Tuesday, January 29, 2013 - Stimulus Truths and Tweaks

Stimulus Truths and Tweaks

by Sinclair Noe

DOW + 72 = 13,954
SPX + 7 = 1507
NAS – 0.6 = 3153
10 YR YLD +.03 = 2.00%
OIL + .88 = 97.32
GOLD + 9.40 = 1664.90
SILV + .54 = 31.48

We have a gaggle of economic reports this week and we'll try to keep up.

The Conference Board reported that its gauge of consumer confidence dropped to 58.6 in January, the lowest level since November 2011. Consumers are more pessimistic about the economic outlook and, in particular, their financial situation. The hike in the payroll tax is taking the brunt of the blame for the less-than-rosy outlook. Disposable income is actually declining. It's hard to be happy when your purse shrinks.

The sales price on existing homes dropped in November according to the S&P/Case-Shiller home-price index, down a non-seasonally adjusted 0.1% decrease in November following a 0.2% decline in October. After seasonal adjustments, the 20-city home-price index rose 0.6% in November. Despite the recent decline, prices were 5.5% higher than during the same period in the prior year, for the strongest year-over-year growth since August 2006.

Tomorrow, we'll get a glimpse of 4^th Quarter GDP. The economy likely grew at a 1% pace, which is very weak.

Also tomorrow, The Federal Reserve wraps up its first FOMC meeting for the new year. They will likely continue with a fairly aggressive approach to stimulate the economy. In December, the Fed committed to adding $45 billion of monthly Treasury purchases to the existing QE3 program to buy $40 billion in mortgage debt a month. The purchase program has no end date. Last week the Bank of Japan announced a stimulus plan that includes US Treasury purchases. The Fed also adopted a new policy that targeted short-term interest rates to the outlook for unemployment, saying rates would stay low until the jobless rate falls below 6.5% as long as inflation stays tame.

The official unemployment rate is 7.8%, down from the 10% rate recorded in late 2009. Employment in the private sector has risen by more than 5 million over the past three years but it represents a sluggish recovery. Just over 12 million people are classified as unemployed (meaning they are actively looking for work), with an additional 6.5 million who aren’t looking but say they want a job; many of those people are long-term unemployed. Long-term unemployment imposes additional costs in the form of higher social spending and reduced economic output.

The unemployment rate in Europe is 10.7%, with 26 million out of work. Last week, the International Labor Organization reported nearly 200 million people worldwide are unemployed. Compared to the rest of the world, the US looks pretty good.

The British economy is flirting with a triple dip recession. The UK's gross domestic product fell 0.3 percent in the fourth quarter. One of the major problems has been a strong austerity program which cut investment spending. To be clear and fair, spending in the UK has changed composition rather than shrunk. Spending on social maintenance has gone up but investment spending has tanked. And of course I mean government investment spending, not private. This would indicate that removing government investment spending hurts the economy, not because it displaces private investment, but because it supplements and enhances private investment.

It’s not as if observers hadn’t warned about the effect of contractionary fiscal policy. In the summer of 2012, the IMF issued recommendations, saying deeper budget-neutral reallocations could support recovery. Such reallocations within the current overall fiscal stance could include greater investment spending funded by property tax reform or spending cuts on items with low multipliers. Automatic stabilizers should continue to operate freely. It will also be important to shield the poorest from the impact of consolidation.

The IMF said, scaling back fiscal tightening plans should be the main policy lever if growth does not build momentum by early-2013 even after further monetary stimulus and strong credit easing measures. Temporary easing measures in such a scenario should focus on infrastructure spending and targeted tax cuts, as they may be more credibly temporary.

It's not as if we haven't seen contractionary policies fail in the past. Andrew Mellon, as Secretary of the Treasury, advised Herbert Hoover: "Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”

So, the evidence continues to accumulate to overwhelming levels in favor of a front-loaded fiscal and monetary expansion, and the evidence supports the view that growth cannot be induced by contractionary policies in the current economic environment. And while tax increases could slow growth, there is no indication tax cuts in this environment are enough to encourage hiring.

One idea is to push US banks to lend more. The banks now have about $1.6 trillion in reserves parked at the Federal Reserve, not doing anything except making the banks feel safer. The Fed could put a cap on bank reserves, forcing the banks to do something with about $1 trillion in excess reserves, like lending it out to small businesses that are now being strangled by tight credit. It might help move money, but who will take a loan without a need. We have a demand problem, not a supply-side problem.

Any spending now, which would increase the deficit, must decrease the debt burden in the longer-term. In other words, we need investments, not just throwing money around. Infrastructure spending puts people to work n projects that promote economic growth. Those newly employed people spend their paychecks, circulating money, increasing the velocity of money in an otherwise stagnant environment. Economic growth is the optimal way to reduce the long-term debt burden. The money spent on infrastructure improves productivity and improves efficiency and saves us money over time.

We have neglected routine maintenance of our infrastructure for too long. We all know that it is cheaper to change the oil in our car's engine than it is to replace the engine. It is cheaper to fix a leak in the roof of the house than to interior of the house get soaked in a downpour. Pay now or pay more later.

But what about the cost versus benefit for new infrastructure? On the cost side, money is cheaper now than ever. Interest rates are near zero. High unemployment has reduced wage costs. On the benefits side, we have sufficient technological improvements to warrant upgrades in roads, bridges, water works, the electric grid, energy, transportation, and shipping in order to remain competitive globally.

Of course, there is an alternative lesson to be learned from the British triple dip. Some believe the UK government is desperate to keep interest rates as low as possible in order to avoid a housing market collapse where most mortgages go unpaid, which would result in the collapse of all UK banking – you know, something like a repeat of 2008. Also, if interest rates rise, interest payments on private and public debt would balloon. Further, if interest rates rise, the pound would strengthen, causing exports to slow even further.

According to this train of thought, in order to keep nominal interest rates low the UK government has chosen many years of recession as their strategy, because recession keeps down imports of oil and allows nominal interest rates to be low without triggering higher inflation, which is already running fairly high because of the higher cost of imports.

If nominal interest rates go up, and the housing market debubbles causing the collapse of the UK financial systems, the UK will be in an situation similar to Ireland or Lithuania, with a very sharp, long depression, instead of a milder, longer recession.

There is yet another possible motivation for the lack of investment in the US economy. The Fed is effectively printing profits to the largest Fed member institutions in exchange for MBS the banks have accumulated with cash from earlier sales to the Fed in lieu of lending because banks' net margin is negative in real terms after charge-offs and delinquencies as a share of loans.

All of the stimulus by the Fed is designed to disguise the fact that the banks still have hundreds of billions of dollars, if not trillions, in charge-offs to clear, which is preventing banksters from growing their loan books. "Stimulus" is really "bank liquidation".

In the meantime, the US government is borrowing and spending $1 trillion a year to prevent nominal GDP from contracting and thus forestall further contraction in bank assets and corporate profits, which are now at a record to GDP, as is non-financial corporate debt to GDP. Of course, that's just a theory and it does nothing to improve the unemployment picture, but it does provide a convenient target for the Federal Reserve to aim at, and keep just out of reach; this provides a reason for the Fed to continue QE because there is no viable exit strategy.

I'm sure there are plenty of other considerations or theories which might apply, but tweaking monetary and fiscal policies at the margins is largely irrelevant, and in an environment of tweaking, it leads to speculation. What this tells us is that there is a small window of opportunity to try to grow the economy. If we don't grow it now, it will be increasingly more difficult to grow it in the future.