Wishful Thinking, in Toronto

Here's yet another story about deficits, debt, fragile minority governments with nonetheless ambitious financial goals, and wary credit-rating agencies. And it's not about a European economy.

The Province of Ontario, Canada's most populous and largest provincial economy (though no longer its richest), has a new Premier, Kathleen Wynne, who won a closely-fought Liberal party leadership race earlier this year. Her minority government tabled its annual budget at the beginning of May. Despite the left-leaning New Democratic Party's hold on the balance of power in the Legislature, Ms. Wynne's budget seemed a model of fiscal responsibility, referring - easily over a hundred times - to the government's full recognition and intention of reducing then eliminating the persistent annual deficits. Thus, the current budget deficit for the fiscal year ending March 31, 2013 of $9.8 billion (equivalent to some 1.5% of gross provincial product) is projected - in a series of very colorful charts and tables - to disappear by fiscal 2018, after of course a "temporary" jump to $11.7 billion this fiscal year.

Here's the issue. The budget says almost nothing about how this eventual, disappearing act is to be accomplished, other than to cite accelerating economic growth in future years and "spending constraints". But, Ms. Wynne, with a need to placate the New Democratic Party, has pledged to protect funding for the politically-sensitive expenditures of health care and education, which taken together account for some two-thirds of discretionary spending. And with total accumulated debt reaching $281 billion this year (or some 40% of provincial GDP), and projected to rise, interest payments, which cost some $10 billion annually, could become especially onerous if interest rates were to rise from record low levels.

This is what Standard & Poor's, one of the world's major debt-rating agencies, must have had in mind yesterday when it reiterated its "negative" outlook on Ontario's credit ratings. The agency did not cut the current rating (AA-minus), as did another agency, Moody's, a year ago, but said that the negative outlook "reflects our view regarding the minority legislature's ability in the next one to two years to meet what we view as aggressive cost-containment targets necessary for the debt burden to peak in fiscal 2015 as planned".

An actual rating cut, by Standard & Poor's or other rating agencies, could bring into question the very ability of the province to continue to borrow. (Bond markets have a way of forcing politicians to wake up to financial reality.) A rating cut would at least increase financing costs substantially, leaving less room for all other expenditures. Ms. Wynne, facing opposition on the right to raising taxes, and on the left to cutting social programs, faces a very delicate environment in which to implement nonetheless essential fiscal restraint. It's not colorful chart projections, but rather specific measures - aimed, for example, at public sector wages, salaries and benefits - that are required now. ​A big test for Ontario lies ahead.

Shock, in Detroit

Even for Detroit, this was shocking. It's the kind of thing that finally happens after corruption and ineptitude have been allowed to persist for years.​

Kevyn Orr, the emergency manager of Detroit (in office for 2 months with 16 to go) announced today that, should Detroit need to declare bankruptcy, the Detroit Institute of Arts (DIA), among other city assets, may "face exposure to creditors", that is, "the city's creditors could demand the city use its assets to settle its debts". The Institute, which opened its doors in 1885, is one of perhaps two or three cultural gems still operating in Detroit, housing a massive art collection ranked in the top six in America. Notable in the collection, valued at some $2 billion, are, among many others, Mexican artist Diego Rivera's Detroit Industry fresco cycle, which Rivera considered his most successful work, and Vincent van Gogh's Self Portrait, the first Van Gogh painting to enter a U.S. museum collection. The entire collection of 60,000 pieces, assembled over decades, is regarded as a comprehensive representation of classic to cutting-edge.

Of course, DIA executives, the broader art community, and the Detroit City Council were quick to express disbelief and outrage that a sale of the art could be even considered as part of a program of reducing Detroit's $15-17 billion debt They even dispute the legality of such a sale, arguing that while the art is owned by the City, it is held in a trust for the public, and that under an operating agreement the museum is prohibited from selling art for any purpose other than enhancing the collection.

What is being missed here is that Mr. Orr has broad power to cancel or modify city labor contracts and other agreements as he reorganizes finances. One can only imagine how many times, over the next year and a half, he (along with his fellow Emergency Managers in five other Michigan cities) will hear objections similar to the DIA's - essentially, don't touch us, go after everyone else. But along with the DIA, the public sector unions, ​bond holders and all other creditors will come to the realization that contracts and promises, and business-as-usual, mean little or nothing to Mr. Orr, who is empowered to achieve only one goal - solvency in Detroit.

A Fascinating, But Unintended, Consequence

In a recent blog, about Japan's new Prime Minister, Shinzo Abe, and his push since coming to office in December 2012 to reinvigorate the Japanese economy,  this writer cited the pernicious effect of Japanese citizens' deflationary expectations over the past 20 years. One word - stagnation - summarizes that experience. (The average annual growth in real Japanese GDP in the period 2005-10 was 0.3%.)

