Premeditated Thought

What's the Republican Position?

I find myself puzzled this morning by John McCain's comments that the large stimulus bill will leave Americans saddled in debt for generations to come.  I agree that we will need to pay for all this borrowing in the future, but McCain ignores the basic tenet of what we are trying to do: stimulate the economy through deficit spending.  Even Republicans want to do that, but with a heavier emphasis on tax cuts than on spending.  In the end, this is a compromise bill with lots of tax cuts and lots of spending.

If someone can explain to me how McCain intended to address the current situation without increasing the deficit, I'm all ears.

Stimulus debate

One of the most annoying aspects of our political system is that we can seldom get beyond rhetoric and soundbites to have an open discussion of what we want to achieve and how best to achieve it.  Add the need for a good public flogging and political theater and you end up with the current debate around TARP and the stimulus bill.

O.k, the Republicans believe the best thing to do is to cut taxes.  The Democrats are following the Keynesian dictate for deficit spending to make up for the lack of private spending.  Note Republicans are a bit disingenuous arguing against deficit spending - they just prefer to do it by cutting taxes.  I haven't heard any proposal from them to cut taxes and reduce spending.   But what are they trying to do?  What is the affect they are looking for?  How will success be measured. 

Huh, you ask?  We are trying to heal the economy.

But the answer is not as simple as that.  As a starter, here are two alternatives that don't lead to the same policy decision: a) are we trying to grow the economy, or b) are we trying ensure the vast majority of people are better off tomorrow than they are today?  Unless you still believe in trickle-down, these are very different, even if they are correlated.

So what are some of the possible goals that we are inherently discussing today:

• Grow the economy, regardless of income distribution.  This tends to be how the Republicans think of the economy, and also tends to be where most popularly-known macro-economic theory focuses.
• Provide a cushion for the unfortunate.  This is where Democrats spend a lot of time and leads the welfare state.  Republicans would classify some of the unfortunate as "unable" - in terms of ability - and "unwilling" to this list.  Democrats favor this goal even if it comes at the expense of some economic growth.
• Create jobs.  This is like the second bullet, but not the same.  Everyone likes to create jobs because it is easy politically; not everyone agrees how to do it.
• Stabilize the stock market.  This is not the same as the first bullet.  The market is not the economy.  The market represents, in the long run, a reflection of the earnings and earnings growth of public companies.  But the economy can do well in terms of GDP when a greater share of revenues are going to employees than to the bottom line.  Still, this is an important category because so many Americans rely on the stock market for their nest egg.  In a different society that provided more of a social safety net, this may be less important.
• Stabilize particular industries.  This can be important for a variety of reasons.  The banking industry touches so many aspects of our economy that we decided we could not let the market dictate its health.  The auto industry was deemed critical in part because of how many people it employs.  As a policy motive, arguments about aiding particular industries is rife with political theater.  
• Do things we expect government to do. Have you flown to JFK, been through customs, and tried to get to Manhattan via public transportation, all the while using a cell-phone or surfing the internet?  Our infrastructure is quickly becoming second-rate.  I'm always shocked coming back to NY from Europe.

The Stimulus and TARP bills touch on each of these bullets.  That is not a problem, but it is a problem for a political system that is polarized and talking at one another, not to one another.  We don't admit the competing or mixed agendas that goes into the creation of these bills.  And the result is a hard-to-understand bill that does not satisfy any ideology.

Post-Bust

Just like the Dot Com bust altered an entire industry, so will the current Banking Bust.  What I find scary about the Banking Bust is the central role banking plays in our economy.  During the "Dot Bomb" era, problems in the broader economy were limited to mostly touchpoints of the internet companies.  If we say the same thing today - that the problems with the economy will be limited to what the banking industry touches, well, ka-boom.

Fire Up The Money Presses!

Americans continue to party while Rome burns.  After eight years of wildly spending on credit, you would think the current crisis may have had a small impact on our behavior.  Instead, in order to pass the bailout package, the senate had to guarantee the champagne would keep flowing on our children's tab.  Here;s my favorite one (courtesy bizjournals)

Buried in the plan are numerous other tax breaks, including doing away with a 39-cent excise tax on makers of wooden arrows designed for children as well as tax breaks for movie producers and stock-car racetrack owners.

In theory, I support some of the tax breaks in the Senate bill, including extending AMT relief and breaks for research in alternative energy.  (Though I do wish AMT relief covered more people, including myself).

