Upsides of the Shutdown

The federal government shutdown isn't all bad.  Some of the good things that resulted include:

White supremacists had to cancel their rally at Gettysburg National Park, because National Parks have been closed.  Poor knuckleheads.

Federal spy agencies have been cut back 70%.  We now have a lot more privacy than we had just a day ago.

Spying on pandas halted, as the National Zoo's panda cam has been cut off.  A lot of people are disappointed, but consider the pandas' point of view.  Wouldn't it be creepy to have a camera focused on you for hour after hour after endless hour?  Aren't pandas entitled to some privacy and dignity?

School lunches and breakfast still being served.  Or maybe, from the kids' point of view, this isn't so good.  Many of them might have been hoping for an excuse to binge on junk food.

Free and discounted food and drinks are being offered to feds and sometimes non-feds by many Washington, DC area bars and restaurants.  Theaters, museums, gyms and other businesses are also advertising free or discounted admissions, goods or services.  Close the government and what do you get?  Party central.

Stock market up.  The S&P 500 rose about 0.8%.  If this is what a shutdown does, there are probably a lot of market players rooting for more government dysfunction.

The Key To Obamacare's Survival?

Even though the House of Representatives has just voted to use the budget bill to defund Obamacare, its chances of survival are pretty good.  Not just because the Senate will delink the defunding from the budget bill, but also because Obamacare suddenly seems to have some powerful supporters.

Not that these supporters are speaking openly.  But here's the scoop.  Major American corporations are moving their workers or retirees to the private exchanges.  Wahlgreens, Sears, and Darden Restaurants (think Olive Garden, Red Lobster, Longhorn Steakhouse, Capital Grille and more) have announced that employees will move to the private exchanges.  IBM and Time Warner are moving retirees to the private exchanges.  Apparently, these companies will pay employees or retirees subsidies to reduce their premium costs.  But these companies, and others making similar moves, are offloading a very important risk--the unpredictability of health care costs.  They provide fixed subsidies, thus stabilizing their costs.

Businesses love predictability and certainty.  Profits are more likely if you can control major cost items like health care coverage for employees and/or retirees.  In essence, Obamacare is on the verge of becoming an important subsidy to big business.

Experience teaches that government subsidies are virtually impossible to eliminate.  Long after the Great Depression and Dust Bowl, agricultural subsidies that make no public policy sense persist.  Even after being nationalized just before they could bring down the entire U.S. economy, Fannie Mae and Freddie Mac roll along, now more centrally positioned in the financing of residential real estate than ever before.  Virtual giveaways of access to minerals on federal land continue unabated even though the settlement of the West was effectively complete by 1890.

With Obamacare in the process of becoming a potentially really, really important subsidy to really, really big corporations, do we really think that it's going to be eliminated?  The Tea Partiers in the House make a lot of noise, but can they take on the political firepower that big business lobbyists can bring to bear?  Recent polls indicate that a majority of Americans support Obamacare, and politicians in a democracy eventually have to pay attention to the polls (see Obama-Syria-poison-gas-response for more on this point).  But, just as importantly (or more so), powerful business interests can arrange the survival of big subsidies no matter how loud some people in the House of Representatives scream.  This may reflect poorly on the nature of the political process, but it's the truth.  And Obamacare may well now have the backing of some highly influential lobbyists who will speak softly (to stay out of the cross-hairs of the Tea Party) but will wield big sticks to keep their clients well-subsidized.

How To Stop the Too Big From Failing

Congress, and financial regulators in America and other nations, have struggled endlessly with the problem of financial institutions too big to fail.  Capital requirements have been increased, and regulation has been tightened (somewhat--much of the implementation of the Dodd Frank Act remains unfinished).  But the problem remains.

There is a simple way to seriously reduce the possibility of another taxpayer-funded bailout.  If a financial institution needs a government bailout, force the CEO, COO and CFO, and the members of the Board of Directors, to pay to the government the value of their entire compensation for the preceding five years.  This would include salary, bonuses, stock options, restricted stock, fees, country club memberships, company cars, and all other perks and compensation.  This payment would be required without regard to whether or not the executive officer or director was proven to have participated in any wrongdoing or neglect.  It wouldn't be a penalty for misconduct.  It would be an incentive to avoid sticking the government with the costs of mismanagement.

