Recession Warrants Fiscal Stimulus – But Not at Cost of Long-Term Problems

Stocks had another awful week, dropping between 4-5%. The broad-based S&P 500 slumped 5.4% this past week, its biggest weekly decline in five years. Last week we compared the stock markets to a chronic alcoholic who has had frequent unsuccessful visits to Alcoholic Anonymous; as time goes by, his addiction gets stronger and it becomes increasingly difficult to wean him away. Even the announcement of a major fiscal stimulus package (read below) failed to evoke any response from the bulls.

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The front-line indexes are now trading well below their summer lows and are a long way off their recent highs. The S&P 500 (SPY) is down 15.9% from its October highs; the Nasdaq Composite (QQQQ), on the other hand, is on the verge of entering a full-blown bear market, having declined over 18% from recent highs. As shown in the table below, a decline of this magnitude has heralded greater downside in previous bear markets.

Only 11% of the S&P 500 stocks are now above their 50 day moving averages. In hindsight, the rally off the summer lows was rather feeble and lacked the conviction typical of a bull market. To further prove our point, take a look at the chart below from Bespoke Investment Group that compares the daily breadth in the S&P 500 stocks with its daily % change. Since 2003, there have been only six days where the S&P 500 advanced more than 1% with a breadth of under 250, i.e. only half of the 500 stocks rose on these days. Four of these six days have come since August 2007.

In the face of a relentless decline since the beginning of the year, volatility is now beginning to pick up. Nine out of the 13 trading days this year have seen a daily closing change in S&P 500 in excess of 1%. The 50-day average trading range for the S&P 500 is at 1.68% - its highest since early 2003. The VIX, a measure of expected 30-day volatility, shot up this week after a prolonged lull, suggesting that fear is setting in the minds of market participants, albeit much later than the 2007 summer panic meltdown. Bear markets are typified by slow grinding downtrends, as traders get accustomed to the idea of daily declines.

On the other hand, the unrelenting market-wide selling pressure is now pushing stocks into oversold territory. Out of 71 technology stocks in the S&P 500, all but two have seen YTD declines. Only four of these stocks are above their 50 day moving averages. The Put-Call ratio, one of our favorite contrarian indicators, spiked up this week, surpassing its 3-sigma 99.73% confidence level for the first time since August of last year. With several stocks now deeply oversold, we would advocate booking some profits at these levels. A pullback to possibly 1360-1370 levels on the S&P 500 would provide an attractive entry point for fresh short positions.

The last two weeks have been anything but dry. But the Baltic Dry Freight index ended down almost 25% in just a week. The index, a widely recognized leading indicator of global economic activity, is now down 37% from its mid-November peak. This is a significant development that could possibly rebuff the entire global decoupling hypothesis. The economic releases this week were mostly negative. The Conference Board's index of leading economic indicators dropped 0.2% in December, its third consecutive drop. Consumer prices rose 0.3% in December, receding from the scorching 0.8% gain in November. For whole of 2007, headline inflation has risen 4.1%, the most since 1990. Housing starts declined 14% in December to an annual rate of 1.006 million, the lowest since 1991. Starts registered a 25% decline in 2007, the biggest since 1980.

The market continues to reel under the weight of massive write-downs. Merrill announced a $16.7 billion write-down in its 4Q results, while Citigroup did even better with a $18.1 billion write-down along with a cut in its dividend. This is most certainly the worst quarter ever for investment banks.

While the economy continues to spiral towards a recession, the concerted central bank efforts to thaw the credit market freeze seem to have worked. The TED spread – the spread between three-month LIBOR and Treasuries of the same duration – is at its lowest since August 13. The 3-month LIBOR rate is now below the Fed funds rate for the first time since June 2003.

The sixth century Chinese poet Lao Tzu penned that those who have knowledge do not predict, while those who predict do not have knowledge. After a vicious decline, a near-term oversold rally looks on the cards. But we have to side with Lao here; in view of significant bearish headwinds mentioned above, we would defer a bullish prediction for now.

A Shot In The Arm?

With consensus forecasts rapidly veering towards a recessionary outcome, calls for some sort of a fiscal stimulus have gathered steam of late... not least because of the posturing by the contesting Presidential hopefuls. Describing it as the 'most pressing economic priority', President Bush announced a growth package that would amount to as much as 1% of the nation's GDP, or about $140-$150 billion, and would be 'big enough to make a difference'. Although specifics on the stimulus plan were not offered, media reports suggest that the administration is considering offering $800 tax rebates for individuals and $1600 for households. The package could create a half million jobs this year. The plan is likely to be temporary, without any tax increases and separate from the Republican idea of making the Bush tax cuts permanent.

The White House and the Congress are said to be keen on hammering out an agreement quickly, with some Democrats saying it could come in 30-45 days. With neither party enthused with the prospect of facing voters in the midst of a recession, legislative progress seems quite plausible. However, what is more difficult to discern is whether the entire exercise is actually justified.

With that in mind, we set about evaluating whether such a proposal makes economic sense. We take guidance from history, notably the Bush tax cuts during the last recession, in gauging the potential risks and rewards in such an exercise.

1. Do We Really Need It?

It is no secret that the economy is slowing. The scales have tilted in favor of a recession in the eyes of several economists, especially following the latest employment report. Some, like Bill Gross, have even suggested that we may already be in a recession. Even if there is no officially defined recession, a significant slowdown in the economy is a near certainty that will nevertheless feel like a recession in many parts of the country and to many businesses and families.

The Federal Reserve has done its bit to stimulate spending by cutting interest rates and trying to ease monetary and credit conditions. Having said that, there is enough room to cut rates further; the current federal funds target rate is 4.25%, well above the 1% target maintained in 2003-2004 to support the recovery following the 2001 recession. Also, as the CBO director Peter Orszag noted recently, historically fiscal stimulus packages have often been 'poorly timed or designed in relatively ineffective way' to do much good in a recession. The Fed, on the other hand, is likely to be more adept at fine-tuning monetary policy to maneuver the economy through muddy waters.

