September 14, 2011

Proper Policy and Economic Growth

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 10:52 PM by Robert Barone

As indicated in a previous blog post entitled “Why the U.S. Can’t Grow Its Way Out Of Its Budget Jam”, http://www.forbes.com/sites/greatspeculations/2011/09/06/why-the-u-s-cant-grow-its-way-out-of-its-budget-jam/2/ , if GDP growth is as slow as PIMCO’s “new normal” would indicate, then even if the Congress could muster the ‘political courage’ to fix the budget and entitlement issues, lack of growth will trump that effort.  The first issue is that we have a government that doesn’t understand why the economy isn’t growing, and, in fact, promotes policies that inhibit such growth, such as overregulation, interference, and the promotion of more debt as the answer.  The second issue is the structural inability of the economy to grow.  The two issues are closely related.

Policy Gimmicks

Since the Great Recession began (and some believe that it still has not ended) policy makers have used various gimmicks to try to kick start the economic engine.  On the fiscal side, we have seen programs like cash for clunkers or first time homebuyer tax credits that simply have pulled demand forward rather than stimulating new demand.  On the monetary side, Bernanke and the Fed, deathly afraid of “deflation” (we can’t understand why falling prices are worse than rising prices – falling prices make incomes go further, rising prices do the opposite!) have managed, through their policies, to significantly raise the dollar prices of food, energy and related commodities.  Meanwhile, those policies have not halted the significant deflation in housing and its surrounding industries.  From a consumer point of view, the things that they own continue to fall in value, while the things that they need to purchase have risen in cost.  How are they better off after QE1, QE2, and most likely, QE3?

The Key To Growth

One critical issue centers around the level of debt of the American consumer, especially relative to income.  Most of America’s larger corporations have already lowered this ratio and have lots of cash to spend.  Thus, we have witnessed the relatively good performance of the share prices for most of these non-financial entities since 2009.  But the U.S. consumer, without job opportunities, is in a different class.  Demand cannot grow without a healthy consumer.  And, without rising demand, the economy simply stagnates. Some who say they have studied the Great Depression and some commentators today, believe that World War II was the primary factor that pulled America out of depression (see Paul Krugman, “Oh! What a Lovely War!”, New York Times, August 15, 2011).  But think about this: after World War II ended, why would there be an increase in demand?  What had changed? (Yes, there was demand from war torn Europe and Japan.  But I don’t think rational folks would advocate that we destroy assets, our own or those owned by foreigners, so that we can rebuild them.  Don’t forget, when an asset is destroyed, a loss to someone has occurred. If insured, the owners of the insurance company pay; if not, the owners of the property pay.)

Why the Great Depression Ended

The build-up of debt over the 16 years ended in 2008 is similar to the same phenomenon of that occurred in the 1920s.  During World War II, there was rationing and forced saving.  People of that generation often talked about the fact that they couldn’t buy a car, or tires, and that gasoline was rationed. Rationing forced the populace to save and pay down their debt, so that, by the end of the War, the consumers’ debt/income ratios were once again healthy and there was the capacity to increase consumption.  Of course, the rationing caused a huge build-up of pent-up demand.

Table 1 shows consumer debt outstanding for selected years prior to and in the aftermath of the Great Depression.  Table 2 shows a similar growth path in consumer debt and debt as a percentage of GDP from 1992 to 2008.

Table 1 – Consumer Debt, Its Growth Rate, and Its Relationship to GDP

The Great Depression

Year

Consumer Debt

(Billions $)

Periodic

CAGR

Consumer Debt/

GDP

1920

2.964

3.4%

1929

7.116

+10.2%

6.9%

1933

3.885

-14.0%

6.9%

1941

9.172

+11.3%

7.2%

1944

5.500

-15.7%

2.5%

Table 2 – Consumer Debt, Its Growth Rate, and Its Relationship to GDP

The Great Recession

Year

Consumer Debt

(Billions $)

Periodic

CAGR

Consumer Debt/

GDP

1992

799.8

12.6%

2008

2563.7

+7.6%

17.9%

2010

2411.6

-3.0%

16.6%

Note the rapid rise in consumer debt in the 1920s followed by rapid contraction during the initial years of the Great Depression.  Then, debt grew rapidly again until 1941, at which point it contracted rapidly during the war effort due to rationing and the unavailability of consumer goods.  Note that the ratio of consumer debt/GDP was lower in 1944 than it was in 1920.  What had changed during the War was a significant reduction in the indebtedness of the American consumer.