Any such proposal would, of course, provoke howls of outrage from financial institutions and their free-roaming packs of mouth-foaming running dog lobbyists.  Such a measure would be unfair if the officer or director hadn't been shown to have engaged in misconduct, it would be argued.  However, the SEC already has the legal authority to force a company's CEO and CFO to pay out all their compensation for the 12 months following the issuance of financial statements that are subsequently modified (in a form called a restatement)--see Section 304 of the Sarbanes-Oxley Act.  The SEC isn't required to show that the CEO and CFO did bad things.  They can be forced to make this payout simply because the original financial statements were wrong and needed to be restated.  The courts have upheld this authority.  There's nothing unfair about requiring senior executives to get important things right in the first instance.

Banks and other financial institutions might also object that they couldn't recruit the executive talent they need if this financial Sword of Damocles were to hang over their heads.  But, when we consider the geniuses at some financial institutions in the recent past who steered their firms right over cliffs and into government safety nets, this argument loses its persuasiveness.  Executive compensation arrangements at the too big to fail seem to incentivize risk-taking, even if it might entail unmanageable complexity.  There needs to be a disincentive--and a strong one.

The government has been criticized for not penalizing the high and mighty for the financial crisis of 2008.  Remember, however, that the statutes and regulations governing financial institutions are complex.  Proof of violations can be difficult.  A simple measure like a penalty of five year's compensation for a government bailout offers a way to nail the top dogs for signing a chit the taxpayers have to pay.

One and Done in Syria, Right? Right? . . . Come on, right?

Once upon a time, there were some nasty guys known as al Qaeda.  In August 1998, they bombed the U.S. embassies in Kenya and Tanzania.  Over 200 people were killed, including 12 Americans.  In order punish the baddies, President Clinton order cruise missile attacks on al Qaeda training camps in Afghanistan and a pharmaceutical factory in Sudan which supposedly made chemical weapons.  Dozens of cruise missiles were fired and hit their targets.  After that, al Qaeda was never heard from again.

Unfortunately, the last part isn't true.  Al Qaeda, as we all know, survived in Afghanistan, killed some 3,000 Americans on September 11, 2001, and triggered wars that have turned out to be America's longest military conflicts.  Over 4,800 Americans died in Iraq, and more than 2,000 in Afghanistan.  American personnel are now engaged in fighting al Qaeda or its affiliates in South Asia, the Middle East, the Arabian Peninsula, North Africa, and who knows, maybe even Southeast Asia (there are Muslim insurgencies in Indonesia and the Philippines).   There is no end in sight for America's war against violent Islamic radicals.

President Obama and his supporters seem to think they can conducted a limited strike in Syria to punish Bashar al-Assad for using chemical weapons, and then be done with it.  Who are they kidding?  The bad guys in this scenario grow beards on the other cheek; they don't turn it.  Iran, Syria and Hezbollah are all promising retaliation if America launches cruise missiles.  Americans and American facilities in Iraq, Afghanistan, and probably other places are likely to be on the hit list.  American allies like Israel, Turkey, and other nations may be attacked.  Sooner or later, Assad or one of his allies will do something that will require further American action.  That's what happened with al Qaeda 15 years ago.  The 1998 cruise missile strikes on al Qaeda's training camps led to the 9/11 bombings, which then led to a war we're still fighting.

There is no chance--as in zero percent--that a U.S. cruise missile strike against Assad's forces will be the last word.  President Obama has yet to explain how he will deal with the many retaliatory responses from the bad guys, all without putting boots on the ground in some distant place and without entangling us in another endless war against people who can outlast us because it's their home.  In all likelihood, he has no explanation, because there is no way to contain America's involvement in Syria once we cruise in. 

