GDP, Federal Deficits, Corporate Cash, and Oil

Risky assets have had a rough two days’ sledding. Most pundits are citing unrest in Libya and the resulting risks reflected in rising crude oil prices, which seems fair to us. However, we also suspect that recent developments in Chinese monetary policy and U.S. budget policy are also weighing on equity markets.

Some articles of interest:

“Basel III: Long-term impact on economic performance and fluctuations” http://www.bis.org/publ/work338.htm

Latest Bank of International Settlements estimates for output losses related to stricter bank capital requirements are about 0.08% per year with a modestly favorable impact on output volatility. Bank lobbyists will continue to kick and scream over tighter capital requirements and liquidity ratios. Keep these findings in mind when they do!

“Goldman sees danger in U.S. budget cuts” http://www.ft.com/cms/s/0/0369c1bc-3f71-11e0-a1ba-00144feabdc0.html#axzz1EslcXk5L

A Goldman Sachs analysis estimates that the budget cuts of $60B+ currently envisioned by the GOP would shave 1.5 to 2% off of 2011 growth, while a more modest $25B reduction would produce a 1% drag on 2Q11 growth. Sounds reasonable to us, as it implies a fiscal multiplier of about four, which is a safe assumption in a very low interest rate environment. The fact that we’re seeking any cuts — and lower output growth — in an environment of slack capacity and high unemployment is beyond us.

Along those same lines, “Senate Deficit ‘Gang’ Tests Power of Bipartisan Teams”, http://www.bloomberg.com/news/2011-02-18/senate-deficit-gang-part-of-bipartisan-push-for-compromises.html

Incredibly (emphasis added), the article states that, “Among the approaches [that a bipartisan] group [of Senators] is discussing, according to an account in the Wall Street Journal confirmed yesterday by an aide familiar with the talks, is a trigger mechanism whereby tax increases and spending cuts would automatically kick in if Congress didn’t cut federal expenditures or take other steps to rein in the deficit.” If you follow our website, you’ll probably know where we stand on this kind of lunacy. It entirely separates the federal budget, one of the two primary tools for dealing with economic downturns in a counter-cyclical fashion, from the performance of the real economy! These folks seem to have absolutely no idea how our economy works, and what role federal budget deficits play in it. We haven’t had such legitimately pro-cyclical policy measures in place — especially automatic ones (“automatic de-stabilizers”?) — since the early 1930s. Why we would ever want to re-implement them is beyond comprehension. See the next article for an interesting take on why terrible policy ideas seem to have so much traction at the moment.

“The golden fetters in our mind” http://www.economist.com/blogs/freeexchange/2011/02/monetary_policy_3

Great little piece of institutional economics from The Economist, in which the author argues that “views of the world formed during a very specific economic period in which the magic of inflation hawkishness developed a similar hold [as the gold standard did] over the minds of central bankers. The stagnation of the 1970s was cured by the central bank engineered downturn of the early 1980s, which ushered in the long, growth-rich Great Moderation. Inflation is the enemy, and the more than can be done to exorcise the inflationary demon from the modern economy, the stronger and more durable will long-run growth prove to be. But just as the gold standard served a useful [purpose] in the late 19th century only to become a mental policy prison in the 1920s, the inflation hawkishness of the 1980s seems to have created a generation of central bankers unprepared to handle the monetary challenge posed by the Great Recession. And it’s interesting: even Mr Bernanke, student of the Great Depression and among the most aggressive and responsive of rich world central bankers, seems reluctant to follow the conclusions of the 1930s to their 2011 implications.” To understand the importance of this assessment, refer back to the Goldman Sachs / federal budget article.

“Split Decisions” http://www.cfo.com/article.cfm/14551027

From CFO.com (emphasis added): “U.S. finance chiefs are sitting on nearly $2 trillion in cash, bringing the ratio of corporate cash to assets to its highest level since 1959. Half of all CFOs responding to the latest Duke University/CFO Magazine Global Business Outlook Survey…say they plan to continue to hold on to their cash in 2011, while the other half say they are ready to put some dollars to work. Of those who will guard their cash, nearly half (again) say they have no excess cash to spend and another 37% say they are retaining cash as a liquidity buffer. Almost a third are hanging on to cash due to ongoing economic uncertainty, while more than 20% say they don’t see any attractive investment opportunities for which they would deploy cash.” Not a single one of these responses supports either GOP or Democrat hawkishness (in the form of spending cuts for the former and tax hikes for the latter). The federal budget deficit is truly the least of our worries at the moment, but so much hysteria surrounds it (see the institutional economic argument in the prior link) that it’s hard to see the forest for the trees.

As we’ve pointed out when it comes to taxpayers voting for premature budget austerity, as long as the risk of politicians making policy errors is high, “incorrect” economic ideas can be perfectly rational. If the GOP cuts spending too deeply and/or the Dems raise taxes (or leave them where they are for that matter!), then it might be better for many U.S. citizens (corporations included) to act defensively. Why put cash to work, in either business investment or consumption, when the long-term outlook for demand is uncertain, and the federal government promises to compete with the private sector when it comes to accumulating savings?

Despite these concerns, conditions still look favorable for equities, even at current valuations. Policy errors, as illustrated by these articles (and in China), remain the greatest risk going forward, and uncertainty in the Middle East adds a worrisome wrinkle. The rising price of crude also tends to support the idea, floated by Barry Ritholtz and others, of the federal government implementing (and funding — to quote Rick Santelli in a way he never intended, “Are you listening, President Obama???”) an energy-related Manhattan Project. There are powerful interests aligned against such a thing, which unfortunately will get plenty of political cover from continuing deficit anxiety among both parties.

Mauboussin on Incentives

In his latest piece, the thinking investor’s strategist, Michael Mauboussin writes about the complex nature of incentives and the importance of “intrinsic motivation” — as opposed to purely external rewards — in encouraging desirable behavior: 

[I]ntrinsic motivation only thrives when an organization fosters autonomy, a sense of mastery, and a feeling of purpose. Unfortunately, these conditions are frequently absent in a corporate setting. Many popular management techniques—budgets, goal-setting, and financial reward systems—actually undermine the conditions that encourage intrinsic motivation…

Intrinsically-motivated people are not simply going through the motions to reach an end; they believe that their actions contribute to a greater good. Purpose often comes through as passion.  

Maybe I’m being old-fashioned, but the words “drive and mindset” seem like poor substitutes for “character”. Intrinsic motivation is neat, cutting-edge stuff, but there are plenty of mundane or uncomfortable situations where people face a choice between doing the right thing and doing something else. No matter how much we learn about ourselves, character will always count — and the fact that character is made, not born makes it all the more relevant. 

That quibble aside, it’s a great piece as usual from one of the most interesting minds in our business. Should be of interest to investors, executives, HR folks, and psychology buffs.