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Bill Gross Proven Half Right (For Now): Fed's Kocherlakota Just Reduced His 2011 GDP Forecast From 3.0% To 2.5%

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A week ago we wondered how it was that Pimco's Bill Gross, who is now rumored to be Larry Summers replacement as the QE infinity whisperer on the right side of President Obama, had an advance look into how the Fed will adjust its GDP forecast ahead of the general public. Today, we got the first half of the response: in a speech to the European Economics and Financial Centre in London, Minneapolis Fed president Narayana Kocherlakota has just lowered his GDP forecast from 3% to 2.5%. And most importantly, the Fed President's speech in decidedly QE-negative: our favorite quote on QE from a Fed president so far: "The Fed cannot literally eliminate the exposure of the economy to the
risk of fluctuations in the real interest rate. It can only shift that
risk among people in the economy. So, where did that risk go when the
Fed bought the long-term bond? The answer is to taxpayers." Thank you Fed.

Among the other things Kocherlakota has announced is that:

  • the recovery in the US is underway but "distinctly modest"
  • inflation will rise to a more desirable 1.5% to 2% in 2011
  • unemployment will be above 7% well into 2012. 
  • Impact of QE will be "muted", and confirms rumors that the hawk-wing in the Fed is not likely to roll over and accept a November QE2 announcement:" My own guess is that
    further uses of QE would have a more muted effect on Treasury term
    premia."

We expect another Fed president to pick up the torch soon, and announce that a re-revised GDP forecast will be 2%, once again confirming that when it comes to matters Fed-related, the Oracle of Newport Beach is second to none.

Full Kocherlakota speech:

Economic Outlook and the Current Tools of Monetary Policy
Narayana Kocherlakota - President
Federal Reserve Bank of Minneapolis

Thanks for the generous introduction. I’m delighted to have this opportunity to speak with you today.

As you just heard, I became president of the Federal Reserve Bank of
Minneapolis last October. Here’s the start of a rather typical
conversation that I would have had with my friends and relatives last
fall. “Congratulations! That’s fantastic. Now, what is it that you will
do exactly?”

As it turns out, the job has a lot of interesting aspects. But I think
I’ve been invited to speak here today because I help formulate monetary
policy for the United States. So what I plan to do is give you some
feel for how this part of my job works. In doing so, I’ll highlight the
Federal Reserve’s quintessentially American structure. Unlike the
central banks of other countries, you’ll see that ours is specifically
designed to draw upon the insights of small-town businesses, farmers
and ranchers, and large manufacturers, among others, to formulate
monetary policy. Before I proceed, I must remind you that any views I
express here today are my own, and not necessarily those of others in
the Federal Reserve System.

What do I mean by an American structure? Well, relative to its
counterparts around the world, the U.S. central bank is highly
decentralized. The Federal Reserve Bank of Minneapolis is one of 12
regional Reserve banks that, along with the Board of Governors in
Washington, D.C., make up the Federal Reserve System. Our bank’s
district extends from the Rocky Mountains on the west to the Great
Lakes in the east and borders Canada, an area roughly four times the
size of the U.K. However, the U.K. has about seven times the
population.  

Eight times per year, the Federal Open Market Committee—the FOMC—meets
to set the path of short-term interest rates over the next six to seven
weeks. All 12 presidents of the various regional Federal Reserve
banks—including me—and the seven governors of the Federal Reserve Board
contribute to these deliberations. (Actually, in the meeting last
week, there were only four governors. The good news is that the White
House has nominated three excellent candidates for the three
vacancies.) However, the committee itself consists only of the
governors, the president of the Federal Reserve Bank of New York, and a
rotating group of four other presidents (currently Cleveland, St.
Louis, Kansas City, and Boston). I’ll be on the committee in 2011.

In this way, the structure of the FOMC mirrors the federalist structure
of our government. Representatives from different regions of the
country—the various presidents—have input into FOMC deliberations. The
input from the presidents relies critically on information they receive
from their districts about local economic performance. We obtain this
information through the work of our research staffs—but we also obtain
it from people in industries and towns, in my case, across the Upper
Midwest. The Federal Reserve System is deliberately designed so that
the residents of Main Street—and not just Wall Street—are able to have a
voice in monetary policy.

