As the new Obama administration prepares to enact the mother of all “stimulus” packages, it seems that some still can’t get straight what caused the current worldwide recession. Hank Paulson still believes the problem was caused by Asians saving too much:
In a recent interview with the Financial Times, U.S. Treasury Secretary Hank Paulson blamed the credit crisis on global imbalances. Specifically, he repeated a storyline popularized by Alan Greenspan and Ben Bernanke: that a global savings glut (otherwise known as an imbalance) pushed interest rates down around the world and drove investors toward riskier and more leveraged investment activities.
If we live in a global economy, and I think everyone would agree that we do, don’t some of the planet’s inhabitants need to be savers? If no one saved, where would the capital come from for future growth? Is there some magic percentage of income above which savings becomes a vice rather than a virtue? If so, who should decide what that percentage should be? Hank Paulson? Ben Bernanke?
American policy makers just don’t seem to be able to come to grips with the fact that it is the US that caused this problem. It was not caused by Asians saving too much or because the Chinese held down the value of their currency. It was caused by Americans borrowing too much money and spending it on consumer goods and houses we didn’t need. For the last 30 years or so, we have been told relentlessly that consumption is the source of economic growth and we took that to heart. The Federal Reserve abetted this economic fallacy by stepping in to cut interest rates every time consumption started to flag a bit. Lower interest rates came to be understood by policymakers and the public to be a painless method for fending off recession.
Now that the party has ended, the Fed is being revealed as a one trick pony whose trick is no longer amusing. Americans have finally figured out that they can’t spend their way to prosperity or happiness. After 25 years of a declining savings rate, Americans have started to save again:
And how are these newly virtuous savers treated? They are already being blamed for potentially prolonging the recession:
BOISE, Idaho — Rick and Noreen Capp recently reduced their credit-card debt, opened a savings account and stopped taking their two children to restaurants. Jessica and Alan Muir have started buying children’s clothes at steep markdowns, splitting bulk-food purchases with other families and gathering their firewood instead of buying it for $200 a cord.
As layoffs and store closures grip Boise, these two local families hope their newfound frugality will see them through the economic downturn. But this same thriftiness, embraced by families across the U.S., is also a major reason the downturn may not soon end. Americans, fresh off a decadeslong buying spree, are finally saving more and spending less — just as the economy needs their dollars the most.
Usually, frugality is good for individuals and for the economy. Savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation’s standard of living. But in a recession, increased saving — or its flip side, decreased spending — can exacerbate the economy’s woes. It’s what economists call the “paradox of thrift.”
Frugality is not something that is good only when practiced by a small number of citizens. Savings today is the fuel for growth tomorrow. What these families - and a lot of others - are doing is shifting their time preference. Due to circumstances, they are being forced to forego consumption today in favor of consumption tomorrow. The Fed is doing everything it can, by suppressing interest rates, to counter that shift. Lower real interest rates (adjusted for inflation) are a deterrent to savings. Why would the Fed prefer consumption today over consumption tomorrow? What gives the Fed the authority to make that decision for individuals?
This focus on the short term reveals the Fed for the political entity that it has always been. Politicians who must face voters periodically have no incentive to enact policies that are in the long term interest of the nation. Theoretically, the Fed should be able to ignore these short term pressures and set monetary policy in a way that is beneficial to the long term growth of the economy. The reality is obviously different as the Fed governors must please the political masters who appoint and confirm them. The Fed has been used by politicians to avoid making the hard choices that are required for long term growth and price stability.
Thus we have the outgoing Bush administration’s serial market interventions that attempted to forestall the inevitable recession and drag John McCain across the finish line and retain the White House for the Republican party. Now that that effort has failed, the Republicans can revert to their traditional backbench status and object to the new interventions of the Obama administration. They will say all the right things now about fiscal rectitude and small government without having to worry that they will actually get what they claim to want.
The Obama administration is already trying to counter this public relations battle by co-opting the language if not the alleged policy preferences of the minority party. Monday, they started to release details of their stimulus plan which is now being touted as heavy on “tax cuts”. These “tax cuts” have little in common with what most people would characterize as tax cuts. For tax cuts to be effective, they must be permanent and they must provide incentives to work and invest. The proposal so far comes up short on all counts and manage to once again reward failure.
The main business tax cut offered will allow companies to use current losses to offset profits as far back as five years. There are even proposals to provide tax “rebates” to companies that have never turned a profit. Thus, companies that have lost money recently (namely financial institutions and construction companies) will be rewarded while those who managed their businesses profitably will be forced to support their competitors. Another “tax cut” will allow companies to accelerate the depreciation schedule for capital investments they make over the next two years. This has been tried before and had little impact on total investment. Companies will merely use the break to expense capital investments that were already planned and unavoidable. It is unlikely to convince companies to make investments they weren’t already planning at a time when they are concerned about their future revenue. While this type of temporary tax cut has little effect, making this type of accelerated depreciation permanent could have an effect over the long term. Unfortunately, that isn’t being considered.