Further, as the economy decelerates, slower growth of income, payrolls and profits causes tax receipts to dip relative to spending. Simultaneously, outlays on programs such as unemployment insurance and Food Stamps rise. This combination temporarily boosts demand for goods and services, thereby helping to offset some of the weakness in demand. The CBO estimates that, since 1968, these so-called 'automatic stabilizers' have added between 1-2.5% of GDP to the deficit during recessions, translating to about $140-$350 billion in today’s terms.

Having said this, the case for a fiscal stimulus is strong. The recovery from the 2001 recession has been weak by historical standards. The latest employment report showed that job growth screeched to a halt in December with only 18,000 jobs added overall, an actual decline of 13,000 jobs in the private sector and a sharp jump in the unemployment rate to over 5%. Although real economic growth rocketed along in 2Q and 3Q of 2007 (3.8% and 4.9% respectively), near-term projections are for the economy to grow at a much slower pace, in the face of ongoing adjustments in the housing market, declining consumer spending and stubbornly high oil prices. There is also a risk that financial markets could turn on its back due to the spreading of the sub-prime contagion.

2. What Should Be The Nature Of The Stimulus?

Fiscal stimulus is aimed at boosting economic activity by raising short term aggregate demand to engage more of the nation's existing productive capacity. This is in contrast to traditional policies that are designed to improve long term economic growth by increasing the total productive capacity. Short-term demand-focused stimulus operates on a set of principles that is frequently at odds with the underlying long-term supply-based policies. Demand may be increased directly, as in the case of direct government spending on goods and services, or may have happen indirectly, by raising household consumption or business investment. Household consumption is generally stimulated when either after-tax income or expected lifetime wealth increases as a result of either reduction of taxes or increase in transfer payments from the government. Business investment can be stimulated by sufficiently boosting the after-tax return on capital to make additional investment profitable.

But as is the case with any potent medicine, a stimulus if mis-administered could actually end up doing more harm than good. So what should such a package comprise of? Most economists agree that the characteristics of a sensible fiscal stimulus should confirm to the three Ts: timely, targeted and temporary. Timely measures are those that, once triggered, stimulate new spending quickly so that businesses do not have to cut back on production or lay off workers due to weak demand. Simple measures such as tax refunds or enhanced benefits work most effectively obviating the need to devise new programs that could see delays in implementation. The package should be designed in such a manner that the funds would be targeted where they are most in need and to those who are most likely to spend the bulk of the new resource provided to them. Tax cuts that mainly benefit high-income individuals are a poor choice to provide stimulus, because those individuals are more likely to save a large share of any increase in disposable income they receive than are people of more modest means. The stimulus should also be temporary, so as to not hamper the country's long term fiscal position. If this maxim is not followed, stimulus could persist even after the economy recovers and policymakers run the risk of a bout of inflation, high long term interest rates and higher capital costs. If fiscal credibility is to be maintained, it is equally important that no measure be enacted on a temporary basis that will at a later date generate overwhelming political pressure for an extension.

It is often assumed that tax cuts are inherently stimulative, while spending increases are inherently less desirable as an economic stimulus. However, as pointed out by Nobel laureate Joseph Stiglitz and current CBO director Peter Orszag in 2001, both spending increases and tax cuts can be as effective – or ineffective – as a stimulus, depending on their nature and design. Increases in government spending tend to have a greater stimulative effect as more of such an increase translates quickly into an increase in total spending in the economy, as compared to tax cuts where a substantial part is generally saved.

3. But Are There Any Risks?

The balance of risks facing the economy is now clearly on the side of recession rather than inflation, as admitted even by the Fed recently. Even as fuel prices continue to surge, core prices have remained under check. Inflation as measured by the Fed's preferred personal consumption expenditure index, excluding food and energy, rose 1.9% over the last year, within the Fed's comfort range. Measures of inflationary expectations as inferred from the Treasury Inflation Protected Securities [TIPS] are close to their lowest point in the last two years.

Besides inflation, the other major risk is that of timing. The major drawback with past fiscal interventions has been that the stimulus has come too late. Conventional wisdom recognizes two types of lags – inside lag, the time between recognition of a problem and action and outside lag, the time between action and the resultant impact. For monetary policy, inside lag is short, while outside lag is longer. The reverse is true for fiscal policy. Spending, and associated multiplier effects of spending, can usually be effected fairly rapidly. With the Congress seemingly in a hurry to push through some legislative action, any inside lag can also be whittled down.

4. Will It Work?

In our opinion, the looming possibility of a recession (and a major one at that) warrants fiscal stimulus, on top of the one that monetary policy can provide. Calculations by Douglas Elmendorf of the Brookings Institution suggest that a temporary tax rebate worth $100 billion could boost the annualized rate of GDP growth by between 0.8 and 3 percentage points in the quarter in which it was enacted. A study published last year on the 2001 tax rebates found two-thirds of the money was spent within six months of receiving it. In contrast, monetary easing, in the form of interest rate cuts, can take a year or more to have an impact. Countercyclical measures can provide the economy a significant shot in the arm.

Having said that, it is important that concerns over a possible recession in the short term are not used to justify fiscally irresponsible measures that could exacerbate the nation's already serious long-term fiscal problems. Any plan should be intended to provide additional cost-effective short-run stimulus on top of the one that monetary policy can provide. The decidedly mixed historical record of fiscal stimulus actions in the past should also be taken into consideration. But it is still likely to serve its intended purpose. Even if it fails to avert a recession, it should certainly help reduce the severity of one.