As part of my contributions to recent FOMC meetings, I discussed my
outlook for GDP, inflation, and unemployment. In terms of GDP, I believe
that a modest recovery is under way and is likely to continue. In
terms of inflation, I expect a slight but welcome uptick over the next
18 months. Finally, in terms of unemployment, I see ongoing deep
problems in labor markets.

I’ll talk first about GDP. Real GDP growth has been positive in each of
the past four quarters, and the government’s second estimate is 1.6
percent for the second quarter of this year. We have recently updated
our estimates for future growth from our Minneapolis forecasting model.
Our September estimates are distinctly lower than our August
estimates. I now expect GDP growth to be around 2.4 percent in the
second half of 2010 and around 2.5 percent in 2011. Together over 2010
and 2011, I’m now predicting that GDP will grow around 2.5 percent per
year. In contrast, in my first speech about seven months ago, I
predicted that GDP would grow around 3.0 percent per year over 2010 and
2011.
There is a recovery under way in the United States. But it is a
distinctly modest one—and even more modest than I expected at the
beginning of this year.

Let me turn now to inflation. From the fourth quarter of 2009 through
the second quarter of 2010, the change in the PCE price level was just
over 0.5 percent, which works out to an annual rate of just over 1
percent. The Fed’s price stability mandate is generally interpreted as
maintaining an inflation rate of 2 percent, and 1 percent inflation is
often considered to be too low relative to this stricture. I expect
inflation to remain at about this level during the rest of this year.
However, our Minneapolis forecasting model predicts that it will rise
back into the more desirable 1.5-2 percent range in 2011.

So the news about inflation and GDP is in the “OK, but certainly could
be better” category. However, the lack of vitality in the U.S. labor
market can only be termed disturbing. The national unemployment rate
remained at 9.6 percent in August. Private sector job creation remains
weak—only 67,000 net private sector jobs were created in August. I do
not expect the unemployment rate to decline rapidly, and so I expect it
to be above 8.0 percent well into 2012.

If one digs deeper into the data, the situation seems even more
troubling.
Since December 2000, the Bureau of Labor Statistics has been
keeping data on the job openings rate, which is defined as the number
of job openings divided by the sum of job openings and employment. It
has also been keeping track of the layoffs/discharges rate, which is
the fraction of employed people who have been laid off or discharged in
a given month. The job openings rate rose by around 30 percent between
July 2009 and July 2010. The layoffs/discharges rate has fallen by
over 10 percent over the same period.

Nonetheless, despite this apparent increase in the demand for labor
from employers, the unemployment rate actually went up slightly from
July 2009 to July 2010, from 9.4 percent to 9.5 percent. And other
measures of labor market performance actually tell an even bleaker
story. From July 2009 to July 2010, the employment/population ratio
fell from 59.3 percent to 58.4 percent. At the same time, the seasonally
adjusted labor force participation rate fell from 65.4 percent to 64.6
percent. This was the biggest July-over-July fall in the 60-plus year
history of that statistic.

To summarize: GDP is growing, but more slowly than I expected or than
we would like. Inflation is a little low, but only temporarily. The
behavior of unemployment is deeply troubling.

With that economic outlook in mind, we can now turn to the choices
facing the FOMC if it were to choose to provide more stimulus.
Currently, the FOMC has set its target range for the fed funds rate at
between 0 and 25 basis points. It has committed to keeping the rate in
that range for “an extended period,” contingent on economic conditions
being appropriate. The FOMC is also maintaining a portfolio of roughly
$2.3 trillion. Over 2 trillion of those dollars are invested in
Treasury securities or government-backed securities issued by Fannie
Mae, Freddie Mac, and other government-sponsored enterprises.

In his address at the Federal Reserve Bank of Kansas City’s annual
policy forum in August, Chairman Bernanke described three possible
tools that are available to the FOMC if it chooses to provide further
stimulus. The first is to buy more long-term securities. The second is
to offer more forward guidance in the FOMC statement. The third is to
reduce the interest on excess reserves (IOER) by 15 or even 25 basis
points. As Chairman Bernanke indicated, using these tools does not come
without costs, and due consideration must be made of both costs and
benefits. Along those lines, I will discuss my thoughts on how these
tools impact the economy. Again, I must underscore that my thoughts are
my own and do not represent the views of anyone else in the Federal
Reserve System.

