FP: Martin Feldstein

Foreign Policy magazine has published a short interview with Martin Feldstein, conservative Keynesian economist, on the looming stimulus package. Excerpts:

MF: In the post-World War II period, recessions have been preceded by a combination of increased oil prices and high interest rates. And we certainly got a dose of both of those this time. The Fed raised the federal funds rate from 1 percent to 6 percent, and oil prices tripled…I wrote a piece in the Wall Street Journal a couple of years ago, asking: Why did the jump in oil prices (that we had then observed—from roughly $20 to $60 a barrel) not push the economy into recession? And I answered that by saying: because there was this surge in home-equity borrowing that allowed individuals to increase their consumption faster than their incomes. I concluded by saying that if energy prices continue to increase, we cannot count on that kind of offset from higher consumer spending financed by mortgage borrowing.

Fair enough. Consumer debt levels in the U.S. are at a level that requires higher asset values and/or higher future incomes. Asset values are not providing any support at the moment, and are actually working against this process.

The FP interviewer then offered a choice quote from a George Mason University economist in framing the following question: 

FP: …Russell Roberts says the very idea of an economic stimulus package is “like taking a bucket of water from the deep end of a pool and dumping it into the shallow end.” As he put it, “If you can make the economy grow, why wait for bad times?” So, is the idea of a stimulus package just political theater, or do you expect it to really help?

Feldstein’s reply:

MF: I do expect it to help, but let me be clear about why it’s not like moving water from one end of the pool to the other, or more accurately, why it is not a way of making the economy grow under all circumstances. If the economy is fully employed and growing at a normal pace, 3.5 percent, with unemployment under 5 percent and no expectation of a downturn, then aggregate demand is not the problem. Then, the only way to get the economy to grow more is to have more investment in capital equipment, people working harder, more innovation, and so on. And you can’t do that by simply giving money back to taxpayers to spend more. So, the “spend more” approach to increasing economic activity is not about long-term growth. What it’s about is offsetting the risk of an economic downturn.

Our take? The U.S. economy is still at or near full employment. An expected decline in aggregate (domestic) demand is not the problem, it’s a symptom. The underlying problem is over leveraged household balance sheets in the U.S. (in 1997-1998, it was over leveraged sovereign balance sheets in Asia and Russia). And as we’ve pointed out previously, the only way to support the timely repair of a balance sheet–and thus provide some comfort to risk averse credit markets–is through higher real cash flows over time. A one shot "stimulus" can’t accomplish that! But the long term investments that Feldstein describes above–which he seems to imply are not needed in the current crisis–would accomplish this goal. And for those kinds of investments to occur at a sufficient level, marginal returns on capital int he U.S. must be globally competitive. That’s something that corporate taxes, taxes on capital investment, trade barriers, and excessive regulation work directly against. If those wedges to productive activity are allowed to increase in 2009 and beyond, the U.S. economy is likely to start down a path similar to Japan’s since 1989.

Economist: Obama Quote

The following excerpt is from the current issue of The Economist, in its "Primary Colour" sidebar on page 33:

"…I thought that [the question actually] meant, ‘What’s your biggest weakness?’ If I had gone last I would have known what the game was. And then I could have said, ‘Well, you know, I like to help old ladies across the street. Sometimes they don’t want to be helped. It’s terrible.’" Barack Obama explains why his admission during a debate that his paperwork was disorganised came to be used against him. Associated Press, January 18th

I know that many of my colleagues in the investment industry, and in business generally, are very concerned about some of the anti-growth policies that an Obama administration would be likely to pursue. So are we. But this quote, and the story, capture the man’s essential and undeniable charisma. Of the Presidential candidates that I’ve observed in my lifetime, Ronald Reagan and Bill Clinton have always stood well above the rest of the crowd, but Obama is right there with them, which has almost certainly contributed to his meteoric political rise.

But I think the real reasons this anecdote appealed to me is because (1) he elevated candor over the usual BS, and (2) I can (unfortunately) sympathize with his paperwork affliction.

House Reaches “Stimulus Package” Deal

The House has crafted its version of an "economic stimulus" plan that includes tax rebates, an earned income supplement (our working label for "tax rebates" to those who earn a paycheck but don’t owe any taxes), a child credit, temporary accelerated business investment deductions, and expansion of Fannie and Freddie’s mandates.

Some stubborn issues were not addressed. One is the disparity between tax rates on different kinds of productive activity, including labor. Another is the uncompetitive U.S. tax rate on corporate income. And the other is the uncertainty surrounding expiration of the 2003 tax cuts. It now appears that clarity on that issue will only come with the Presidential election results in November.

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SCM: Wednesday’s Boomerang Market

U.S. stock markets staged a dramatic rally yesterday beginning shortly after 1:00PM EST:

The rally appears to have coincided with mid-day news that the New York Insurance Department was attempting to coordinate a bail out of bond insurers by major banks, in order to minimize risks to the municipal debt markets (many bond insurers insure state and local debt in addition to consumer debt–if they go belly up, interest rates for municipal issuers are likely to rise). If correct, that would be another tip of the hat to Jim Cramer’s thesis.

