Economic Policy in the Decade of the Twenty-Tens: More of the Same

Happy New Year!

I have spent a good portion of the last week and a half reviewing my perception of the foundational philosophy undergirding the economic and financial policies of governments in the United States and Europe and I come to the same conclusion over and over again.

Governments in the United States and Europe and the people working in and for them have learned little or nothing over the past fifty years.

These governments are still united in their belief that continuing credit inflation is what their economies need. It is the policy that they plan on delivering. And, if troubles develop, then they just bail troubled institutions out and continue on their merry way. Europe, in the first quarter of 2011, seems to be headed for another round of this bail and run behavior.

The underlying rationale for this is that the leaders of these governments believe that every effort must be made to keep unemployment as low as possible for as long as possible by aggregate governmental actions.

These leaders are unwilling to accept the fact that their policies only make it harder for them to achieve their goal over time and just applying more and more stimulus to the economy will just make things worse.

It is not enough to see that, in the United States alone, underemployment has gone from around ten percent in the 1960s to about twenty-five percent now and that over these past fifty years the income distribution has become more and more skewed toward the higher income end of the spectrum.

The reasons for these results? First, you cannot keep putting people back in their legacy jobs by means of fiscal and monetary stimulus and expect them to maintain their productivity and job competitiveness in a fast changing world. Second, credit inflation can only be taken advantage of by the wealthier people in the country; the less wealthy in such an environment, even though they might be benefitted by it in the short run, lose out to the wealthier over the longer run.

Stock markets, of course, like this environment of credit inflation. Note the following measures of stock market performance. Here we have charted Bob Shiller’s CAPE measure (Cyclically Adjusted P/E Ratio) and Jim Tobin’s q ratio. These statistics, obviously, roughly measure

the exact same thing, whether or not the capital stock in the United States is over- or under-valued. In the 1960s and early 1970s equities seem to be overvalued as the period of credit inflation gets underway. In the late 1970s, of course, we get the period of extremely tight monetary policy aimed at thwarting the rapid acceleration taking place at the time. However, the 1980s revived the bias toward credit inflation, and, as can be seen, the stock markets seemed to take advantage of this policy stance as both measures never dropped below their long-term averages even through the “Great Recession” up to the present time.

This fifty year period was, of course, the time in which the financial sectors of the economy grew to become such a large proportion of the economy and it was the heyday of financial innovation.

It was not the less-wealthy part of the country that benefitted from this policy stance over this period of time.

If the current foundational policy stance of the government remains one of credit inflation similar to the one in place for the last fifty years then all we can expect is more of the same.

And, in my mind, there is no separating out Republicans or Democrats on this issue. Both have proven equally committed to the same policy stance (just using different words to justify it) and both seem to remain oblivious to the facts.

Also, in my mind, the amount of debt people carry matters, but many of our policymakers seem to believe that the existence of debt carries with it no consequences. In fact, the belief seems to be that the solution to the problem of too much debt outstanding is the creation of even more debt. And, if the amount of debt outstanding seems to be troublesome, well, then just let a central bank buy it.

I see nothing on the horizon to change my mind concerning the economic philosophy that serves as the foundation for policy making in the United States and Europe. Credit inflation remains the underlying stance of the economic policies of these governments for future.

Thus, we can expect, over the next decade, a continuation of the economic and financial environment of the last fifty years.

Whither Economic Policy? Whither Investments?

President Obama has returned to Washington, D. C. We are told that he plans upon his return to focus on domestic economic issues.

The president has had two weeks that have not necessarily been the best of his administration. The mid-term election did not go the way he wanted and his sojourn into the international waters of the East did not go swimmingly.

Now, where is he going to go on the economic front?

His economic team is crumbling before his eyes and Ben and Tim are not getting the best critical reviews.

The economic news is not exactly what he would like to hear. It seems as if the results the economy is posting are exactly the opposite of what he has tried to do.

The front page of the Wall Street Journal trumpets: “Paychecks for CEOs Climb”. Here are the opening words:

“The chief executives of the largest U.S. public companies enjoyed bigger paydays in their latest fiscal year, as share prices recovered and profits soared amid the country's slow emergence from recession.

At these 456 companies, the median pretax value of CEO salaries, bonuses and long-term incentives, such as grants of stock and stock options, rose by 3% to $7.23 million, according to an analysis of their latest proxy filings for The Wall Street Journal by consulting firm Hay Group.

The Journal usually tracks executive compensation each spring. To provide a fuller post-recession picture, it followed up this year by analyzing pretax CEO pay at every U.S. public company with at least $4 billion in annual revenue that filed proxy statements between Oct. 1, 2009, and Sept. 30, 2010.

The results differ markedly from the April analysis, which covered 200 such companies and found median total direct compensation had dropped 0.9%.” (http://professional.wsj.com/article/SB10001424052748704756804575608434290068118.html?mod=wsjproe_hps_MIDDLESecondNews.)

The largest companies in the United States and their chief executives seem to be doing just fine, thank you. Plus, these companies are able to raise debt at record low interest rates and they seem to be piling up cash as fast as they can.

Recent headlines also reported that the income distribution in the United States again has moved more and more toward the wealthier end of the spectrum.

And, what do the policymakers and economists supporting the administration recommend? More spending because the administration has been too timid. More liquidity for the financial markets because we are in a liquidity trap.

Will this continue to be the economic policy of the Obama administration going forward?

I see no indication that it’s economic policy will change. And, if this is the case then this environment should drive investment decisions going forward.

The foundation of these investment decisions, I believe, is that the “largest U. S. public companies” will continue to prosper. The economic policies being proposed have little or nothing to do with resolving the underlying economic imbalances that exist in the United States and that is why the recovery, as it continues, will be skewed toward the larger companies.

Of course, not all of the largest U. S. public companies are going to thrive, but I believe that this is where a lot of the action will be. The action will be in the following companies: companies that will be bought by the large companies building up the large piles of cash; the companies that are engaged in “bubble” assets like commodities, emerging market financial instruments, and bond markets; and a select few companies that are doing the buying of the smaller companies.

I don’t immediately like companies that are doing the acquiring because mergers and acquisitions don’t always work out. In fact, my research indicates that at least two-thirds of the corporate combinations don’t work out. First off, those that move earlier tend to fare better because the acquisition prices don’t get inflated until the merger frenzy progresses: followers get killed. Second, I don’t trust a lot of executives in making mergers work. So many get caught up in “ego” problems that they either overpay for the target or move to make mergers without the culture or the expertise to pull off the acquisitions.

This makes the potential targets for takeover extremely attractive. Why? Because the targets in this instance will be those companies that are not performing well due to the recession and the tepid recovery and the price of their stocks will be relatively low with few prospects, except for being acquired, for they are still basically struggling companies.

To me the pieces are in place for a substantial consolidation of companies in the United States. The largest companies have cash and will have the ability to garner much more as they need it. Note: this just came across the net: Caterpillar Strikes $7.6 Billion Deal for Bucyrus. Caterpillar is offering $92 a share in cash for Bucyrus, a 32 percent premium, as the heavy equipment colossus makes a big push into mining equipment.

Alright!

The executives of these companies stand to make lots and lots of money by making their companies bigger, whether or not they make them bigger successfully. Given the information presented above, this seems to have already started. Continuing the government’s existing
economic policy will see this environment lasting for quite some time.

Companies dealing in “bubble” assets can obviously benefit from “going to the dance.” The downside is “staying too long at the dance.” But, the Treasury and the Fed have signaled that their current policies will continue for “an extended time.” Let the music play on.

The results of this? The income distribution will continue to skew toward the wealthy end. Big businesses will get bigger. Small businesses will do alright, but they will be on the periphery not at the center and will be devoted more to upper income tastes. Employment will continue to be weak because mergers and acquisitions tend to result in layoffs and a shrinking workforce rather than an increasing one. Capital investment will not be too lively because mergers and acquisitions, at first, result in the scrapping of old physical plant and equipment and not the expansion of it.

Basically, the scenario I have described translates in the following way: the stimulus is going to be paper, and, therefore, the profits and wealth that are going to be created are going to be primarily paper.

Money will be made in this environment…lots of it! Just don’t remain too long at the dance!

Why Future Bubbles Can Be Expected

We have been told for at least two years now that the problems in the banking sector are liquidity problems. But, liquidity problems are of short-term nature and need to be resolved within a relatively short period of time. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

The policies that are used to combat a liquidity crisis are also of a short-term nature. These policies are based upon the need to supply the market with liquidity so that asset prices will stop dropping.

Given this interpretation, the Federal Reserve, under Chairman Bernanke’s leadership, has supplied liquidity…and more liquidity…and more liquidity to resolve the issue.

This is a sign that the model being used by Bubble Ben and the Fed is inappropriate for the particular situation that they face.

But, this was the policy prescription for the Federal Reserve in the early 2000s when interest rates were kept around one percent for about 18 months. And, what did we get…a pair of asset bubbles.

In terms of fiscal policy, the situation is similar. The “experts” in the Obama administration, led by Treasury Secretary Tim Geithner, have called for more spending…and more spending…and more spending.

In both cases, the reason given why the policy prescription is not working is that the particular stimulus package tried has not been large enough. The solution Ben and Tim have given is to make the policy package larger. More spending…and more liquidity!