Let me talk first about forward guidance. In part, firms make their
decisions about capital expenditures and hiring by comparing the
returns to those internal projects to the inflation-adjusted yields
available in financial markets for investments of similar horizon. Thus,
the real yields on medium-term and long-term government bonds matter
for firm investment decisions. Those yields are, in part, shaped by
current expectations of future short-term interest rates. The current
FOMC statement shapes those expectations by providing forward guidance
about its future plans for the behavior of the fed funds target.

Right now, the FOMC states that it will keep the fed funds target range
exceptionally low for as long as economic conditions warrant. The
statement also predicts that exceptionally low fed funds rates are
likely to be warranted for an “extended period” of time. In this way,
the statement influences current expectations of future short-term
rates and thereby shapes current medium- and long-term interest rates.
The FOMC could provide stimulus by saying that it predicts that low
rates are likely to be warranted for an even longer period of time than
an “extended period.” This kind of stronger language should lead to a
decline in medium-term and long-term interest rates.

I view lowering the IOER as another form of forward guidance. I think
that it is unlikely that lowering the IOER by 15 or 25 basis points
will have much direct effect on loan markets. However, it is likely that
investors would view this move as a signal that the FOMC is planning
to keep its target rate even lower for an even longer period of time.
In that way, lowering the IOER would serve to lower medium-term and
long-term interest rates.

So, the FOMC can influence the economy through various forms of forward
guidance about how long it plans for the fed funds rate to be so low.
However, the FOMC has another tool at its disposal: what is often
termed quantitative easing—QE for short. Under quantitative easing, the
FOMC buys long-term securities in the open market. In exchange for
those securities, it credits the sellers’ accounts at the Fed with more
reserves. The upshot is that there are fewer long-term securities being
held by private investors, and banks hold more reserves.

Just to be clear on one point: The FOMC is only authorized by Congress
to buy a limited set of securities. Ideas like “the FOMC should buy
corporate bonds” would require a change to the Federal Reserve Act—a
change that I for one would view as undesirable. In meetings earlier
this year, FOMC participants indicated their strong preference to
return to an all-Treasury portfolio. So, I’ll proceed in this speech
under the presumption that any new purchases would take the form of
long-term Treasuries. But, as I’ll discuss, the idea behind QE is that
the yields on those long-term Treasuries will affect yields on all
long-term securities.

I see QE as affecting the economy in four main ways. I’ll first discuss
them from a theoretical perspective and then discuss what’s known
about these effects empirically.

The first effect of QE is that it represents another form of forward
guidance about the path of the fed funds rate. It is a way for the FOMC
to signal—in a perhaps more striking way—that it plans to keep the fed
funds rate low for an even longer time to come.

Second, QE creates more reserves in banks’ accounts with the Fed. The
standard intuition is that this kind of reserve creation is
inflationary. Banks can only offer checkable deposits in proportion to
their reserves. Economists view checkable deposits as a form of money
because, like cash, checkable deposits make many transactions easier. In
this sense, bank reserves held with the Fed are licenses for
banks to create a certain amount of money. By giving out more licenses,
the FOMC is allowing banks to create more money. More money chasing the
same amount of goods—voila, inflation.

This basic logic isn’t valid in current circumstances, because reserves
are paying interest equal to comparable market interest rates. Banks
have nearly $1 trillion of excess reserves. This means that they are
not using a lot of their existing licenses to create money. QE gives
them new licenses to create money, but I do not see why they would
suddenly start to use the new ones if they weren’t using the old ones.
With that said, I have indicated in earlier speeches that $1 trillion
of excess reserves does create a potential for high inflation
at some point in the future if the FOMC does not react sufficiently
fast when it starts to see inflationary pressures. But I do not see
this risk as being heightened in any meaningful way by banks holding
even more excess reserves than what they are holding today.

The third effect of QE is the one that is usually stressed: It reduces
the exposure of the private sector to interest rate risk. The holder of
a long-term Treasury is exposed to interest rate risk. If interest
rates rise, the price of the bond falls, and the bondholder is less
wealthy. Now think about an example of QE in which the Fed buys $1
billion of 10-year Treasuries. On the margin, the bond portfolio of the
private sector is now less exposed to interest rate risk. As a
consequence, private investors will demand a lower premium for holding
other bonds that are exposed to interest rate risk. All long-term
yields fall, and so firms should be more willing to undertake long-term
capital expansions or hire permanent employees.