No such rapid consumer debt reductions are evident in the Great Recession, at least not through 2010.  There has been some reduction as shown in Table 2.  But, we believe this is due more to mortgage defaults than to actual consumer debt repayments.  Note the rapid declines in debt in both the 1929-33 and 1941-44 periods.  Reductions of that magnitude are not present in the current economic climate, and some government policies (cash for clunkers, and foreclosure moratoria) discourage debt reduction.  Given what was necessary in the debt area for the consumer to pull the U.S. out of the Great Depression, it appears that we have quite a long way to go in the current environment.

What Policy Can Accomplish

The key to economic growth is rising demand.  This doesn’t happen when existing roads are repaved or unemployment benefits are extended because demand falls back as soon as the road project is finished or the unemployment benefits run out. And, if the funds came from Washington, all we’ve done is raise the level of debt for the sake of current consumption.  If fiscal policy is to be used to stimulate demand, there are several directions it should take.  Today, America suffers from high and rising real costs of energy at a time when real incomes have been stagnant and debt to income ratios have strangled consumption growth.  A fiscal policy that promotes the development of cheap energy now would 1) create jobs, 2) put cash back to America’s consumers via lower gasoline and energy bills, 3) improve America’s balance of trade, and 4) provide less cash to middle-east oil nations and impede their ability to finance terrorism.  We do believe in alternative energy sources when they make sense.  But, the U.S. has an abundance of oil, natural gas, coal, and nuclear technology know how.  Those are the areas that will immediately help the real economy, and, perhaps, reduce the need to send our young people to fight on foreign soil.  Ask yourself why the unemployment rate in North Dakota is 3.3%.  The answer: oil and agriculture.  From 1976 to 2010, Canada’s unemployment rate averaged 8.5%.  In July, it stood at 7.2%.  The reason: Canada has become a major exporter of oil (to the U.S.!) and natural resources.  Consumer confidence there is much higher than similar measures in the U.S.  And its deficit/GDP is half.

Policy Interference

The second way fiscal policy can positively impact U.S. economic growth is to reduce government interference in business.  This isn’t only a federal issue, as state and local governments do their part to harass small business.  But, let’s face facts: the banking system is nearly nationalized with “Too Big To Fail” (now codified in Dodd-Frank as SIFIs -Systemically Important Financial Institutions) allowing the giants to take excessive risk while government regulators strangle the entrepreneurial spirit of most community banks.  For sure, the government is the only real player in the mortgage market through the bankrupt FNMA and FHLMC entities which control 90% of the market (while losing billions of dollars every month).  Additional regulation via Dodd-Frank and the encouragement of and participation in lawsuits against those private companies still in the mortgage business has already, or will soon, reduce private sector participation in mortgages just when the economy needs a recovering housing sector.

Housing Leads

Housing has always led the economy into recession.  But, it has always led it out.  Not this time.  The mortgage pendulum has swung from one extreme (breathing qualified one for a 125% LTV mortgage) to the other (huge down payments, high income/payment ratios, and a near universal requirement to qualify for sale to FNMA or FHLMC, which, as of October 1 will have lower maximum loan acceptance levels).  The promotion of a universal mortgage refinance idea being bandied around Washington may stimulate some demand as consumers who get lower rates and payments may have more monthly disposable income, but what has been forgotten, or conveniently not discussed, is the loss of that cash flow to the investors who own the mortgage instruments.  In other words, this is just an income redistribution scheme which may not produce many jobs because the owners of the now lower yielding mortgage paper are more than likely the job creating entrepreneurs.  The real issue here is the continued downward spiral of home prices.  The policies followed in Washington have simply prolonged the pain.

Tax Code Gibberish

The personal income of one of the authors is derived from wages and consulting income.  Yet, his tax return is more than an inch thick, costs $1,500 to produce, and is a maze of incomprehensible gibberish.  This is symptomatic of the unnecessary and burdensome set of rules that the federal government has imposed on its citizenry.  Because Dodd-Frank and the Obamacare legislation have yet to be fully implemented, we can expect higher costs and more job killing rules and regulations.

The Private Sector Creates jobs

The real creation of jobs occurs in the private sector, by the private sector, not in government or by government.  Policy can encourage or discourage such job creation.  More than any other era in our lifetimes, government policy has discouraged private sector job creation.  Today, like in the 1930s, consumers need to reduce their debt burdens.  Policy cannot do this directly.  The gimmicks used thus far have pulled demand forward, have taken from one set of citizens and given to another, have increased the debt which will reduce future consumption, or have inflated food and energy prices via money creation.

However, proper policies can encourage economic growth.  Unfortunately, there is no “instant” cure.  Equally unfortunate, a Presidential election is but 14 months away, and that “instant” cure is what is being sought.  What America needs are policies that encourage and promote cheap energy, reduce government regulation, a complete reformation of the tax code, and the encouragement of debt reduction all while addressing spending and entitlements.  The track record in Washington to accomplish this is nil.  It’s no wonder that the price of gold continues its ever upward path.

