January 21, 2012

∴ Repairing the Global Plumbing

Mohamed El-Erian is the chief executive of PIMCO, the world’s largest bond investment company, and an author. He’s well-regarded in economic and investment communities.

He’s penned an outline for political action to improve the world’s economies, in sum:

“Rather than just pumping liquidity into clogged pipes, countries can and should do more to build a more effective network of compensating conduits.”

(Via Global Public Square.)

El-Erian is saying that we should be doing more than simply providing cheap money with a low Fed Funds rate and correspondingly lower loan interest rates.

Here’s how his outline pertains to the US:

  • Countries such as Spain and the US need to be more forceful in unblocking the housing sector by making overdue decisions on burden sharing, refinancing, and conversion of idle and foreclosed housing stock. While many homeowners are stuck with their existing mortgage due to owing more than their property is worth, many owners in the black are likewise unable to refinance due to sharply reduced property values. Doing so would evaporate most or all of their equity. Yet refinancing out of five- or ten-year old mortgages into loans at today’s historically low rates would free up hundreds of dollars per month for most homeowners. There’s an opportunity here for the US government to back “no cash out” refinancing of existing mortgages at existing valuations solely for the purpose of lowering homeowner monthly outlays. Homeowners could then use their improved cash flow for purchases or other debt reduction.
  • Countries with excessive debt, such as Greece and Portugal, need to impose sizeable “haircuts” on creditors. There’s a somewhat hidden danger to the US economy in Greece’s looming debt disaster. Our risk is not only the interconnected nature of international economies, but also the huge liability among US investment banks that have traded in credit default swaps. A form of insurance by another name, these instruments put the seller on the hook for losses in the event of default on counterparty debt investments. In other words, CDS sellers (our investment banks) will be liable for losses on Greek debt unless the holders of that debt (Euro Zone banks, mostly) agree to voluntary losses, i.e. a “haircut.” Such liability will trigger another credit crisis, similar but worse than that of 2008. Voluntary write-offs, however, won’t trigger payout on CDSs. Euro Zone leaders have already negotiated one such haircut for 50%. Some estimate the final haircut will reach 100%. The sooner the better.
  • In several Western countries, public-private partnerships should be formed to finance urgently needed infrastructure investment. This one’s easy. Expire the Bush tax cuts and use the additional tax revenue to fund a WPA-style facility for repairing and upgrading our infrastructure. Road, bridge, utility, and other projects long in need of attention will be a source of employment and economic stimulus. Rather than directly employing people to accomplish these tasks, the additional tax revenue should be used to employ private-sector firms, which in turn will hire from the pool of unemployed workers.
  • Finally, governments should inform their electorates explicitly and comprehensively that a few contracts written during the inadvisable “great age” of leverage, debt, and credit entitlements cannot be met. In short, we can’t afford Social Security and Medicare as currently configured. There are too many beneficiaries in the pipeline vs. the number of workers paying in, and those beneficiaries have a habit of living longer than was assumed when the programs were designed. Something’s got to give. We need to address that fact now. Higher FICA and Medicare tax rates, higher retirement eligibility age, lower payout rates are among the choices. A mix of all of the above is more palatable than a single solution.

It’s worth noting, too, that our economy, and those of the rest of the world, is slowly recovering. We’re not suffering through a routine business cycle recovery-after-recession, which would be moving back to the black much quicker. We’re in a deleveraging, or balance sheet recession recovery.

Simply put, as a friend likes to say, our economic activity was unsustainable, coming on the strength of borrowing for so long. First we maxed out the credit cards, then our home equity credit, and then it all went boom. So we’re paying the piper.

Consumers will increase consumption again when personal debt has subsided to a supportable level. In the mean time we need to clear roadblocks to the already weak recovery.