In a speech after the release of the employment figures Friday, President Obama said:
“Today, we’re pointed in the right direction. While we’ve rescued our economy from catastrophe, we’ve also begun to build a new foundation for growth.”
I’m sorry Mr. President, but I’m going to have to respectfully disagree. The economy is “recovering”, but the new foundation for growth you seek has yet to be laid. A new foundation for growth cannot be built on the very policies that produced our current situation. The “recovery” we are experiencing now is a product primarily of the actions of the Federal Reserve and was entirely predictable. In an email I sent to clients on March 10th (and produced as a blog entry entitled, Bottom?), I said:
In the shorter term, the actions of the Federal Reserve will have a positive effect on economic activity. The recently passed stimulus bill, while very poorly designed, will also have an effect on activity. These coordinated actions will likely show evidence of success soon, especially the Fed actions. This will show up first in higher asset prices and later in the economic statistics. My concern is for the longer term. Neither of these actions can be sustained in the long term and are actually just more of the same policies that got us in this mess to begin with…..I believe the economy and the markets are hitting their nadir now.
Now, obviously, the fact that I wrote that within a day of the bottom of the stock market was just luck, but the reasoning was sound. The expansion of the Fed’s balance sheet and its lending into private markets is unprecedented only in size and scope, but Bernanke’s policies are no different than the policies of the Alan Greenspan Fed. And despite all the disagreement regarding the causes of the housing inflation and its aftermath, hopefully everyone can now agree that Fed policy played a large role. If we are still following the policies that produced first an inflation of stock prices, then an inflation of house prices - and two crashes - how can we say we’ve built a new foundation for growth?
Rebuilding our economy is not something that can be accomplished in the short time since the crisis erupted in earnest last fall. We could be laying the foundation the President speaks of, but to date I’ve seen no policy or proposed policy that actually addresses the underlying causes of the crisis. The policies of the current administration, like the last one, are nothing more than a shell game intended to dupe the rubes into believing the crisis has passed. The pea slipped from beneath the shell briefly last week when the Fed entered the Treasury market to purchase Notes auctioned just the previous week by the Treasury Department. After a terrible 5 year auction, it appears the Treasury and Federal Reserve combined to rig the 7 year auction and provide at least the illusion of strong demand. While it keeps the game going for now, one wonders what the Treasury will do to keep up appearances once the Fed exhausts the $300 billion they’ve earmarked for the Treasury market (they’ve spent over $200 billion already). Or will the Fed, like the Bank of England last week, just expand the program and keep inflating?
Ben Bernanke has kept his promise to Milton Friedman and not allowed a debt deflation through the extraordinary expansion of the Fed’s balance sheet and by providing another does of cheap credit to the markets, but the extent of the government interventions verges on the absurd. The Fed has been purchasing mortgage backed securities and agency debt in the open market (with newly created money) so when Fannie Mae reported another huge loss last week and requested another $10 billion from the Treasury, the circular flow of funds whirled a little faster. Fannie Mae will now get funds from the Treasury Department so they can continue to make the interest payments on their debt owned by the Federal Reserve. It will also cover the principle payments on any Fannie Mae guaranteed mortgages that default and are owned by the Fed. And remember the Fed provided the money to the Treasury in the first place by monetizing newly issued debt. This convoluted three card monte finance game would make Rube Goldberg blush.
In addition to buying Treasuries, Agencies and mortgages, the Fed is buying commercial paper, providing financing for the securitization market and lending to banks through the discount window and the Term Auction Facility. While credit spreads have narrowed, it seems ridiculous to talk of healing credit markets until the Fed exits the markets for private credit. In addition to the Fed, other government agencies are also neck deep in markets. The FDIC is guaranteeing $350 billion in bank debt, the Education Department is the largest buyer of student loans, Fannie Mae and Freddie Mac dominate the mortgage market and TARP has provided capital to banks that by any objective financial measure should have already been liquidated. Essentially the government is borrowing from the public so the public can keep borrowing. Does that sound sustainable?
The activity we are seeing in the housing market should also not be mistaken for something that is sustainable or for that matter desirable. The $8000 first time home buyer credit (which gives new meaning to the phrase ”first time”) is subsidizing housing demand for now, but what happens when the program ends in November? Will Congress extend the program indefinitely? Isn’t the subsidization of the housing market at least partially to blame for the current oversupply? What are we accomplishing by snaring another generation of Americans into a lifetime of debt to purchase a non productive asset? Does it really make sense to waste precious capital building houses in a country with 19 million vacant housing units?
The execrable Cash for Clunkers program is no better. We’ve committed to spending $3 billion to destroy serviceable, paid for vehicles to subsidize the purchase of new cars, most of which are being bought on credit. Could that credit have been used to fund productive investments instead of an asset that depreciates the minute it’s driven off the lot? We’ll never know.