This is a sign that something is wrong!

The model and the analysis being used are not appropriate. The model being used to develop economic policy must be changed.

In the financial markets, the problems that exist are solvency problems. Households are declaring bankruptcy in record numbers and foreclosures on homes continue to run at very high rates. Small businesses are also declaring bankruptcy and loan demand coming from small businesses is dropping as of the last Federal Reserve survey. Thousands of small banks are on the verge of insolvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

And, guess what? The monetary policy that the Federal Reserve is following has successfully resulted in the accumulation of massive amounts of cash in the hands of large banks and large corporations. I am just waiting for the acquisition binge to begin once the economy stabilizes a little more. So much for "Main Street"!

In the economy, the “consensus” economic model that has been used over the past fifty years is still contributing to the “more-of-the-same” policies that are being followed by the Federal Reserve and the Treasury Department.

Yet, over these past fifty years the application of this model has produced the following results: the United States has moved from an “under”-employment rate of around 8% of the working population to about 25% in the current environment; these policies have also resulted in the capacity utilization in industry moving from about 93% in the 1960s to about 75% at the present time, constantly eroding throughout the whole time period; and, the distribution of income in the United States over this fifty years has moved dramatically toward the end of the most wealthy.

The foreign exchange markets have signaled to the United States that something is wrong! Over the past fifty years, the value of the dollar has declined by more than 40% in foreign exchange markets. After a recovery in the latter part of the 1990s, the value of the dollar once again tanked until we hit the financial crisis of 2008 and there was a “stampede to quality.” Once this “stampede” was over and markets and economies stabilized, the value of the dollar declined once again. And, after Ben made his remarks in Jackson Hole concerning the forthcoming quantitative easing, the value of the dollar plunged 7% in a matter of weeks.

Paul Volker has written that the most important price in a country is the price of its currency in terms of other currencies. If the value of your currency declines, this is a sign of weakness…weakness in your economy and in your economic policies.

And, here we are. Thursday November 11, 2010, the President of the United States was lectured to by Hu Jintao, the Chinese President, over the United States currency. Other world leaders, from Germany, Great Britain, and Brazil, have also reprimanded the President over the United States currency situation. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)

Furthermore, given the election results in the mid-term elections held last week, the American people seem to have a problem with United States economic policies.

The policy direction in Washington needs to be changed and changed soon.

However, I don’t expect a change to be made in the near future. President Obama seems to be adamant that this policy must be effectively enforced.

Therefore, like the early 2000s I expect bubbles to occur here and there.

The problem is, as we well know…that, sooner or later, bubbles burst!

The Basics of Turnarounds: the United States Situation

A part of my life has been connected with company turnarounds, bank turnarounds to be more precise. I would suggest that the United States is in a turnaround situation right now but its leaders claim that the economic model it is using is still relevant and that all that is needed is a little more time and a little more co-operation from others and everything will turn out alright.

My experience has led me to some conclusions about what is needed in a turnaround situation. (By-the-way, all my turnarounds were successful and I can say that now because I am not doing turnarounds any more.) We don’t have much space to discuss these things so let me just summarize what I believe to be the four most important factors in achieving a turnaround: the business model; information coming from the market place; the need for transparency and openness; and the existing business culture.

Although these factors relate to a business situation, I believe that they can be applied to any “turnaround” situation, including the “turnaround” of a government.

First, and foremost, an organization gets into trouble because its business model, or economic model, is not working. But, because a leader or a management team believes that the organization has gotten where it is because of that business model, they tend to stick with the model and apply the model even more forcefully.

In some cases, the success of the model has come because of the timing of the model’s use and not because of any inherent characteristics of the model are correct. To justify this statement I refer the reader to the book “Fooled By Randomness,” by Nassim Nicholas Taleb.

In terms of the economic model that the United States government is applying, and has been applying for a very long time, there is no real evidence that it works. I am, of course, speaking of the Keynesian macro-economic model.

Ever since the 1930s when the model was first presented, all I have ever heard in times of difficulty is that the reason the Keynesian model falls short is that not enough stimulus has been forthcoming. Keynesian economists contend that the Great Depression continued on for as long as it did because governments did not create sufficient budget deficits. Only the war effort, World War II, got the US out.

This criticism has been applied over and over again during the last fifty years. All we have been hearing from the fundamentalist preacher Paul Krugman is that the Obama stimulus package must be greater. He has been consistent in applying this remedy since early on in the Great Recession. More spending, more, more!

Maybe the economic model the government is using is wrong!
The application of this model over the past fifty years has produced falling capacity utilization, rising under-employment, and greater income inequality.

Maybe the economic model has not been applied correctly!

Defensive comments like these are heard over and over again within a company that is in decline.

Second, it seems that others recognize the decline in the company even though the leaders and management of the organization do not. That is, the market recognizes that the model of the organization is not working and that the organization is in decline.

And, what is the response of the leaders or managements of the targeted organization. The response is “The market doesn’t understand us!” I don’t know how many CEOs I have heard express this sentiment in the face of a falling stock price.

The thing is, the market does understand the company and the fact that the company is applying an inappropriate business model.

The market response to the economic policy of the United States? Well, the behavior of the United States government in the 1960s resulted in the need for the United States to go off the gold standard. Since the United States has been off the gold standard, the value of the United States dollar has declined almost constantly (with the two exceptions, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve system and during the 1990s when Robert Rubin was the Secretary of the Treasury).

Obviously, for the value of the United States dollar to substantially fall, almost continuously, over a fifty year period, indicates that something must be wrong with the economic model the government is using. During the past fifty years, the government has relied on a credit inflation whose foundation is a federal deficit that has resulted in the federal debt increasing at an annual compound rate of growth of more than 9% over this time period. The government has created other avenues of credit inflation through programs like those built for housing and home ownership. The whole economic model was based upon inflating the economy causing people to constantly “leverage up” and take on more and more risk.

Third, transparency and openness goes by the wayside as organizations experience decline. Cover ups abound! President Obama came into office declaring that he was going to change the way things are done in Washington. Yet, his administration is now charged with opaqueness and obfuscation like every other presidential administration. Even little bits of information, like the recent report by the special inspector of the TARP program, only adds to the accusation that this administration is hiding things. This was in all the papers this morning. (See “Treasury Hid A. I. G. Loss, Report Says,” http://www.nytimes.com/2010/10/26/business/26tarp.html?ref=business.) This does not help!

Fourth, the culture of an organization begins at the top. In a turnaround situation, a new culture
must be implemented and that culture must begin with Number One. The new leader that takes on a turnaround situation must change the way things are done and introduce a new business or economic model into the organization.

However, this new business model cannot be introduced or implemented if the (new) leader assumes that little or nothing needs to be changed. And, this implementation cannot be carried off unless the members of his or her team are all on board.

In my view, things need to be changed in Washington, D. C. The evidence in the market place is hard to ignore, although Washington has done its best to shift attention to others. But, the weakness of the United States position has been observed and others (China, Brazil, and India, and others) have moved into the void to take advantage of it. (See my post http://seekingalpha.com/article/229112-the-imf-bowl-u-s-vs-china.)

Even if the philosophy of economic policy used by the United States government was appropriate forty or fifty years ago, things have changed since then. (See my post http://seekingalpha.com/article/232044-maybe-things-have-changed.) The United States needs to be “turned around”. But, to do a turnaround, those that are in leadership positions must accept the fact that a turnaround is necessary. I don’t see this happening any time soon.

Questions for a Monday Morning

Beginning in 1961 with the inauguration of President John F. Kennedy, the United States government has basically operated from a “Keynesian” economic philosophy. The economists that Kennedy brought into his administration were avowedly Keynesian and the Kennedy tax cuts that followed were developed from a Keynesian model.

This has been a bi-partisan effort and Republicans are as guilty as anyone in terms of the emphasis upon stimulative government budgets. President Richard M. Nixon confessed in the early 1970s that “we are all Keynesians, now!”

Government economic policy was written into legislation beginning with the The Employment Act, Act of Feb. 20, 1946 which was followed by the Humphrey-Hawkins Employment Act, the Full Employment and Balanced Growth Act, enacted in October 1978. Congress enacted laws that required the government to produce economic growth policies that were aimed at high levels of employment.

A growing economy and high levels of employment became a necessary goal of any presidential candidate running for election (“Get the economy growing again,” and “It’s the economy, stupid!”) or for re-election.

And, what was the result?

Since 1960 through 2009 the United States economy has grown at an average annual compound rate of growth of around 3.2%. Economists in the 1960s calculated that full-employment growth in the economy was about 3.2% and so economic policy was targeting a potential for growth in the United States economy of 3.2%.

If, after 50 years, these economists were to look back they might be astounded that the economy grew roughly at what they presumed to be the rate at which the economy could potentially grow during that time period.

Yet, not all is well with the world.

These economists could argue that fiscal policy really worked. The gross federal debt grew at an average annual rate of more than 9% during this 50 year period. Fiscal policy must have worked?

Financial innovation in the United States government was astounding during this period. As Niall Ferguson has claimed in several of his history books that governments have always been the number one innovator in finance historically. The United States government certainly proved this to be true over the last 50 years.