As Americans know from hard experience, the road to Hell is paved with good intentions, and President Obama has the road we're now on very well paved.   Good intentions aren't the only thing that counts.  Competence and diligence matter, too.  You have to have a strategy to win--convincingly and quickly.  If you don't have such a strategy, don't dive into a war.  Ask the 58,000 Americans who died in Vietnam and the 4,800 who died in Iraq about this point.  There doesn't seem to be much strategic thinking going on in the White House; just political maneuvering in the hope of preventing the President from losing credibility for shooting from the hip.  Some of the U.S. troops in Afghanistan today were seven or eight years old at the time of the 9/11 bombings.  Today's parents of elementary school students should pay close attention to the discussion of U.S. military action in Syria.

How Does Obama Define Success in Syria?

Barack Obama has flinched.  Not once.  Not twice.  But three times in the last year or so.  Each time, he rattled the saber at Syrian President Bashar al-Assad, Assad called Obama's hand, and Obama flinched.  Now, evidently rattled himself by the unexpected rejection of military action by the British Parliament, Obama seems to be looking around for someone to offer a fist bump.  French President Francois Hollande has been supportive, but Obama has called for Congress to pass a resolution endorsing a military response to Assad's use of chemical weapons on Syrian civilians.

The Democrats, who control the Senate, are feeling queasy, but may support a narrowly crafted resolution.  The Republicans, who control the House, are skeptical and may reject the resolution. 

The Administration has offered a variety of negative reasons for striking Assad's forces, arguing that bad or negative consequences will ensue if the U.S. does not strike.  Chemical weapons are horrible and are prohibited by international law.  The United States, and especially the President would lose credibility.  The Iranians would be emboldened in their quest for nuclear weapons.  The North Koreans would be emboldened to pull more septic content.  The Russians would be emboldened in any number of ways. 

Chemical weapons are horrible.  But does the President see himself as a referee, seeking to penalize Assad for face masking?  Is the President's plan to throw down a yellow flag, move Assad back a few yards, and then let the slaughter continue?  Is it okay for Assad to continue his nationwide massacre if he just limits himself to conventional weapons?  Why don't we issue striped uniforms to the U.S. military and give them whistles to blow along with cruise missiles to fire?

As for credibility, Assad is in a fight for his very life.  He couldn't give a rat's left ear what Obama does, because Obama won't put U.S. boots on the ground and hasn't even provided military support to the Syrian rebels that he promised months ago.  Obama doesn't present a significant threat to Assad.  Maybe Assad's forces will refrain from obvious use of chemical weapons for a while and employ more conventional but plenty lethal weaponry to kill many more Syrians.  But nothing Obama is contemplating will make him more credible to anyone who matters.

The Iranians are, if the vaguely sourced information published by the press over the past few years is accurate, hellbent on building nuclear weapons on the fastest possible schedule.  It won't matter a bit what Obama does in Syria.  A U.S. military strike there will only lead the Iranians to more comprehensively disguise their activities.  But it won't dissuade them in the least from halting their nuclear program.

The North Koreans are constrained by the presence of 26,000 U.S. troops stationed along the demilitarized zone in the Korean peninsula.  North Korea can't do anything substantial to South Korea or any other nation without affecting these troops.  As long as those troops are there, what Obama does or doesn't do in Syria isn't significant.

As for Russia, Prime Minister Vladimir Putin is ex-KBG.  If there was an intelligence service that knew how to spot and exploit human weakness, it was the KGB.  Putin surely has Obama figured out--the man isn't bold.  He's not a risk taker.  He wants to be on the winning side no matter who that is or what happens (this is how the U.S. wound up being detested by everyone in Egypt--we tried to be everyone's buddy and ended up no one's buddy).  Obama is like the political equivalent of Microsoft--very successful, but not so likely to continue that success in the future because of an aversion to taking real risks.  Whatever carefully calibrated and narrowly focused military strike Obama now orders isn't going to convince Putin that Obama is anything except a smart, but cautious man trying to stay on his feet in a back alley brawl.  The smartest man in the alley might win the brawl, but the meanest man is the one you have to watch out for.

