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Happy Holidays



.. from my family to yours. When I think back to a year ago, I realize this has been a great year. Not a perfect year, of course, but much better than most people would have expected. It hasn't been the end of the world as we know it. The financial crisis has passed, and the economy is improving. We hope that things will continue to improve.

In the meantime, we are fortunate to have all of our children and grandchildren—with the exception of my son and his fiancee who live in Hawaii—with us tonight. My job today is to fix the turkey and prepare the gravy and mashed potatoes. This year I've added a mushroom casserole thanks to my Aunt's recipe. My wife is doing a leg of lamb and a ham, and our friends and relatives (we'll have about 35 for dinner tonight) are bringing the rest. It's a wonderful tradition that is enjoyed by old and young, and if all goes well we'll be toasting with champagne and dancing come midnight.

Capital spending picks up



Business investment is definitely picking up, with new orders for capital goods about 10% higher in November than they were at the low last April. Capex is still woefully below the levels it reached in the booming late-90s, but it is following the typical pattern in which it rebounds as a recession ends. It will take us many years to return to the heydays of the past, but at least we are moving in the right direction.

The fatal flaws in healthcare reform (4)

The list of fatal flaws is growing longer by the day. My last post on the subject was just two days ago, here, where you can also find links to supporting documents. Here is the summary so far, with the most recent addition being #4:

Fatal flaw #1: The penalty imposed for not buying a policy is very likely to be less than the cost of insurance for a great many people. This, combined with the requirement that insurance companies may not deny coverage to anyone with a pre-existing condition, means that a large number of people will forgo signing up for a policy, knowing that they a) will save money and b) can always sign up for insurance if they turn out to develop a serious medical condition. Thus, the actual revenues will far way short of projections.

Fatal flaw #2: Mandating that people buy a health insurance policy simply because they are alive is unconstitutional. It is also a way of hiding the fact that young people will effectively be paying a huge new tax in order to subsidize older people.

Fatal flaw #3: Regulating the price which insurance companies must charge for policies, coupled with a requirement that companies must rebate to their customers the amount by which their loss ratios fall below 90%, effectively turns these companies into government-run enterprises and would likely result in the effective nationalization of the healthcare industry, something that the CBO has also noted. That is a violation of the Fifth Amendment, and of a Supreme Court requirement "that any firm in a regulated market be allowed to recover a risk-adjusted competitive rate of return on its accumulated capital investment."

Fatal flaw #4: A government-imposed restructuring of the healthcare industry can't possibly improve our healthcare system, and is extremely likely to make it worse. As Don Boudreaux notes, "Trying to restructure an industry that constitutes one-sixth of the U.S. economy is ... so complicated that it's impossible to accomplish without risking catastrophic failure." Here are some excerpts from his article, but be sure to read the whole thing:

Our world is full of complexities that defy human engineering.  Attempts to consciously redesign the health care industry are ... hubristic and hazardous. That industry is one of billions of unique, often personal, relationships, each of which is part of countless long chains of efforts to transform raw materials and human effort into life-improving and life-saving drugs and treatments.

Like weather and the mysteries of love, these long chains of human relationships weren't designed by anyone. Like weather and love, they change, often unexpectedly; they also possess as many unique properties as there are persons involved.

And like weather and love, their all-important details are beyond the comprehension of would-be redesigners. These long chains of human relationships cannot be undone and reassembled at will by politicians and "experts" without risking enormous and unintended catastrophe.

It's as if a committee of engineers trying to design, say, a bridge to connect New York and London draft a blueprint that is so huge and complex that none of the engineers can possibly comprehend its details. No engineer knows, or can know, exactly what it is he or she is helping to engineer.

If an engineer can't read and understand even his own blueprint, why should we trust him to understand the vastly more complex reality that his blueprint allegedly represents? And, more importantly, why should we trust that what is built based upon the incomprehensible blueprint will work as advertised?