Certainly, credit inflation was the name of the game during this time period as the private sector came to emulate the government sector in terms of creating financial innovation and financial leverage became the necessary means of competition for firms to gain an edge in financial performance.

On the way to the bank, however, certain other things happened…and these raise some serious questions.

During all of this time period, in the United States industrial sector, capacity utilization went from over 90% of capacity to about 75% of capacity. If growth was proceeding at 3.2% a year, how come our industrial base has been used less and less over this period?
Also, the big concern in terms of unemployment was that we reach and sustain a 4% unemployment rate. Yet the unemployment rate has progressively increased and the under-employment rate, hardly different from the unemployment rate in the 1960s, is now above 20%. Why hasn’t the economic stimulus put more people to work?

Housing, which used to be the backbone of the private sector is now primarily the realm of the federal government. Who owns most of the mortgages in the country?

In the 1960s there were over 14,000 commercial banks in the United States. Now, there are less than 8,000 and, in my view, we are going to 4,000 in the next several years.

We had a vibrant sector of thrift institutions in the 1960s. By the end of the 1980s the thrift industry was almost gone. By the end of 2011, the thrift industry will be gone. This was the result of sound fiscal policies?

Income inequality has risen dramatically over the last 50 years. We have found out that the wealthy or the financially savvy can protect themselves during times of inflation and credit inflation. The blue collar worker, the less financially sophisticated, the middle class cannot protect themselves nearly as well during times when hedging or speculation becomes the way to financial wealth. Weren’t the Keynesian policies supposed to help the less well off by keeping them employed?

The “piggy bank” that the middle class and finally the less-well-off were supposed to exploit and protect themselves against inflation and lead them into a better financial future eventually busted. Housing was the “piggy bank” that many were supposed to ride to retirement leisure. But, falling house prices and foreclosures are turning the dream of many into nightmares? Couldn’t credit inflation keep this ball in the air?

There are many other question going around right now. The concern is the validity of the economic model that has been the foundation of our economic policies over the past 50 years. It appears as if we got the economic growth. What happened to all the other benefits we were supposed to receive once we achieved this economic growth?

It's All About Leadership, Stupid!

I got on a Michael Douglas kick this weekend because his new flick “Wall Street: Money Never Sleeps” was coming out in the theaters. I, of course, took in Wall Street 1.0 again. Among the other Michael Douglas films I reprised, “The American President” caught my attention.

The particular line that got to me was one uttered by Michael J. Fox, who played a sort of George Stephanopoulos character to the President. The scene was set in the Oval Office of the President and the President and his chief advisors were discussing the direction that should be taken with respect to a crime bill. The conflict being addressed concerned whether or not the President should “play politics” and disappoint his friends, including his “girl friend” Annette Bening, or be true to his leanings and go for the environmental package.

He, at the time, chooses to “play politics”, and is taken to task for it by Michael Fox. The line that stuck with me was this:

“People want leadership and in the absence of leadership they’ll listen to anyone who comes to the microphone.”

This statement really resonated with me because I believe that is the situation we are in now in the United States. People want leadership, but they are not getting it.

Leadership starts with the CEO, the Chief Executive Officer.

There is no way others within or without the organization can exhibit leadership and set up the tone and the culture of the organization. But others try, especially opponents.

And, if the leader does not take charge, people will “listen to anyone who comes to the microphone.”

President Obama speaks. He is constantly speaking. Something small comes up and he goes out and makes a speech about it. Something large comes along and he goes out and makes a speech about it. The problem is that he is just speaking…not leading.

One of my firmest beliefs is that CEOs and their teams need to listen to the market and try and discern what the market is attempting to tell them. The “market” may be wrong, but, to me, the wisest action is to listen to the market and only claim that the market is wrong after a serious and thorough study attempting to support the fact that the market is correct.

What is the market saying right now?

Well, who is dominating the airways and printing presses these days? John Boehner. Christine O’Donnell. Stephen Colbert. Jon Stewart. Rush Limbaugh. Nancy Pelosi. Carl Rove. The Tea Party movement. The Party of “NO”. And, so on.

President Obama spoke at the United Nations this week…and it was just another of his many speeches. Who really listened to him?

President Obama is visiting homes trying to establish the “common touch.” Where is the leadership?

Obama is speaking a lot, but, people seem to be listening to other people who are grabbing the microphone. Conclusion: people do not feel that Obama is leading the nation.

A health care bill was passed on the watch of President Obama. But, the view of the voters is that Harry Reid and Nancy Pelosi and Congress did all of the work.

There is a new financial reform package the Chris Dodd and Barney Frank crafted. Where was Obama?

And, the earlier stimulus bill. The public perception was that the Obama administration turned this over to the Congress, fully supporting a bill that contained a lot of old programs that benefitted the interests of members in Congress. All Obama just praised the fact that a stimulus bill was passed.

The market perception seems to be that President Obama, himself, did not send up any bills to Congress in these areas; he turned the tasks over to Congress, urged them along, and accepted whatever Congress produced and sent to him.

The market does not see President Obama as “the” leader in any of these initiatives. His absence, then, has allowed the microphone to be dominated by others.

This lack of leadership has particularly been felt in the areas of economics and finance. No one seems to know where the administration is going or what the administration is going to do. What about another stimulus program? What about the Bush tax cuts? What about foreclosures? What about the big banks? What about the consumer protection agency? What about the insurance companies that are raising rates? What about the credit card companies that are raising fees? What about the Chinese currency? What about the government’s 61% ownership in General Motors? What about how GMAC pursued its foreclosure efforts? What about…you name it?

Talk about a free market!

If there is no leadership, then anarchy takes over.

There was the cry against big banks. But, the Obama administration (including the Fed) seems to be doing everything it can to help the big banks at the expense of the smaller ones. The administration talks about the United States being strong economically, yet its policies are just accelerating the re-positioning, economically, of China and Brazil, Russia and India, and other emerging nations. The administration talks about helping out the middle class and blue collar workers yet its policies promote the bifurcation of the work force, lessened capacity utilization in industry, and greater income inequality.

And, this is why people, other than the President, are dominating the microphone.

The Michael Douglas President finally did make a stand and began to tell the people where he really stood. The Michael Douglas President became a leader. Although this change came right at the end of the movie, it was the turning point of the movie. And, you knew what the President was going to do in the future, nothing more needed to be said in the movie. In taking this turn, the President began to dominate the discussion again.

Do you think this might happen in the real world? In the United States? Do you think it might happen in the near term?

Jobs and Skills: the Current Mismatch

For at least 18 months, I have been arguing that the United States economy is going through a transition period that is more than just a cyclical slowdown and recovery. My argument has been that the economy is going through a period of restructuring that will take an extended amount of time to work out all the changes that are necessary.

As a consequence, “blunt-edge” efforts to stimulate jobs by means of the fiscal policy of the federal government will not achieve a great deal of success.

The reason for this in many cases is that the fiscal stimulus of the past 50 years has caused companies to keep aging physical capital in use and has resulted in these companies hiring people to perform jobs related to “legacy” technology.

The evidence I have provided for this is the increasing amount of unused capacity in the manufacturing realm and the growth in the number of employable Americans that are under-employed. To be under-employed, one is either unemployed, not fully employed and looking for full-time work, or discouraged and not seeking a job.

I have argued that this is not unlike the 1930s when the United States economy was going through a transition period in which jobs and employment were shifting from rural and agricultural areas to cities and industrial areas. The restructuring that took place accelerated during World War II and did not really calm down until the 1950s and 1960s.

Two reports came out toward the end of last week that support my claim of an economy that is in the process of restructuring. The first was an article by Motoko Rich that appeared in the New York Times on Friday July 2, with the title “Jobs Go Begging as Gap is Exposed in Worker Skills.” (http://www.nytimes.com/2010/07/02/business/economy/02manufacturing.html?_r=1&scp=2&sq=motoko%20rich&st=cse) Rich writes that “Plenty of people are applying for the jobs. The problem, the companies say, is a mismatch between the kind of skilled workers needed and the ranks of the unemployed.” The subheading to the article reads that “Shifts in Manufacturing are Leaving Many as Unemployable.”

The second report came from the Labor Department on Friday, July 3. Although the unemployment rate declined in May to 9.5 % from 9.7% in April, this was because the labor force shrank as more people left the labor force than were added to payrolls: the labor force shrunk by 0.3% while the number of individuals employed dropped by only 0.2% (due to the loss in jobs connected with the collection of Census data).

The official statistics report that the “underemployment” rate has been in the 17% range for the past year or so. I estimate that, currently, about one out of every four or five individuals that are in the employable age group are under-employed. The reason is that there is a tremendous mis-match between what employers need to be competitive in the future and the pool of skills and experience that are available in the labor market. Products are being made differently now than they were several years ago and this trend will continue. The current downturn has provided additional justification for manufacturers to make the changes that they need to make.

Why do they need this added justification?

Well, over the past 50 years, every time there was a recession (and even in periods when there was not a recession), the federal government provided fiscal stimulus to get people “back-to-work.” Back-to-work, however, meant putting people back into jobs that they were in before the workers were laid off. This is what the government wanted to happen.

However, putting people back to work in “legacy” jobs did not contribute to modernization and improved productivity. It did increase employment and reduce unemployment which is what the federal government wanted to achieve.

