More on Obamanomics

* Yesterday I left off with Allan Meltzer’s piece which suggested that something dramatic needs to be done to solve the current economic conundrum we find ourselves in. My general thesis is that we are in the middle of a deflationary storm which is threatening to sweep the economy into a full, blown out depression. The longer the federal government continues to spend money to maintain the status quo in state and local budgets and various aid programs, the further this country will sink into debt, without solving the structural problems behind the abysmal employment situation. Clearly something needs to be done, but in my opinion, continuing the government deficits to plug budget gaps will not do the trick. This is exactly what Japan has done for the past 20 years, and now they have a deficit which is two times its GDP. The difference between Japan and the US is that Japan completely funds its deficit with domestic money, while $4 trillion of the US deficit is financed from overseas investors. And that is what will ultimately lead to future problems. For the time being, given the malaise in Europe, lots of money has been flowing into the dollar, and US debt. To quote George Dowd in a previous interview on CNBC: “The US dollar happens to be the best looking horse in the glue factory”.


For my part, I do not have any great designs on whether or not the current predicament is solvable without the deflationary forces sweeping away all of the government’s valiant attempts to get the economy growing again. What I do believe is that the government had better stop spending money on programs which the economy cannot support. The comparison to Japan is real, because that is exactly what Japan has done for the last 20 years, and Japan is still suffering under the weight of deflation. What the US needs to do is spend money as a company would spend on investments. What gets spent needs to have a return, not just maintain the spending status quo. But lacking that sort of response by the US government, we will eventually push ourselves to a tipping point at which time investors will flee our debt markets. Clearly, this is not happening today, so on average, no one is really worrying about such an event. 


For the time being, aggressive Fed policies to raise the level of money and credit in the economy are helping support the dollar debt and asset markets. The most notable example of this has been their purchase of $1.7 trillion of US debt securities last year, with a total duration of $7 trillion. Anecdotally, a reader who is involved in the commercial real estate (CRE) markets, reports that trophy properties are now selling a levels comparable with 2007, up from down 25% last year, while an average property is down 25%, which is up from down 50% a year ago. The prevalence of zero percent interest rates on short term money, is attributed to be the major contributor to this resurgence, along with a generally improving outlook.


Is the improvement in CRE a head-fake prior to the next leg down? While I am bearish, I am also a bit concerned that many folks have jumped on the bearish band-wagon, so from that perspective, I am on alert that the deflation trade might be too crowded at this point in time.


* In response to yesterday’s piece by Allan Meltzer, a reader writes in with the following:


“Dear Rick, The gentleman (Meltzer) who uses the early 1980 recession as an example of how to recover from this downturn is making a common mistake of trying to simplify the problem to arrive at a predetermined solution. In other words, he is making the facts fit his goals instead of letting the facts lead him to a solution. The 1980 recession was caused by a massive dose of inflation which was cured by the Fed ratcheting interest rates up to the point that it halted and reset the economy. Pent up demand (caused by the effects of the rate hikes and economic slow-down) for all things as well as the fact that much of the baby boomers came into their main consumer ages led to the recovery. Reaganomics had little to do with it. In any event that recession did not include this type of overwhelming deflationary cycle where very significant amounts of the dollars in the world evaporated. The two problems are different and must be looked at differently. 


Part of the two trillion dollars you see on the sidelines is not the result of investors taking their ball home and choosing not to play. Banks have allowed their balance sheets to grow substantially. They know, now that they are not working under mark to market rules, their true collateral and hence reserves are much less than they are reporting. They are hording this cash because they are not nearly as healthy as they are reporting. They are not playing because they have nothing to play with. 


What would cutting business taxes and individual taxes accomplish at this time? Would the money go to spending which might create more jobs and growth, or would it more likely be used to pay down debt? So far tax cuts have been used to pay down debt.  I would argue that the typical business and individual would use a tax cut to strengthen their weakened balance sheets by paying down debt. By making a broad tax cut you are simply trading private debt for public debt. It is not going to create spending and is not going to create jobs. There is no appetite for risk taking in this type of deflationary atmosphere and there will not be until some new spending program gets the economy growing once again and brings the consumer back to the ball game. The dollar is too strong and we should take advantage of that to build the infrastructure we have allowed to decay over the last 100 years. The onus might be a weakened dollar which provides enticement to export from the U.S. once again. 


Converting private corporate and individual debt to public debt (a tax cut) is no better than creating public debt outright. It is worse if the new public debt is properly targeted to new projects of lasting value.” (end of readers comment)


This reader makes a couple of points which I would like to emphasize:


1>  Banks and insurance companies are sitting on lots of loan losses which they are not recognizing. Is this the reason why corporate cash levels are at all time highs? It’s a good point which I hope to investigate in future blogs.


2> If tax cuts will not help the economy, then should we be raising taxes to help bridge the gap between spending and revenues? A tax increase for the well to do, is coming, but will a VAT (value added tax) get proposed? Some would argue that a VAT would encourage investment over consumption, so on that basis, it might have some beneficial side effect, if it wasn’t for the fact that a VAT tax would hit all parts of the economy, and on all levels of income. My guess is that we will see nothing until after the elections.


3>  The 1980s is not a comparable time period to compare to today’s environment. I agree with that comment. In fact, if you refer to the works of Howe and Strauss, which I have often quoted, the 1930s are a better comparison. In short, this does not give me a warm and fuzzy feeling. It ultimately took a global war, with lots of lost fortunes, until the US emerged from this crisis phase. With this as a back-drop, I remain concerned that we could be heading to an escalation of the wars we are currently engaged in.


But the point that Meltzer makes, which I will reiterate, is that industry and corporate America needs to know what the playing field will look like in the future, so they can make smart business decisions. With the exact costs of health care and a carbon emissions tax up in the air, and uncertainty about the formulating a plan to reduce the US’s budget deficits, which will likely include new taxes, it is unlikely that corporate America will spend the hoards of cash they have stock-piled. My take-away is that the sooner the Obama administration gets on with real efforts to address the deficit, the sooner the economy will likely respond to a known playing field. With Obama’s deficit reduction committee not scheduled to report back until after the November elections, it is likely that the general malaise, and lack of mojo, should persist through the fall. Conveniently, this fits with the bearish stock market seasonals which run through October, despite the plethora of bears who are now circling the wagons.