With hundreds of millions of customers ... the idea that 535 geniuses on Capitol Hill can design this industry so that it will improve human well-being is laughable.

There are steps that Congress can sensibly take, but all of these involve removing government-imposed restrictions on the abilities of individuals to seek out, and to supply, health care provision within markets.

Health care will be improved only by unleashing the creativity of millions of people and by market competition. Health care will be severely damaged if it is designed and restricted by a few hundred arrogant political operatives.

Financial conditions back to normal



Today the Bloomberg index of financial conditions moved into positive territory for the first time since July 2007. This ranks as one of the best indicators of a V-shaped recovery that I've seen. The financial markets have largely healed, and that is a precondition for healing to spread and normalcy to return to the rest of the economy. This is very supportive of an optimistic outlook for growth next year.

HT: Mark Perry, who has a more detailed chart of this index over the past two years.

Household financial burdens continue to ease



Every time I post an update of this chart I seem to get a number of incredulous responses. What the chart shows is that households' financial burdens are, on average, lower today than at any time in the past five years. Moreover, they are not any worse today than they were in 2001, and financial burdens have not risen materially for the past three decades. What most people believe, however, is very different: there seems to be a consensus out there that households are over-stretched and over-burdened by debt. Many people have indeed succumbed to mortgage and credit card debt, but the great majority, as suggested by this chart, have managed to stay afloat and have even reduced their debt burden over the past two years. It's very hard—if not impossible—to get from this chart to a conclusion that there is anything seriously wrong with households' finances.

I think this is very supportive of an optimistic outlook for growth going forward. 

Improvement on the margin







What's more important: the news that third quarter GDP was revised down to only 2.2%, from an original estimate of 3.5%? Or the news that credit spreads continue to decline yet are still at levels that in the past have been consistent with recessionary conditions? I'll take the spread news any day, since it's real-time, and not subject to revision. GDP news is always old and always subject to revision.

The downward revision to GDP amounts to only $46 billion, when you de-annualize the numbers. That's a rounding error these days. Heck, the federal government alone spends that much money in fewer than 5 working days. The important thing about the GDP numbers is the change on the margin. Q1=-6.4%, Q2=-0.7%, Q3=2.2%. Going from minus 6.4% growth to plus 2.2% growth, that's a big deal. And growth in the current quarter is very likely to be higher than 2.2%. Things are improving significantly on the margin.

Declining credit spreads tell us that the outlook for the economy is improving almost daily. Cash flows are stronger, profits are stronger, default risk is declining. Unemployment claims tell us the same thing: fewer people are getting laid off, more people who have been laid off are finding jobs. Rising commodity prices tell us that global growth is improving. Implied volatility in equity options today reached a new low for the year, and that tells us that confidence is returning and uncertainty is diminishing.

The equity market is grudgingly coming to terms with the improvement, but still has along way to go, just as credit spreads have a long way to go before they get back to "normal" levels. The dollar is strengthening on the margin, which means that conditions here are turning out to be better than they world had thought. The dollar is still extremely weak, of course, but on the margin it's getting better. Same can be said for the economy: there is a whole lot of idle capacity out there, and many millions without a job, but things are getting better on the margin.

I don't see a reason for all this improvement to suddenly falter. The news from Washington has been awful all year, and I am just as dismayed as anyone that ObamaCare has advanced as far as it has. But on the margin the clear message is that the people increasingly don't like the far-left agenda. There is a significant amount of resistance brewing out there, and the people will have their revenge in November if the politicians persist in pursuing a wrong-headed policy direction. Even if healthcare passes, it is going to be mired in lawsuits and consitutional challenges for many years.

Obama's greatest legacy might not be the one he dreams of. Instead of permanently and massively expanding the role of the state, he may end up being the catalyst for a new political awakening, and a return to this country's libertarian roots. That would be the most astounding change on the margin imaginable.