However, the CBOE Volatility Index (VIX), a widely used gauge of fear levels among equity investors, went above 34 about 30 minutes prior to the market turnaround, something that some pundits felt had been the ‘missing piece’ in the current correction:

The two prior stock market rallies since the current financial panic began both started after the VIX reached similar levels, so the current rally may be based on a perceived "technical" relationship between VIX and stocks that has been apparent for the past 6 months:

As of last night, there were reports of some resistance to a bailout of bond insurers, but this hasn’t hurt stock market futures. On that basis, we suspect the VIX blow off might indeed have played a bigger role in yesterday’s rally.

BCA Chart: Echoing Cramer?

Hyperanimated financial pundit Jim Cramer made the case last week, during discussions on CNBC about federal stimulus packages, that the specific problem affecting markets was the uncertainty surrounding bond insurers, and that therefore the most targeted and effective response would be a supervised industry takeout, to speed up the bankruptcy and recapitalization process, akin to the S&L bailout of the late 1980s and early 1990s. However the guy rubs you (we like to tell people who hate his style, "it’s a Philly thing, don’wurryaboudit"), it was an interesting observation. Regular readers know that, while we’ve acknowledged the overleveraged position of certain economic sectors, we’ve mostly been harping on the longer term issue of global tax competition. But judging by this chart from their website today, the BCA appears to side with Cramer:

Here’s an excerpt from the rather pessimistic assessment accompanying the graph:

It is too late for the Fed to prevent a recession, they cannot rescue monoline insurers, and they cannot turn bad paper into good paper. But engineering a positively-sloped yield curve will help financial intermediaries, and ultimately will put a floor under the economy.

On those first two, we don’t know. On the third one, we would qualify it: if misguided Fed policy has been responsible for good paper turning bad, then better policy can reverse the process (in this case, we think that easy central banks incentivized the creation of paper that was bad to begin with). Engineering a positively sloped yield curve should be positive for financials and cyclicals, and it may indeed put a floor under the domestic economy. But our base case still holds–supporting the U.S. economy thru monetary policy is likely to increase inflation pressures.

Presidential Politics Update

On the GOP side, Thompson has dropped out, although one of his advisors was making some chatter about his qualifications for VP. He might well end up competing with Huckabee for the position.

There are rumors on the Dem side that Edwards might be ingratiating himself to the Clinton campaign as a potential VP. That would take our Obama-Edwards hypothesis off of the table if true.

Finally, the WSJ editorial board penned an assessment of the GOP candidates’ tax plans. On our favorite one, Huckabee’s platform to enact the Fair Tax, they offered the following:

Mike Huckabee is the most unusual, combining an anti-corporate message with the most radical reform of all — the so-called FairTax…that would replace all federal income and payroll taxes. We have our doubts that such a root-and-branch upheaval could ever pass Congress, even if it did survive a Presidential campaign.

No opinion is offered regarding the likely economic effects of removing all taxes on productive investment. A 30% rate is claimed without citation (the one we’re familiar with is 23%). Too bad. It looks to us like the WSJ has lost touch with its earlier tax radicalism, when folks like Bob Bartley and Jude Wanniski dared to think outside the box, and helped set tax policy on much sounder footing in the 1970s and 1980s.

SCM: There’s a Bubble Here Somewhere

It appears that U.S. common stocks are now officially in a bear market. What’s really interesting to us though is that the decoupling of Treasury and commodity markets continues. Treasuries are screaming recession, deflation, rate cuts, and risk aversion, while commodity prices, though they have pulled back on recession fears, are still at levels that predict robust global growth. Is one of them a bubble? Or both? Only time will tell. It’s a fascinating dynamic to watch in the meantime.

FT: Brown Invites Sovereign Wealth to London

The Financial Times recently reported that British Prime Minister Gordon Brown is courting China’s sovereign wealth fund (SWFs, which invest public financial resources on behalf of a country’s citizens; they are becoming more prominent given the high levels of growth in many emerging economies in recent years). According to the article:

Gordon Brown urged China’s new £100bn ($195.5bn) sovereign wealth fund to use London as a hub for its international operations – contrasting Britain’s “open door” policy with protectionist signals from the US, France and Germany…

Britain is keen to demonstrate its openness to CIC [China Investment Corporation] and other sovereign funds, in contrast to the more guarded attitudes in some western nations. Chinese investments are a hot topic in the US…

On his first trip to China as prime minister, Mr Brown…set his sights on securing a bigger slice of the country’s soaring wealth for the City.

He hopes that CIC, which was set up to boost returns from China’s swelling foreign exchange reserves, will soon open an office in London, and told business leaders that it would be “welcome” in Britain.

URL: http://www.ft.com/cms/s/0/ce9e1bea-c575-11dc-811a-0000779fd2ac.html

Bartlett: In Defense of Keynes

Bruce Bartlett penned an op-ed for the WSJ in which he defends Keynes while attacking the nature of the allegedly ‘demand stimulating’ tax rebates being pushed in pending fiscal policy legislation in Washington:

The underlying theory for the rebate idea traces back to the British economist John Maynard Keynes. He believed that spending was the driving force in the economy. It didn’t matter whether the spending was done by businesses on capital equipment, by governments on public works, or by consumers — spending is spending in the Keynesian model, and all of it is stimulative.

