Bernanke Said What?

Since the housing market peaked and the financial crisis began, the government has spent:
$3.6 trillion (net after some repayments) on various stimulus programs,
$16.3 trillion in government guarantees to various financial institutions; plus
$7.2 trillion in federal government spending (the budget) trying to hold up the economy.

That’s a lot of money for a $14 trillion dollar economy. Yet the net result so far is an economy barely growing at 1.6 %, unemployment at 9.5% (or 17% depending on how you count unemployment,) a very troubled housing problem (inventories last month were at 12.5 months supply) and a financial system that can’t afford to lend (for fear of future defaults and/or the risk-free money they are getting because of Fed policy.) And this is only a few of our problems.

Now, last Thursday at the Jackson Hole Conference (isn’t that more expensive than Las Vegas,) we were told by Federal Reserve Chairman Bernanke that he has changed his mind and the economy may be showing down even more than he thought. Also, that the economy can not even handle the Fed keeping the interest and early payoff money the Fed is receiving from the bonds it purchased. That he is going to spend that money as fast has he receives it rather than shrink the Fed’s balance sheet. What a confidence builder. Plus, and this a big one, that the Fed is ready to print more money, in addition to what they have already done, to keep the economy going.

We have been debating how the Fed is gong to reduce its balance sheet. Now we learn that even the simplest reduction seems impossible. So get ready for Quantitative Easing, round 2.

As you know, critical thinkers have to look at all sides of the argument. Here is a summary of their analysis and proposals.

The Keynesians, economists like Paul Krugmanand and James Galbraith, want the government to significantly spend more money because we didn’t spend enough to begin with. They say the economy is not recovering at all. Federal Reserve policy has been “grossly inadequate”. The Fed should increase its balance sheet from $2 trillion to $4 or $6 trillion (would this cause a printing company bubble?) Most economists are Keynesians and they are putting a lot of pressure on Congress and the Federal Reserve to stimulate more and print more money. They, as always, are concerned only about the short-term.

The Keynesian-lite or Supply-side economists like Brian Wesbury or Larry Kudlow want additional tax cuts and more incentives for businesses to expand and hire employees. They say the economy is recovering, but very slowly. I am not sure they still believe in the V shaped recovery. They also claim that uncertainty, especially in tax policy, healthcare policy and undefined new financial regulations are some of the reasons the economy is not growing faster. They also believe tax cuts and incentives will result in more production which will keep inflation low. But, since a tax cut without an offsetting spending reduction is a stimulus, it would mean more borrowing, more quantitative easing. They too are only concerned about the short-term.


The Capitalists like Peter Schiff, Mark Faber and other Austrian economists want the government to get out of the way and let the economy heal itself. Sooner or later, we have to get to price equilibrium (in housing, wages, interest rates, etc.) They say the government has already spent far too much money. They believe that the free market, if left alone, will self-correct. That is how we get to the bottom. That is a recovery, getting rid of the excesses. All this government intervention is doing is delaying the recovery and laying a base for the next boom or bubble. The mal-investments caused by artificially low interest rates and the excessive expansion of money not only delays recovery but cause the next boom. For example, what is going to happen to wind power when the stimulus goes away? Or what’s going to happen to bond prices when inflation (caused by inflating the money supply) begins to rise rapidly?

We all see the economy through different lenses, but I am sure you will agree that most Americans think spending and then printing the money are out of control. Short-term and long-term. We may not be able to go from over indulgence to austerity in one step, but we sure need a plan and we sure need to get started.

Get Ready For the Next Big Stimulus Program

The government has been trying to hold housing prices up for two years without much success. Many “experts” agree that we will see another drop in housing prices due to high prices, lack of demand, unemployment, wages, etc. It has also been estimated that an additional 10% drop in prices is possible (which would get us to about the 50 year trend line) which would put a significant number of additional residential mortgages under water (negative equity). Being underwater is one of the major (if not main) reasons people walk away from their mortgage commitment. Plus, the economy is not helping and may be turning down again.

So with politician’s approval ratings extremely low and pressure from their economic advisors (Keynesian economists in both parties) to put more stimulus into the economy, it might happen soon. Evidently, the trillions spent so far haven’t been enough (for example, “The Third Depression” Paul Krugman in the NYTimes) to turn the economy around yet. Now add to this, the clamor (after financial reform?) to do something about Freddie Mack and Fannie Mea (FNF).