To persuade Congress and the American people that military action in Syria is justified, President Obama has to present positive reasons.  We need to know how we succeed, how we win.  Waging war for the purpose of stopping bad people from being bad isn't likely to work, unless one is prepared to wage total war and completely conquer the enemy, as America did to Germany and Japan in World War II.  No one has suggested that America conquer Syria.  For the past fifty years, America has dived into military adventures for poorly conceived reasons, and not surprisingly done poorly.  The only clear case for offensive military action--the 2001 invasion of Afghanistan-- was thoroughly botched by the second Bush Administration when it failed to deal definitively with Osama bin Laden after trapping him in late 2001 at Tora Bora.  We're still suffering the consequences of that failure.  If President Obama wants our support for a strike in Syria, he should tell us how we attain victory.  If there is no victory that can be defined or attained, we should hold our fire.

The Hidden Inflation

The Federal Reserve assures us that inflation is modest, and can point to measures of inflation it prefers (the PCE price index) or doesn't prefer (the CPI), both of which tend to be modest--in the 2% range or less.  But if you ask a lot of people out in the real world, they'll tell you inflation is worse than that.  And they are right, once you take account of what inflation really means.

The ultimate problem created by inflation comes up when price increases exceed income increases.  If your real income is falling, your standard of living will drop.  That's cause for concern.  When incomes rise faster than price increases, people complain but then dig into their steaks and lobster. 

Incomes today are, in real terms, falling for a lot of people.  Workers on average earn less, net of price inflation: see http://www.bls.gov/news.release/realer.nr0.htm and  http://money.cnn.com/2013/08/15/news/economy/cpi-inflation-wages/index.html.  Median household incomes have fallen since the beginning of the Great Recession: http://www.cnbc.com/id/100980411.  While the fall in household income may in part be due to higher unemployment, it would also reflect the drop in worker earnings. 

Once you look at earnings and household incomes, you can see that inflation in the broader sense isn't so modest.  Since the Great Recession began in 2009, government statistics show that real average weekly pay for full-time workers has fallen 3.5% from 2009 to the second quarter of 2013.  (See http://data.bls.gov/cgi-bin/surveymost.)  The social discord and turmoil that can come from inflation is rooted in falling real incomes, not nominal price increases.  Despite all the statistical soothing the Fed may offer, many Americans today are hurting from this hidden inflation. 

There is little the Fed can do about falling real incomes.  Its monetary tools and bond purchases have little connection to wage and salary levels.  They may boost household income to the extent they promote greater employment.  However, because they significantly reduce interest income for savers, they may also exacerbate the problem of falling incomes. 

As for Congress and the Administration, they're on August recess right now.  And they won't do much about this problem when they get back.  Fights over a budget for the next federal fiscal year (beginning Oct. 1, 2013) and the looming debt ceiling will provide photo ops and Sunday morning talk show invites for the high and the mighty.  The dreariness of ordinary life is likely to get lost in the shuffle.  Talk at the state level about raising the minimum wage may have some impact.  But falling incomes is as much a problem of the middle class as of lower income persons.  Minimum wage laws won't help the middle class very much. 

The overall structure of American society, with its exceedingly generous corporate compensation practices to tax laws favoring the 1% to the decreasing degree of upward social mobility to the astonishing growth in the cost of college educations and more, is thinning out and pushing down the middle class.  No nation has gone on to its greatest days with increased social stratification and top-heavy distribution of wealth.  But nothing is happening right now to change the trend.  This story won't end well.

Why No Great Rotation?

A popular view among market aficionados is that, with bond prices falling while stocks have been rising, money would shift from bonds to stocks.  Stocks and bonds have historically often moved inversely.  When stocks rose, bonds fell, and vice versa. With bonds falling now, it would seem reasonable to expect investors to rotate their money into stocks.  But there has been no rotation.  Why not?

First, for the past five years, we've had a brave new Fed which has manipulated asset values in ways beyond historical experience.  Since early 2009, central bank easy money has helped to spur a stock rally accompanied by a bond rally.  Both asset classes rose simultaneously, instead of moving inversely.  With their traditional relationship out of whack, it is hardly surprising that they don't cha-cha when they're supposed to.  Investors would be understandably suspicious of stocks in a market that is seemingly dependent on the Fed's methadone program, especially when the Fed is talking about easing out of its role as Dr. Feelgood.