Robert Barone, Ph.D.

Matt Marcewicz

September 12, 2011

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

 

September 13, 2011

The “New Normal” May Trump Political Courage

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 10:23 PM by Robert Barone

There are two huge issues facing the American economy today.  The first is a government that doesn’t understand why the economy isn’t growing, and, in fact, promotes policies that inhibit such growth, such as overregulation, interference, and the deployment of more debt as the answer.  The second issue is that inability to grow.  The two issues are closely related.

Despite Promises, Federal Spending is Out of Control

In looking at the trends in the Federal budgets, especially over the last decade, one word comes to mind – gold!  Despite all of the hand wringing and promises about spending cuts, it just doesn’t happen.  According to the Wall Street Journal (August 24), CBO projects that total Federal spending for fiscal year 2011 (which ends at the end of this month), will be $141 billion higher than 2010, and even higher than that of 2009 which was supposed to be the temporary spending peak.  The growth in Federal spending just for 2011 will be 4% higher than that of 2010.  Furthermore, exactly one month after the brouhaha over the debt ceiling in which a “temporary” debt ceiling cap some $400 billion higher was enacted, we find that the total debt has again exceeded the ceiling (Zerohedge, Déjà vu All Over Again…, 9/2/11).  Growth in Federal spending over the 50 years ending in 2010 has been at a compounded annual rate (CAGR) of 6.5%, while the growth rate of GDP during that same span was 5.7%.  Everyone knows that continual growth in Federal spending that exceeds the growth in the economy is simply unsustainable.  This, of course, has all come to a head because in the last 10 years, Federal spending grew at a CAGR of 7.1% compared to a CAGR of GDP of 3.9%.

Growth Rate of Entitlements

It isn’t a secret that the biggest issue in Federal spending is the so-called “entitlement” issue (although some object to the characterization of some aspects of “entitlements”, having contributed to Social Security and Medicare for all of their working lives).  Defining “entitlements” as “transfer payments” from the government to individuals, and going back to 1960, we find that such “transfers” were 26% of Federal tax collections.  Since then, those “transfers” have grown at a CAGR of 7.8%, while tax receipts and the economy have grown substantially more slowly, 5.6% and 5.7% respectively.  Thus, in 2010, “entitlement” payments were over 92% of Federal tax receipts.  That percentage was 64% as late as 2007, and has grown because of the demographics of Social Security and Medicare, but more so because of a massive jump in “Income Security” payments (defined by USDebtClock.org as Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, and Making Work Pay).

Current Trends Mean Exploding Debt Ratios

Table 1 extrapolates current budget, tax and demographic trends using the underlying assumptions shown, most of which are drawn from CBO estimates for 2015 and then extrapolated further.

Table 1: GDP Growth = 3% CAGR

Entitlements/

GDP

Entitlements/

Fed Budget

Entitlements/

Tax Receipts

Deficit/GDP

Debt/GDP

2011

14.4%

60.7%

95.3%

8.6%

97.9%

2015

14.1%

54.4%

78.3%

7.9%

118.2%

2025

15.9%

61.5%

88.6%

7.9%

157.4%

2035

17.6%

68.1%

97.9%

7.9%

186.6%

Assumptions:
1) Social Security and Medicare expenditures per capita are from CBO 2015 estimates of approximately 1.6%.  The same CBO expenditures per capita are extrapolated to 2035.
2) CBO estimates that the 65+ age cohorts, as a percentage of total population, will increase from 21% in 2011 to 36% in 2035.
3) Population growth extrapolates the .94% CAGR for the decade ending in 2010 throughout the forecast period.
4) “Entitlements” in the model are defined as Medicare/Medicaid, Social Security, Income Security, and Federal Pensions per the definitions found at USDebtClock.org.
5) Federal Pensions are projected by CBO to grow at a CAGR of 2.5% through 2015.  The table above extrapolates that CAGR throughout the forecast period.
6) Taxes/GDP rise from 15.1% in 2011 to 18.0% (near the 50 year mean of 18.3%) and remain at 18% for the forecast period.
7) The Federal budget grows at a 5.3% CAGR (per CBO) to 2015 after which its level is fixed as a percentage of GDP at that 2015 level.
8) The “Income Security” portion of “entitlements” shrink under CBO assumptions as “Unemployment Compensation” is assumed to fall.  After 2015, the Table assumes this category to grow at a CAGR of 1%.
9) Defense budget growth is 1.7% annually.