Now, businesses can use the excuse of the extreme downturn in the economy to justify the changes in who is hired to meet the reality of changes in training, skill levels, and experience that have occurred. And, this transition will not be completed overnight.

We see the same thing in the use of physical capital in the United States. Since the 1960s, the capacity utilization of manufacturers has declined steadily. As with the increase in the underemployed, the employment of the physical capital in the United States has fallen over time.

In January 1965, American manufacturers were working at 89.4% of capacity. The next peak in manufacturing usage (capacity utilization is very cyclical) came in February 1973 at 88.8% of capacity. The following peaks were: December 1978 at 86.6% of capacity; January 1989 at 85.2% of capacity; December 1997 at 84.7% of capacity; and April 2007 at 81.7% of capacity.

Note that the troughs of the cycles in capacity utilization also fell since the 1960s. In December 1982, manufacturers in the United States worked at 70.9% of capacity and in June 2009, they worked at 68.2%. Currently, manufacturers are working at 74.1% of capacity.

In essence, businesses in the United States have been utilizing less and less human and physical capital over the past 50 years relative to the amounts of these productive factors that have been available. And, the policy makers just don’t seem to get it.

From Rich, in the article cited above, “Christina D. Romer, chairwoman of the Council of Economic Advisers, said the skills shortages reported by employers stem largely from a long-term structural shift in manufacturing, which should not be confused with the recent downturn. ‘I do think that manufacturing can come back to what it was before the recession,’ she said.” So, manufacturing will return to the new, lower level of capacity utilization that was achieved at its previous peak level, roughly 82% of capacity. And, this is good?

My guess is that capacity utilization will hit, maybe, 80% at the next peak. We are still talking about 20% of the manufacturing capital of the United States being underemployed, right in line with the 20% to 25% of employable labor in the United States being underemployed.

The fiscal stimulus proposed by “fundamentalist” Keynesian economists will not do the job. Additional, “blunt-edge” governmental expenditures may alleviate some of the current worker distress, but at the cost of postponing the adjustments that need to be made to restructure the economy, the restructuring that is now going on.

The problem with the “fundamentalist” Keynesian view is that it is constructed from a short term perspective. The basic attitude is that which is attributed to Keynes: “In the long run we are all dead.” This approach leads to a focus on only “current” problems. What is not explicitly stated is that we will deal with the longer-term problems when they become current problems.

The difficulty with this: the longer-term problems may require a different “medicine” than did the short-run problems.

Well, one could argue that the longer-term problems have become current. The short-term solution of forcing many companies to continue to employ people in “legacy” jobs and to continue to use “legacy” plant and equipment has resulted in higher and higher rates of worker under-employment and lower and lower rates of manufacturing capacity utilization.

Just more of the same does not seem to be an adequate answer.

The Coming Stimulus Package

Yes, we do have a President (elect)! (See “A Whiff of Leadership?” posted November 22, 2008 at http://maseportfolio.blogspot.com/ . An economic stimulus package is in the works. The underlying philosophy…the risks of not doing something big are bigger than the risks associated with inflation and an economic cleanup when the economy shifts into first gear rather than reverse.

We have seen this attitude taken by the Federal Reserve. The Fed, as we have been writing about in this blog, has not wanted to be short in supplying liquidity to the financial markets. Federal Reserve assets have more than doubled in the past ten weeks. Chairman Ben Bernanke has been given the name Helicopter Ben during this barrage of funds. But, the argument goes, the risk is too great to not put money into the financial system until the financial markets begin to function again.

Liquidity is apparently not going to get the economy humming again…spending of the private sector is going into the tank. Lending in the financial markets is not going to kick-start consumer spending or investment spending…state and local government expenditure is also in decline…so the belief is that the federal government must step into the gap and stimulate incomes and employment.

The talk seems to indicate that the Obama economic stimulus package is going to be somewhere in the neighborhood of $700 billion…of similar size to the bailout package of a couple of months ago. The idea…like that of the bailout package…is that the stimulus package must be a large number.

One thing that is crucial in all of this is that the Obama administration must give off the impression that it is operating under control…that it is disciplined. This is a hard thing to do when the philosophy of the stimulus package is the one described above. However, the administration must appear to be very intentional, on top of the situation, and ready to do what is necessary in response to new information. That is, the Obama administration must rebuild confidence in the federal government. Establishing confidence at the top is necessary because it will help to rebuild the confidence of the whole system as I discuss in “Discipline or the Lack Thereof” posted November 20, 2009, at http://maseportfolio.blogspot.com/.

President-elect Obama seems to be aware of this need to set the tone for the future. I think people, and markets, will respond very well to this because they are so hungry for leadership at this time…and are very, very anxious. So, we see two things going on right now…first, the appointment of top quality people to important positions…and, second, the intentional effort to create programs and get the discussion in Congress and the economy going so that action can be taken as soon as possible. The important emphasis right now is that the effort is intentional, not passive or just reactive.

Just a final note about the apparent appointment of Larry Summers to head the National Economic Council: this may be an inspired choice. No one questions the intelligence and ability of Summers. Being in the White House, acting as the coordinator of the economic policies of the President, monitoring the President’s economic agenda, and serving as close advisor to the President may not only fit his personality best but may be the real place his talents can fill the needs of the nation. It also superbly complements the other appointments that the President-elect has made to build his economic team.

Fundamentals 101

Mase: Economics and Finance. September 15, 2008

Fundamentals 101

The United States (and the world) is in a crisis mode. It will continue to stay in a crisis mode for some time. In working through this transition period it is crucial to remember…that fundamentals are important.

Americans are always ones for sports analogies. Let’s start with the need to develop fundamentals. We emphasize the fundamentals of the golf swing in golf. We emphasize the fundamentals of hitting a baseball in baseball. We emphasize the fundamentals in football…and so on and so on.

But, in finance and economics we constantly reflect upon a new economics, a new era in finance, and a new…whatever. We keep finding reasons to believe that we have entered some new period that negates part or all that we have learned. And, when we follow this path, we always end up finding out that…well…that the fundamentals really do still apply.

We can certainly blame the leaders of the corporate world of finance and industry for their putting the fundamentals of finance aside in their quest to become the biggest and “the best”. (What “the best” means we will save for another time.) All I will say here and now is that they were followers…not leaders…and that led to the downfall of those that have failed or will fail.

The leaders I have most scorn for at the present time are those leaders that created the atmosphere…the culture…in which others had to operate. These leaders completely ignored the economic and financial fundamentals that have, over time, proven to be so important in performance. And, the leaders I am talking about here are the political leaders that “set the table” for the period of upheaval that we are now going through.

The number one fundamental that must be adhered to is the one that relates to the value of the currency of a country. The leaders of a country must not…let me repeat…must not…let the value of its currency decline precipitously. I am not talking about slavishly keeping the value of a currency at a particular price. History has shown that this kind of policy does not work either.

Focus upon the value of ones currency causes one to focus upon what your country is doing relative to what other countries are doing. Many people do not like this thought because it seems to make the economic and financial policy of our country dependent upon what everyone else is doing. These people do not want to give up their sovereignty.

The problem with acting independently of everyone else is…we are not independent of everyone else! We live in a world where everyone else is dependent upon everyone else…whether we like it or not!

First finger pointed in blame…the Bush 43 administration. It came into office believing that the United States was so special that it could act unilaterally on anything it chose…it acted that way.

Second finger pointed in blame…Alan Greenspan and the Federal Reserve System. Whether or not they claim that they were paying attention to the value of the United States Dollar they did not act as if the value of the dollar was of any interest to them. They allowed the dollar to decline in value for about seven years. The value of a country’s foreign currency is the NUMBER ONE price that a central bank needs to focus upon!

Why, does a central bank need to focus on the value of its currency in foreign exchange markets? It is because the value of the currency provides information about how market participants are perceiving the economic policy of a specific country vis-à-vis other countries. Sure, the markets can be wrong in the short term, but over seven years the markets must contain some pieces of information that are not totally off-the-charts in terms of what is going on.

This is an important fundamental...pay attention to the value of your currency in foreign exchange markets.

But, Greenspan has argued that the Federal Reserve HAD to keep interest rates low because WITH THE BUSH TAX CUTS, FINANCING OF THE DEFICITS WOULD HAVE FORCED INTEREST RATES UP AND THIS WOULD HAVE CAUSED SLOWER ECONOMIC GROWTH!

But, that is why central banks are supposedly independent of the government of a nation.

Greenspan acted as if the Federal Reserve was nothing but a lackey of the Bush Administration!

If the Federal Reserve had acted as a real independent central bank…

Well, it didn’t…and see where it got us.

I am writing these things because we are currently in the midst of a presidential campaign. My concern is that not one of the candidates is addressing the real economic issues that the country faces. Furthermore, I don’t believe that they will before the election in November. This is due to the fact that neither of the major candidates wants to discuss the fundamentals that need to be re-addressed if the country is to get back on its feet. People want to hear what the candidates are going to do for them and not what fundamentals need to be re-established.

First, let me say that I believe that we are going to get through the current period of financial dislocations…there will still be failures, maybe even some large ones…but, we will get through this adjustment in the next eighteen months or so.

