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Financial fundamentals are quite healthy

It's curious, to say the least, that financial market fundamentals should be relatively calm and healthy at a time when the economy faces significant risk in the form of the so-called fiscal cliff. That is not to say that all is well, however, since the consensus of the market looks for years of very slow growth.


This chart of swap spreads is one of my favorite indicators, not only of systemic risk and financial market health (the lower the spread the better), but also of the outlook for the economy. Swap spreads have a record—albeit not a very long record—of anticipating changes in the health of the economy. They rose in advance of the past three recessions, and fell in advance of the past three recoveries. Currently, swap spreads are unusually low, a sign that financial markets enjoy plenty of liquidity and there is little if any fear that conditions in the financial markets or the economy will deteriorate meaningfully in the next 2 years. In short, considering the low level of swap spreads, it would be very surprising to see the economy slip into a recession over the next year.


Bloomberg has developed a "Financial Conditions Index" which includes not only swap spreads but 14 other key indicators of financial market health. Not only has this index improved significantly over the past year, it is now at a relatively high level from an historical perspective. Nothing here would suggest any deterioration in the financial market fundamentals. When financial market fundamentals are as healthy as they are today, that points to a very low probability of any meaningful deterioration in the economy.


Yet despite all the encouraging signs of financial market health, the extremely low level of real yields on TIPS suggests that the market believes that the economy is likely to be relatively stagnant over the next several years. Nominal yields on Treasuries are at rock-bottom lows as well, and both nominal and real yields are consistent with a view that the Fed will keep interest rates near zero for the foreseeable future. That, in turn, will only happen if the economy continues to struggle, and continues to suffer from a significant "output gap."


Ordinarily, the extremely low level of nominal yields that exist today would be a sign of very low inflation or even deflation. Yet as this chart shows, the expected inflation rate for the next 5 years that is embedded in TIPS and Treasury prices is more or less "normal." Expected inflation according to the Treasury market is 2.1% per year for the next 5 years, and 2.9% for the subsequent 5 years, and that is not at all out of the ordinary compared to the past 15 years. So very low real and nominal yields say nothing unusual about inflation; instead they shout out a very dismal outlook for the economy.


Consumer confidence has increased over the past year, and now stands at a post-recession high according to the University of Michigan's survey. While this is encouraging, the level of confidence is still relatively low from an historical perspective, and only slightly better than the levels we saw during the tumultuous years of the early 1980s. As I see it, consumers are saying that although we have pulled back from the abyss, the outlook remains bleak.

Healthy financial fundamentals, but miserable expectations for economic growth: quite an unusual combination that can only mean that the market is braced for a lot of bad news, as I've been arguing for a long time.

Bank lending continues to expand


This chart of C&I Loans represents bank lending to small and medium-sized business. The expansion in this important source of funding for companies unable to access directly the credit market has been impressive and ongoing for the past two years. This measure of outstanding loans is up 12.5% in the past year, and is up at an annualized rate of 11.5% over the past six months. From the post-recession lows two years ago, C&I Loans are up by almost $300 billion.

The most important takeaway here is not the volume of new loans, but the fact that the ongoing increase in new lending is symptomatic of important changes on the margin: banks are more willing to lend, and businesses are more willing to borrow. This reflects improved confidence in the future, and that in turn holds out the promise of continued—albeit relatively slow—economic growth.

Housing market continues to improve

If I had to guess, I would say that a majority of people in the country still view the housing market in a negative light. They note the still-large overhang of foreclosed properties, the still-low rate of new housing starts, and the still-depressed level of housing prices in many parts of the country. But that is looking at the market from a static viewpoint; on the margin, there have been some very important improvements in the housing market over the past 18 months. It's hard for me to believe that these changes are ephemeral—they have all the makings of a clear turnaround that is underway and likely to continue.


The chart above shows the results of a monthly survey of home builders' perceptions of current single-family home sales and sales expectations for the next six months. Even though home builders' sentiment is still below 50—which signifies that somewhat more builders still view conditions as poor rather than good—the improvement in the index so far this year has been dramatic.


There may be lots of housing inventory "waiting in the wings," but currently the number of homes for sale is relatively small compared to the current rate of sales. Again, dramatic improvement on the margin.