It would be a lot faster to “do something about housing” then turnaround the economy in the next three months. Some are now thinking that the government will begin a massive, new, program of mortgage modifications where FNF will offer low, permanent interest rates on reduced mortgage amounts. This may happen before the election. The money was allocated a year ago when FNF were given unlimited funding authority (at least up to $1 trillion) even though they had not used the $200 billion already allocated at that time. After all, they are owned by the government where spending has no limits. Also, the government does not have to go to Congress for this as it has already been “approved.”

If you are a Keynesian, this kind of spending and short-term fix makes sense. Spending is what you must do in a recession. If you are a capitalist, you understand that this will only add to our problems short- and long-term; prolong the recession; and increase inflation further.

If Bernanke continues to punish savers, should you change your strategy?

If Fed Chairman Bernanke continues to punish savers by holding (“for an extended period”) interest rates at extremely low levels, should you increase your risk and buy higher yielding bonds and preferred stocks? His actions seem to indicate that is what he wants you to do.

Before doing this simply by increasing risk (lower rated bonds) or extending maturities (going from short-term to long-term bonds), you should consider approaching the income portion of your portfolio with a strategy hedge funds use to reduce some of this risk. Think about both principal risk (return of principal) and market risk (volatility of your principal.)

You know that selecting strong companies or government bonds (with taxing authority) that have the financial ability to pay the principal (at maturity) plus every interest/dividend payment should reduce your principal risk.

But there are ways you can also reduce your market risk. Start by asking, “What could cause my principal value to decline during my holding period?” One big reason is inflation or an increase in interest rates.

Therefore, to hedge or minimize market risk (principal volatility), you would want to purchase a security that moves in the opposite direction of the security you purchased for income. When one security goes up in value, the other goes down. This should leave your principal “flat” while you collect the higher interest rate.

Stocks too, may require a different strategy

A protracted slow growth period for the economy will have its effect on stocks as well. It may be very difficult to increase revenues, maintain margins and earnings, etc.; so you may want to consider stocks that are not dependent on the economy for growth.

Look at companies that have a product or service whose success depends on the growth and acceptance of their product rather than on the success (general growth) of the economy. It helps if they are not limited to the U.S. economy only, but are able to sell worldwide. Also, in this environment, it might help if they do not need to raise money for the next few years.

If: the economy continues to slow down and the government does not pass new stimulus programs, will the U.S. head into a deflationary spiral?

Recent economic data and Chairman Bernanke’s recent statement suggest the economy is slowing down. The “’09 stimulus package” has peaked and its effects will be gone by the end of the year. The G20 agreement reached over the weekend says governments “agree” to cut their deficits by 50% within two years. The U.S. would have to cut almost $800 billion of the $1.5 trillion deficit in 2010 alone. Good luck with that. Here are some reactions:

Keynesian (Demand-Side) economists are up in arms. Paul Krugman in an article in the New York Times today has an article titled, “The Third Depression.” He states that we are worried about inflation when the real problem is deflation; and the failure to stimulate (re-inflate) the economy will result in a long, Japanese style deflationary environment. He has suggested another $one trillion in stimulus.

The Keynesian-lite (Supply-Side) economists are still convinced the economy is turning around (although they have become less passionate in the past week) and that inflation is the potential risk. They do want taxes reduced to create jobs (but without cutting spending, you simply have a different type of stimulus program.)

The Capitalist economists see de-leveraging or deflation which is normal after our world-wide, gigantic credit bubble fighting inflation (low interest rates and the massive printing of money.) If this deflation-inflation struggle continues, it will take a long time to get to price equilibrium (e.g., bottom on home prices) and the amount of money created by that time will cause huge inflation. Therefore, the sooner the government gets out of the way, the sooner the recovery can begin.

Since we have a mixed economy rather than a capitalist economy, I do not expect the government to get out of the way. And since we have Keynesian government and Federal Reserve, I expect more stimulus rather than austerity.

However, many taxpayers are upset with all the spending. I had expected another large stimulus package this year, but one large stimulus package does not seem viable in this climate. Then, I expected to see the large stimulus package broken down into smaller pieces (a $50 billion package for unemployment benefits, a $50 billion package to help the states, an $8 billion package to hold up home prices, etc.). But last week, the Senate was unable to get closure on the unemployment package and therefore could not vote on it.. This might signal that additional stimulus through fiscal policy, may be difficult to do.

However, I think the answer to question posed is no. The government is to frightened of deflation to let it happen. Therefore, the Fed and Chairman Bernanke may be called upon to stimulate the economy through monetary policy (keep interest rates low and print, print, print money.)