The fourth effect of QE is less widely discussed. The Fed cannot
literally eliminate the exposure of the economy to the risk of
fluctuations in the real interest rate. It can only shift that
risk among people in the economy. So, where did that risk go when the
Fed bought the long-term bond? The answer is to taxpayers.

To see this more clearly, suppose hypothetically that the Treasury
wants to borrow $1 billion today and is choosing between two ways of
doing so. One way is to issue a 20-year, zero coupon, inflation-indexed
bond. The bond requires the Treasury to repay $1.5 billion in real
terms in 20 years (roughly a 2 percent real yield). Under this plan,
taxpayers face no tax risk, but the buyers of the bond can lose a lot
if real interest rates rise greatly. The other way is to issue $1
billion of one-year indexed bonds and then keep rolling over that debt
for 20 years. Now, taxpayers have to repay a lot more than $1.5 billion
in 20 years if short-term real interest rates end up being high.

Basically, if the government uses short-term debt, it exposes taxpayers
to interest rate risk. If it uses long-term government debt, it
exposes the bondholders to interest rate risk. QE is a special case of
this general principle: When the Fed buys long-term government debt from
the private market, it shifts interest rate risk from bondholders to
taxpayers.

What is the ultimate impact on the overall economy of this shift in
risk? In the baseline models used by central banks, all bondholders are
taxpayers. In these models, QE is essentially shifting risk from one
pocket to another. As a result, the increase in tax risk (what I’m
calling the fourth effect of QE) completely undoes the decrease in
interest rate risk (the third effect of QE). QE ends up having no
effects, except for those associated with any new forward guidance that
it signals.1

QE will have nontrivial effects over forward guidance in the context of
a more realistic model in which people differ from one another in some
relevant way.
Along those lines, we might think that some people are
active participants in the Treasury markets. Others are not. Then, if
the Fed buys long-term Treasuries, it takes risk from the former group
and imposes it on the second group. The ultimate macroeconomic impact
of QE depends on the extent to which the extra tax risk deters economic
activity on the part of this second group. We know little about this
effect, either theoretically or empirically.

To this stage, my discussion of QE has been purely theoretical in
nature. The Fed engaged in QE from January 2009 through March 2010 by
buying over $1.5 trillion worth of agency debt, agency mortgage-backed
securities, and Treasuries. How did this operation—termed the
Large-Scale Asset Purchase, or LSAP program—affect the economy? We don’t
know as much as we would like as yet. However, I think that the best
empirical work on the question of how the LSAP affected long-term
Treasury yields has been done by Gagnon, Raskin, Remache, and Sack
(2010). Their paper is a thorough investigation of this key issue. My
conclusion from their work is that the LSAP reduced the term premium on
10-year Treasury bonds relative to 2-year Treasury bonds by about
40-80 basis points (on an annualized basis). (The term premium is a
measure of the difference in yields that is not explained by the
expected path of short-term interest rates.) This fall in term premia
led to a slightly smaller fall in the term premia of corporate bonds.

These estimates are extremely useful benchmarks. My own guess is that
further uses of QE would have a more muted effect on Treasury term
premia. Financial markets are functioning much better in late 2010 than
they were in early 2009. As a result, the relevant spreads are lower,
and I suspect that it will be somewhat more challenging for the Fed to
impact them.

I’ve talked about three possible tools—lowering the IOER, strengthening
the forward guidance in the FOMC statement, and quantitative easing.
As I mentioned earlier, Chairman Bernanke observed in his August 27
speech that each of these tools has benefits and drawbacks that must be
balanced against each other. With QE, I would say that the multiple
effects make the calculus even more difficult than usual.

So I’ve talked about a lot of issues today, and I could certainly
talk about a lot more. But I have a feeling that you’ve got plenty of
questions, and we are likely to hit on many key topics. So I will stop
here and happily take your questions.

 

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Wed, 09/29/2010 - 10:36 | 612478 berated
berated's picture

" Inflation is a little low, but only temporarily."

Let's re-visit this little gem in a few years and have a good laugh....

Wed, 09/29/2010 - 10:40 | 612492 ZeroPower
ZeroPower's picture

More like stagnation in the near future, inflation later on. What did you think the printing press would achieve?

Wed, 09/29/2010 - 10:38 | 612485 RobotTrader
RobotTrader's picture

People still hate stocks, and continue to flee into bonds.

AGG within a hairsbreadth of making new highs.

