Longbrake discusses Super Committee’s Failure

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Nov 222011

Yesterday, the Joint Select Committee on Deficit Reduction (“Super Committee”) announced that it was not able to come to an agreement to cut at least $1.2 trillion from the budget deficit.  Bill Longbrake, Executive-in-Residence at the Center for Financial Policy, addressed some questions about the implications of the committee’s failure, potential effects on the U.S. economy, and the possibility for further Congressional action.

Q:  What are the most significant implications of the automatic, across-the-board spending cuts that will result from the Super Committee’s (Joint Select Committee on Deficit Reduction) failure to reach an agreement?  Are there any other options left to avoid this?

A:  The annual sequester, as it is officially called, would amount to $109 billion, divided equally between domestic spending (approximately half discretionary and half Medicare) and security spending (mostly defense). The cut to defense spending would equal about 8% of the current defense budget and does not include Iraq and Afghanistan war expenditures. Entitlement programs, such as Social Security and Medicaid, are specifically exempted and reductions in Medicare are capped at 2%.

Congress could repeal or revise the sequester during 2012. This seems unlikely and President Obama has promised to veto any legislation that weakens the sequester. There is a small chance of very modest deficit reduction legislation prior to 2013, which could be tied to extension of the payroll tax reduction or extension of extended unemployment tax benefits.

Q:  The Super Committee’s failure has built up uncertainties about a range of tax benefits, including the payroll tax cut and extended unemployment benefits, that are set to expire at the end of the year.  If these benefits are eliminated, are we likely to see a significant effect on the U.S. economy?

A:  The 2% payroll tax cut and extended unemployment benefits expire at the end of 2011. Unless both are extend, expiration will result in substantial fiscal drag in 2012 – $110 billion for the payroll tax (0.7% of GDP) and $49 billion for extended unemployment benefits (0.3% of GDP).

GDP growth during 2012 generally is expected to range between 2.0% and 2.5%, assuming extension of both tax breaks. Without either, GDP growth would fall to 1.0% to 1.5% and could be even lower, with a good chance of recession, if the sovereign debt crisis in Europe worsens materially.

The stage is set for fiscal policy to have a potentially very significant adverse impact on GDP in 2013. Under current law, government spending and tax revenues are set to reduce the deficit by $535 billion, or approximately 3.5% of GDP, in 2013. This includes $109 billion in spending cuts (the sequester), $255 billion from the expiration of the Bush tax cuts, $112 billion in the expiration of the payroll tax reduction (assuming Congress extends this tax cut for 2012), $21 billion from Medicare tax increases mandated by the Health Care Reform Act, and $38 billion from expiration of the alternative minimum tax reduction.

Depending upon the outcome of the 2012 election, it seems likely that Congress will enact significant tax reform in 2013 which will have the impact of reducing the budget deficit and stabilizing the public debt to GDP ratio, or even put that ratio on a declining trajectory.

Q:  After a long, drawn out process to raise the debt ceiling, S&P downgraded the US’s rating to AA+ in August.  How likely is another downgrade due to the committee’s inability to reach a deal?

A:  There are three credit rating agencies – S&P, Moody’s and Fitch. All three have indicated that an immediate rating downgrade is unlikely in the wake of the Super Committee’s failure. However, both S&P and Moody’s have stated that a rating downgrade is likely in 2013, if significant long-term deficit reduction does not occur. Previously published rating agency statements provide the following guidance:

  • S&P – AA+:   Rating downgrade to AA possible within next two years, if there is less spending reduction than $1.2 to $1.5 trillion, higher interest rates, or the long-term trajectory of the public debt to GDP ratio worsens.
  • Moody’s – AAA:  Downgrade will occur if fiscal discipline weakens in 2012, deficit reduction is not adopted in 2013, the economic outlook deteriorates, or government funding costs rise appreciably above current expectations. Because of the automatic sequester provision, failure of the Super Committee will not, by itself, lead to a rating downgrade.
  • Fitch – AAA:  Failure of the Super Committee and a worsening of the U.S. economic outlook will most likely result in a “Negative Outlook”, which means there would be a 50% chance of downgrade within the next two years. Fitch committed to review the rating if the Super Committee failed, which could result in a change in the outlook to “negative”.