Because CBO assumed that the spike in “Income Security” that has occurred since ’07 would largely dissipate by 2015, the “entitlement” ratios shown in Table 1 all shrink until 2015.  However, despite the low (optimistic) 1.6% growth in per capital Social Security and Medicare expenditures of CBO, the “entitlement” ratios rise rapidly after 2015.  Worse, even under this extremely rosy set of assumptions, including the return of the tax take to 18% of GDP by 2015, the deficit as a percentage of GDP remains unsustainable, and the Debt/GDP ratio rises inexorably.

What Political Courage Means

Given this base case scenario, what do the Washington politicians have to do to fix the situation.  Table 2 uses the same model as Table 1 with the following changes:

  • The Social Security and Medicare growth rates are reduced from 1.6% to 1.0% over the forecast horizon;
  • The CAGR of the “Income Security” category is reduced from 1.0% after 2015 to 0.5%;
  • The CAGR of Defense spending is reduced from 1.7% to 1.0%;
  • The CAGR of Federal Pensions is reduced from 2.5% to 0.5%;
  • Total Federal spending only grows at a CAGR of 0.5% over the forecast horizon;
  • The tax take as a percent of GDP rises to 19%;
  • GDP growth remains at a CAGR of 3% over the forecast horizon.

Table 2: GDP Growth = 3% CAGR

Entitlements/

GDP

Entitlements/

Fed Budget

Entitlements/

Tax Receipts

Deficit/GDP

Debt/GDP

2011

14.4%

60.7%

95.3%

8.6%

97.9%

2015

13.7%

63.6%

72.0%

2.5%

105.1%

2025

14.5%

67.3%

76.2%

2.5%

100.4%

2035

15.0%

69.9%

79.2%

2.5%

96.8%

As is evident from the table, if the Washington politicians can find the courage to make hard decisions around the growth rate of “entitlements” and put itself on a no growth (0.5% – likely less than the rate of inflation) budget (still giving Washington 21.5% of America’s GDP, an historically high number), all of the critical ratios either slow their climb or reverse course.  Yet, even under such a politically unlikely scenario, many would say that even the outcome shown in Table 2 is not acceptable.

The “New Normal” May Trump Political Courage

Critical to this analysis is the growth rate of the GDP.  Clearly, a faster rate than the 3% shown above would have better results.  But a faster growth of GDP implies higher rates of inflation, and it is unlikely that the spending assumptions for Table 2 could be accomplished in an environment with significant inflation.  In real terms, the CAGR of GDP has been 3.1% over the 50 year period ended in 2010, but only 1.6% since 2000.  Recently, PIMCO’s Bill Gross stated that he believes that the U.S. has structurally changed such that nominal GDP growth will average between 0% and 2%.  Literally, this is more of the same anemic growth that we have seen in the U.S. since ’07.

Table 3 embodies the same assumptions as Table 2 except the CAGR of the GDP is reduced to 1%, per PIMCO’s view.

Table 3: GDP Growth = 1% CAGR

Entitlements/

GDP

Entitlements/

Fed Budget

Entitlements/

Tax Receipts

Deficit/GDP

Debt/GDP

2011

14.7%

60.7%

95.3%

8.8%

99.9%

2015

15.1%

63.6%

79.4%

4.7%

121.0%

2025

19.4%

81.9%

102.3%

4.7%

154.9%

2035

24.6%

103.4%

129.2%

4.7%

185.5%

Thus, even if the Washington politicians can summon the courage to do what they have never been able to accomplish in the past and slow the growth of “entitlements” and its own profligate spending, the debt and deficit levels remain unacceptable if the economy grows in nominal terms at PIMCO’s “new normal.”  This threatens the U.S.’s status in the world, and certainly the dollar’s role as the world’s reserve currency.

Conclusion

It is imperative that U.S. economic growth return to its historic path of 3%.  And even then, the economic results depend on the level of political courage from the Washington pols.  To accomplish a return to economic health, fiscal and monetary policies must first return to balance.  Fiscal policy must refrain from the gimmicks used in the recent past, like cash for clunkers or homeowner tax credits, which have simply pulled demand forward, and monetary policy must stop monetizing the deficit.  Rather, the encouragement of investment through a rational and sane tax policy (e.g. flat tax or national sales tax), a reduction in government interference in the private sector (e.g., Dodd-Frank, the EPA, and Obamacare), and the use of policy to encourage the development of the nation’s natural resources (e.g., cheap energy) would be a good start to revive the nation’s economy.  But, as an election year approaches, doesn’t the word “gold” ring true?

Robert Barone, Ph.D.

Matt Marcewicz

September 6, 2011

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778