Wed, 09/29/2010 - 10:45 | 612504 snowball777
snowball777's picture

  • the recovery in the US is underway but "distinctly modest"
  • inflation will rise to a more desirable 1.5% to 2% in 2011
  • unemployment will be above 7% well into 2012. 
  • Impact of QE will be "muted", and confirms rumors that the hawk-wing in the Fed is not likely to roll over and accept a November QE2 announcement
  • the recovery in the US is a complete fabrication
  • inflation will rise to at most 0.5% in 2011
  • unemployment will be above 10% well into 2014. 
  • QE2 will be too little, too late...can't blow up a tire with a dixie straw, bitchez.

Wed, 09/29/2010 - 12:46 | 612840 mnevins2
mnevins2's picture

"unemployment will be above 7% well into 2012."

Typo in this comment from the headline - and it's not a good one. The narrative has him actually saying "unemployment will be above 8% well into 2012."

For me, this is the issue that, for the Fed, determines/trumps everything: deficits, taxes, inflation/deflation, gold - everything.

Wed, 09/29/2010 - 10:58 | 612532 sushi
sushi's picture

Bill Gross half right??

But which half??

Wed, 09/29/2010 - 10:58 | 612533 Sudden Debt
Sudden Debt's picture

Among the other things Kocherlakota has announced is that:

  • inflation will rise to a more desirable 1.5% to 2% in 2011

MY ASS! For example inflation in Europe is up from 2.4 to 3.1% IN ONE MONTH!!!

Wed, 09/29/2010 - 11:04 | 612542 NOTW777
NOTW777's picture

when do they downgrade the summer of recovery to half a summer of recovery.

MSM is a total fraud - they are ignoring the disaster; the crooks are sneaking out the back door little by little

Wed, 09/29/2010 - 11:07 | 612544 Buttcathead
Buttcathead's picture

I still aint buy'n nuttin, But I raised my Dow target price from 444 to 2447.  I mis calculated one of the waves.  I will buy something once we get to 2500.

Wed, 09/29/2010 - 11:11 | 612554 Dr. No
Dr. No's picture

Make sure you wait until it bounces off 2447.

Wed, 09/29/2010 - 11:08 | 612545 Cognitive Dissonance
Cognitive Dissonance's picture

Pimco's Bill Gross, who is now rumored to be Larry Summers replacement.....

Bill Gross was interviewed on CNBC by Erin "Tiny Bubbles" Burnett yesterday. And he flatly gave a non denial denial, saying he was a poor candidate and that there were many more qualified people.

I love absolute denials, don't you?

Wed, 09/29/2010 - 12:30 | 612786 BearOfNH
BearOfNH's picture

Ah, but the "many more qualified people" don't swing the 0bama way. Smilin' Bill wins by default.

 

Wed, 09/29/2010 - 11:09 | 612550 buzzsaw99
buzzsaw99's picture

Gross was only half right because the fed altered their forecast after he spilled the beans that Pimpco always has the insider info. RICO bastards.

Wed, 09/29/2010 - 11:10 | 612552 Ragnarok
Wed, 09/29/2010 - 11:25 | 612591 Cognitive Dissonance
Cognitive Dissonance's picture

I have no idea why people would be afraid to trade.

Oh wait, maybe it's because the HFT computer algos can eat my lunch before I can even remember if I had any.

Wed, 09/29/2010 - 11:17 | 612570 septicshock
septicshock's picture

Tyler,

Any word on the riots all over Europe?

Wed, 09/29/2010 - 11:48 | 612647 Spalding_Smailes
Spalding_Smailes's picture

 

`Toxic bank' cement truck blocks Irish parliament

DUBLIN — A cement truck plastered with anti-bank slogans blocked the entrance to the Irish parliament Wednesday as tensions mounted over the country's debt crisis and enormous bank bailouts.

At least one police guard narrowly escaped being hit as the truck drove up to Leinster House about 7:15 a.m., one lawmaker said. The truck stopped as it touched the entrance's ornate wrought-iron gates but caused no significant damage.

Police arrested the 41-year-old driver, who climbed out of the truck cabin's skylight. The doors of the cement truck — which has been used before in anti-government demonstrations — were welded shut and its windows covered in metal grills to prevent police from gaining access.

 

Update ***

Those tensions were writ large on the truck itself. It displayed the slogans "All politicians should be sacked" and, in huge capitalized red letters, "TOXIC BANK," alongside the corporate logo of government-owned Anglo Irish Bank.

