Sunday, November 9, 2008

The Ignorance of our Chattering Classes


I am just now watching Fareed Zakaria talking on ABC's This Week with George Stephanopoulos. I had my doubts about his knowledge before, but now he's demonstrated even further that he doesn't have a solid grasp of the facts.

He said Barack Obama will be able to spend plenty of money to stimulate the economy "because interest rates are very low."

He was half right... Yes, the federal government's borrowing costs are still near historic low levels, but it has come at the cost of companies, and to a smaller extent, state and local governments. Investors are fleeing all borrowers with any kind of risk. As their financing costs rise, they will have less money for capital expenditures and dividends. The average person might ask "so what", but it will mean less investment in the economy and fewer jobs.

What's happening right now is an unprecedented crisis in the credit market that threatens to destroy thousands of companies and eviscerate the value of trillions of dollars in assets.

The two charts below illustrate what's happening. The top one shows corporate borrowing costs in blue and government borrowing costs in red, steadily declining since the early 1980s. They diverged during recessions or times when companies like Enron and WorldCom went bust, but the two more or less tracked each other lower -- until the present. The cost of money for companies, i.e. employers, is up about 37% since May, while the government's 10yr rate is up only 2%. If a company has $500mln of bonds to refinance, it will now cost them an extra $13mln a year. If they pay workers an average $50,000, that's equivalent to 259 jobs.


Even more important than the job losses are the consequences. Companies are already facing a sharp falloff in demand, so these higher interest costs come at a terrible time. Profits will plunge and the overall value of businesses will decline. This means the stock prices will continue to fall, devastating the savings of families and state and local governments. We're going to wind up with no one other than the federal government able to borrow money, no one other than the federal government able to invest, no one other than the federal government able to hire. In other words, it will be an economy run by the federal government.

The second chart gives a longer term view of how much above the government's rate companies must pay. This is called "spread." The wider it goes, the worst off we all are. We're now looking at the widest levels since at least 1962, when the data set begins. Spreads usually peak late in a recession. The fact they are this high before the economy has even yet officially contracted, or before the inevitable wave of bankrupcties hits, is very ominous. What will this look like after GM goes bankrupt?

Sadly, we are demonstrating the normal human tendency to "fight the last war." The conventional wisdom during a recession is to spend large amounts of money to "stimulate" the economy. The government is expected to sell more than $900bln of bonds before the end of March. They're doing this at a time when savings have already been devastated by stock market declines and foreign investors will be less interested than ever before in loaning us money. Those hundreds of billions will come at the expense of the private sector. It's going to be a zero sum game between companies and the government. Who will win?

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