The concern seems to be growing that the economic problem will be one of stagflation. Let me just say here that the fundamentals of supply and demand analysis has not been surpassed. The problem with stagflation is that economic growth is slower than desired and that inflation is higher than desired.

NOTE: this is not a DEMAND-SIDE problem, IT IS A SUPPLY SIDE PROBLEM! ! !

Just goosing up aggregate demand with popular economic stimulus programs will not overcome the problem. Focusing just on demand-side solutions will only exacerbate, and not relieve the situation.

So, here is a fundamental teaching that we must not ignore.

Second, we live in an inter-dependent world. The United States cannot…repeat, cannot…just go off on its own and act unilaterally. We must talk with others. We must devise out programs, both economic and financial, within the context of what other nations are doing. Yes, this sacrifices some of our valued independence, but that is the way the world is. We must plan and live in such an inter-dependent world.

Here is another fundamental teaching that we must not ignore.

Third, the Federal Reserve must regain its independence once again. It must focus on what it should focus upon, the value of the United States dollar, and if other areas of the government cannot do what they want to do…then sorry, but this is the discipline that a real central bank bring to its nation.

This fundamental teaching cannot…let me repeat…cannot be ignored!

The Reign of Uncertainty

The most dominant factor operating in markets at this time, domestic and international, is uncertainty. Yes, the price of oil is down. The price of gold and other commodities is down. The dollar is stronger. And, question have been raised…like has the dollar reached a bottom in value and now will recover (“Historical Trends Suggest That the Buck Is Back”, http://online.wsj.com/article/SB121961240718867281.html?mod=todays_us_money_and_investing.) Is inflation going to drop as the economy weakens so that interest rates don’t need to be raised? And so on, and so on.

What I see in world markets these days is not a “trend” here or a “trend” there. What I see is uncertainty. I see volatility with no clear direction, one way or the other. And, the uncertainty that exists is not connected to events, but to fundamental issues.

Three international issues immediately come to mind. The first of these has to do with Russia, the more active role it now seems to be playing, and the response of the rest of the world to the new feeling of power being exerted by Russia. The United States has expended a lot of its good will over the past seven years or so and is, at present, in no position to lead others against this exertion of will.

The second has to do with the other BRIC countries and the role they are going to play in the world economy in the future. China, of course, coming off the successful execution of the Olympic Games, is gaining in confidence every day. India, although it has its problems, is going to play a major role in the world economy going forward. And, Brazil seems to be growing stronger every day. The United States has little or no influence over the direction these nations move since it forfeited it’s ability to work with them when they were, economically, just emerging countries.

And, of course, there is the uncertainty related to world energy sources and the role that the Middle East plays within these markets. Although the demand for oil seems to have dropped off in the United States due to Americans driving less, the overall demand for energy in the world continues to climb. And, there is always the uncertainty relating to supply…we just don’t know what might happen here in terms of leaders and in terms of cultures. Of course, the militant forces of terrorism play a role in how this issue works itself out.

This just represents a start. We can remain at the world level and talk about the unraveling of the global consensus on trade. (http://www.ft.com/cms/s/0/111b33e6-71ff-11dd-a44a-0000779fd18c.html) Current economic relationships have been built upon the efforts of many people and nations to build a more global economy. This consensus is showing signs of weakness now and is in danger of collapsing. A world with more restricted trade and greater emphasis upon nationalism would certainty have major economic and financial ramifications for the world at this time.

There are other factors causing uncertainty internationally, but let’s take this discussion into the national level and focus on the United States. First, there is great uncertainty concerning the health of the financial system. The number one concern at this time is what is going to happen to Fannie Mae and Freddie Mac. Is the Federal Government going to have to step in and do something about them and if so what is going to be the resultant structure of the companies and what is such a bailout going to cost the American people? But, there is still concern about the health of investment banks and how large the additional write offs are going to be. There is concern about the commercial banking industry, whether or not there will be more bank failures and whether or not there will be a failure of one or more “major” banks. The fact that the FDIC is pulling back former employees that worked in bank examination and bank closures and workouts to augment its current staff is a source of some concern. Furthermore, there is no good estimate of the amount of charge offs that financial institutions will face…first in terms of mortgages, then credit cards, then…

Then there is the housing industry. How much further down will it go and how long will it take before the industry bottoms out and construction really begins again?

What about unemployment? The unemployment rate hit 5.7% last month and the projection is for this number to go higher and higher. But, how much higher? It seems as if layoffs and firings are just beginning. Many industries are going through major restructurings and we don’t know, as yet, what the final effect will be in terms of the employment numbers. Companies are going into bankruptcy. Other companies are reducing the number of retail outlets they have retrenching for the growth at any cost efforts of the past. The auto companies are asking the government for major dollars to help them make adjustments to the changing nature of the industry. And, in this environment, would you be terribly aggressive in expanding output or hiring new employees?

Higher unemployment means higher payments for unemployment compensation. The government will almost certainly give the auto companies financial help. The government is promising relief to people facing foreclosure on their homes. The bailout of “Fannie” and “Freddie” could run up to $200 billion. And, what if commercial bank failures, let alone the possible failure of another investment banking firm, put pressure on the FDIC’s insurance fund requiring the government to set aside more funds, how would that add to the deficit? And, these potentials demands for government monies are just a few of the possibilities along with the worldwide problems that could cause the Federal deficit to become even larger. What price will the United States Government pay to finance all the debt that could be amassed in the near future to handle the multitude of potential crises that could unfold?

Then there is the leadership concern. The Bush Administration is history…yet, it still is in office for almost five months. There are still members of the administration trying to leave some positive legacy behind them. There have been several recent articles discussing the efforts of Condoleezza Rice and Henry Paulson to do something positive before they leave office. The “big one” for Paulson is, of course, the Fannie Mae/Freddie Mac bailout. Everyone else seems to have just disappeared into the woodwork.

And, there is the case of the presidential candidates. I won’t go into that again…you can read my thoughts written in my blog for August 18, 2008 (http://maseportfolio.blogspot.com/). All I will say right now is that I don’t believe that either of the two candidates have given us a clear idea of what we can expect from them in the economics or financial arena if they are elected President.

The world is a highly uncertain place today. Given the nature of many of the factors contributing to this uncertainty, I don’t see how the uncertainty can be resolved in the short run. Because of this uncertainty, the risk associated with any business or investment decision will be higher than it has been for quite some time. Over the past several months we have seen this risk being built into market relationships, especially into the interest rate spreads that exist on financial markets. However, we are also seeing changes in relative pricing in the “real” economy as businesses adjust for the changing assessment of risk that exists within these markets. These re-evaluations, obviously, are not very encouraging for the stock market.

The prognosis for the future, therefore, is for volatility. Markets are going to go up and markets are going to go down, but it is going to be very difficult to determine longer term trends in such markets. There is just too much noise.

What will get us out of this mess? The answer to this dilemma is time, information, and leadership. Nationally, as well as internationally, we don’t have a vision of where we need to go. There is still much “pain” to be felt in the United States. Someone is going to have to “own up” to this pain and provide a map for getting through it, helping those hurt where possible. Until we get some idea of what is going to be done…uncertainty will reign in financial and economic markets.

The "Inflation Threat" and the Strength of the Economy

Today's article in the Wall Street Journal reporting on the speech of Federal Reserve Chairman Ben Bernanke at the Jackson Hole conference (http://online.wsj.com/article/SB121941429990263697.html?mod=hps_us_whats_news) contains this paragraph:

"Some Fed officials have called for raising rates before long to address worries about inflation. Consumer prices rose 5.6% in July from a hear earlier, a 17-year high. However, most officials believe a weak economy will lessen the inflation threat, and they want to keep rates lower for now to offset tightening credit conditions."

This speaks precisely to the point I made in my post of August 22, 2008, "It's the Supply Side, St....". If you believe that the problem being faced by the policy makers is one of insufficient aggregate demand, then there certainly should be pressure for inflation to weaken.

However, if you believe that the weakness in economic growth comes because of a shift in aggregate supply then there WILL NOT be pressure on the general rate of inflation to decline.

Of course, both aggregate demand and aggregate supply shift. Thus, it is a question of which one of the two dominates. If shifts in aggregate demand dominate then the economy will weaken and inflation will lessen. However, if the shifts in aggregate supply dominate then the economy will weaken but inflation will not lessen.

How the current situation is interpreted is IMPORTANT both for the policymakers in Washington, D. C., but also for business leaders and investors!

It's The Supply Side...

This is the third of three posts in which I aim to present the outline of my vision of where the economy is going into the fall. The first, “The Candidates and Economic Leadership” (August 18, 2008) framed the political environment, and the second,” The Most Important Price in the Economy” (August 20. 2008) presented my view of where the focus needs to be centered for economic policy making. This third post will be more specific as it tries to define the dilemma the policy makers are facing within the current environment.

In my view the implicit model of aggregate economic activity that we default to is one in which the aggregate supply of goods and services is assumed to be fixed or constant. That is, the aggregate supply curve is perfectly inelastic with respect to the aggregate price level. (This, of course, is a very simple picture and does not take into account the potential growth of the economy. Both of these points can be addressed. I am just trying to KISS the analysis for reasons of space and exposition.)