It took three hours to remove the truck from the parliament entrance because its brake lines were also cut to make the move difficult.

 

http://www.google.com/hostednews/ap/article/ALeqM5ikpqJHgh3-55o5fRl1zZIC...

Wed, 09/29/2010 - 11:58 | 612685 RockyRacoon
RockyRacoon's picture

You're expecting a personal reply on something off topic?

Google it.    May we peel you a grape as well?

 

Europe ETFs Fall As Riots Take Hold

 

News roundup: Strikes in Europe protest austerity measures
Wed, 09/29/2010 - 11:18 | 612573 Gloomy
Gloomy's picture
Meredith Whitney's new target: The states

The housing crash not yet realized its full impact on budgets in the most vulnerable states. It's the banking crisis all over again – and it's time to stop ignoring it.

Meredith Whitney, the superstar analyst who famously forecast disaster for America's big banks before the credit crisis struck, is now warning about another looming threat: The wreckage from over-stretched state budgets.

Today, Whitney is releasing a 600-page report, colorfully entitled "The Tragedy of the Commons," that rates the financial condition of America's 15 largest states, measured by their GDP. Whitney claims that the study is the most comprehensive, in-depth analysis of the states' murky patterns of spending, revenues and benefits programs ever assembled by the government, foundations, or another research firm.

What Whitney found reminds her of the poor disclosure and arcane accounting rules that hid the fragile condition of the banks and monoline insurers that she unmasked. "The states represent the new systemic risk to financial markets," says Whitney. "I see a lack of transparency and an abundance of complacency on the part of investors and politicians, just as we saw before the banks imploded."

The study represents a departure for Whitney, whose boutique research firm specializes in providing its clients, including hedge funds, big institutions and banks, with proprietary research on the financial condition of consumers, ranging from projections on credit card defaults to regional employment trends. So why the mega-work on the states? "It's not that my clients requested it," says Whitney. "I was just so shocked by what I was seeing that I couldn't stop. Any long-term strategic plan needs to take account of the dangerous, mostly overlooked problems in the state finances." Whitney describes the reports as "her favorite child."

The title, "The Tragedy of the Commons," ­­comes from a parable about greedy farmers who let their sheep gobble up all the grass in a pasture, leaving the land barren and unfarmable––reflecting the spending frenzy that promises to decimate the prospects for many of America's largest, and formerly most prosperous, states.

Bigger economies, lower ratings

In the report, Whitney rates the fifteen states on four criteria, their economy, fiscal health, housing, and taxes. For each category, she assigns a rating of one, two or three for best, neutral or negative. Only two states get positive overall ratings: Texas and Virginia. Eight are either negative, or rated neutral, with a negative bias. The rub is that those are typically the states with the biggest economies: California, Ohio, New Jersey, Michigan, and Illinois (all negative) and Florida, Georgia, and New York (neutral, negative bias).

The full rankings:

Worst states

1. California

2. New Jersey, Illinois, Ohio (tie)

3. Michigan

4. Georgia

5. New York

6. Florida

Best states

1. Texas

2. Virginia

3. Washington

4. North Carolina

Neutral states: Pennsylvania, Maryland, Massachusetts

Put simply, the study warns that the giant gap between states' spending and their tax revenues, estimated at $192 billion or 27% of their total budgets for the 2010 fiscal year, presents two dangers that investors are seriously underestimating. First, municipalities could start defaulting on their bonds guaranteed by the cities and towns themselves, an exceedingly rare event over the past three, mostly prosperous, decades.

"People keep saying it can't happen, just as they said national housing prices could never go down," says Whitney. "Now, it's a real danger."

The reason: the municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won't have the funds to make their interest payments. "It has to happen," says Whitney. "The states will secure their own shortfalls, and leave the cities to fend for themselves." It's all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities.

Housing fallout continues

Second, Whitney sees the budget shortfalls as a far stronger leash on both employment growth and overall expansion than investors realize. The common thread between the banking and looming state financial crises, she says, is housing. "The entire financial system was over-leveraged to real estate," says Whitney. "So were the states."

During the boom years from 2000 to 2008, the states that grew the fastest were the ones where housing prices grew fastest, and where construction flourished, including California, Florida, New York, and New Jersey. In Florida, almost 30% of income growth came from real estate, an astoundingly high figure. Tax revenues soared during the real estate frenzy, and spending soared along with them. Now, revenues have collapsed with housing prices, and spending is proving far stickier. The legacy: Today's gigantic deficits.

