A number of prominent economists have recently upgraded their outlook for the economy. Richard Berner (Morgan Stanley), James Glassman (JP Morgan), Stephen Stanley (RBS Securities), Lawrence Myer (former Fed governor) and Neil Soss (Credit Suisse) have all recently commented on the likelihood that growth in the coming quarters will be more robust than the consensus expectation. They all tend to cite a recovery in auto production and housing construction as well as inventory restocking as reasons for their renewed optimism. It’s nice of them to catch up; that’s the same argument I made almost two months ago in my June economic outlook.
Fresh evidence to support the quick recovery scenario arrived this week when Germany and France both reported economic growth for the most recent quarter. It wasn’t much and most of it was due to changes in net trade figures, but it must still be quite a surprise to those who were predicting doom a few months ago if the continent didn’t follow our insane fiscal policies and run larger deficits to fund larger stimulus plans. Angela Merkel and Nicholas Sarkozy rejected President Obama and Gordon Brown’s call for more government spending at the G-20 conference back in the spring. They took a lot of heat for their stand domestically and internationally but it would appear their common sense has been vindicated.
Some will argue that Germany and France have just been free riders on the US stimulus package and there may be some validity to that argument, but it certainly wasn’t direct US government spending that made the difference. The only significant contributor to the recovery from the stimulus package so far is from the tax cuts. The vast majority of the more direct government spending has yet to happen and with the economy seemingly past the trough, one has to wonder how much more robust the economy would be if the tax cuts had been a bit more aggressive. In my opinion, government policy to date has done more to delay the recovery than advance it. That isn’t just a knock on the current administration; most of the big mistakes were made before President Obama took office. The myriad Fed lending programs, the bank bailouts, the auto company bailouts and housing market fiasco all started before the new administration moved in. Unfortunately, despite the rhetoric of hope and change, the new administration displays a pessimism about the resilience of the US economy that prevents the real changes needed to ensure our future prosperity.
In a recent article for The New Republic, Noam Scheiber makes the pessimists’ case:
So far as I can tell, the only solution to the underlying economic problem is something that’s been a dirty word in Washington the last generation or two: industrial policy (that is, an active government role in the development of certain industries.) In his LSE lectures, Krugman quipped that “if someone could invent the 21-st century moral equivalent of the railroad, or actually even the moral equivalent of IT in the ’90s, that would help a lot.” I agree–that would help a lot. But waiting around for this to happen seems risky when the alternative is a decade of stagnation.
If, on the other hand, the government were to place some massive bets on R&D, we might substantially increase our chances of stumbling onto a major technological breakthrough–or at least accelerate the process.
We have millions of companies and individuals across the country and around the world, but Mr. Scheiber and his fellow central planners apparently believe the best way to enhance the odds of innovation is to employ fewer minds in the pursuit of it. I’m not sure which is more disconcerting; the utter lack of logic in that thought process or the stunning lack of faith in the abilities of the American people. How does this work? Is there something in the DC water supply that endows politicians with a foresight not available to the rest of us? Do dollars attain some kind of magical quality that ensures success when they are passed out by government agencies? President Obama obviously understands the power of the network; he used his own grass roots network very effectively to get elected. What is the value of a network? To put it in the language of mathematics; as the number of nodes in the network increases arithmetically, the value of the network increases exponentially. We have a network of millions; all the government needs to do is make sure the network continues to function and remains accessible. Economic policy should focus on accelerating the accumulation of new pools of capital so it is available to fund the good ideas that emerge naturally. What seems more likely to be successful? Allowing politicians to make a few large bets or encouraging millions to make the investments of their choice?