In Keynes’ defense, his theory was developed during a severe, world-wide deflation. Spending of all kinds was paralyzed by a lack of liquidity, and the Federal Reserve had difficulty injecting money into the economy because so many banks had closed. Under these circumstances, deficit spending by governments made sense as a means of getting money into circulation and overcoming deflation.

Bartlett is right about this, and he also praises Milton Friedman’s "permanent income" hypothesis that questioned the likely effectiveness of tax rebates in 1975. But there’s another critical piece to the puzzle, which was Robert Mundell’s observation in 1971 that Keynes developed his General Theory at a time when the global economy was rapidly disintegrating, with most countries becoming "autarkic" (that’s an economist’s word for isolated and self-contained; consdier the common root in autism). In a world of closed economies, policy makers in each country could be reasonably confident that lowering real interest rates to a level more supportive of economic activity, whether by monetary or fiscal means, would have the intended effects. That’s because the possibile outcomes for both monetary and fiscal policies were constrained at the country level. However, once the global economy began to reintegrate after WWII, the "Keynesian" nostrums of the Depression era began to fail, and fail miserably.

For example, in the 1970s, the Fed was lowering real USD interest rates through easy monetary policy, in an attempt to stimulate domestic employment. However, tax rates on economic activity in the U.S. had risen–and were expected to continue rising–to levels that were prohibitive to additional domestic investment. As a result, foreign economies with more favorable conditions for investment were able to attract most of the financial capital that was created through the Fed’s easy monetary stance. In the 1970s, although many emerging markets participated in the boom, the most notable beneficiary was Japan. Today, the most notable beneficiary is China, although the number of countries enacting favorable economic policies has multiplied dramatically since the 1970s (in this hemisphere, Canada is a wonderful example, as are parts of Latin America). And of critical importance is that since late 2006 when the Democrats won a Congressional majority, expectations have been growing–in our little shop anyways–that tax rates are set to rise and perhaps continue rising, and that the Fed will be called upon (incorrectly, just as in the 1970s) to support the domestic economy in the face of foreign tax competition. The result of such a course can only be domestic stagflation, unless other countries were to dramatically reverse course on economic policy, which looks like an extremely remote possibility to us.  And if USD policy is exceedingly lax, the dollar’s status as a global reserve currency could become increasingly shaky over time.

How does this domestic-global paradox work? Let’s look at China for example. Due to its dollar peg, we can assume that short term interest rates on reserves in China is equivalent to the Fed’s target rate in the U.S., 4.25%. Given a misallocation of capital in residential real estate and other assets in the U.S. that has to be unwound, and (most importantly) given the expectation of higher U.S. tax rates relative to the rest of the world, let’s assume the U.S. growth rate for the next 10 years is roughly 2% per annum. We’ll assume somewhat conservatively that China’s will be 7.5% per annum. A 4.25% rate will clearly be more supportive of growth in China than the U.S.

So what is a superpower to do? Obviously there are a few courses to choose from. One is to try to force China to break its currency peg to the USD. This one continues to be a favorite of those policymakers who prefer that their domestic policies not be subject to the stress of foreign competition. Another is to hope for (or encourage) policies in China that will force down its expected growth rate, something that has happened in Japan since the late 1980s. The other, which happens to be the only one over which U.S. policymakers have control is to support the expected rate of growth in the U.S. economy. Doing so means nothing short of significant, if not radical, overhaul of the federal tax code. There are a lot of people who benefit from the tax code’s complexity. Significant changes to the tax code always bring the lobbyists out in droves (for a real world example, if you happen to know a lobbyist for the 401(k) industry, ask them what their position was on social security reform a few years ago). And radical overhaul would require sensible transition management. But it’s clearly the more peaceful and prosperous of the paths outlined above.

Primary Update: 2 Dems, 4 GOP?

On the GOP side, Mitt Romney won Nevada handily. Ron Paul was a "surprising but distant" (WSJ) second place. It’s not surprising to us that Ron Paul showed well in a state noted for its libertarian and pro-business leanings. But this victory is another positive for Romney’s campaign, coming on the heels of his Michigan win, and in McCain’s neighborhood. We have noted that Romney is emphasizing the need for a more competitive federal tax code in recent weeks, which could be playing well, especially in places like Nevada. In South Carolina, John McCain edged out Mike Huckabee in a contest notable for (a) civility between the two front runners, who could conceivably become a Pres-VP ticket, and (b) the apparent handwriting on the wall for former Senator Fred Thompson.

Similar signs came out of Nevada’s Democratic primary for another former Senator, John Edwards, as he barely registered there. Sen. Clinton won by a 5% margin over Sen. Obama, but Obama’s campaign is claiming an edge in total delegates, while anticipating victory in South Carolina. The Dem field has clearly been narrowed down to two, and we anticipate that the intensity and animosity will continue  to pick up between the two campaigns. There’s a risk for the Dems, given the far more open state of competition in the GOP at the moment, that their eventual nominee will come out of the primary campaign in pretty rough shape.