Economic Policy Reset
You may recall early in the Obama administration Secretary of State, Hillary Clinton, offering a "reset" button to Russian leaders regarding U.S. diplomatic efforts. I would like to ask the administration, are you ready to offer the American people a reset on your economic policies? I understand our economy is complex, I was just hoping for policy that was more transformational from the president. Instead, he and his advisors implemented the same policies that got us into this mess.
Most of the economic challenges faced by global economies relate to one simple fact, much of the world is downing in debt.
In the U.S., fiscal and monetary policy makers have chosen to address our current economic challenges with standard issue tools that work well during an expansion but not so well during a credit contraction. This has led to a poorly designed set of policy actions that have failed to stimulate the economic growth needed to sustain the recovery. We see this firsthand in the high unemployment rate and weak housing recovery.
One of the tools used by The Fed has been a low interest rate policy. I find it ironic that one of the cornerstone policies in this recovery has been a giveaway to the big banks, one of the key players in the credit crash of 2008. Not only did they get away with alleged fraudulent activity that led up to the crisis, they made unthinkable sums of money doing it. Then our government rewards them with a free money policy.
Current dollar policy has caused the dollar to decline in value, down around 35% since 2001, which combined with other factors, has aggravated commodity prices. This has caused developing countries to struggle with rising food and energy costs which in turn are hampering their economic recoveries. Perhaps it has even helped spark some of the unrest in the middle-east. Free and democratic countries are welcome developments, but we can't be sure what will result from the new governments being formed, especially in terms of oil prices.
The U.S policy I am focused on at present involves reviewing activities at the Federal Reserve, Treasury Department and Primary Dealer Banks. I believe this is going to provide our best view of near term economic and market outcomes. There has not been a clear signal that our economy is about to weaken significantly, but there is little evidence our government has been able to stimulate meaningful growth and current monetary programs (QE2) will be coming to an end soon. With little appetite for increased spending, it appears D.C. is going to need to formulate a new plan.
The most recent example of current U.S. policy is the payroll tax cut. It is still early but data may be starting to indicate that federal withholding taxes are declining. Historically a payroll tax has been simulative because individuals spend the small additional income they receive each pay period, increasing demand for goods and services, which increases withholding taxes as workers clock more hours and new employees are added to payrolls. As of February 16th, month to date taxes were down 1.4% compared to a year earlier. Total tax collections were down 11%. Some tax collections, especially corporate, can vary significantly due to changes in filing patterns. It is too early to draw concrete conclusions, but in the era of deleveraging it appears the pro-growth policies of the past are not delivering like they use to. Just like the Fed can't force banks to lend (but congress can to a certain extent through policies like the Community Reinvestment Act), the government can't force consumers to spend.
In another development, the amount injected into the banking system via QE2 peaked on February 2nd at $186.5 billion. At the same time total assets in non-fixed income trading accounts (where they do their millisecond trading) of large domestic and foreign domiciled U.S. banks fell. This may be a sign banks are becoming risk adverse which would be negative for stocks and commodities.
Bank lending peaked in July 2010, and loans outstanding have now declined by $26 billion since QE2 started. Banks continue to hold on to liquidity injections. If QE2 money does not find its way into the economy via borrowing, the multiplier effect cannot do its work. Loan demand is down and borrowers on the margin are not getting funded. Apparently The Fed forgot that many of the borrowers in the last credit bubble should not have been approved but somehow they expected a new crop of borrowers to step up to the window. That is not happening.
The U.S. economic condition is only complicated by state and local government budget and debt problems. The demonstrations unfolding in Wisconsin may be just the beginning. Estimates vary but government expenditures at all levels have grown to represent a significant amount of our economy, as high as 25% of GDP. Reduced government spending is bound to have a negative economic drag but a necessary development. Back room deals have delivered promises we cannot afford.
I have always felt we needed to deflate further to get through this mess. That means the too big to fail banks need to fail. If they are insolvent when their assets are market to market, then they need to be taken over and wound down. Instead, we have made them larger. To remove the systemic risk in our financial system, we should reinstate the Glass-Steagal Act, which restricted commercial banks ability to engage in underwriting and other broker-dealer activities. The Dodd-Frank reform did little to change things. It added some rules and government agencies, but we already know regulators can't regulate with the rules they have. If they have been terribly ineffective at their jobs, why should we think new rules and agencies will change anything?
These developments, among others, have caused me to lock down profits in our strategies, move to a defensive posture, and prepare for our next move. There is strength in the current rally and current policies could support higher asset prices into the summer so I may be adding some equity exposure soon. Or I may find opportunities to add value in other areas. The important thing is we are staying nimble with our strategies. We will get through this environment and I am confident better days are ahead. It just may take a little longer than any of us expected. I have great faith in the entrepreneurial spirit and innovative capacity of this great country. But to move forward we need to demand our policy makers provide us an honest assessment of our situation and demand lobbyist reform. Once we know our policy makers have a true assessment of the challenge ahead and a platform where self-interest has been removed, then we can implement policies that are good for the whole of the country and a real recovery can take root.