Q:  Are we likely to see a return of the “Gang of Six” to try to come up with a bipartisan proposal to reduce the budget deficit?

A:  Failure of the Super Committee and President Obama’s decision not to attempt to intervene means that both Republicans and Democrats have decided to let the issues of tax policy and deficit reduction be a 2012 election issue. This means that it is unlikely that there will be serious attempts to consider tax reform during 2012. However, because this is now an election issue, there will be considerable debate in coming months. It is possible, perhaps even likely, that there will be limited bipartisan proposals, such as the “Gang of Six’s” 2011 proposal, but it is unlikely that Congress will do anything during 2012.


Endogenous Information Flows and the Clustering of Announcements

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Nov 202011

by CFP Academic Fellow Viral Acharya
Professor of Finance, Leonard N. Stern School of Business, New York University

This article was originally posted on The Harvard Law School Forum on Corporate Governance and Financial Regulation on November 16, 2011.

One of the most important ingredients to the process of price discovery in financial markets is the flow of new information, particularly apparent during times of market “crisis,” when it often seems that bad news is being reported simultaneously from multiple sources. While it is not surprising that firms’ news are affected by market and sector conditions (given the correlation of their cash flows), the timing of the announcements is suggestive that these disclosure decisions are not made independently. Indeed, recent empirical work suggests that corporate earnings warnings within an industry are clustered and that firms speed up their warnings in response to poor market conditions. Interestingly, however, such clustering is asymmetric in that good news does not generate such clustering, only bad news does. In the paper, Endogenous Information Flows and the Clustering of Announcements, forthcoming in the American Economic Review, my co-authors (Peter DeMarzo and Ilan Kremer, both of Stanford University) and I provide a theoretical explanation for this asymmetry.

We study disclosure dynamics when a firm possesses information that is correlated with market conditions, and explore incentives of managers – who maximize the present value of their compensation tied to firm’s market value – to delay the disclosure of news, until news become public knowledge. Because investors are uncertain whether a manager has learned the information, in equilibrium only those firms that have sufficiently positive news release their information.  Firms with more negative information prefer to keep their market value higher – at least temporarily – by claiming that they do not yet have any information to report.  Importantly, external public signals about market conditions that are correlated with firm’s own news are also likely to reach the market at future dates. Then, the firm has the opportunity to disclose its information before or after the public news announcement.

Our main theoretical insight is that because disclosure is irreversible, the firm faces a “real options” problem with regard to its disclosure decision: disclosing positive information may raise the stock price immediately, but this way the firm gives up the option that the external public news would have had an even more positive impact on the stock price if the firm had not yet disclosed.  As a result, information disclosure isdelayed relative to the no public news case.  Indeed, there can be an “information blackout” period prior to the public news, when firms refrain from any voluntary disclosures. However, once the public news is released, if it is sufficiently negative it may trigger an immediate disclosure by the firm.

An important implication of our results is that the process of information arrival to markets is different from the process of information arrival to firms and managers. One, the underlying information process may have constant variability over time and no skewness, but this need not be true of the process describing disclosed information:  In periods without public news, stock returns will be positively skewed as the firm voluntarily releases good news; however, when public news is announced, returns will be negatively skewed.  Second,  as documented empirically, correlations between individual stock returns and the market returns will be much greater for downside moves, especially for extreme downside moves, than for upside moves, and  that these correlations will differ from the conditional correlations implied by a normal distribution.  Third, the asymmetry in response to public news and the resulting downside correlation of firm returns helps explain the empirical result that while individual stock returns will tend to be positively skewed on average, stock market indices will tend to have negatively skewed returns.  Finally, the arrival of adverse public news during market downturns will accelerate the disclosure of information by firms and result in greater volatility.

To summarize, skewness and volatility related patterns observed in stock returns are consistent with the dynamics of disclosures by firms and the incentives of managers who have discretion over disclosure timing.  In contrast to the existing literature which has often treated such patterns as a statistical artifact of data, we provide a common information-theoretic foundation for their existence.