Home sales skyrocket





The news from the housing sector continues to be excellent. The surge in sales in recent months was undoubtedly helped by the anticipated expiration of the tax credit for first-time buyers, but I don't think we can dismiss this news entirely (not least because the credit has been extended). Sales are up no matter how you look at it. This market is now clearing, which means that prices have fully adjusted to the new realities. House prices are down and interest rates are down, making housing more affordable now than it has been in many decades. The inventory of homes for sale has shrunk dramatically, thus making room for all the homes that will be coming on the market as the result of the "second wave of foreclosures" that the world has been fretting about for most of the year.

It's extremely significant that the housing market has cleared to this extent. Prices are no longer falling, and that puts an end to the fears of a downward spiral that would undermine the balance sheets of the institutions holding mortgage-backed paper. It also restores confidence to the housing sector, as people realize that they are no longer trapped with a depreciating asset. Household balance sheets are again improving. Those who want to move to where there are more jobs, can. Life goes on, and things get better, and that's the way it should be. A lot of the plans that got put on hold a year or so ago are now being put back on the drawing board.

Obama's approval rating plunges



The latest Rasmussen survey shows Obama's approval ratings are in free-fall. Almost half of the people "strongly disapprove" of the way he is handling his job. This is unprecedented (to use one of Obama's favorite words) for the first year of a presidency, especially considering his lofty approval ratings just one year ago. If Obama and the Democrats persist in passing the Reid healthcare bill, I suspect these ratings will go even lower. As I have been arguing since last February, the country was never ready nor eager for the radical left-wing agenda that Obama has been bent on rahmming through, and these ratings are proof. The people are speaking, and they've had just about enough of this. Will Congressional Democrats take notice before it's too late?

Reviewing last year's predictions

Here's a quick recap of the predictions I made last year. I'll never have a better year of forecasting.

All measures of inflation will head higher. Correct. Headline inflation was negative in the final months of last year, and core inflation barely avoided a negative print. The CPI rose throughout the year and was up at a 4.2% annualized pace in the six months ending in November, while the core CPI was up at a 1.5% rate over the same period.

The economy is going to recover sooner than the market expects, with the bottom in activity coming before mid-2009. Almost spot-on. The official pronouncement of the recession's end won't come until later next year, but for now it looks like the recession ended in late June or early July. The economy greatly exceeded almost everyone's expectations.


Residential construction was bottoming, and housing prices would begin rising well before mid-year. Correct. Housing starts hit bottom in April and as of November were up 20% from their lows. According to the Case-Shiller index of housing prices in 20 major markets, housing prices hit bottom sometime around March, and were up 5% from their lows as of the September release.

Treasury yields will be significantly higher by the end of next year. TIPS yields will hold steady or fall as nominal yields rise. Correct. 10-year Treasury yields have risen from 2.1% at the end of last year to 3.6%. 10-yr TIPS real yields have fallen from 2.1% to 1.3%.

Credit spreads have seen their highs and will continue to narrow. Correct. Spreads actually plunged over the course of the year, leading to the biggest rally in corporate debt on record.

Equity prices will lag other risk asset prices, but they will be significantly higher by the end of next year. Correct. To date, the S&P 500 has generated a total return of about 25%, after plunging to a frightening low in early March. Gold is also up about 25%, after earlier posting a gain of almost 38%.

Commodity prices may take awhile to move higher, but they will be higher within 2 years. Oil prices are unlikely to drop below $35. Correct. Commodities rose throughout the year and are now up over 30%. Crude oil has almost doubled this year, after briefly dipping to a low of $36.50 in mid-January.

The dollar is unlikely to make further gains against most major currencies, given the Fed's hyper-easy stance, and is likely to fall against emerging market currencies as commodity prices rise. Almost spot-on. The dollar rallied through April, but so far is down about 5% against major currencies for the year. The dollar fell significantly against the currencies of most emerging market currencies.