In this simple model, the only way that one can get a fluctuation in output is when the aggregate demand curve shifts. If output is observed as less than ‘full employment output’ (or growth is less than “full employment growth’) the only explanation that can be given for such performance is that aggregate demand must be less than is needed to achieve ‘full employment output.’ That is, demand is deficient.

If demand is less than supply at a given price level shouldn’t the price level fall?

Here we face another assumption, pervasive in modern macroeconomics, which sneaks into our analysis without our really realizing it. This is the assumption that prices either do not fall in a modern economy or at least adjust downwards at a very slow pace.

Our basic instincts tell us, therefore, that the only way we can avoid unemployment and unused resources is to “juice up” aggregate demand. We must create an economic stimulus package that will “goose” the economy so that it will achieve full employment once again. This is what the tax stimulus package enacted earlier this year was all about.

But, what if the drop in economic output (or the slowdown in economic growth) is not due to deficient aggregate demand but due to a shift in the aggregate supply curve?

In this case, with no reduction in aggregate demand, we would face a decline in aggregate output AND a rise in prices!

And, in such a case, what would happen it the economy was stimulated through an economic stimulus package? Possibly economic output would increase a little bit, but the stimulus package would certainly put more pressure on prices! This seems like the situation called STAGFLATION, a replay of the 1970s!

Stagflation is a situation in which there has been a backward shift in the aggregate supply curve combined with economic stimulus. The supply curve shift has resulted from factors, independent of demand, that impact producers…like an energy shortage or changing trade patterns or difficulties in the financial sector or government policies…and cannot, therefore, be offset by an economic stimulus package. Any government efforts in such a situation must be directed at overcoming the things that are causing businesses to produce fewer products and services at given prices.

The attempt to stimulate aggregate demand at such times does very little in the way of creating much additional output. The demand pressures that are created go into price increases that help producers to weather the difficulties they are facing in terms of their output decisions. It is a fact of life that the factors that impact the producers at this time create greater uncertainty for their businesses. Changes in the future of motor vehicles using alternative fuels as energy sources are having a major effect on auto makers. Uncertainty about the structure and regulation of the financial industry cloud the decisions of bankers. The lack of a clear vision of the future economic policy of the government affects us all. In such an environment businesses will take fewer chances with respect to increasing their output but will gladly take any increase in cash flow that they can get from increases in prices. This is the less risky strategy at this time.

How is one to get out of such a bind?

Well, my first response to this is that we need good leadership. No one likes uncertainty. But, uncertainty is rampant in the United States at this time. We see this on the evening news broadcasts. Families are cutting back on school supplies for the fall because of the uncertainty they face with respect to their budgets. What is going to happen to gas prices? What is going to happen to food prices? What is going to happen to employment? And so on, and so on. How should producers respond to this? A tax break to these families is not going to get them to spend more on school supplies. So businesses are uncertain about their future.

What about energy policy? Off-shore drilling or reducing oil reserves is not going to solve our problems. Regardless of the short term responses of the presidential candidates, uncertainty is going to hang over businesses concerning what they should be doing about their future energy sources. Solar panels on all malls or strip centers? Wind sources for electrical energy companies? Companies focusing on these big issues are not focusing on output.

What about the financial system? What about the infrastructure? What about…?

We need a leader who provides us with a vision we can believe in and in whom we can develop trust in to deliver on that vision. We need a leader who can help reduce the uncertainty that exists in the United States at this time.

My second response is that we need to get away from an emphasis on stimulus, stimulus, stimulus. What does such an attitude do? First, is that it creates an atmosphere of go, go, go. Everything is up, bailouts will be given for making mistakes, but, after any short crisis, the emphasis will always be to push the limits. This is the kind of environment in which inflation flourishes. Why should I worry about a slowdown? Inflation will be back and I can let prices buy me out of any mistakes I make. Why should I worry about over-leveraging a position? I will just be bailed-out and the process will start over again. In such situations we concentrate more on financial outcomes rather than on real production and creation.

And, finally, I believe that we need economic policies and regulations that are based upon process and not upon outcomes. An unemployment policy based upon a target number for unemployment, say 5%, is one based upon an outcome. An employment policy based providing education and transition support is a policy based upon process. Anti-trust regulation based upon market statistics and market structure is regulation based upon outcomes. Business oversight based upon openness and full disclosure is regulation based upon process. Taxing corporations that creates incentives to “go offshore” so as to avoid taxes is a tax policy based upon outcomes. Taxing corporations so as to change behavior or to punish those earning “excess profits” is a tax policy based upon outcomes. The tax system that creates incentives to focus on creative accounting and ingenious corporate structure distracts businesses from what they really should be doing. Taxing businesses must be based upon processes…and not outcomes.

I could go on…and I probably will in the future…but, at this time, I firmly believe that we need to focus on what is impacting the supply side of the economy and not the demand side. If we do not focus on the supply side at this time I believe that we are in for continued volatility in the markets and continued fragility of our financial institutions and consequently our whole economic system.

The Most Important Price in an Economy

In my post of August 18, 2008, I argued that neither of the presidential candidates had really staked out a well defined position as far as their economic vision was concerned. The pronouncements of the candidates, I wrote, were either too general or were bogged down in ‘wonkish’ minutia. As a consequence, an uncertainty has resulted that has left people and markets without direction and has fueled a greater volatility in prices.

Given this criticism, the question must be asked, “What is the basis for a sound economic vision?”

I believe that the foundation of a sound economic vision begins with the value of the United States dollar. I continually go back to the statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.)

The reason the exchange rate is the single most important price in the economy is because it reflects the viewpoint of the rest of the world about how an economy is being managed relative to how other nations are managing their economies. In essence, the value of a country’s currency is related to relative rates of expected inflation…the expected inflation of the country in question relative to the expected inflation in other nations in the world.

And, it is expected inflation that is important, not actual inflation as measured by current price indices. Calculated measures of inflation do not always immediately capture what is going on in the world and, as a consequence, do not always pick up economic dislocations that will be reflected in prices at some time in the future.

For example, in the consumer price index, estimates are made of the rental price a home owner would pay for the housing services received from the owned home. These are not directly related to the prices that homes are being sold for. Thus, prices of houses may be rising at a very rapid rate while the estimated rental price of the housing services may be rising very slowly. Since the component of the consumer price index related to housing is quite large, the “measured” consumer price index may rise only modestly whereas the prices of housing might be rising quite rapidly. (Note: this, of course, relates to the situation several years ago and not right now.)

Furthermore, with all the Federal government debt being exported, the nations having investors that have purchased large amounts of this debt face a peculiar situation. Many of these nations have their currencies tied to the value of the United States dollar. The low interest rate policy in the United States has forced these countries to also maintain a low interest rate policy and this has resulted in higher rates of inflation in these countries. The inflation experienced in these countries is now finding its way back into the United States.

Thus, there are many ways that inflation or the possibility of inflation can work its way through the world economy without being captured in currently measured price indices. It would be silly for investors to wait for inflation to show up in the published price indices before they made their investment decisions. Investors must make decisions based on what they “expect” to happen. These inflationary expectations are therefore reflected in current market prices such as a nation’s exchange rate.

It can be strongly argued that if investors believe that a government is acting independently of the rest of the world and behaving in an imprudent and undisciplined manner they will sell the currency of that country and this will result in a decline in the value of that country’s currency. In essence, the market is reflecting the fact that this government is acting in a way that will cause higher relative rates of inflation in the future even thought the explicit evidence of this inflation is not present in currently measured figures.

This, I believe, is what has happened in to the United States dollar over the past six years or so. And, at the present time, no evidence has been given that the economic policy of the United States government has changed and there is little or no evidence that either of the presidential candidates will do anything to correct this situation. This is the cloud of uncertainty that is hanging over international financial markets at the present time. Until this position is clarified, uncertainty will remain and financial markets will remain quite volatile.

Of course, there is more to a vision of economic policy than that related to the nation’s exchange rate. But, the crux of such a policy is the trust that market participants place in the willingness of an administration to keep “expectations of inflation” under control. And, this goes backs to the basic fundamentals…fiscal discipline and conservative monetary management. For monetary policy to focus upon keeping inflation and inflationary expectations low, fiscal policy must be conducted in a way that does not put undue pressure on the conduct of the central bank. When deficits are too large the historical evidence suggests that sooner or later the monetary authorities will have to come in and “monetize” a substantial portion of the debt. This monetization of the debt is, of course, inflationary. Thus, even though a central bank may claim to be focused on keeping inflation low, a lack of fiscal discipline will be translated by market participants as potentially inflationary. Historically, the market participants have not been proven wrong.

Thus, fiscal discipline goes along with conservative monetary management. Again, no evidence has been forthcoming that either presidential candidate has advocated such control.

Economic growth is another facet of economic policy. However, the historical evidence shows that what is done to support long term economic growth is not directly connected with monetary policy or fiscal deficits. Loose monetary policy may spur on economic growth in the short run, but in the longer term, inflation created by fiscal deficits and loose monetary policy stifle initiative and innovation and lead to slower rates of economic expansion. Emphasis upon demand side stimulus (which tends to be inflationary over time) has not been the elixir for a dynamic and growing economy. What is needed is encouragement for a shift in the supply side of the economy. But, this will take an extended period of time.

