Optimism For Fiscal Reform Fading
There was a lot of hoopla last week about the stock market doubling since the post financial crisis low but if the rally is to continue, it is critical that the political class stop the posturing and get on with the people’s business. The release of President Obama’s budget last week was the latest indication that both sides of the aisle still don’t get it and are more interested in creating talking points for the next election cycle than actually doing the serious work required to reduce the budget deficit and enact tax reform. The Federal Reserve policy of quantitative easing in conjunction with rising expectations for reform after the mid term elections created a window of opportunity to reach a compromise but that window is rapidly closing. As Richard Fisher of the Dallas Federal Reserve recently said, the Fed is providing a bridge loan to fiscal sanity but it isn’t permanent financing.
There were two distinct periods to the recent stock market rally. Following Ben Bernanke’s Jackson Hole speech concerning QE II in late August, the market responded by pushing down the US dollar index nearly 10% by early November. The price of gold, responding to the weaker dollar, rose by 23% in the same time frame. Crude oil prices, also sensitive to the weak dollar, rose 27%. Stocks also rose by 18% but if one considers the drop in the value of the dollar, the rally is much less impressive. Measured in terms gold or oil – and a lot of other real things – stocks actually lost ground during that initial phase of the rally. Contrary to popular belief, these market moves were not a result of “money printing” but they were due to the Fed’s actions. Quantitative easing has not, so far, produced a significant rise in the money supply. The increase in the size of the Fed’s balance sheet has been matched almost dollar for dollar by an increase in banking system reserves. Despite Bernanke’s assurances that he can prevent it, market participants fear that all those reserves will eventually show up as a large – very large – increase in money supply and all that implies for CPI inflation. What QE II changed was expectations and a lower dollar indicates it wasn’t for the better.
By contrast, starting in early November and coinciding with the mid term elections, those expectations started to change. Less than a week after the election, the dollar index started to rise while gold and oil fell. Stocks also fell a bit but less than gold. The release of the Fiscal Commission report in late November reinforced the trend. Over the next few weeks gold and oil peaked while stocks resumed their rally. Again, expectations had changed. The election and the Commission report raised expectations that US economic policy would change for the better. A deal to reduce the budget deficit and more importantly for comprehensive tax reform appeared not only possible but increasingly likely. President Obama started his corporate outreach program and appeared to move to the political middle. A deal was cut to extend current tax rates while also extending unemployment benefits. Compromise! Visions of Clinton’s mid term course correction danced in investors’ heads.
Unfortunately, after that brief interlude of pragmatism, the two sides fell back into their previous pattern of attempting to score points for the next election cycle. House Republicans balked at reducing defense spending and targeted programs politically unpopular with their base supporters for spending cuts. President Obama meanwhile averred that while he was proud of the work the Fiscal Commission had done, he was not in agreement with large portions of their plan. Last week he released his budget and raised doubts about his commitment to deficit reduction much less tax reform. It now appears that rather than any grand bargains on deficit reduction and tax reform, gridlock is the more likely outcome. As I argued before the election, doing nothing is not acceptable right now.
The markets, with the notable exception of stocks, have responded. I don’t think it is coincidence that last week saw a resumption of the trends that started immediately after Bernanke’s QE II speech and before the election. The dollar fell, gold, oil and a host of other commodities rose. It would be easy to credit the rise of oil and gold to the turmoil in the Middle East, but it is noteworthy that the dollar hasn’t risen as it has in every other recent crisis. Either the perception of the dollar as a safe haven has changed for the worse or oil and gold are rising for other reasons. For now, stocks are still rising, but it seems unlikely that can continue if the dollar continues to fall and input costs continue to rise. There is a reason Warren Buffet said recently that pricing power is the most important factor when choosing what stocks to buy. Higher input costs and no ability to raise prices means one of two things; either companies will have to further increase productivity – which likely means more layoffs – or their profit margins will fall. Neither outcome would seem conducive to higher stock prices or economic growth.
There is a feeling in the market right now that as long as QE II continues, the stock market will continue to rise. That sentiment rests on a dubious assumption – that QE II and the weak dollar that is its stated goal is positive for economic growth. I would have thought that after our other recent experience with a weak dollar that myth would have finally been punctured, but apparently not. The illusion of GDP growth produced by a weak dollar policy, excessive government spending, easy money and weak regulatory enforcement is what produced the last crisis. Maintaining those policies while expecting a different result is folly.
The path to real economic growth is not hard to find but it will require leadership and compromise on both sides of the political spectrum. It also requires that monetary and fiscal policy be coordinated in a fashion that produces a stable dollar and GDP growth. As President Obama said last week, the Fiscal Commission report provides a framework for compromise and offers many positive ideas about potential reform. Government spending needs to be reduced but the minor cuts offered by the President’s budget won’t get the job done. Social Security, Medicare and Medicaid reform have to be addressed. Defense spending can and surely must be reduced. We are well past the point where we can afford to act as defender of the entire world.
Tax reform is also essential to produce higher rates of growth. The President has spoken repeatedly of corporate tax reform and rather than wait for some great comprehensive compromise, Republicans should take up his offer. Lower rates, a shift to territorial taxation and elimination of preferential treatment of favored industries would produce higher growth and can be revenue neutral. Another area where agreement should be possible is for a carbon tax offset with cuts in other taxes. A phased in tax on carbon emissions in conjunction with a reduction in payroll taxes would make alternative energy more attractive without further subsidies while also reducing the cost of hiring. There are plenty of other ideas for reform that can be positive for growth and also provide Democrats and Republicans political cover.
Positive expectations for fiscal reform must be restored quickly or the gains of the last few months will likely prove temporary. The recently falling dollar, particularly in relation to gold and other commodities, is a warning sign that politicians ignore at our peril. If a compromise such as that produced by the Fiscal Commission cannot be reached quickly, incremental reforms would provide evidence to the market that policy is at least moving in the right direction. Time is running out for fiscal reform on our terms. The Fed’s bridge loan comes due in June but if the dollar starts to fall more rapidly they may be forced to foreclose.
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