The full paper is available for download here.


Public Health Implications of the Mortgage Crisis

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Nov 142011

by Dawn Alley, Ph.D., Assistant Professor, University of Maryland School of Medicine, Department of Epidemiology & Public Health

President Obama has just released a new plan to prevent defaults as foreclosure filings increased in October to their highest levels in seven months. Clearly, the U.S. will be dealing with the economic implications of the mortgage crisis for years to come.

We may also be dealing with the health implications of the mortgage crisis for years to come.  In a recently released paper, our research team looked at a nationally representative sample of older homeowners over a 2-year period to see how mortgage default was associated with changes in health status.[1] We found that those who fell behind on their mortgages were in worse health at baseline, but they were also much more likely to develop high levels of depressive symptoms than their nondelinquent counterparts: 22 percent of the mortgage delinquent sample developed elevated depressive symptoms over the study period, compared to only 3 percent of the nondelinquent sample.

We were also able to examine the tradeoffs that cash-strapped families make when trying to meet mortgage obligations.  Households that fell behind on their mortgages were much more likely to develop food insecurity and to report not filling prescription medications due to cost.  These short-term consequences of a family’s economic situation may have long-term health consequences, because these material deficits are strongly associated with risk of health declines and mobility disability in older adults.[2]

Recent research also points to foreclosure as a cause of ER visits and hospitalization.[3] Taken together, the health consequences of mortgage default increase the total cost of the foreclosure crisis, making it even more important to develop policies to slow the rate of foreclosures.

A variety of policies can be specifically targeted to mitigate the health consequences of foreclosure.  First, policymakers can support safety net providers, community health centers, and others who provide free and low-cost health services.  These agencies’ budgets have been stretched thin during a time of increased need.  Second, policymakers can establish opportunities for health assessment and referral as part of foreclosure proceedings.  For example, foreclosure mediation has been used as a point of entry for services.  Mediation is optional in Maryland, but required mediation (a strategy used in Philadelphia) may both reduce the foreclosure rate and provide an opportunity to link distressed homeowners with health and social services.  Finally, mortgage counselors could be trained to conduct health assessment and referral.  Nonprofit mortgage counselors help clients obtain loan modifications as part of federal programs designed to address the foreclosure crisis.  In the course of their work, they frequently encounter clients with significant unmet health needs.  In a survey of mortgage counselors,[4] we found that counselors frequently encountered clients reporting difficulty affording medical care or food, as well as clients reporting symptoms of depression.  While many mortgage counselors would like to help direct clients to health resources in their communities, most lack the resources and training to do so.  Training mortgage counselors is one way to build on the existing foreclosure prevention infrastructure to help address the health needs of vulnerable homeowners.


Prof. Sicilia’s “A brief history of U.S. unemployment” featured in The Washington Post

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Nov 112011

Professor David Sicilia, CFP’s Henry Kaufman Fellow in Business History, discusses the history of U.S. unemployment through five periods: Post-World War II, Stagflation, Reagan/Bush, Clinton and the 21st Century.  The Washington Post’s feature includes audio of Professor Sicilia discussing each era.

Read the article now.

David Sicilia is an Associate Professor of History at the University of Maryland, College Park. His research and teaching focus on the evolution of global and U.S. capitalism.  The Robert H. Smith School of Business received a $1 million endowment from the Henry & Elaine Kaufman Foundation to support a fellowship in business history, in affiliation with the Center for Financial Policy.  Professor Sicilia was appointed the first Henry Kaufman Fellow in Business History on July 1, 2010.

For more information about Professor Sicilia’s work, click here.

Longbrake comments on Occupy Wall Street in latest interview

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Nov 092011

Bill Longbrake, Executive-in-Residence at the Center for Financial Policy, talks to Michelle Lui, CFP’s Assistant Director, about various aspects of the Occupy Wall Street protests including the main drivers, the group’s demographic makeup, sanitation and safety issues, and the likelihood to affect policy.

Watch the video here.