The chart above shows the fraction of homes for sale that are vacant. While still somewhat high from an historical perspective, there has been a significant decline in the number of vacant homes for sale this year.


As this chart shows, the stocks of major home builders have increased significantly from their lows of October 2011—up 94%. Stocks are still depressed from their bubble highs of 2005, but the recovery from the lows has been dramatic.

UPDATE: October housing starts handily beat expectations. As the chart below shows, residential construction is unquestionably in the midst of a genuine recovery. Starts are up 65% since the end of 2010, and have soared by 42% in just the past year. In retrospect it's easy now to see that the housing construction began its recover sometime around the middle of last year. We are still in the early stages of the turnaround in the housing market, but it's for real.


How Federal largesse traps the poor

Welfare, food stamps, the earned income tax credit, and healthcare insurance subsidies are all designed to help the poor and even much of the middle class. But the unintended consequence of these income assistance programs (i.e., transfer payments) is that they make it much harder for people to work their way out of poverty. That's because all that money being handed out has to be taken away as people climb the income ladder, and that has the effect of increasing marginal tax rates.


This chart, courtesy of the Congressional Budget Office, comes from a new study of effective federal marginal tax rates. The top range of each of the bars is the effective marginal tax rate faced by some people in various income groups covering 80% of all taxpayers. Note that some of those making 100-149% of the poverty rate face marginal tax rates of as high as 60%!! If someone at the poverty line wants to work harder, he or she may only be able to keep 40 cents of each additional dollar earned.

On average, the vast majority of workers have effective marginal tax rates of 30%. As Greg Mankiw notes, "In 2014, after various temporary tax provisions have expired and the newly passed health insurance subsidies go into effect, the average effective marginal tax rate will rise to 35 percent." That is almost as much as the marginal tax rates of the rich.


As the chart above shows, average tax rates for the poor are relatively low, with 80% of taxpayers in 2007 paying an effective average tax rate of between 4% and 17%. We do indeed have a very progressive tax code if all you look at are average tax rates (i.e., total taxes divided by income). But it's marginal tax rates which have the greatest impact on incentives, and marginal tax rates are much higher than average rates under a progressive tax system loaded with subsidies. On a marginal basis, our income tax is actually regressive—the poor face marginal tax rates that are much higher than those faced by the rich.

Although the CBO study is an eye-opener, the reality for some people could be even worse. In a post last year, I quoted Daniel Kessler's WSJ article, in which he describes the punitive marginal tax rates (higher than 100%!) that will be faced by some families if ObamaCare is implemented:

Starting in 2014, subsidies will be available to families with incomes between 134% and 400% of the federal poverty line. For example, a family of four headed by a 55-year-old earning $31,389 in 2014 dollars (134% of the federal poverty line) in a high-cost area will get a subsidy of $22,740. A similar family earning $93,699 (400% of poverty) gets a subsidy of $14,799. 
But a family earning $1 more—$93,700—gets no subsidy. Consider a wife in a family with $90,000 in income. If she were to earn an additional $3,700, her family would lose the insurance subsidy and be more than $10,000 poorer.

There is no getting around it: a highly progressive tax system that relies on subsidies and other income assistance for the poor and even upper-middle income earners will inevitably yield very high marginal tax rates. This makes climbing the income ladder more difficult, and effectively "traps" many of the poor. Why work harder if you can only keep a fraction of the extra income?

Greg Mankiw also provides a reasonable solution:

... we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity.

UPDATE: John Cochrane has an excellent post that nicely expands on the issue of how marginal tax rates for the poor have become prohibitively high, with several real-world examples and more charts. Simply put, very high effective marginal tax rates for those on the low end of the income spectrum end up trapping many people in poverty. The Law of Unintended Consequences is very much alive and well.

UPDATE 2: Here is an excellent presentation by Gary Alexander (Secretary of Public Welfare, PA) that illustrates how disastrous our welfare system is. More importantly, however, it also shows how this can be fixed relatively easily. Here are two charts from the presentation that show how welfare programs create "welfare cliffs" that result in marginal tax rates that exceed 100% (translation: many families on welfare find that they are better off working less than working more, since earning more can cause their disposible income to decline). (click to enlarge) HT: Brian McCarthy