Then, as housing prices fell, the states that grew the fastest and outperformed in the strong years, are now posting the worst economic performance––for the obvious reasons that they face the biggest mortgage delinquency and foreclosure rates, as well as high unemployment due to the collapse in construction and mortgage lending. The "haves," says Whitney, have suddenly evolved into the "have-nots."

The problem is that the states that benefited disproportionately from housing are generally the biggest economies, so their woes have become a deadweight on overall economic growth. "Other states such as Nebraska, even with larger ones like Texas, aren't large enough in total to offset the weak growth in the states that depended on real estate," says Whitney.

What investors are missing, says Whitney, is that growth in those states is destined to remain feeble because of the drastic measures needed to redeem their finances. By law, almost all states are required to balance their budgets. Right now, the Obama stimulus package is making up over $60 billion of the $192 billion shortfall for fiscal 2010. But that money is slated to disappear next year. States are already raising taxes, or planning to -- voters in Washington will soon vote on a referendum to levy an income tax.

The biggest source of funds to fill the still-giant gaps is especially worrisome: Raiding pension and healthcare funds. States from California to New York are shifting contributions needed to pay workers' benefits in the future toward funding current expenses.

The housing collapse will leave a different legacy by forcing big tax increases, and cutbacks in benefits including a rise in retirement ages. Millionaires who provide a huge share of the revenues will leave the high tax states, leaving the poor who need most of the services.

"The scary thing," says Whitney, "is that no one wants to talk about it. When you get the data and mechanics together the situation is as basic as it was for banks or consumers." "The Tragedy of the Commons" should get people talking, and the daunting scale of the numbers should get them outraged.

Thu, 09/30/2010 - 00:54 | 614658 prophet
prophet's picture

ZH consider inviting Whitney, Yamada, and others into the fold via some sort of experts forum observed by all with contributions only by those willing experts.

(Sponsored by those taking the other side of that trade.)

-profd

  

Wed, 09/29/2010 - 11:31 | 612609 JR
JR's picture

August Annual Consumer Inflation: 1.1% (CPI-U), 8.5% (SGS)

http://www.shadowstats.com/

“What’s in a Name?  NBER Declares Recession Ended in June 2009.  Speaking to her beloved Romeo, Juliet declares, "What’s in a name?  That which we call a rose, by any other name would smell as sweet." There is a corollary here involving economic contractions, recessions, double-dips and recoveries, but the final descriptive would involve something other than a sweet fragrance. “ – John Williams September 26, 2010

On today’s Market Ticker, Karl Denninger “illuminates” Gross’ “New Normal”  :

Anyone who has read me for any length of time knows that I have nothing but disgust for Bill Gross and PIMCO, and in fact call them "PIMpCO", because it is my belief that he has repeatedly prostituted himself with both The Fed and Government.

Nonetheless, he is highly intelligent.  And what he's written in his last public missive is something you better pay attention to.

·    The New Normal has a new set of rules. What once pumped asset prices and favored the production of paper, as opposed to things, is now in retrograde.

·    The hard cold reality from Stan Druckenmiller’s “old normal” is that prosperity and overconsumption was driven by asset inflation that in turn was leverage and interest rate correlated.

·    Investors are faced with 2.5% yielding bonds and stocks staring straight into new normal real growth rates of 2% or less. There is no 8% there for pension funds. There are no stocks for the long run at 12% returns.

Got those three points?

http://market-ticker.org/

Wed, 09/29/2010 - 13:10 | 612906 arkm
arkm's picture

If also Plosser sends signals that QE2 is unlikely (ok citing improved market conditions, ahah) why is it that Treasuries are not falling and dollar is not recovering (especially vs €)? non voting members are laughable?

Wed, 09/29/2010 - 16:30 | 613503 wawawiwaa
wawawiwaa's picture

New normal is going to bang Gross and that El-Erian bozo who people listen to because of his retahded accent. That entire firm has been one single trade its entire existence. Long FNM and FRE and GNMA and they got their asses saved in 08 when Treasury said that FRE and FNM were part of uncle sam...

Wed, 09/29/2010 - 21:06 | 614254 gwar5
gwar5's picture

GDP should be contracting in 2011, +2.5% is a pipe dream. Heard it through the grapevine.

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