom and bust) and Greenspan.”

I ought to point out that the David Friedman in this exchange is not David D. Friedman.

Vita Not So Bella: The View From Lazio

The foreign tourists are still visiting Largo di Bolsena and you can still hear the voices on the south Tuscan beaches of affluent Brits, Americans and north Europeans but the visitor numbers are down significantly – and the voices sound a little less sure than when the credit spigots were flowing.

This year in Lazio the consequences of the crisis are more obvious with local businesses complaining their takings are down. Lazio has never been the tourist hotspot of Tuscany or Umbria, but in the late 1990s, and until the financial crisis hit a couple of years ago, the region enjoyed a steady increase in foreign visitors.

And why not the – the countryside is every bit as lovely as Umbria to the north and the Lazio villages are gems. The region enjoys a fine coast and one of Italy’s most unspoilt large lakes with fresh clear water and excellent fish. Slowly but surely property prices had risen, driven by foreigners unable to afford Tuscan prices and Romans seeking tranquility outside the city.

Although property prices have not declined in the last two years they have flattened now and locals appear to be getting more realistic when it comes to foreigners and what they will pay.

If one were to guess which north European countries are not doing badly in the crisis, spotting country number plates in Lazio wouldn’t be a bad way of making an assessment. Throughout the summer there have been few British, French or Belgian cars touring the lanes and roads of Lazio. Dutch and German have been far and away the most obvious. And for the first time in a decade of visiting or living in the region, I noticed some Czech and Polish cars.

But away from the tourists, life for my neighbors and other ordinary Italians has got seriously harder. A psychologist in the nearby town of Bagnoregio told me that many of her clients say they have cut down on the basics and now have only one major family meal a day. Supporting evidence of this would include the local restaurant owners complaining of much lighter traffic and of several local greengrocers telling me that their takings this year are down by about 40 percent.

With the political crisis intensifying – most Italians expect an early parliamentary election this autumn and the departure of Silvio Berlusconi – there is fear about the future in the air.

One thing that Italy does have going for it – and one not noticed by many of the financial commentators in the UK and the United States — is that while the country has been as free and easy as its south Mediterranean neighbors with government spending, Italy owes a large proportion of its debt to itself and not to foreigners – Italian savers have been propping up Italian government expenditure by buying government bonds.  A downgrading by the credit agencies of Italy would have less effect than a downgrading on several other Europeans countries.

Italian economic performance is as ever hard to assess: about 30 percent, and maybe more, of the Italian economy is black, a testimony to traditional widespread tax evasion.

Even so, signs of private and public belt-tightening are clearer now. My local village of Celleno will shortly see the closing of the local school, a consequence of the decision to consolidate schools in the region.