Chairman Bernanke Effectively Downgrades the Economy

Media coverage of the Federal Open Market Committee (FOMC) meeting on Wednesday basically stated that little had changed from the April 28th meeting: interest rates remain at basically zero percent and will remain so for some time, the economy was in recovery, etc. However, there were some serious changes made to Mr. Bernanke’s statement that implied things were deteriorating rather getting better.

Most media coverage focused on what did not change in Bernanke’s statement: they left rates at zero, for an extended period, subdued inflation trends and expectations, continued low rate of plant utilization, unemployment continues to be a concern, etc.

But, here are some significant changes in attitude and content that, I think, effectively downgrades the growth rate for the U.S. economy. For example:

1.Attitude. Less talk about short-term tightening and the timing and plans to do so,

2.Economy. In the previous statement (April), Bernanke stated, “Economic activity has continued to strengthen.” In this June statement, he stated, “The economy continues to recover.” (this is far different from continues to strengthen and I think a downgrade on growth rates)

3.Employment. In April, “Labor markets beginning to improve.” In June, “Jobs are being created, gradually.” (Again, I think a less robust outlook.)

4.Financial System. In April, “Financial market conditions remain supportive of economic growth.” In June, “Financial conditions have become less supportive of economic growth...”

5.Housing. In April, “Housing starts have edged up but remain at d depressed level.” In June, he left out “have edged up” and simply said, “: Housing remains at a depressed level.”

I think this is significant because Bernanke and the Federal Reserve Bank have been trying, very hard, to present the economy as beginning to improve. After all, as good Keynesians, they have already spent a ton of our money and they need those “animal spirits” (I guess that means our greed) to make the handoff from government spending to private spending (or their theory doesn’t work.) Is this a signal that we will get even more government spending?

Should we be worried about future deflation or inflation?

There is a lot of worry these days about weather we are in deflation, slipping into deflation or about to enter into an inflationary environment. It obviously makes a big difference in future planning and how investments are allocated. As you can imagine, there are very different views among the different economic philosophies.

Before I get philosophic differences however, I need to provide a simple definition of inflation and deflation. Very simply, inflation means an increase or inflation of the money supply (more money units) and deflation means a contraction in the money supply. In the case of inflation, an increase in money units means that each unit is worth less or one’s purchasing power is diminished. Therefore prices increase. Inflation, the way the word is used today means an increase in prices. Therefore, the cause of inflation is usually misdiagnosed. I’ll talk more about this in other posts. So lets look at the different viewpoints.

Keynesian/Demand-Side View
The big government economists (Keynesians and demand-side economists) are worried that the money spent to date (the stimulus and fiscal and monetary policy) is not enough to fill the spending gap left when consumers and businesses reduced spending.

Influential economists like Paul Krugman, have said all along that the stimulus packages have not been large enough to fill the gap in spending and that now we need a much bigger stimulus package in the neighborhood of $1 trillion more dollars if we are going to turn this economy around. If we do not get that kind of spending, we will slip into a deflationary death spiral that is very difficult to get out of. Therefore, we could end up like Japan in the 1990’s with 10 years or more of almost no growth.

Their definition of deflation is falling prices (due to lack of demand) and they see falling prices everywhere (housing prices, food prices, car prices, etc.) He doesn’t see falling computer prices over the years as detrimental or deflation however. He also does not mention how we are going to repay the loans.

Keynesian/Supply-Side ViewThe opposite position is taken by the less government economists (Keynesians and supply-side economists) who see a marginal improvement in GDP growth, which they have extrapolated into a V shaped recovery. They are worried about the coming inflation because of artificially low interest rates and high debt levels.

They see inflation (a rising consumer price index or CPI) everywhere. They think that unless the Fed raises interest rates very soon and begins to take money out of the system, we will get severe inflation within the next year to eighteen months. Interest rates should be raised to one percent higher then the nominal growth rate of GDP (growth rate before inflation.) So if the economy is growing at 3-4% as they expect, interest rates should be at 4-5% not zero.

Their definition of inflation is a rising CPI index (which is the symptom of inflation, not the cause.) The CPI index as you know is a basket of goods and services the government uses to measure price changes.

Capitalist ViewThe almost no government economists (Capitalists, Austrians, Objectivists) have a much different definition of deflation and inflation. They see deflation and inflation as it was originally defined: expansion or contraction of the money supply. Their view is that the government has been and continues to pump money into the economy (print money), which will be inflationary. However, consumers are currently over-leveraged (too much credit vs. disposable income) and must reduce spending and increase savings in order to b ring their financial lives into balance. This slowdown in spending looks like deflation (prices are being reduced by almost every store advertising.)