To direct investment from Washington DC is to repeat our most recent mistakes. For years, government policy has explicity encouraged and favored real estate investment over other types of investments. Combined with a reckless Federal Reserve policy, this government investment wisdom created one of the most destructive allocations of capital in history. Further evidence of the wisdom of government directed investment can be found in ethanol policy. How many billions of dollars did it take for us to discover that ethanol is innefficient, destructive of the environment and raises the cost of tortillas? Ethanol policy, like so many other government programs, also seems impervious to the widespread acknowledgement of its failures; it continues to be policy in spite of benefitting no one except pandering politicians and large agribusinesses.
Regarding the accumulation of capital, the recent increase in the personal savings rate is welcome news. Unfortunately, government policy continues to distort investment. FHA and Ginnie Mae have replaced Fannie Mae and Freddie Mac in funding low downpayment mortgages and the $8000 tax credit for first time home buyers is again directing investment to the real estate market. The tax credit is obviously effective at stimulating investment; first time home buyers using the credit are almost half the recent purchases. Why not apply the policy to the economy as a whole? Where is the logic in continuing to pour subsidies on a sector already hopelessly distorted by subsidies? Why are we subsidizing the auto companies through the cash for clunkers program? Haven’t they destroyed enough capital? Why do we continue to subsidize a financial industry that has just spent the last two years proving they aren’t worthy of our investment? Aren’t there other industries more deserving of our attention? Absent government involvement, would a prudent investment manager choose those industries over all the others available for investment?
Federal Reserve policy is also distorting investment patterns. Their purchases of Treasuries, Agency debt and mortgages is designed to keep interest rates low and encourage investment in the real estate market. Isn’t that the same policy that got us in this mess? The expansion of their balance sheet also has implications for future inflation that will just further distort investment. Higher inflation (or a lower value for the dollar which is the same thing) pushes investment toward real assets such as commodities and property as investors try to protect their purchasing power. Foreign investors will also be more reluctant to invest in dollar based assets. Why invest in a country that continually debases it’s currency? Doesn’t it seem more logical to invest in countries where the currency is rising?
I do believe the immediate recovery will be substantial, but as I stated in the economic outlook, unless policy changes I cannot say the same about the long term. What happens when the housing tax credits expire? What happens when cash for clunkers is exhausted again? What happens when the restocking is complete? What happens when the Fed completes their purchases of Treasuries, Agencies and mortgages? Is there a long term plan or just a plan to get to the mid term elections?
Weekly Economic and Market Review
The economic data this week continued to paint a mixed picture that is common in the early stages of a recovery. The trade deficit rose slightly due to higher oil prices. Both exports and imports were higher but imports rose faster. The trade deficit can’t be reduced by devaluing the dollar when your biggest import is oil. Inventories fell again but the inventory to sales ratio is still too high overall to expect any significant increases in production although autos are an exception. Retail sales fell as the gain in autos was offset by decreases elsewhere. Bastiat must be smiling. Jobless claims rose slightly. CPI was flat in July, but the three month annualized change is now +3.4%. Unless oil prices fall soon, year over year numbers will turn positive in the fall. Inflation seems likely to emerge as a problem for the Fed by the end of the year. In the best news of the week, industrial production rose in July for the first time in 9 months. In past recessions, production has turned higher right at the end of the recession.
US stocks fell slightly this week with the S&P 500 off 0.63%. Foreign markets mostly performed better but China’s market continued its correction, falling over 4% on the week. I am becoming increasingly uncomfortable with my bullish stance on US stocks. Market sentiment continues to turn more bullish as the AAII poll of individual investors again recorded the bulls at over 50%. Short interest has fallen pretty dramatically and insiders continue to be aggressive sellers. The long awaited correction may be at hand and with investors still on edge (the VIX is still over 25) it could come quickly and be significant. Time to take some chips off the table.
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The dollar resumed its downtrend, but if the stock market corrects a countertrend rally seems likely
Stocks have flatlined the last couple of weeks. A correction seems imminent. First support at 975 and better support at 950.
China has corrected over the last two weeks and there may be more to go, but I’m still bullish long term
Australia was up on the week and remains one of my favorite markets