But this country is not only in a credit crisis.  It is also in a debt crisis and an economic crisis.  These may all be related, but they are not the same.  The current bill worsens the debt crisis unnecessarily.  At some point, the people and government of this country will have to face the music and pay its bills.  Tax rates cannot go in one direction forever.

What Now?

What to make of this week's proposed massive federal bailout and the mess of the economy we are faced with?  Got me.  Here's some things that worry me though:

• Experts had an impossible time valuing their bad loans, but now the government (e.g. us, the taxpayers) will be asked to buy these bad debts at some price.  Sound like a good investment to you?  Still, I don't have a better solution.
• Remember the housing crisis that started this all?  Housing starts hit a new low this past month.  
• Remember inflation and the energy crisis?  We are back down to the $100 level on oil, but why?  One reason is the strengthening dollar based on expectations that the U.S. will raise interest rates relative to other currencies.  A second is slackening global demand.  But can slowing demand really be seen as good news in the broader scope of evaluating the economy?  And if the fed reverses course and does in fact lower rates, we may the dollar weaken once again.
• Oh, yeah, I forgot.  Lehman Bros, AIG, Fannie Mae, Freddie Mac, Bear Stearns.  Think some jobs may be lost?  Think those people laid off may spend less money?  We have yet to see the fallout of rising unemployment on Wall Street.  Wait for bonus time, Christsmas season, and next year's New York budget.
• Think we won't have partisan rancor passing the federal bailout?  Democrats are already talking about adding consumer relief to the bill.  I am a die-hard democrat, but I think this bill needs to be bailout needs to be done quickly and cleanly.  
• Think the market rebounded this week because we have faith in our government to restore order?  I have a sneaky suspicion the rally was a combination of wishful thinking plus short covering.  I say we're in for a wild ride.

I urged caution in my investment blog earlier this week rather than preaching my normal approach of buying dips.  The unusual congressional briefing by Paulson and Bernanke earlier this week struck fear in the hearts of our government.  We would be wise to heed this fear.  The experts are in new territory here.  Numerous sources have proclaimed the credit crisis the most severe challenge to the system since the Great Depression.  This play has no script.  Even if we implement our best ideas with perfect execution, we don't know how the many comingling stories of our economy will respond.  And how many of you trust our current government to execute flawlessly?

Recession?

Are we in a recession?  CNN puts the word 'recession' in quotes.  Warren Buffet says we are there today, and Greenspan says we probably will be soon.  Americans feel that they are in recession.  Yet there is a cut and dry definition of recession - two consecutive quarterly declines in real GDP - and by this measure, we are not in recession.

Or are we?  This technical measure of recession is not as cut and dried as it may sound.  The problem comes with how we measure inflation.  The Motley Fool explains why we feel that inflation is higher than what the government reports.  This may not  be as sinister as it sounds: with items like milk and gas skyrocketing, we are reminded daily of price increases, but less frequent purchases, like big ticket electronics, are dropping in price. This is not an anti-government rant - I am just pointing out that measuring inflation is not cut and dried.

Bill Gross, the bond expert at Pimco, writes that CPI has chronically be understated by 1%.  This is because of the use of 

• substitution effects: if you buy chicken instead of beef because beef prices increased, the government does not view this as inflation.
• "core" CPI that excludes food and energy: if it costs you 25% more at the supermarket every week, this is not inflation!
• hedonic quality adjustments: if you buy a more powerful computer for the same price - the government views this as deflation!
• rent-equivalent housing costs.  if it costs you more to buy a house, but rents stay the same, this is not inflation according to the U.S.

Gross estimates the net of all this is that inflation is understated by 1% and has been since the nineties, when most of the above inflation-adjustments were initiated.  (The lone exception was using core CPI, which Nixon introduced to keep inflation data relatively stable in the face of sudden OPEC price moves.) Most of these adjustments to inflation are unique to the U.S. 

If inflation is understated by 1%, you can make the argument that we are "technically" in recession today. Certainly this would jibe with what most Americans have been experiencing.

Even more worrisome, consider these impacts of underreported inflation:

• We have been chronically overstating our GDP.
• Our vaunted productivity gains have been overstated.
• Bond and TIPS have 1% lower real-yield than is typically reported.  This is about half of their expected real return!

In other words, in irony of ironies, our fairy tale Goldilocks economy may have been, after all, simply a fairly tale.