Second, the Great Rotation is an investment strategy for the medium to long term.  Today's stock market is dominated by high-speed, computerized trading, where the holding period for stocks is measured in milliseconds.  The long term human investors that might consider rotating greatly have mostly been supplanted, and many have chosen to invest on autopilot, buying index funds and throwing salt over their left shoulders.

So whither the markets?  That's the $64,000 question, and in truth nobody knows the answer.  With both stocks and bonds having enjoyed years-long bull markets, logic and experience, especially recent very painful experience, tell us that when markets can't keep rising indefinitely, they won't.

Why an SEC Victory Counts More Than an SEC Loss

Since the SEC won a jury verdict against former Goldman Sachs VP Fabrice Tourre last week, the financial press has published semi-snarky commentary about how the SEC has lost more financial crisis cases than it has won.  This game of statistics misses an essential point.  Wall Streeters, corporate executives and directors, and their attorneys are cautious folk.  You might not think so from some of the inexplicably risky things they occasionally do, but on the whole they are more concerned about downside risk than upside potential.  (Even good hedge fund traders look first at how much they can lose before they focus on how much they might make.)

A high profile SEC win, like the Tourre case, makes the risk averse pause and reflect all the more so before taking the plunge.  It's better to settle and hide behind your PR person who repeatedly declines to comment to press inquiries than to be photographed outside a federal courthouse wearing a nice suit and a gloomy expression.  People will remember that expression for a long time.  Tourre didn't have to do a perp walk, but there's nobody--absolutely nobody--on Wall Street, Main Street or anywhere else in the corporate world who wants to wear his suit. 

When the SEC loses in court, the defendants have a day in the sunshine.  But then their cases are largely forgotten.  Major SEC victories are remembered.  The SEC's cases against notorious insider trader Ivan Boesky and junk bond king Michael Milken still receive public mention, even after 25 or so years.  Who remembers the cases the SEC lost in the 1980's?

In the plush conference rooms and offices where corporate lawyers and their clients under SEC investigation discuss the risks of settling versus litigating, you can be sure that the SEC victory in the Tourre case is getting a lot of attention.  The SEC's losses are probably mentioned as well.  But no good attorney wants to be caught making, or even implying, a promise s/he can't keep, and the story of Fabrice Tourre is likely being presented as a cautionary tale.  People with a lot more to lose from an SEC victory than they have to win from an SEC loss may well see the merit of capping their downside risks.

SEC 1, Tourre 0, Goldman 0, Financial Press -1

Today's jury verdict finding Fabrice (the "Fabulous Fab") Tourre liable on six of the seven civil counts against him represents a major victory for the SEC.  That's not simply because of the prominence of the case, which involved the sale of a controversial motgage-backed derivatives investment and is the highest profile SEC enforcement action to come out of the 2008 financial crisis.  It's because the agency's very efficacy has been under attack for the better part of a decade.  Widely viewed as ineffectual, the SEC has re-established its presence as a cop on the beat.  While one victory doesn't win the war, a victory this big will make a lot of corporate and white collar defendants think harder about settling, even if the price involves admitting to making bad choices.

Fabrice Tourre rolled the dice and lost.  Litigation is a gamble, and some bets turn out to be losers.  Perhaps he chose to fight instead of settling up front because he was angry about being a lower level guy who was singled out as a named defendant.  But anger doesn't equate to victory in court.  Above all, what matters is the evidence.  Tourre may have been his own worst enemy, seemingly adding insouciance as too much of a fillip to his e-mails.  Most likely, his attorneys will soon make motions for this and that, and perhaps later file appeals.  But now that the jury has spoken, Tourre faces an uphill battle.