I'll have my fearless 2010 forecast out by next week.

The fatal flaw in healthcare reform (3)

Even as the chances of healthcare reform passing are rising, the list of fatal flaws in the reform bills gets longer. I've discussed these before, here and here. Here's the summary so far:

Fatal flaw #1: The penalty imposed for not buying a policy is very likely to be less than the cost of insurance for a great many people. This, combined with the requirement that insurance companies may not deny coverage to anyone with a pre-existing condition, means that a large number of people will forego signing up for a policy, knowing that they a) will save money and b) can always sign up for insurance if they turn out to develop a serious medical condition. Thus, the actual revenues will far way short of projections.

Fatal flaw #2: Mandating that people buy a health insurance policy simply because they are alive is unconstitutional. It is also a way of hiding the fact that young people will effectively be paying a huge new tax in order to subsidize older people.

Fatal flaw #3: Regulating the price which insurance companies must charge for policies, coupled with a requirement that companies must rebate to their customers the amount by which their loss ratios fall below 90%, effectively turns these companies into government-run enterprises and would likely result in the effective nationalization of the healthcare industry, something that the CBO has also noted. That is a violation of the Fifth Amendment, and of a Supreme Court requirement "that any firm in a regulated market be allowed to recover a risk-adjusted competitive rate of return on its accumulated capital investment." Richard Epstein has a detailed article explaining this here: "Impermissible Ratemaking in Health-Insurance Reform: Why the Reid Bill is Unconstitutional"

As Epstein notes at the end of the article, there are so many problems with this bill that at the very least it will take many, many years to implement.
This ill-conceived legislation has many provisions that regulate different aspects of private health-insurance companies. Taken together, the combined force of these provisions raises serious constitutional questions. I think that these provisions are so intertwined with the rest of the legislation that it is difficult to see how the entire statute could survive if one of its components is defective to its core. How courts will deal with these difficult issues is of course not known, but rate-regulation cases normally attract a higher level of scrutiny than, say, land-use decisions.

There is, moreover, no quick fix that will eliminate the Reid Bill's major constitutional defects. It would, of course, be a catastrophe if the Congress sought to put this program into place before its constitutionality were tested. Most ratemaking challenges are done on the strength of the record, and I see no reason why a court would let a health-insurance company be driven into bankruptcy before it could present its case that the mixture of regulations and subsidies makes it impossible to earn a reasonable return on its capital. At the very least, therefore, there are massive problems of delayed implementation that will plague any health-care legislation from the date of its passage. I should add that the many broad delegations to key administrative officials will themselves give rise to major delays and additional challenges on statutory or constitutional grounds.
 UPDATE: Senators Jim DeMint (R-SC) and John Ensign (R-NV) have raised a Constitutional Point of Order on the Senate floor, which calls for a vote on the constitutionality of the healthcare bill. Their statement is worth repeating here:

'I am incredibly concerned that the Democrats’ proposed individual mandate provision takes away too much freedom and choice from Americans across the country,' said Senator Ensign. 'As an American, I felt the obligation to stand up for the individual freedom of every citizen to make their own decision on this issue. I don’t believe Congress has the legal authority to force this mandate on its citizens.'

'Forcing every American to purchase a product is absolutely inconsistent with our Constitution and the freedoms our Founding Fathers hoped to protect,' said Senator DeMint. 'This is not at all like car insurance, you can choose not to drive but Americans will have no choice whether to buy government-approved insurance. This is nothing more than a bailout and takeover of insurance companies. We’re forcing Americans to buy insurance under penalty of law and then Washington bureaucrats will then dictate what these companies can sell to Americans. This is not liberty, it is tyranny of good intentions by elites in Washington who think they can plan our lives better than we can.'
HT: The Club for Growth

UPDATE: The WSJ now has a much better and easier-to-understand version of Epstein' article here.

