There’s important potential for the economy to strengthen significantly if there’s a greater level of security and confidence about where we’re going. A plan for resolving the nation’s longer-term budgetary issues without harming the recovery could help make the new year a very good one for the American economy.

Ben Bernanke in a speech last week to the Economic Club of New York

Damn. Just last week I talked about how a resolution to the fiscal cliff could be very positive for the economy and the markets. Now Bernanke has to ruin it by agreeing with me. If there is one thing Ben Bernanke has proven beyond any doubt during his tenure at the Fed it is that his economic forecasting skills leave a lot to be desired. And it isn’t only Bernanke that is expressing optimism. Bloomberg reported last week that the highest percentage of Americans in a decade think the economy will get better. With two bubbles to their credit in the last couple of decades, I’m not exactly thrilled to hear that the man in the street is bullish too.

On a brighter contrarian note, Bloomberg’s survey reveals that, despite it being a decade high, the total percentage of Americans who think things are or will be getting better totals only 37%. Not exactly a nation of optimists us Americans and I guess that makes sense considering what happened during that decade. Another detail from the poll also reveals quite a bit about today’s America. The surge to a new high was led by Democrats, 63% of whom believe things will get better while Independents and Republicans were just a tad less optimistic at 26% and 15% respectively. That’s a sad commentary for many reasons not least of which is the implied faith, by both sides of the political aisle, in the ability of politicians to positively affect economic growth. I am certain those numbers would have been flipped if the outcome of the election had been different.

Obviously, government plays a large role in our economy – much larger than I’d prefer certainly – but the degree to which it affects growth is vastly overstated by both parties. I am constantly amazed at how little faith even the capitalists among us have in the self healing powers of market economies. Economies have an ebb and flow all their own driven by millions of individual decisions and government policy plays a small role in most of them. Some of these daily decisions are influenced by government economic policy but most of them are driven by the simple economic law of supply and demand. Of course, history informs us that government can become so oppressive that it overwhelms the inherently self correcting nature of economies but only the most extreme among us believe we are anywhere near that point. If we are on the Road to Serfdom we are just exiting the on ramp.

With all the talk about fiscal cliffs, tax rates, broadening the base and all the other things being negotiated, it is disconcerting that the one area that really needs to be addressed is being completely ignored. The scores of individual economic decisions we make every day based on the laws of supply and demand do require one thing from government for them to be made well – sound money. True price discovery is the most crucial of inputs for producers and consumers alike and without it our economy will never function at its true potential. The so called Great Moderation – the period of steady growth produced in the 80s and 90s – was produced not through tax or regulatory policy so much as it was through the magic of price distortion as practiced by a hyperactive Federal Reserve. The money illusion of the 80s and 90s did produce a period of stable GDP growth but as we’ve found out over the last decade, there is no such thing as a free lunch. Thinking about it now, would you have accepted more frequent, shallow recessions during that time if you knew it would prevent what happened in 2008? I think the answer is obvious.

No matter what happens with tax or regulatory policy, the Fed will still remain at the center of our economy systematically distorting prices and impeding the natural processes that produce a healthy economy. The Fed’s policies have a much greater impact than anything Congress or the President might do and investment decisions must take that into account. Tax and regulatory policies may affect certain sectors and individuals but the effects are more micro than macro. And for as long as the Fed is at the controls of our economy, it is the macro that matters for most investors.

The reason I believe we may be on the verge of better GDP growth is that there are several trends converging that resolution of the fiscal cliff could hasten. If I’m right about these trends they will naturally push growth higher and in combination with extraordinarily loose monetary policy could produce much higher growth than is expected by the new normal crowd. These trends are:

  • Housing: As I pointed out last week, household formation is rising again and the US population continues to grow. There is pent up demand for 2 to 2.5 million new housing units in addition to the annual needs due to population growth.
  • Manufacturing: As I’ve said many, many times, there is no such thing as a free lunch in economics and the Chinese are discovering that truism. Their policy of pegging the Yuan to the dollar and accumulating foreign reserves has produced massive wage inflation. For some industries, it is already cheaper to produce goods in the US than in the recent offshore havens. As Chinese wages continue to lag productivity growth, that trend will accelerate and encompass more and more industries.
  • Energy: Natural gas prices in the US are considerably lower than the rest of the world due to the increased supplies from fracking. I have expressed pessimism about the long term sustainability of that trend but for now it gives the US a major advantage. We are also continuing to reduce our energy consumption thanks to higher oil prices. Energy use per capita and per dollar of GDP have been falling for decades but the trend accelerated during the weak dollar period since 2002 and during the recession. These efficiency gains will be sustained even if oil prices fall because the behavioral changes high prices precipitated will persist.
  • Rising dollar: The most damaging economic policy of the last decade – by far – was the weak dollar. While many place blame for this with the Federal Reserve it is actually more directly linked to the Treasury department. A resolution of the fiscal cliff should accelerate the emerging trend of a strengthening dollar. The identity of the new Treasury Secretary may influence the dollar in the short term but there are other reasons to be positive about the dollar. China’s reduced growth rate, which I believe is likely permanent, reduces the attractiveness of other countries as investment destinations. The US Dollar may win favor by default as emerging market economies – dependent to a large degree on Chinese growth for demand for their resources – slow. European growth will also likely lag the US even as it recovers from recession.
  • Technological change: Technological change and innovation did not stop during the Great Recession and it continues to alter the ways we do business and the ways we live our lives.

None of these trends, with the possible exception of the course of the US Dollar, are dependent on a resolution of our budget woes. They could however, be accelerated by a resolution that is truly balanced. We know that companies have been holding off on investments due to fears of another stalemate so if that is averted we should see corporate investment start to recover from the stall we’ve seen over the last 6 months. If that leads to a higher rate of job growth it will accelerate the housing trend. If the deal includes some relief on corporate taxes the trend to relocate manufacturing here might also accelerate. A rising dollar would also push down oil and other commodity prices which would expand our cost advantage over the rest of the world. It would also free up disposable income for consumers.

So over the next few years I think there is the potential for a more “normal” rate of growth and maybe something even greater. The wild card, as usual, is monetary policy. Some of these trends will no doubt be accelerated by Fed policy beyond what would occur naturally. Mortgage rates distorted lower will affect the housing market. Interest rates for corporate borrowers held below the natural rate will induce investment that would not have otherwise occurred – and will turn out to be mistaken when interest rates inevitably rise. Artificially low interest rates will also make the stock market look cheap and could easily fuel another bubble. Lastly, if the Fed continues to ignore the US Dollar as it has for decades, a constantly rising dollar will again create problems just as it did in the late 90s. If we want true economic stability it can be found in a stable dollar.

In the very short term, optimism over the resolution of the fiscal cliff has probably outrun reality. A near term correction of the recent rally would not be a surprise but unless our politicians irrationally refuse to cut a deal, the trends above should continue asserting themselves over the next few years. If a deal isn’t reached they might be delayed but only a much larger shock would prevent them from happening at all. These trends are part of the natural fluctuations of a global, mostly market economy and are more powerful than fiscal policy. Monetary policy, for now, will act as a tailwind but absent reform will also sow the seeds of our next crisis. Let the bubble blowing begin.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773.

Click here to sign up for our free weekly e-newsletter.