Goldman Sachs wasn't a party to the case.  But it reportedly financed Tourre's defense.  And perhaps it has reasons beyond loyalty to a former employee.  Goldman faces potential liability in private civil lawsuits involving charges similar to those in the SEC case.  If Tourre had won, Goldman might have negotiated more favorable settlements in those cases.  Now that he's lost, GS has shifted closer to the 8-ball.  But that's all just a matter of money, of which GS has a fair pile.  GS isn't going to be kicked out of the securities business, as Tourre might be, because GS already settled with the SEC, thereby capping its regulatory liability.   Now that he's been held liable by a jury, Tourre not only faces SEC sanctions, but perhaps demands for payment from the plaintiffs' attorneys in those private civil lawsuits as well.  Poor Fab.  Not so fabulous any more.

The financial press ends up looking silly.  Not one publication of any prominence, to this writer's knowledge, predicted the SEC's victory.  Many expressed serious doubt about the SEC's case.  The coverage during the trial was frequently skeptical of the SEC's evidence and efforts.  It might be interesting to know why the press coverage was so imbalanced.  Whatever the reason, the press was scooped by the SEC staff, which convinced the jury to announce the real story. 

From the Fed: Short Term Gain, Long Term Pain

As the Fed's ultra low interest rate policies grind on for a fifth year, we can see ever more clearly that there is no such thing as a free lunch, even when it comes to central bank policies.  The benefits of the Fed's low interest rate policies were easy to see at first:  cheap credit, stimulus to housing, a boost to the economy.  The costs didn't seem so great. 

However, by persistently favoring borrowers and heaping mulch on income-seeking investors for five years, the long term costs of the Fed's policies are emerging--and painfully so.  Detroit is in bankruptcy, and other cities teeter on the brink. Corporate defined benefit pension plans are becoming less common than the ivory-billed woodpecker. It's no wonder why.  Pension funds rely on safe long term investments that provide solid returns.  U.S. Treasury notes and bonds used to be crucially important components of pension fund portfolios.  AAA-rated corporates, which would have to pay slightly better than Treasuries, also were favored investments.  But pension plan returns came under stress as the returns on these low-risk investments nosedived.  And pension fund deficiencies, calculated on the basis of long term returns, balloon when returns fall.  Plan sponsors have to increase contributions--sometimes enormously--to keep the plans solvent.  Corporate executives intent on making the big score with their stock options see little upside to signing off on these contributions.  Shrinking cities like Detroit have little ability to make them.  Something has to give, and pensioners seem to be doing a lot of giving these days.  Detroit's problems go well beyond low long term interest rates.  But the city really didn't need the Fed to push it closer to the abyss. 

Neither did a lot of corporate employees whose retirements are less secure after losing their defined benefit pensions or seeing the plans capped.  Most people aren't skilled at managing their finances.  When fewer have defined benefit pensions, more are likely to end up with just Social Security, even if they start retirement with good-sized 401(k) account balances.  When people have fewer or no private resources, cutting benefits from the government becomes political anathema. 

Low interest rates hurt older folks in other ways.  As income from their interest-bearing investments dries up, fear drives them to become serial economizers.  That's a hard habit to break even after rates rise again (assuming they do).  Consumption may be impaired for a long time.  In addition, long term care insurance is getting scarce and expensive.  While poorly conceived estimates by insurers of the cost of care have much to do with that, the inability of insurers to obtain decent, safe returns on investments has added to the problem.  Fewer people are able to afford such policies.  So we have a ticking demographic time bomb, with lots of uninsured elderly likely to need Medicaid in a decade or two or three instead of being able to rely on their own resources.  Low interest rates are beneficial to the federal government's borrowing costs right now, keeping the budget deficit lower.  But positioning a lot of people to need Medicaid in decades to come means we'll have pressure toward an increased deficit in the long term.

 The Fed is taking a page from corporate America:  focus on short term returns at the risk of increasing long term costs.  The great corporate success stories don't follow this plot line.  But there's not much chance the narrative will change.  The Fed's easy money merry-go-round keeps the stock market buoyant.  With mid-term Congressional elections coming up next year, the Obama administration needs to keep the market feeling chipper.  Ultimately, everything in Washington happens for political reasons.  And politics dictates that Janet Yellen, a monetary dove, will be Obama's nominee as the next Chairman of the Fed.