Last chance for a 5% mortgage





According to BanxQuote, the nationwide average for 30-year fixed-rate conforming mortgages yesterday was 5.03%. Call it 5%. I seriously doubt whether we'll see this rate go much lower, and I think there is a very good chance it will be moving higher next year. If you're in the market for a home, this is most likely your last chance to lock in what are essentially the lowest fixed rates on mortgages in history.

The Fed has been buying hundreds of billions of mortgages since last March, and will continue to do so for the next few months. But it's not clear that this has produced a significant decline in mortgage rates (see my earlier post on this subject), and it's questionable whether the Fed can keep rates from rising going forward. As the second chart shows, the spread between wholesale mortgage rates and 10-year Treasuries is about as low as it has ever been. And as the next chart shows, 10-year Treasury yields are creeping higher. They have been unusually low this year mainly because the market has worried that the U.S. economy was very weak. With every day that passes, we see more evidence that the economy is getting stronger.



As the next chart shows, the spread between 2- and 10-year Treasury yields is now as wide as it has ever been, driven largely by rising yields on 10-year Treasury bonds. This unprecedented (to use one of Obama's favorite words) steepness of the yield curve is a powerful signal of recovery, and it also reflects rising inflation pressures. As a confirmation of that, I note that the 5-year, 5-year forward breakeven spread on TIPS reached 2.8% today, its highest level since early last year. 



The Fed has awesome power, but it can't keep bond yields from rising. The more the Fed insists on keeping short-term rates low, the more this fuels inflation concerns, and that in turn pushes long-term yields higher. The harder the Fed tries to keep rates low, the more likely it becomes that rates will move higher.

The way the political map should be drawn

Now that the politicians of both parties have led us to the brink of fiscal destruction—the unfunded deficits of social security and medicare were already staggering, and now healthcare reform could up the ante by an order of magnitude, while attempts to "save the planet" could create a global government bent on transferring significant wealth from rich nations to poor nations while also mandating a switch to more expensive energy sources—the ideological battleground is emerging in stark relief. It's not about Democrats vs. Republicans, or liberals vs. conservatives, it's about government power vs. individual liberty.

Don Boudreaux explains it quite nicely:

The “conservative/liberal” division – although thought of in America today as the two alternative, relevant “sides” of political opinion – is no such thing.  If we talk seriously of two “sides,” a much more realistic division is between those persons with a fetish for centralized power and those persons who distrust such power.

Modern “liberals” long for Washington to design and control the economy in great detail.  Modern conservatives look to government to engineer the polity’s moral tone...  Despite their differences on particular policy issues, both modern “liberals” and conservatives have a fetish for centralized coercion.

So the side opposite both the modern “liberal” and conservative is occupied by those persons who are neither conservative nor “liberal” but, rather, deeply suspicious of entrusting government with power.

And these “power skeptics,” as we might call them, are far more willing than are “liberals” and conservatives to let individual men and women choose their own courses in life – to buy and sell and work as they wish; to save and invest – and ingest – as they choose; to partner with each other romantically, socially, and commercially in whatever peaceful ways they like and never in ways that they dislike; to keep the full fruits of their efforts and risk-taking, and not be coerced into subsidizing those who are less industrious or adventurous; and not to be forced to support military adventures that have no direct and compelling relationship to the protection of peace and property at home.

This is the nature of the political debate we should be having: Obama's agenda for a massive expansion of government, versus the platform that seems to be emerging from the Tea Parties. The Tea Parties are revealing a new political platform that has been obscured for decades by those who argue about whether the government should regulate such things as abortion, immigration, and marriage. Those debates were all about government intrusion in our lives. The new platform takes us back to our country's roots: less government, not more; less spending, not more; lower taxes, not higher; less coercion, not more; citizen politicians, not professionals. These are turbulent times, but, as Charles Krauthammer points out, they are also "politically and intellectually invigorating." Let the true battle begin. The stakes haven't been so high in generations.