I believe that a vision of future economic growth must be based upon three factors. First, organizations, both financial and non-financial, must stop focusing on financial methods as their key to performance and return to a focus on the products and services they produce as their strength. When the government emphasizes demand side policies, companies, unfortunately, seem to de-emphasize their “core competencies” and turn to financial leverage and added financial risk-taking as sources of exceptional performance.

Second, economic policy must support a “bottom-up” approach to economic creation and development. Real economic vitality comes about when entrepreneurial energy is released in an economy. Organizational conglomeration and size ultimately seem to primarily benefit the executives that build such giants. Why? Executive salaries, bonuses, and other benefits are related to size…because the system bases executive remuneration on comparables…and this has a cumulative effect that only encourages more inefficient mergers and efforts to achieve growth for growth’s sake. This area needs to be examined more thoroughly in order to create a supply side shift in aggregate economic performance.

Finally, in my view, the current world is a world of life-time education. To me, a safety-net begins by creating a world in which everyone, in a real sense, is trained for and participates in transition. The world is constantly changing. Major problems occur when people, companies, unions, and others want to “protect” people, companies, unions, and others from change. Government, at all levels, is going to have to play a role in creating this safety-net. But, the safety-net should begin and end with education…not just to start out…but throughout ones life.

The Most Important Price in an Economy

In my post of August 18, 2008, I argued that neither of the presidential candidates had really staked out a well defined position as far as their economic vision was concerned. The pronouncements of the candidates, I wrote, were either too general or were bogged down in ‘wonkish’ minutia. As a consequence, an uncertainty has resulted that has left people and markets without direction and has fueled a greater volatility in prices.

Given this criticism, the question must be asked, “What is the basis for a sound economic vision?”

I believe that the foundation of a sound economic vision begins with the value of the United States dollar. I continually go back to the statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.)

The reason the exchange rate is the single most important price in the economy is because it reflects the viewpoint of the rest of the world about how an economy is being managed relative to how other nations are managing their economies. In essence, the value of a country’s currency is related to relative rates of expected inflation…the expected inflation of the country in question relative to the expected inflation in other nations in the world.

And, it is expected inflation that is important, not actual inflation as measured by current price indices. Calculated measures of inflation do not always immediately capture what is going on in the world and, as a consequence, do not always pick up economic dislocations that will be reflected in prices at some time in the future.

For example, in the consumer price index, estimates are made of the rental price a home owner would pay for the housing services received from the owned home. These are not directly related to the prices that homes are being sold for. Thus, prices of houses may be rising at a very rapid rate while the estimated rental price of the housing services may be rising very slowly. Since the component of the consumer price index related to housing is quite large, the “measured” consumer price index may rise only modestly whereas the prices of housing might be rising quite rapidly. (Note: this, of course, relates to the situation several years ago and not right now.)

Furthermore, with all the Federal government debt being exported, the nations having investors that have purchased large amounts of this debt face a peculiar situation. Many of these nations have their currencies tied to the value of the United States dollar. The low interest rate policy in the United States has forced these countries to also maintain a low interest rate policy and this has resulted in higher rates of inflation in these countries. The inflation experienced in these countries is now finding its way back into the United States.

Thus, there are many ways that inflation or the possibility of inflation can work its way through the world economy without being captured in currently measured price indices. It would be silly for investors to wait for inflation to show up in the published price indices before they made their investment decisions. Investors must make decisions based on what they “expect” to happen. These inflationary expectations are therefore reflected in current market prices such as a nation’s exchange rate.

It can be strongly argued that if investors believe that a government is acting independently of the rest of the world and behaving in an imprudent and undisciplined manner they will sell the currency of that country and this will result in a decline in the value of that country’s currency. In essence, the market is reflecting the fact that this government is acting in a way that will cause higher relative rates of inflation in the future even thought the explicit evidence of this inflation is not present in currently measured figures.

This, I believe, is what has happened in to the United States dollar over the past six years or so. And, at the present time, no evidence has been given that the economic policy of the United States government has changed and there is little or no evidence that either of the presidential candidates will do anything to correct this situation. This is the cloud of uncertainty that is hanging over international financial markets at the present time. Until this position is clarified, uncertainty will remain and financial markets will remain quite volatile.

Of course, there is more to a vision of economic policy than that related to the nation’s exchange rate. But, the crux of such a policy is the trust that market participants place in the willingness of an administration to keep “expectations of inflation” under control. And, this goes backs to the basic fundamentals…fiscal discipline and conservative monetary management. For monetary policy to focus upon keeping inflation and inflationary expectations low, fiscal policy must be conducted in a way that does not put undue pressure on the conduct of the central bank. When deficits are too large the historical evidence suggests that sooner or later the monetary authorities will have to come in and “monetize” a substantial portion of the debt. This monetization of the debt is, of course, inflationary. Thus, even though a central bank may claim to be focused on keeping inflation low, a lack of fiscal discipline will be translated by market participants as potentially inflationary. Historically, the market participants have not been proven wrong.

Thus, fiscal discipline goes along with conservative monetary management. Again, no evidence has been forthcoming that either presidential candidate has advocated such control.

Economic growth is another facet of economic policy. However, the historical evidence shows that what is done to support long term economic growth is not directly connected with monetary policy or fiscal deficits. Loose monetary policy may spur on economic growth in the short run, but in the longer term, inflation created by fiscal deficits and loose monetary policy stifle initiative and innovation and lead to slower rates of economic expansion. Emphasis upon demand side stimulus (which tends to be inflationary over time) has not been the elixir for a dynamic and growing economy. What is needed is encouragement for a shift in the supply side of the economy. But, this will take an extended period of time.

I believe that a vision of future economic growth must be based upon three factors. First, organizations, both financial and non-financial, must stop focusing on financial methods as their key to performance and return to a focus on the products and services they produce as their strength. When the government emphasizes demand side policies, companies, unfortunately, seem to de-emphasize their “core competencies” and turn to financial leverage and added financial risk-taking as sources of exceptional performance.

Second, economic policy must support a “bottom-up” approach to economic creation and development. Real economic vitality comes about when entrepreneurial energy is released in an economy. Organizational conglomeration and size ultimately seem to primarily benefit the executives that build such giants. Why? Executive salaries, bonuses, and other benefits are related to size…because the system bases executive remuneration on comparables…and this has a cumulative effect that only encourages more inefficient mergers and efforts to achieve growth for growth’s sake. This area needs to be examined more thoroughly in order to create a supply side shift in aggregate economic performance.

Finally, in my view, the current world is a world of life-time education. To me, a safety-net begins by creating a world in which everyone, in a real sense, is trained for and participates in transition. The world is constantly changing. Major problems occur when people, companies, unions, and others want to “protect” people, companies, unions, and others from change. Government, at all levels, is going to have to play a role in creating this safety-net. But, the safety-net should begin and end with education…not just to start out…but throughout ones life.

The Candidates and Economic Leadership

I have just returned from two weeks of vacation in the mountains and lakes of New England. More than enough rain…but a magnificent two weeks of vacation, anyway.

Catching up is always the price one pays for taking some time off and with two weeks off, the price is quite high. But, it was hopeful to see the decline in the price of oil, the price of gold, and the strength in the dollar. I see that even Barack Obama took some time off in Hawaii, proving that he is human as well.

I have found in the past that it is always helpful in beginning to write again to discuss something that is more general in nature so as to attempt to gain a focus that might be lost if one starts out with something very specific. (I know, one commentator has stated that my perspective is one of 40,000 feet above the fray anyway.) Therefore, I would like to write about two major issues that I believe are going to provide the background for economic activity, not only in the near term, but also for the foreseeable future. These issues both have to do with Presidential leadership.

As many readers of this blog know, I am very interested in leadership…political leadership, business leadership, social leadership, cultural leadership…. Leadership is important because the leader defines the cultural of his or her administration, the world view and the operating procedure that lies behind all that the leader hopes to achieve. I have found that it is imperative that the leader of an organization reflect this culture in everything that he or she does or says or breathes. Only in this way can the leader galvanize his or her troops to accomplish what is being attempted.

The first issue that strikes me in getting back to the “real world” is that neither candidate for the presidency seems to be presenting us with their world view when it comes to the economic and financial affairs of the country. (The ‘operating policies’ of the candidates are another story…maybe for another time.) Returning to the battle I see little beyond vague generalities on the one hand and the facts and figures of ‘policy wonks’ on the other. In terms of Obama I see vague claims that he is moving toward “Rubinomics” (http://www.bloomberg.com/apps/news?pid=20601070&sid=aJ.pKsYB_DfU&refer=home) and other claims that he lacks “passion” when it comes to presenting his program (http://www.nytimes.com/2008/08/18/opinion/18krugman.html?hp). In terms of McCain, Ben Stein has been particularly brutal in claiming that McCain has no systematic thinking at all behind his statements about economic policy. According to a New York Times article this past week, McCain’s campaign leadership attempts to keep McCain off his cell-phone because many of his statements tend to reflect the last person he has talked with.

In my estimation, both candidates are currently lacking in leadership when it comes to the realm of economic policy. The United States…and the world…are facing some very serious economic problems…problems that will carry over for many years to come. And, we have little or no idea about what the economic ‘culture’ would be forthcoming from either candidate.

Robert Rubin states that Obama is focusing on “competitiveness and economic growth on the one hand, and distribution and fairness on the other.” (See the Bloomberg article cited above.) But, what does this mean?

The value of the dollar has declined for the last six years or so. Inflation seems to be picking up. Although commodity prices have declined recently, many see this as just a pause. What about the financial system and regulatory reform? Just what is the world view that Obama is presenting.

Unfortunately, I see nothing on the McCain side that can lead to any specific comments. Here I don’t know when I have seen such inconsistency in what has been presented.

This leadership void bothers me because it does not allow those of us that must operate in the economy any sense of direction. (Mason’s Rule # 5 is that markets hate uncertainty!) Even if we disagree with the world vision that a leader presents, we have something to go on by which we can make decisions. All decisions are based upon our forecast of possible future outcomes. A leadership void implies that the distribution of future outcomes is larger than it would be if there was a better idea of what policies might be implemented. A greater distribution of future outcomes portends greater volatility in business and financial markets. That is, it implies that the future will be quite risky!

So, the first thing that concerns me upon returning to civilization is that no economic leadership currently exists in Washington, D. C. and that the presidential candidates are not stepping up to the plate and providing a vision of economic leadership for when they are elected. This is bad for economic and financial markets because volatility is not conducive to either “competitiveness and economic growth” or to “distribution and fairness.” It is downright horrible for innovation and productivity.

The second issue of concern derives from the recent unpleasantness created by Russia and Georgia. It is not often that I quote Paul Krugman twice in something I write, but he has presented a viewpoint that I think must be taken very seriously. His column on August 15 (http://www.nytimes.com/2008/08/15/opinion/15krugman.html) discusses the possibility that we could be entering an age in which the world becomes more fragmented, economically as well as politically, leading to greater political and economic instability, slower economic growth, and more war. Krugman points out that into the 1910s the world seemed to be approaching a time of real global interconnectivity and peace. There was real optimism that this could be achieved. And, this collapsed into a lengthy period of revolution, war, and depression.

The question that the Russia-Georgia conflict raises along with the world wide battle against terrorism is whether or not we are now at the crest of another period when world connectivity seems possible and globalization seems ready to make us all world citizens. Could this edifice all come crashing down in another round of regionalism, protectionism, isolation, and war? Krugman presents us with this possibility.

This possibility directs me to another subplot in the upcoming election. This is the stance that organized labor is taking with respect to global trade, government regulation, and sound economic policies. We see this stance presented in the article “Obama Tilt Toward Rubinomics Stirs Warning From Organized Labor” (http://www.bloomberg.com/apps/news?pid=20601070&sid=aJ.pKsYB_DfU&refer=home). To me the worst economic scenario for labor is one in which globalization collapses, a world in which nations cut themselves off from other nations, where economic growth is dismal, and where war and terrorism are a part of daily lives. To me, organized labor is taking a stance that it believes will help the ordinary worker in the United States but is, at a minimum, very, very shortsighted.

Organized labor in the United States is in a bad way. Over the past forty years or so it has become mostly irrelevant and, as a consequence, has lost a lot of its power. It is now attempting to exert itself once again. However, the more power it regains, the less well off will be the worker it is trying to help. Certainly the American worker needs an advocate. That advocate is not currently organized labor.

Here again, leadership is needed on a national scale. The world must avoid a return to protectionism, isolationism, and turmoil. The United States President must support globalization, integration, and inter-connectivity. The United States President must promote communication, education, mutual respect, and worldwide economic growth. Here again, it is time for one candidate or the other to step up to the task and present us with a vision we can buy on to.

Investment strategies in this time of transition (I)

In my post of July 29, 2008, “Understanding the Economy” I discussed two possible interpretations of the current economic situation. One interpretation concentrated upon demand side changes in the economy whereas the other interpretation concentrated upon supply side changes. I argued that it was important to get the correct interpretation because the policy prescriptions would be different in each case and would produce substantially different results.

I gave two reasons for focusing upon the latter explanation as the cause of the business cycle and stated that it was important to create policies that provided supply side stimulus rather than policies that just attempted to stimulate demand. If the United States focuses on demand side stimulation, the argument is that this will just exacerbate inflationary pressures with little or no response in terms of increased output. Any governmental efforts need to be aimed at stimulating supply so that output can increase without undue pressure on prices.

A similar proposal has been presented by Kenneth Rogoff of Harvard University on Wednesday July 30 in the Financial Times, “The world cannot grow its way out of this slowdown.” (See http://www.ft.com/cms/s/29a40a90-5d6f-11dd-8129-000077b07658,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F29a40a90-5d6f-11dd-8129-000077b07658.html&_i_referer=http%3A%2F%2Fsearch.ft.com%2Fsearch%3FqueryText%3Dthe%2Bworld%2Bcannot%2Bgrow%26aje%3Dtrue%26dse%3D%26dsz%3D.)

Rogoff argues that “if all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.” He goes on to say, “In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up.”

Furthermore, Rogoff states, “Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.”

In other words, pumping up aggregate demand at this time is not going to get a supply response and hence almost all of the increase in aggregate demand will go into prices increases. Not a very pretty view of the future.

My description of this scenario was presented in the earlier post. In this post I want to examine investment strategies for the two different scenarios. Since we started on the demand side responses and believe that policies aimed at spurring on aggregate demand have the highest probability of occurring, let’s begin here.

Demand side programs, according to the scenario presented by Rogoff (and myself), will have more impact on increasing inflation than they will on increasing output. As a consequence, investor focus should be on protecting oneself from rising prices. (Sounds like the seventies doesn’t it!)

What to look for? More tax rebates (already being discussed); support for housing (already being discussed); keeping interest rates low (already being discussed); and other programs and policies being presented by presidential candidates and Congress.

Investment strategy? Where are your inflation hedges? Gold…commodities…housing seems to be out this time (it was a great hedge in the 1970s)…inventories…paintings…rare coins…

Obviously, these types of investment do not do a great deal to contribute to increasing output or stimulating productivity. This is what happened in the 1970s as the focus changed and people pulled back from investing in innovations and capital that resulted in increases in productivity and which also created positive externalities that spurred on the economy.

Demand side strategies at a time like this divert attention away from productive investment and toward investments that hedge against inflation and contribute little to resolving the underlying economic problems that plague the United States (and the world). But, demand side strategies are very popular with politicians because they can allow the candidate to talk about help to the ‘disadvantaged’ and the ‘little guy’ and beating up the ‘bad guys’. And, they promise faster results. Furthermore, when investors hedge against the inflation that is created, these same politicians can blast the ‘wealthy speculators’ for driving up prices which additionally harm the less well off. And, this is what happened during the years of the Carter administration.

Rogoff concludes his analysis with this warning: “In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater ad more protracted downturn.”

What about supply side policies? Not as easy to do and certainly not as easy to sell! First off, the fiscal authorities must take pressure off the monetary authorities by exerting discipline over the government’s budget. The irresponsible behavior of the current administration must be overcome by bringing the deficit under control. Doing this will help strengthen the value of the dollar, something that will help the performance of the United States economy in the longer run.

The attention of the monetary authorities must be focused on keeping inflation at a low level. What finally got the United States out of the malaise of the 1970s? Some tough policy actions on the part of Paul Volcker and the Federal Reserve that broke the back of inflation (even though this is not what Jimmy Carter really wanted). Inflation is counter-productive to economic growth, productivity, and innovation. We cannot get a supply side response as long as businesses and investors focus on inflation. Keeping inflation at a low level will also contribute to the strength of the dollar. (See Fred Mishkin’s last lecture before leaving the Fed: http://online.wsj.com/article/SB121726587261090311.html?mod=todays_us_page_one; and http://www.federalreserve.gov/newsevents/speech/mishkin20080728a.htm.)

Other supply side policies are still needed to spur on a recovery, but these will not result in programs that generate a short term payoff, something, of course, that politicians do not like. But, it must be remembered…it took us a long time to get where we are now and it will take a long time for us to get back ‘on track’. People must remind the politicians that they turned their heads aside for a long time allowing this economic dilemma to arise…and they are not going to be able to get us out of this mess with a wave of a magic wand!

It seems to me that there are at least two aspects to creating the platform for the next period of expansion. First, we must go through the economic transition to get our financial legs back under us, both in our financial institutions, but also in non-financial areas as well. Second, we must go through the technological transition that will result from the advent of new sources of energy. And, this transition will impact almost every sector of the economy. The important thing here is that the government must introduce policies and programs that will support the PROCESS of transition and which will not impede that process by shooting for specific OUTCOMES.

What to invest in given a supply side response by the government? Well, this is a time of transition and that means we must look into areas in which the transition is going to take place. One possible source for investment is in companies that are getting back to basics and bringing their focus back into the areas that they have or can establish sustainable competitive advantage. Here we can look for turnarounds, restructuring firms, and acquisitions to gain scale, customer captivity, or create barriers to entry. Second, we look toward those innovators that are working in the energy field to construct technologies or market structures that might create sustainable competitive advantage. This means that the scope of potential investments may be quite large, but the focus will be on future market structure. I will write more on these in the next two posts.