2011-10-25

How I would solve the EU Sovereign Bond Crisis and stop it from happening again

  1. Pool all sovereign debt into a central fund. At the end of 2010, this amount totaled €7,822,443 million. Source.
  2. This central fund will be run by a supranational entity under the control of the European Union, much like the ECB.
  3. A Eurozone-wide financial services tax is introduced. This would be based upon either a Tobin Tax or a Market Capitalisation Tax. The purpose of this tax would be to pay off the sovereign debt that has been pooled into the central fund.
  4. Because nation governments have shown that they cannot be trusted to maintain the fiscal agreements of the Maastricht Treaty, a Eurozone-wide supranational entity - let's call it the European Revenue Service, or ERS - is set up to a) determine a nation's tax rates, and b) take over the tax collection duties of member nations. This will necessitate the ceding of tax setting and tax collecting by all levels of Eurozone government.
Let me expand on these idea further.

The central fund and the financial services tax.
The pooling of debt into a single fund and then paying it off by a Tobin tax or Market Capitalisation tax takes care of the current mess. Individual Euro governments will no longer be responsible for the debt that they have accrued up until this point. It's a way of both "cleaning the slate and starting again" while still setting up structures to ensure that the debt gets paid off (and not defaulted upon). Moreover, the tax that is instituted is aimed squarely at the financial industry (who helped set up the current crisis) rather than upon ordinary wage earners. A central Eurozone-wide fund is better than a series of national funds simply because the central fund (preferably backed by the ECB) would be given clear parameters and not be subject to the whims of individual nations.

The short-term goal of the fund is to provide market confidence in the payback of sovereign debt.
The long-term goal of the central fund is to pool together and eventually retire all levels of Eurozone sovereign debt by way of a financial services tax
.

The European Revenue Service.
The setting up of the ERS is certainly a controversial proposal - but it is a proposal that will ensure that this crisis never occur again. Ceding the sovereign authority  to set and collect taxes may sound frightening to those who do not support an ever-closer union, or who think the EU should no longer exist. Yet it is essential for the future of the EU - since it will prevent the blowing out of sovereign debt again.

Under this system, each member country has the power to spend as much they usually do - the ERS will not be responsible for spending decisions. What each nation will no longer have is the ability to set tax rates or tax law or have the ability to collect taxes - these things will be left to the ERS. The ERS will then set tax rates and tax laws for each member nation of the Eurozone to match the amount of spending they indulge in. Scandinavian nations, like Finland or Sweden, will continue to have big spending governments, which means that the ERS will set up high tax rates in those nations. Nations who have smaller governments in proportion to the economy will have lower tax rates. If a country decides to expand government spending, then the ERS will naturally increase the taxes in that nation over the long term; similarly, if a nation decides to cut spending, then the ERS will lower taxes over time. If a nation wants to "run a surplus" in order to create a sovereign wealth fund, then they will simply file this investment under spending, and the ERS will set taxes accordingly.

The ERS will also be the supranational tax collection agency, ensuring that the same quality of operations exists across the entire Eurozone.

The ERS will also have the authority to change tax rates in individual nations, or across the entire Eurozone, in response to certain economic conditions such as recessions or expansions. This would be done in conjunction with the ECB. Keynesian stimuli enacted by member nations will also be conducted in conjunction with ERS policy.

Individual nations can "reduce taxes" on certain industries if they wish through subsidies, which would have a net effect upon the taxes on that industry.

The short-term goal of the ERS would be to set tax rates in member countries, collect them and distribute them to these member countries.
The long term goal of the fund is to ensure that all nations maintain zero net sovereign debt over the course of the business cycle.


Notes:

The fund and the ERS will only operate within the Eurozone. Members of the EU who are not members of the Eurozone will not be subject to these entities (eg UK, Denmark). However, once an EU country joins the Eurozone, these policies will affect them: their sovereign debt will be transferred to the central pool and their tax system will be run by the ERS. The idea that sovereign debt may be paid off on entry to the Eurozone gives potential member nations a huge incentive to join.

As for the importance of government bonds in the European Financial industry, the ECB would be able to issue enough bonds to cover this need. Just because debt is being/has been retired does not mean that government bonds need to disappear as well.

2011-10-20

US Recession Indicators - October 2011

According to data from negative Real Interest Rates, another US recession is likely to begin between now and 2012 Q4, with 2012 Q1 the most likely... See below.


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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has remained high at 659 in September 2011.

These results continue to be high and any future recession will either be delayed or else the results will begin to drop drastically.

Already there has been two months of straight decline in both M0 and Excess Reserves (2011-08 and 2011-09 results). Nevertheless Net M0 remains positive because reserves had declined faster than M0.

Inflation in September was 3.9%, the highest it has been since October 2008. This is the third straight month of price increases since a deflationary monthly result in June. The rate of monthly inflation has decreased however, with 6% in July, 4.5% in August and 3.6% in September.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.


Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP
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Federal Funds Rate vs 10 Year Bond Rate (spread)

September ended with a reading of 190 after 10 year bond rates continued to decline. This is the lowest spread since May 2008. The recent decline is increasingly precipitous.

What I said in August needs to be remembered:

If this indicator stays true to its historical data, then there will be one of two events leading up to the beginning of the recession.

The first is if the Federal Reserve will keep the Federal Funds rate effectively at zero, which it will do barring any major inflationary outbreak. If this occurs then 10 year bond rates will drop to zero as well, or at least converge to within a few basis points. This appears to be the situation currently.

The second event will occur if the Federal Reserve increases rates in response to an outbreak of inflation. If this occurs then the Federal Funds rate will exceed the 10 year bond rate, thus placing the indicator into negative and presaging a recession. Inflation has been increasing markedly in the last six months, so this event may yet be the result.
Will Ten Year Bond rates drop to zero? Or will there be an outbreak of inflation first?
Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).

Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Note: All recessions are preceded by a negative result.



Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Real Ten Year Bond rates came in at -1.32% in September. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will begin between now and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.
Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.

Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.



Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP


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Market Capitalisation adjusted by USDX




(The orange line is the recession line, the red line is the line of resistance)

Data Sources




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2011-10-19

Cost of US oil consumption as percentage of GDP

The most recent figure is for 2011-Q2, which comes in at 1.17%.

With oil prices now $20 cheaper than 2011-Q2, 2011-Q3 will likely see a drop.

Methodology:

The average oil price for the quarter is multiplied by oil consumption for the quarter, which is then measured as a percentage of nominal GDP.

Sources:
  • West Texas Intermediate, price averaged out for quarterly figure. Link.
  • US Oil Consumption, quarterly. Link.
  • Nominal GDP, quarterly. Link.
Notes:
  • Orange lines represent recessions (annual decline of real GDP per capita)
  • Yellow line represents historical average of 0.82% of GDP.

2011-10-10

US Defense Cost Overruns: F-35 vs F4

The F-35 is a fighter-bomber aircraft that will be used by three of the four branches of the armed forces. The last time the Air Force, Navy and Marines had the same jet fighter was back in the 1960s when they all adopted the F-4 Phantom II fighter-bomber.

A good way to determine just how bad defense cost overruns are is to compare the relative cost of the F-35 with the F-4.

Of course there are a number of determining factors. One is the fact that inflation has distorted prices somewhat since the mid 1960s. Another is that real GDP has grown significantly in that time. The final thing to realise is that technology since then has improved markedly, thus granting "more bang for the buck" so to speak. So let's play with these adjustments:
  • F-4E Phantom II "flyaway cost" in 1965 was $2.4 million (wikipedia source)
  • Nominal GDP in 1965 Q4 was $747.5 Billion. (St Louis Fed source)
  • The cost of a single F-4E Phantom II thus represented approximately 0.00032% of GDP.
  • Adjusted for inflation, the cost of a single F-4E Phantom II in 2010 dollars is approximately $16.4 million (inflation calculator)
  • F-35A Lightning II "flyaway cost" in 2011 is $122 million (wikipedia source)
  • Nominal GDP in 2011 Q2 was $15,012.8 Billion (St Louis Fed source)
  • The cost of a single F-35A Lightning II thus represents approximately 0.00081% of GDP.
  • The cost of 0.00032% of GDP in 2011 Q2 was $48 million.
  • The F-35A is, in dollar figures, 644% more costly than a F-4E.
  • The F-35A is, in percentage of GDP, 154% more costly than a F-4E

So naturally the question arises: is one F-35A better than 2.5 aircraft that could've been built at lower cost but with far better technology that was ever available for the F-4? Or, better still, is one F-35A better than 7.4 of these aircraft?

The idea I'm trying to promote here is not a return to building F-4s, nor whether it would be better to build increasingly obsolete F-18s, F-16s or F-15s instead. Rather I'm trying to point out that a cheaper alternative could've been built than the F-35, and that this theoretical alternative would've replaced the F-18s, F-16s or F-15s.

This theoretical aircraft would not cost $122 million (like the F-35A), but be between $16.4m - $48m. While the chances are that this theoretical aircraft would be inferior in some ways to the F-35, it would still be superior to the aircraft it replaces and probably still be one of the best aircraft around.

Maybe the Pentagon should focus its attention upon cost, and let the developers and engineers work within that framework.

EDIT: Since the F/A-18E/F Super Hornet currently costs $55 million each, maybe it should replace all the obsolete fighter-bombers currently in service in the Air Force, Navy and Marines?

EDIT 2: Fixed up the last two dot points above to read "more costly than" rather than "the value of".

2011-10-05

Market Failure

When a market is dominated by a monopoly or a cartel, and they use their market powers to reduce supply in order to boost their own profitability, then the market has failed.

Were Cali Dairy Cows Slaughtered to Raise the Price of Dairy?