Therefore we are currently in a period of de-leveraging, not deflation and until the consumer starts spending again (by using or reducing his savings or expanding his credit) we will not enter an inflationary phase. But based on the money that has been added and expected to be added to the economy, we could be in for serious inflation.

Conclusion

Therefore, your current position should be focused on a de-levering economy, which will take considerable time and considerable pain. However, if the government pumps too much money into the economy (a debatable number) or credit becomes too easy again, too soon, it will be time to reposition yourself for inflation.

Consumers Are Beginning to Spend, But Where Is the Money Coming From?

Retail sales were up 1.6% in March and 10% year-over-year. These are not new highs but, the short-term trend offers some hope at least. However, faced with many and much talked about headwinds, the question really is: Where is the money coming from and is it sustainable?

This is very difficult to answer, on a fundamental basis, because the government is so involved in the economy that it’s hard to tell what is real and what is stimulus. None the less, following are the current positions of the three major branches of economic thought.

Keynesians (Demand-Side Economists)

Consumers are spending, and are being helped by government stimulus programs (the $800 billion dollar stimulus program plus cash for clunkers, mortgage modification, home purchase incentives, extended unemployment benefits, etc.) However, consumers are not spending enough and credit is too restricted for the economy to grow again without government help. The problem now is that stimulus money peaks in June 2010 and then trails off. Therefore, we need to keep interest rates low and we need additional stimulus spending to keep consumers and the economy “growing.”

Here is quote from the Cleveland Federal Reserve that I think sums up the Fed’s position,

“What does all of this bode for a recovery of consumption, the primary driver of the U.S. economy? The data shown here point to a long road ahead for a sustainable recovery. Consumers are paying down loans or defaulting, and those looking for new consumer loans are likely to find that banks are still pulling back on lending, though individuals who can secure a loan face historically low interest rates. Given the hangover of outstanding debt and recent memories of shrinking asset values, consumers may not be motivated to ramp up their expenditures. Rather, consumption will likely recover slowly as households save more and await the return of an improved labor market and the sustainable source of funding—disposable income—that it typically provides for consumption.”

Keynesian Light (Supply-Side Economists)

Consumers are spending more and that spending is becoming broad based. According to Brian Wesbury, Chief Economist at First Trust in Chicago,

“Economic data clearly traces out a V shaped recovery.”

He acknowledges that many headwinds do exist, but not right now --not until some time in the future. His reasons for increased consumer spending include: 1, the pace of debt reduction is slowing (if you pay off less, you have more of your income to spend) and 2, incomes are growing and recovering (a three month trend of incomes show a slight increase.) This is a very short-term view, but Keynesians are focused on the short-term.

Capitalists/Austrian Economists

Capitalists agree that on a short-term basis, consumer spending is increasing, at the margins, but for mostly the wrong reasons. Capitalists look at consumer spending differently. First, the short-term, aggregated numbers do not tell the real story. For example, gasoline prices have gone up about $1.00 over the past year increasing spending in this category. That will/could amount to a lot of consumers spending; but it certainly hasn’t helped the consumer or the economy.

Capitalists contend that it’s not government or consumer spending that is the problem, it’s the lack of investments. Investments and productivity are what generate job creation. That should be our concerned. Savings (ours or foreigners) are needed in order to have investment. Also, the consumer is still deeply in debt and needs time to reduce debt levels (and hopefully save) before meaningful spending can be sustained.

But, where are consumers getting the money?

Here are some other ideas:

1.One source is “strategic defaults.” These are people who are underwater on the value of their homes and can afford to pay their mortgages, but are chose to let their homes go into default and eventually foreclosure. There are currently about 6 million people in the process of foreclosure. These strategic defaults may be adding about $200 billion to annual household cash flows. (Per economist David Rosenberg.) Some of these people have not even been contacted by the bank in over a year.

2.Tax refunds which might be lower than previous years but do fuel consumer spending.

3.Savings rate has dropped from a recent high of 4.6% to 3.1%. That alone would explain a lot of spending.

4.Additional stimulus programs to come.

Short-term, it appears that consumers are spending more and adding to GDP (which certainly looks good ;) but long-term, we need to solve the problems that caused this recession in the first place and that will take time not money.

Comments always appreciated.