Most of the other “tax cuts” are actually tax credits that should be classified as income subsidies. While there may be social benefits to a negative income tax and it is certainly more efficient than traditional forms of welfare, tax credits shouldn’t be confused with something that will drive future economic performance. It is just another attempt to prop up consumption at the expense of savings. Higher taxes on the most productive will be used to supplement the income of the less productive. Money is merely transferred from those with a high propensity to save to those with a high propesity to consume. Once again, we are merely trying to borrow from the future to fund consumption in the present. We may forestall a deeper recession today but only at the expense of a bleaker economic future for subsequent generations.
And those who believe that only government spending can save us from ourselves can’t even bring themselves to embrace these limited, temporary and ineffective tax cuts. Paul Krugman has already taken to the pages of the NYT to wonder aloud whether Obama is depending too much on tax reductions:
Let’s lay out the basics here. Other things equal, public investment is a much better way to provide economic stimulus than tax cuts, for two reasons. First, if the government spends money, that money is spent, helping support demand, whereas tax cuts may be largely saved. So public investment offers more bang for the buck. Second, public investment leaves something of value behind when the stimulus is over.
Krugman gets off to a poor start. Recent studies have shown that tax cuts are actually a greater stimulus than deficit financed government spending. That’s because deficit financed government spending increases produce an effect similar to tax hikes. The taxes to pay for that spending may be in the future, but the effect is felt today as people adjust their behavior to prepare for those higher future taxes. Any stimulus from the spending is mostly offset by the expectation of higher future taxes. With a tax cut, even if it is saved, to Krugman’s horror, at least people will have the dollars to pay those future, higher tax rates and the present change in behavior is limited. And does Krugman really believe that if the tax cuts are saved (and therefore fund private investment) there is no benefit? Does he live in a world where only “investments” made through the political process produce returns?
The stock market has been rallying recently and the apparent driver is a belief that the Obama stimulus plan will produce an economic recovery. While there may be an economic recovery, it will not be because of, but rather in spite of the efforts of the politicians. It has been my contention for some time that the economy is not in nearly as dire straits as the political class would have us believe. As the panic of the 4th quarter subsides, it is possible that conditions in the credit markets improve more quickly than currently believed. While credit is certainly harder to find today than it was even a year ago, that has not translated, yet, into a general lack of credit creation. Total commercial and industrial loans are still rising in sharp contrast to the last recession:
Obviously, that is not the entire credit picture and I don’t deny that credit is more difficult to get than it has in the past. It seems to me that what is really going on is that credit conditions are normalizing. Those companies and individuals with good credit and good reasons for obtaining it are able to get loans. Those who don’t have good credit or good reasons for borrowing cannot. That isn’t a credit crunch. That is how the world is supposed to work and if we had applied the same standard over the last 10 years we wouldn’t be in this situation.
So what happens if the Fed is successful in reinflating the bubble economy? What if consumers start borrowing and lenders start lending again? What if the banks succumb to political pressure and start making more questionable loans? Would that constitute a real economic recovery? My answer is no; we would merely be extending the game we’ve been playing for years - borrowing growth from the future through excessive credit creation. The only path to a real recovery is through increased saving and investment for the future. Everybody talks about doing things for the sake of our children but the political class enacts policies that make that difficult at best.
If banks start to ramp up lending again and the government borrows and spends even more, what will be the result? If that is indeed the course we take, the result will be inflation and an even larger economic problem in the future. We cannot put off the day of reckoning indefinitely. Eventually, we need to produce enough to support our consumption. That can only be accomplished by investing in productive assets rather than spending on consumables and as long as the Fed keeps punishing savers with low interest rates, that can’t happen. As long as the government share of the economy continues to grow, that can’t happen. Nevertheless, it would be a recovery of a kind and investors should be prepared for it regardless of whether it is sustainable in the long run.
So, what are the investment implications of such a false recovery? It seems obvious that such a recovery would be inflationary and the leaders of the recent rally seem to support that. The best performing groups are almost all resource related. The DJ Industry groups with the best performance over the last month include: Coal, Aluminum, Industrial metals and mining, Precious metals, Iron and Steel. Other good performers are groups that would benefit from a recovery in spending: Mortgage finance, Hotels, Heavy construction, Travel and tourism.
We have identified a number of ETFs that could benefit from a recovery of this type: Materials (IYM), Oil Exploration (IEO), Oil drilling (IEZ), Gold (IAU), Silver (SLV), China (FXI), Brazil (EWZ), Canada (EWC), Australia (EWA), Latin America (ILF), Mortgage REITs (REM).
A quick recovery would also likely mean a narrowing in the spread between Treasury and riskier debt. Falling treasury prices would benefit the inverse ETFs such as PST (7-10 year treasury) or TBT (20+ year treasury). Rising prices for riskier debt would benefit Corporate bonds (LQD), High Yield (HYG) and Emerging market debt (EMB).
Let me emphasize here that this is not a prediction. It just seems that with everyone assuming that the recession will be long and deep it is prudent to consider the alternative scenario. For now, the market seems to be indicating that a recovery of some kind is in the offing. It may be a short term trend that ends soon or it may be something that is more lasting. Only time will tell.
Disclosure: Alhambra Investment Management and its clients may have positions in any of the securities mentioned.