The Bank of Japan, under its new Governor, Haruhiko Kuroda, was given one overall mandate from Mr. Abe - to adopt an inflation target of 2%, to be reached in two years, to rid the country of deflation - essential if domestic demand is to revive. The Bank has, accordingly, massively expanded its purchases of long-term government bonds and other assets through its program of quantitative easing, with the goal of depressing their yield, thus spurring banks to lend, and companies to borrow and invest in the real economy, or abroad, where yields are higher. Though quite suddenly much bigger in scope, this mirrors Federal Reserve policy.

But here's the rub. Success in raising inflation expectations can lead - and did dramatically yesterday in Japan - to investors, uncertain as to how far such success may go, demanding a higher risk premium for holding government bonds. This is why Japanese 10-year government bond yields spiked yesterday - despite quantitative easing -  from near-zero, to above 1% at one point. Investors were suddenly, for the first time in many years, wondering, perhaps even concerned, about a re-emergence of inflation over the next ten years. Such worry carried over to the equity markets, with the Nikkei 225 plunging some 7.5% in one day after a nearly straight-up trajectory since December last year.

So, Japan's monetary policy experiment is producing some early surprises, and lots of volatility. Governor Kuroda's staff may have already engineered just a little more success than they counted on; mitigating volatility will be one of their daily tasks.

Anticipation

Financial markets strive to anticipate changes, whether in economic policy, macroeconomic developments, or corporate earnings. So it was today as Fed Chairman Bernanke testified in front of the Senate/House Joint Economic Committee.

The especially acute challenge for market participants today, in listening to the testimony, was to discern the likely course of America's highly stimulative monetary policy. The Fed is currently making $85 billion in bond purchases every month (the so-called program of quantitative easing) to foster low long-term interest rates, thus encouraging lending to spur economic recovery. Though a number of economic indicators have improved, the U.S. economy is not yet registering growth at rates sufficient to lower significantly the still high 7.5 per cent rate of unemployment (despite consistent falls in recent months). And deflationary pressures (like those that have led to long-term stagnation in Japan) remain.

    Thus, in today's address, Bernanke warned that a change in policy now would "carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further". On these words, the markets jumped - relieved that a tightening of monetary policy was not imminent - with the Dow industrial average rising late morning by as much as 155 points, and the 10-year government bond yield dropping below 2%. But then, Mr. Bernanke spoke further, in a question-and-answer period with Congressional committee members, suggesting that a tapering of the bond-purchasing program could be decided over the next few Fed meetings, if the job market shows "real and sustainable progress". And he wouldn't rule out curtailing the purchases by Labor Day. On these words, markets began to reverse course.

Then, shortly after the testimony, minutes of the previous Fed meeting were released, indicating a willingness of "a number" of members to scale back quantitative easing, perhaps as early as June. This news served to accelerate the market reversal, such that a 155 point rise in the Dow turned into a rout of as much as 120 points by mid-afternoon, finally closing down some 80 points.

Traders have an expression - "don't play on days when the Fed sneezes". This was certainly true today. But, all this seesawing leaves us with little, if any, better idea of when monetary tapering might start - indeed, the latest minutes make it apparent that Fed members themselves are sharply divided on the timing. The same can be said of the future direction of fiscal policy - will Washington ever address entitlement spending, or the byzantine, distorting tax code?  Markets would do well to pay far less attention to the vagaries and in some cases ineptitude of policy-makers, and focus instead on economic fundamentals and corporate earnings.

Trends

There has been much discussion this past week about the concentration of carbon dioxide in the atmosphere, and the attendant impact of such on climate. Not only has the concentration passed 400 parts per million for the first time in 4.5 million years, but, as concerning, it is continuing to rise at a rate of some 2 parts per million every year. Extrapolating this trend to the end of this century, commentators note that CO2 concentration would be 800 parts per million. Thus, the argument runs, the risk of apocalyptic climate change (warming) is large and growing.

A century and a bit ago, there was a similar alarm sounded over quite a different trend. On July 24, 1881, the New York Times noted that "deprived of their human servitors, the horses would quickly perish; deprived of their equine servitors, the human population in cities - dependent upon their daily food from the outside, and upon the regular flow and reflow of traffic - would soon be in straits of distress". In short, urban dwellers couldn't do without their horses. Such dependency, together with a secular drop in demand for manure as fertilizer (as phosphate substitutes were appearing in the market) produced "The Great Manure Crisis of 1894". The world, according to pundits of the time - who were also extrapolating current trends - was about to drown in manure. But, then, over the next few decades, humans invented automobiles, and, as importantly, a means of making and distributing them in an affordable way to many. The manure crisis was no more.

The point here is not to trivialize greenhouse gas emissions, their impact on climate change, and in turn its impact on humans. This writer's tongue is not firmly in his cheek. The manure crisis was real, at the time, as is the CO2 crisis now. The point is  that innovation has dramatically and frequently intervened at critical points over the centuries to render dangerous trends irrelevant - Malthus would have never imagined in the 18th century how the 21st-century world feeds and clothes as many as it does. Technology keeps improving things, notwithstanding the gloom of the day.