Yes, we will get a “recovery” in economic activity, but how long it lasts is anyone’s guess because the hard work still lies ahead. The balance sheets of over leveraged banks, firms and individuals need to be restored to health. The best way to accomplish that is through increased cash flow which is most easily accomplished through tax cuts. To his credit, President Obama included tax cuts in the stimulus plan but too much of the plan depends on government spending that even Lord Keynes rejected as stimulus:
”Organized public works at home and abroad, maybe the right cure for a chronic tendency to a deficiency of effective demand. But they are not capable of sufficiently rapid organization (and above all cannot be reversed or undone at a later date), to be the most serviceable instrument for the prevention of the trade cycle” (Collected Works, vol. XXVII, p.122).
We also need to recognize that some institutions and individuals are just too deeply indebted to rescue. The FDIC needs to accelerate the process of closing failed banks and some individuals need to face facts and make the acquaintance of a bankruptcy attorney. Yes, it’s sad when someone loses their house or sees their credit rating damaged but it can also be liberating. Abraham Lincoln, Henry Ford, Walt Disney, Milton Hershey, H.J. Heinz and P.T. Barnum all filed bankruptcy and went on to great success. In fact, probably the only reason they succeeded later is because they were able to discharge their previous debts in bankruptcy.
No, Mr. President, we haven’t built a new foundation for anything except another episode of inflation, malinvestment and eventual collapse. The most pernicious aspect of most of these policies is how they tend to favor one group of citizens at the expense of another. The Fed’s artificial suppression of interest rates favors debtors and banks over savers. Cash for clunkers perversely subsidizes the middle class and the wealthy at the expense of the poor who might buy those cheap clunkers being destroyed. The first time home buyer’s tax credit favors not only one class of buyers over another but also buyers at the expense of renters. TARP bailed out bank shareholders and bondholders at the expense of those who acted more prudently with their investments. The pitting of one group of Americans against another has to end.
If the imagination that has been employed in the effort to resurrect the status quo had instead been employed to construct a new platform for long term prosperity we could already be producing sustainable results for the benefit of all Americans. That platform needs to be constructed on a tax system that encourages savings and investment rather than consumption. It needs to be constructed on financial market regulatory reform that ends once and for all the idea that some institutions are more equal than others and that doesn’t install an institution dominated by bankers (the Fed) as the primary regulator of banks. It needs to be constructed with a health care system that protects citizens from the economic castastrophe of illness, reconnects doctors with their patients while removing both government and insurance companies as third parties to private decisions. It needs to be constructed with a government that lives within its means and treats all citizens equally rather than one that robs Peter to pay Paul. Above all, it needs to be constructed on a system of sound money rather than the illusion of prosperity produced by the printing press.
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Weekly Economic and Market Review
The economy continued to shed jobs in July but the trend continues to improve. One can argue about the quality of the report – the census added workers last month – but things are slowly improving on the quantity side. I still think the pace of job creation will be severely limited in this recovery though. Long term unemployment is a major problem – and one of the reasons the jobless claims data is so hard to analyze – and there are signficant doubts about the sustainability of any recovery. Unless that changes, companies seem unlikely to expand their payrolls beyond the absolutely necessary. The employment report Friday got all the attention last week, but the other reports were arguably more important. The ISM manufacturing survey continues to inch toward the 50 level that indicates expansion although the services index released Wednesday slipped a bit. Construction spending rose; residential and public construction were higher while non residential fell. Income fell and spending rose slightly but the spending increase was due primarily to higher gas prices. Pending home sales rose again. Factory orders rose for the fourth time in five months. New jobless claims fell by 38,000.
US stocks made new highs for the year with most of the weekly gain coming Friday after the employment report. Things are getting a little frothy though and I still expect some kind of correction to start soon. The AAII investor poll reported a full 50% in the bull camp with 35% on the bear side. I would be more concerned if the bear component slipped into the 20s, but still that 50% bothers me. I suppose the crowd can be right for a while more but caution is warranted. In one of the strangest market moves in a year of strange moves, REITs shot higher last week. Foreign markets, particularly in Asia, took a bit of a breather with China falling over 4%. Bonds took it on the chin again and the dollar rose from the dead on Friday with the “good” employment report.
Despite the rally Friday, the dollar is still in a downtrend. Is this the bottom? I have my doubts but sentiment is very negative and a rally would frustrate the maximum number of traders, so this might be the start of something:
What got into REITs last week? Low occupancy rates in retail and commercial buildings, foreclosures everywhere, hotels on life support; none of that seemed to matter. I’m underweight and still like foreign real estate better, but this was an impressive move:
The dollar rally Friday knocked the wind out of the commodity sails, but still a good week:
Copper made new highs early in the week:
The corporate bond market finally pulled back, but the uptrend is intact:
The start of something in Natural Gas?
Regional banks have lagged the financials rally all year, but have staged an impressive rally in the last two weeks. I’m looking at individual names in the sector and may start taking positions on a market correction: