Why Donald Trump Can't Stop a Recession

A recession may be on the horizon.  The Federal Reserve doesn't think so.  Some others do.  Only time will tell who is right.  But if there is a recession, President Trump can't stop it before the 2020 election. 

The principal tool for the President to fight a recession would be to partner with Congress and put together a package of spending bills that would increase federal expenditures.  This sort of program, called fiscal policy, sometimes includes tax cuts, but not always.  The greatest fiscal stimulus in U.S. history, military spending for World War II, included a massive tax increase and an even greater increase in deficit spending.  The result was both victory in the war and an economic revival at home. 

Today, however, there is an almost complete absence of agreement between the President and the Democrats in the House as to how to deploy fiscal policy.  Although both sides speak of infrastructure spending, agreement on the fine points and details has remained elusive since the President was inaugurated and won't be achieved before November 2020.  For more than the past 20 years, the federal budgetary process has been largely dysfunctional, and it has grown more so as political divisiveness has increased.  With only one full budget cycle remaining before the election, it's simply too late to implement fiscal measures in time.

To make things worse, the President would likely seek a tax cut as part of the stimulus package.  But, having alienated the Democrats by ramrodding through the 2017 tax cuts with nary a shred of consideration for Democratic views, the President has essentially no good will left with the House majority when it comes to tax policy.  The Democrats will agree to tax changes only if there is a substantial rollback of the 2017 cornucopia of tax cuts for the wealthy, and the President won't agree to that.  So no deal on tax legislation is possible.

Of course, central banks can endeavor to combat recessions.  But the President does not control central bank policy.  Monetary policy and other economic management measures such as quantitative easing and the setting of bank reserves lie within the purview of the Federal Reserve.  The President attempts to influence the Fed with shrill demands on Twitter for much more aggressive interest rate cuts than the Fed seems inclined to make.  But the Fed strives to maintain its independence, and the President would be wise to back off.  If the financial markets lose confidence in the independence and integrity of the Federal Reserve, stocks will crater and the economy will get a tummy ache.   Moreover, Fed interest rate adjustments often take 18 months or longer to affect the economy.  Although they may almost instantaneously be reflected in asset prices in the financial markets, they take a long time to wend their way through the processes of the economy.  There isn't enough time before November 2020 for interest rate cuts to have a big impact. 

The prospects for a recession remain uncertain.  Unemployment is at a 50-year low, a remarkable development that no doubt informs the Fed view of the economy.  The stock market is dancing near its all-time highs.  Transportation and manufacturing are slowing, and the business community is pulling back on new investment because of confusion and caution arising from President Trump's trade wars.  It's difficult to tell how things will go.  But if a recession is coming, it's coming.

How to Stimulate the Economy

With current economic indicators mostly signaling a slowdown in the economy--and perhaps a recession--a lot of attention is focused on stimulating the economy. The dialogue revolves around central bank accommodation (via lowering interest rates and bond purchases in the form of quantitative easing) and fiscal policy (i.e., deficit spending).  Fiscal measures are essentially impossible because of political gridlock.  And central banks, having devoted the past decade to accommodation, have only limited ammo left.  So what can stave off recession and renew economic growth?

There's no simple answer.  But one important factor is the availability of inexpensive energy.  Modern life is dependent on vast amounts of cheap energy.  The Industrial Revolution that created our high tech lives was the result of the development of inexpensive ways to harness and utilize large amounts of energy.

Let's begin in A.D. 1700.  Living standards in A.D. 1700 worldwide were about the same as they were in A.D. 700 and 300 B.C.  In other words, things had hardly improved over thousands of years.  But within the 150 years following 1700, people had developed the steam engine and learned how to harness electricity for commercial use.  These developments were followed by new ways to extract large amounts of fossil fuels that could be sold inexpensively.  Then, after 200 years (i.e., by 1900), people had developed the internal combustion engine.  The internal combustion engine could be used widely in transportation, manufacturing and many other ways.  Large scale generation and distribution of electricity became feasible, and the widespread availability of electric motors greatly enhanced living standards.  Economic growth and improvement of living standards accelerated at an exponential pace.  In essence, access to inexpensive energy sources (carbon based fuels and electricity) triggered a monumental amount of economic growth and a phenomenal rise in living standards in a historically short amount of time.  Of course, we now have pollution and other byproducts of the Industrial Revolution to contend with.  But the simple truth is the astounding economic growth of the past 300 years resulted to a large degree from ever increasing access to cheap energy.  Cheap energy and the technology developed to exploit it made modern life possible.   

Why is energy so important to economic growth?  Because energy is a key input into all economic activity.  From manufacturing to transportation to farming to fast food to government offices to hair salons to slimy corporate lawyers peddling excuses for their greedy clients to sordid lobbyists plotting to kill health insurance coverage for all to the performances of rock stars in large arenas, energy is an input into essentially all economic activity.  If the cost of energy is lowered, all economic activity gets a boost and economic growth in all sectors of the economy is facilitated.  

It's no accident that America's economy grew briskly in recent years concurrently with a drop in the price of natural gas, solar and wind energy, and to some degree, oil.  The proliferation of fracking not only has capped the price of oil, but also created demand for a lot of drilling equipment, trucks of various kinds, and so on.  So it boosted the manufacturing and transportation sectors. 

We use enormous amounts of energy stored in the past to make our current lives more comfortable and enjoyable.  We now understand we can't keep relying so much on energy from fossil fuels.  We have to develop more sustainable lifestyles.  However, in order to maintain and improve our lives, we need to continue our access to cheap energy in better ways.  After decades of frustration, solar and wind energy have actually become cheaper than fossil fuels.  That is a very positive development.  More technological advance is needed. 

The policies needed continue the availability of cheap energy would be varied and sometimes controversial.  Increased federal funding of basic research is an obvious one, although the GOP has done much to cut this from the federal budget.  Republicans seem fear science.  But ignorance will not spur economic growth.

Building more gas pipelines is obviously controversial to the NIMBY crowd.  But we do need better distribution systems for gas--and electricity as well.  All the windmills and solar farms in the Plains states won't do much good without power lines to transport the electricity to the big cities that need the power.  These power lines entail a huge NIMBY problem.  But this will have to be dealt with somehow, because distribution systems have to be enhanced if there is to be growth.  We need not bow to big, bullying energy and power companies and give them everything they want.  But we should acknowledge the need for better distribution systems.

Fostering greater fuel efficiency also helps to lower energy costs.  It may not lower the stated price per unit, but it reduces the number of units people have to buy.  So it would help to pursue efficiency as well as reduce unit costs.  One hidden cost of efficiency, though, is people consume more energy when it effectively becomes cheaper--many ordinary cars and SUVs today have engines that are as powerful as those in the muscle cars of the 1960's, since engine technology has improved so much, and people drive more miles per year.  So greater efficiency isn't an improvement if it doesn't reduce the use of fossil fuels.

There are many other factors besides energy that affect economic growth.  But a lot aren't controllable by any branch of the government.  Energy policy, though, can be implemented through government.

In the 1940's, 50's and 60's, the U.S. had ultra-high marginal tax rates, not that much deficit spending (the government focused on reducing the deficit, not increasing it), a rather inactive Fed, relatively high wages that provided for a comparatively equitable distribution of wealth and income--and an era of brisk economic growth and low unemployment.  This is an era still remembered as a golden age in America.  Why?  Because oil was damn cheap.  What happened after the first OPEC oil embargo in 1973?  A decade of economic stagnation followed by decades of economic uncertainty.  When we had cheap energy, we had lots of prosperity.  When energy rose sharply in price, prosperity as we had enjoyed it went away and still hasn't returned.  We don't need to sell our souls to the fossil fuels companies.  But we need to recognize that our standard of living and future improvements to our standard of living are dependent on access to cheap energy.  And we need to find responsible and sustainable ways to keep that gravy train rolling.

Is the Central Banking Bubble Bursting?

America's economy is stuck in first gear, China's economic growth is slowing, Europe's economy is dead in the water, and Japan's economy has been lost in a fog bank for decades.  Corporate profits have been declining on a year-to-year basis.  But stocks keep reaching new highs.  Given the backdrop of pessimistic data from the real world, one must wonder how much longer the delirious jollity of the markets can continue.

It's no secret that the frothiness of stocks stems from the service-minded attitude of the world's major central banks:  they aim to please.  Accommodation is the word of the day.  Money will be printed early and often, and served on a silver platter with a flute of champagne.  The central bankers are not about to take the champagne away, even though some Federal Reserve officials occasionally mutter something or other about raising rates.  The markets know this--the futures market seem to view rate rises as likely as pigs flying.  So the central bank bubble persists.

It's true that the central banks' tools are becoming dull.  Quantitative easing--the purchasing of bonds by central banks--is playing out.  Vast amounts of government bonds have been bought up, and now corporate bonds are being targeted.  Private sector retirement savings are being pummeled by the lack of sources of reliable long term earnings.  Pension fund deficits are like festering sores, annuity payouts are shrinking, long care insurance policies are becoming extortionately expensive, and interest payments on personal savings are going the way of the passenger pigeon.  With shrinking retirement prospects, people are saving more so that they can limit the need for dog food in their retirement diets.  As a result, both current and future consumption are constrained.  Since consumption is 70% of the U.S. economy, the Fed is seeking short gains in aggregate economic statistics by sacrificing long term financial prospects.  We've had eight years of ultra low interest rates with no end in sight, and recovery from the resulting income losses will take many years, if it ever happens.

More recently, the monetary tool that has become au courant among central bankers is the negative interest rate.  Negative rates are a counter-intuitive policy where borrowers are paid to take out loans.  They are supposed to stimulate lending by penalizing commercial banks for holding deposits.  However, despite being all the rage among central banks in Europe and Japan, they haven't worked out. It seems that people, concerned by the weirdness of negative rates, aren't borrowing but instead are saving more.   See http://www.cnbc.com/2016/08/09/bonds-and-debt-negative-yields-are-doing-the-opposite-of-what-they-were-intended.html.  Negative interest rates signal that the world is not well.  People are hunkering down and building up financial reserves in case times get worse.  This, too, dampens consumption and current economic growth.

But the deleterious effects of ultra low and negative interest rates are more likely to cause further economic stagnation, not a sudden collapse of stock prices.  The reality is that central banks aren't subject to market forces the way the rest of us are.  They are, however, subject to a lot of political pressure to keep current economic statistics looking good.  They know that the political process is largely dysfunctional, and fiscal proactivity isn't on the agenda. So they keep exchanging small near term benefits for large long term costs without any immediate consequence.  The bubble won't burst simply because they are making a bad long term deal. 

Could the central banking bubble burst?  The breakup of the EU might do the trick.  A return of significant inflation would be a major risk factor.  But it's hard to predict the likelihood of either.  In the meantime, stock prices could remain manically frothy.  Central banks can't defeat market forces when the market works against them, as the Bank of England found out in 1992 when it tried to support an overvalued pound against market forces pushing the pound down.  But right now, the financial markets want the central banks to be accommodative.  They applaud the idea.  Since the central banks face no reality checks, they can keep printing money indefinitely.

So, should you suspend belief and keep buying stocks?  Certainly, seeing stocks go ever higher just about every day is encouragement to drink the Kool-Aid and invest more.  But staying well-diversified, with a healthy dollop of cash, may be the sanest choice in an insane world.

Economic Consequences of the Mid-Term Elections

The economic consequences of yesterday's mid-term elections will be zero.  In order to boost the economy, the federal government would have to raise taxes, cut spending or both.  Even though President Obama now faces a majority Republican Senate as well as House, he won't agree to major tax cuts and the Republicans won't agree to major increases in spending.  So the fiscal impact of the mid-term elections will be effectively zero.  With the federal deficit lower than the historical average of 3% of GDP, there's room for fiscal stimulus but no political impetus for it.

Modest spending boosts may come from an increased military role for the U.S. in the Middle East.  Trying to suppress ISIS is becoming a game of whack-a-mole.  And American air power may have to target an al-Qaeda affiliate called the al Nusra front as well.  But such mission creep will be constrained as there is no public support for a resumption of ground warfare by U.S. troops.  The defense budget won't provide major stimulus.

Monetary policy is the only real game in town, and central bankers are the croupiers.  The Fed has just ended quantitative easing in the face of 3% plus growth by the economy, but there's nothing that stands in its way if it wants to fire up the monetary printing press again.  Just the push of a few computer keys, and the QE program is up and running again.  The Japanese central bank has recently placed a lot of QE chips on the table, putting a punch bowl on the table even as the Fed takes one away. 

The newly empowered Republicans in the Senate will probably increase pressure on the Fed to step back from accommodation.  That would be a fool's errand, as there is nothing the Republicans could actually do over the next two years to substitute for the loss of Fed accommodation.  If Republican pressure on the Fed slows the economy to stall speed, look for smashing Democratic victories in the 2016 Presidential and Congressional elections.

Emerging Markets: Another Asset Bubble Popping

The emerging markets asset bubble is popping.  Financial markets in China, Brazil, Turkey, Russia, and India have been falling, with no end in sight.  Commodities prices have declined.  And the major stock markets--in Japan, Europe and the U.S.--have been dragged down in consequence.  All because the Fed began to reduce its quantitative easing program.

We've been here before.  Fed easy money policies contributed to the tech stock craze of the late 1990s and the real estate and mortgage bubbles of the 2000s.  Those earlier bubbles popped when the Fed began to withdraw accommodation.  You have to wonder whether the Fed will ever learn:  long periods of accommodative policies inevitably create asset bubbles somewhere, and when the accommodation is reduced, the bubble will pop.  Painfully, since there is no other way for an asset bubble to pop. 

When tech stocks, and then real estate and mortgage markets, crashed, recession and unemployment followed.  The results included, among other things, higher and higher levels of unemployment and greater inequality of income and wealth over the past 15 years.  When the Fed repeatedly uses its very blunt monetary weaponry to combat economic slowdowns, the rich get richer and everyone else stagnates or declines. 

What will the Fed do in response to the emerging markets downturn?  Initially, nothing.  It will hope that the positive momentum that has emerged in the U.S. and to a limited degree, in Europe, will be enough to maintain overall global economic equanimity.  But if the decline extends for several more months (particularly in major stock markets), expect the Fed to rethink its stance and get the monetary printing presses revved up again.  As we have discussed before (see http://blogger.uncleleosden.com/2014/01/expect-nothing-from-government-in-2014.html), fiscal policy will be darn near nonexistent this year.  Fed easy money policy is the only way for the federal government to combat economic distress.  And even if more money printing means yet another asset bubble a few years down the line, and more income and wealth inequality, the only choices nevertheless remain easy money or easy money.  The Fed's policies are the only game in town.

One might lament that the Fed never seems to learn that too much accommodation leads to yet another asset bubble that pops, causing distress and dislocation that leads to more accommodation, which only continues the cycle.  But the problem is the Fed has little choice.  Congress and the White House mostly stare at mirrors and ask who is the fairest of all.  The business community waits for the federal government to stimulate the economy, reduce its risks and heighten the potential for profits.  The Fed personifies moral hazard:  the rest of the world has learned that, when push comes to shove, the Fed will act.  So there's no need for anyone else to step out front and center and take the lead. 

How do we break this vicious cycle?  Well . . . uh . . . there was once a time--long, long ago--when the private sector would lead the way out of recessions.  Businesses would start to expand, banks would start to lend, investors would start to take risks.  But how likely is that to happen now? 

The Fiscal Crisis: Can Kicks Are All We Can Expect

Tonight (Wednesday, Oct. 16, 2013), Congress has temporarily "fixed" the fiscal and debt crises by re-opening the government until Jan. 15, 2014, and raising the debt ceiling until Feb. 7, 2014.  In other words, the government will resume operations and not default on its debt until early next year, when we return to crisis mode again.

Can kicking is all we can expect.  The government that the voters elected in 2012 isn't capable of decisive action on divisive issues like government spending.  With the House held hostage by a small but very loud group of Tea Partiers, and the rest of government controlled by the Democrats, dysfunction is baked into the cake the voters made last year.  Maintaining the status quo--a/k/a can kicking--is the only thing a sharply divided government can do.

Early next year, when Congress and the White House revisit the fiscal and debt crises, they will again kick the can through the end of the 2014 fiscal year (which ends Sept. 30, 2014)--because they won't be able to do anything else.  Maybe they'll make minor tweaks, but nothing big will happen.  Come late September or early October 2014, with the 2014 Congressional elections imminent, they will kick the can again past the election date, perhaps into early 2015 for the next Congress to deal with.

To end can kicking, voters need to elect a functional government next fall.  Yes, the idiots in Washington are to blame for behaving like children.  But the electorate put them in office.  Democracies function by compromising.  If narrow-minded, uncompromising fanatics are elected, expect the can to be well-kicked for years to come. 

Why the Republicans Blinked

The Republicans, especially those in the House of Representatives, are rapidly giving ground in their fiscal battle with the Democrats.  A resolution is pretty likely within a week or less.  It will probably provide a short term delay of the debt ceiling and re-open the government, while the parties negotiate over long term fiscal issues.

Why did the Republicans blink?  Because they tried to manufacture a crisis out of a non-problem and a long term problem.  The non-problem is Obamacare.  The truth is that Obamacare offers valuable benefits to millions of people.  The huge traffic jams on health exchange websites demonstrate that lots of people understand Obamacare's value and want to participate in the program.  The Republican attempt to de-fund Obamacare would take away something millions of people want, and that's usually a very poor political strategy.  The Republicans seem to have belatedly figured this out, but not before forming a circle and firing volleys inward.

The long term problem is the federal deficit.  It is a serious problem.  But it's not an immediate problem.  The Republican effort to create a crisis at this moment over something that will play out years and decades from now is too obvious a political ploy.  The minority party wants to call the shots by gratuitously inflicting damage on the economy with a government shutdown and coercing an unnecessary default on the most important financial instruments in the world, U.S. Treasury securities.  Political parties thrive by winning over a majority of voters, not by wrecking economies and financial systems.  The fiscal deficit is not an immediate crisis.  It needs to be addressed, and will be, over the next years and decades as it becomes more pressing.  But the Republican tactic--give us everything we demand or we will destroy your government and wreck your finances--is bound to, and in fact did, alienate a majority of the electorate. 

After Barack Obama's re-election last year, the Republicans launched a process of reflection and reconsideration.  It's unclear that they made much progress, and the fiscal brawl of the past few weeks has surely left the party more damaged than before.  The Tea Partiers have prevented the Republicans from doing the thing that's necessary to political domination--shifting toward the middle.  Since political power abhors a vacuum, the Democrats have easily moved into the breach. 

No Fiscal Discipline in the Stock Market

As the federal government belly flops into sequestration, the stock market merrily rolls along.  Europe is sinking into recession, an inevitable result of its austerity and deleveraging policies.  Japan is in recession, and has pledged to worship at the altar of monetary accommodation in an effort to revive its economy.  American consumers are creeped out by continued government dysfunction, continued economic dysfunction and an increase in Social Security taxes.  Retailers are reaching for the little paper bag in the seatback on front of them.  But stocks are delirious.

Of course, it's all because Federal Reserve Chairman Ben Bernanke yesterday swore up and down that central bank accommodation is next to godliness, or something to that effect.  If the most powerful agency in the United States government promised to subsidize you indefinitely, you'd be delirious, too. 

By ignoring real world problems, and flying high on the Fed's fiat paper meth lab, the market is letting Congress off the hook.  Without someone or something twisting their arms behind their backs, the members of Congress have little or no incentive to get real and work out the nation's fiscal problems.  The stock market has the leverage to make Congress devote its full attention to a problem. In the fall of 2008, when the financial system teetered on the brink, Congress voted down a rescue package.  The market promptly nosedived, and squashed 401(k) accounts from sea to shining sea.  Constituents deluged Congressional offices with negative commentary (that's putting it mildly).  Congress immediately reversed course and enacted the TARP rescue legislation.

Today, however, fed by the Fed with printed money, the market romps.  Congress fiddles.  And the rest of us get nervous about the smell of smoke that waffles through the air.  By not holding Congress accountable, the market enables government dysfunction.  The market can be quite effective when it imposes discipline.  But an undisciplined market is scary.

Over the Fiscal Cliff and Through the Woods

Over the cliff and through the woods,
To a grand recession we go.
Congress knows the way to waste its last day,
raising taxes and adding woe.

Over the cliff and through the woods,
To a grand recession we go.
The Fed is on deck, printing money like heck,
Investors are losing dough.

Over the cliff and through the woods,
To a grand recession we go.
The Dems go their way to make the rich pay,
Republicans say no no.

Over the cliff and through the woods,
To a grand recession we go.
Where the deficit shrinks, while the jobless drink,
Eating cake is for the po'.

Happy New Year.

Will Stocks Drop Over the Cliff?

The stock market has been eerily calm in spite of all the sturm und drang over the fiscal cliff.  After a brief sell-off following President Obama's re-election, the Dow Jones Industrial Average has treaded water right around the 13,000 mark.  Evidently, the market believes the anonymously leaked assurances from both the Republican and Democratic sides that a deal on the fiscal cliff will be reached.  And, rationally speaking, that should happen.  So maybe the market is justified in its equanimity.

But is it?  Looking back at the most recent comparable instance of fiscal dysfunction, the 2011 debt ceiling scrum, we find that "resolution" of the political problem was followed by a drop in the market.

The debt ceiling fight simmered until June and July 2011, when all hell broke loose and records were set for political dysfunction in Washington.  Only at the last minute, on August 2, 2011, was a deal to lift the debt ceiling finalized and approved by Congress.  The Dow, which floated around in the 12,000s during July, fell below 11,000 within a week.  One might have thought that resolution of the debt ceiling battle would produce a market rally.  But, no, just the reverse happened.

The debt ceiling fight revealed the depths of America's political dysfunction.  Standard & Poor's cut America's credit rating on August 5, 2011.  The future looked, if anything, more uncertain than before the debt ceiling crisis.  The resolution to the debt ceiling problem was to kick the can down the road, and defer confronting the government's tax and spending issues until after the November 2012 elections.  Stalling and delaying isn't the kind of thing to inspire investors.  The market's frothiness before the deal and its drop after the deal seemed like a classic case of buy on the rumor and sell on the news.

Well, that may be where we are headed today.  There are plenty of nice sounding rumors being floated by politicians who have plenty of incentive to shade the truth.  Reality is that whatever compromise the Republicans and Democrats reach on the fiscal cliff will surely be ugly.  The pie is too small to be apportioned in a way that will make many, if any, happy.  With the "resolution" to the fiscal cliff likely to make most of the nation grumpy, stocks aren't likely to be exuberant.  Whatever you do, don't bet on politics to produce investment gains.

Political Risks of the Fiscal Cliff

Who faces the greatest political risks from the fiscal cliff?  It ain't the Democrats.  They could do nothing, and watch the pre-Bush tax rates go back into effect in 2013.  While this would have a near term negative impact on consumer spending, it would lower the federal deficit.  That would promote long term economic growth.  The President would take some heat for the economic slowdown, but the Democrats would have four years to recover before facing the 2016 Presidential election.  By then, the economy might well be improving.

If there is a deal on the fiscal cliff, it would probably include some cuts to Medicare and Medicaid, and perhaps to Social Security (although the latter is less likely, since Social Security is actually much less of a fiscal problem and more visible to the voting public).  The Democrats would blame these cuts on Republican insistence (of which there is plenty).  Meanwhile, the Democrats would take credit for whatever tax increases or enhancements or whatever else would be part of the deal, which probably would fall more heavily on the rich than the 99%.

The Republican insistence on no tax rate increases allows President Obama to replay his winning electoral strategy of advocating tax increases for the rich.  Republicans believe too much in their own P.R., that all taxes increases are invariably bad and that spending cuts would somehow be made to prevent taxes from increasing.  A majority of the electorate thinks otherwise, and the Republicans conceded these voters (let's call them the 51%) to President Obama. 

 The baseline problem with the Bush tax cuts is that they reduce federal revenues to the point where Social Security and Medicare--the two most sacred bovines of American politics--are imperiled.  It's one thing to attack federal funding of bridges leading to nowhere.  It's another to take away bread and butter from the elderly.  Republicans have managed to put themselves in a corner where they seek to protect low taxes for the wealthy while trying to squeeze pensioners having modest incomes.  They ultimately can't protect the wealthy from a tax increase--the Democrats can do nothing and those increases will take effect at midnight, Jan. 1, 2013.  But the Republicans can manage to look like Scrooge during the Christmas season as they advocate cuts for moderate income retirees.  Politically, it won't be the Democrats who tumble over the fiscal cliff.

How Government Adds Risk to Risk Assets

The Federal Reserve has been on a tear, squashing interest rates in order to coerce investors into risk assets.  But investors, especially individual investors, have been zigging where the Fed wants them to zag.  They have succumbed to post traumatic stock disorder, and abandoned equities with abandon. 

Fear of stocks isn't just a product of the market busts of recent years.  It's also driven by too many known unknowns.  The role of government in pumping up asset prices has become so great that it receives more attention from financial news services than economic fundamentals.  But, as mandated by the law of unintended consequences, government actions have made risk assets less attractive.  Here's how.

The Fed has become less predictable.  In years past, the Federal Reserve was slow to reveal its thinking and the reasons for its policy actions.  Chairman Ben Bernanke has endeavored to be more transparent.  And he has been more transparent about the workings of the Open Market Committee and its thinking.  But what has been revealed only confounds.  The Fed is quite open about its intention to provide monetary stimulus in order to boost employment.  But no one knows what level of employment will cause the Fed to ease back, or what rate of inflation will lead it to move interest rates up.  No one knows what type or form of additional quantitative easing the Fed will employ if employment levels remain unsatisfactory (however unsatisfactory may be defined).  Will it buy car loans, credit card debt, bankers acceptances, commercial paper, corporate bonds, junk bonds, common stocks, or something else?  Whether or not, why, when, how, how fast, and how much are important, but unanswered, questions concerning the Fed's potential unwinding of its massive $3 trillion plus balance sheet. Any purchaser of risk assets would want answers to these questions.  But answers are unavailable.

The Fed is relentlessly driving its monetary wagon train under the motto "full employment or bust."  By acting so vigorously and creatively, however, it has created a lot of uncertainty even as it has stabilized the financial system.  There are so many uncertainties about the route the Fed is taking that individual investors don't want to hitch up their wagons and join the trek.  What the Fed will do next is anybody's guess, and because of its outsized impact on risk asset prices, this unpredictability makes risk assets riskier.

Fiscal funk.  Congress's dysfunction was on full display last year when those freakin' idiots--excuse me, the esteemed members of Congress--almost blew up America's creditworthiness in the debt ceiling debacle.  Things haven't changed.  Forecasting fiscal policy is like peering into a black hole.  It's impenetrable.  Whatever happens could make things worse.  Also, consider the permanently temporary nature of the Bush II tax cuts, which have fallen into the habit of being extended a year at a time.  The analysis of risk assets becomes labyrinthine when the tax system is established for only a year at a time. Another big, bad black hole is known as the fiscal cliff, which is huffing and puffing furiously.  Yet we don't know if we're in a house of straw, wood or brick.  All these fiscal foulups accentuate the risk in risk assets. 

Rational investors trying to reason their way to well-founded decisions haven't got a popsicle's chance in hell of figuring out the upsides and downsides of risk assets.  They just know that these known unknowns heighten the risks.  In such circumstances, digging the fox hole deeper and hunkering down all the more make sense.

The Great Government Risk Transfer

One of the most singular characteristics of government policy since the Great Depression has been to shift financial risks from private hands to the government. Early programs in this respect had broad support because they benefited most citizens. Federal deposit insurance, Social Security and Medicare are notable examples. Other such programs benefited those thought to deserve special protection, such as subsidies for farmers, Aid for Dependent Children, and Medicaid. Fannie Mae, Freddie Mac, Ginnie Mae and HUD were created to boost home ownership, which was believed to promote good citizenship. America, once riven by dissension and social conflict from the sufferings of the Great Depression, stabilized and prospered (helped in part by the fact that it was the one big industrialized nation left standing after WWII). The middle class, in particular, enjoyed the fruits of a life in which many of the vicissitudes of dependency in an industrialized world were lessened. Income inequality shrank and optimism swept away the despair of the Depression.

In the past thirty years or so, the nature of government risk transfers has changed. More recent federal policies have taken financial risks off the hands of the well-to-do and transferred them to taxpayers. Most prominent has been the Federal Reserve's relentless low interest rate program, which boosted the value of risk assets like stocks, bonds and commodities. The Greenspan/Bernanke put--a dramatic lowering of interest rates and expansion of the money supply every time the stock market throws a hissy fit--is now a permanent feature of federal monetary policy. The Fed could not step back from providing, at zero cost to investors, the Grand Put without triggering a horrendous stock market crash. It's no wonder that the rich--whose burgeoning wealth derives mostly from stocks and other risk assets--have gotten richer. With the almighty Fed running interference for them, it's hard for the owners of risk assets not to get wealthier.

Other aspects of federal risk transfer benefitting the wealthy include Fannie Mae, Freddie Mac and HUD, without which the mortgage-backed securities market could not exist. Wall Street banks and financiers are among the biggest beneficiaries of this market. Other familiar examples are the evolution of large-scale farming subsidized by large amounts of farm subsidies and physicians who speed-treat patients to maximize their Medicare billings. Developers and homeowners in flood zones benefit from federal flood insurance, at the expense of taxpayers living on higher ground. Bailout programs like TARP disproportionately benefited the wealthy, while federal mortgage refinance and principal writedown programs that would benefit the unfortunate, have been largely ineffectual.

It's no surprise the wealthy have gotten the most out of federal risk transfers. They control the political process and can steer government policy in their favor. Mitt Romney's narrow victory in the Iowa caucuses only reinforces this trend. Money talks. Those with money have staying power in the political process. The ABM movement in the Republican Party (read Anyone But Mitt) isn't over his wealth, but his moderate views. So if another candidate surpasses Romney in the end and wins the White House, expect the Republicans not to disturb the prosperity of the well-to-do, although those less well-off and retirees should be apprehensive.

The Obama administration, for all its rhetoric, has presented little true threat to the wealthy. It agreed to a moderate temporary version of the estate tax, and has grudgingly gone along with a temporary continuation of the Bush II income tax cuts. Its Treasury Secretary has, overall, been a solid supporter of Wall Street (in spite of occasional politically motivated rhetoric to the contrary). And, despite policy proposals floated to the contrary, Fannie Mae and Freddie Mac continue in their central role financing the U.S. real estate market.

The question is whether this risk transfer can continue. Taxpayers don't have endless resources. Already we have a fierce debate over federal deficits, and there is much talk of imposing more risk on those of moderate and low income (by reducing Social Security, Medicare and Medicaid benefits). In Europe, we see the makings of a taxpayer revolt, with those in southern Europe objecting to paying more to cover the profligacy of their governments while those in northern Europe object to paying more to cover the profligacy of their southern neighbors.

American taxpayers haven't really honed in on the Great Government Risk Transfer in the U.S., even though it underlies many of today's political controversies. If the costs of such risk transfers continue to mushroom, citizens will eventually figure out that their pockets are being picked. If we truly believe in a market-based economy, governed by the principles of free markets, we have to cut back on the government's risk transfers, especially the ones benefiting the wealthy. Those who have capital to invest can do the most for society if they invest in ways undistorted by government subsidies. As things stand now, the wealthy have the incentive to profit off of taxpayers. It's fine if someone works hard, saves, invests wisely and gets rich. It's not fine if someone pigs out at the public trough. Income inequality honesty earned is deserved. Income inequality fostered and supported by government policy is unacceptable.

Why the EU Has No Policy Options

Why has it been so difficult for the EU to resolve its sovereign debt crisis? Because it has no policy options.

Fiscal policy is limited by the EU's ostensible restriction of government deficits to 3% of GDP. Virtually all EU members, including powerhouse Germany, have violated this commandment. With deficits already exceeding 3%, EU members can't go Keynesian (more so than they already have).

The European Central Bank, guardian of the Euro, is constrained by its charter to promote currency stability, meaning that it is duty bound to keep inflation low. At 2.5%, inflation in the Euro zone is moderate. But the ECB can't take the low road of expediency and inflate the Euro in order to ease the burden of repaying the EU's sovereign debt and make the Euro zone more competitive internationally. Aside from violating its charter, the ECB would rile up the Germans, for whom inflation is anathema and perhaps cause enough to leave the EU.

Germany was the wealthiest proponent of the EU, and created the union in its own image. Fiscally prudent and indefatigably vigilant against inflation, the EU allows member nations to combat excessive debt only by enhancing the productivity of workers and elevating economic growth. A very German solution, but not all of the EU is German or inclined toward that persuasion.

So what's left? Right now, talk therapy is being offered. Rumors of Chinese interest in Italian bonds surfaced first. These preliminary discussions are less than first touted, focusing on strategic investments in Italian companies than Chinese purchases of Italian government bonds. In other words, the Chinese are trying to cherry pick the best of Italy's assets in a moment of Italian weakness. That ain't a bailout in anyone's book. The Chinese premier has also made noise about Chinese support for EU debt, but only if China gets improved trade access to Europe. That's just talk for now. Europe's immediate cash flow needs won't be served by this proposal.

Rumor mongers also proffer tales of Brazilian and other BRIC interest in Euro zone sovereign debt purchases. But these eager whispers appear to be just an agreement to meet and talk next week in Washington. The market has bobbed up and down the last couple of days. Its modest rises may be little more than short covering by hedge funds that don't want their butts fried in case some outside money actually wants to bet on Euro debt.

Outside money would appear to be Europe's only hope. It can't use fiscal policy, nor can it deploy monetary policy. But outside money may be far from a panacea. It can be profitably invested in EU sovereign debt only at a discount, something that by definition would preclude a bailout. And, even if the BRICs are willing to lend a helping hand, the hundreds of billions (and maybe more) of hinky Euro sovereign debt may defy the best of BRIC intentions. The BRICs are growing quickly, but don't by themselves have the sheer financial horsepower to haul Europe back from brink.

Europe remains a wealthy part of the world, with substantial economic resources. Europeans won't have to live on air. But the vision of living ever larger indefinitely into the future dangled by EU enthusiasts is as mythical as the chimera. The only way for the EU to survive is to endure a long, painful test of shared sacrifice and loss, leavened only by disappointment and disillusionment, before a true United States of Europe can be forged. And it's far from clear that Europeans will meet that test.

Forget Washington. Watch Europe.

The President's $447 billion proposed jobs program is largely irrelevant. Congress will pass it in some form. The Republicans can't afford, 14 months before the next election, to entirely block the proposal. They need to demonstrate that they are part of the solution. Their obstructivism on the debt ceiling legislation hurt them more than it hurt the President. Their obstinacy now would let the President set them up to take the fall next year for high unemployment levels. So we can expect a jobs bill soon, probably in the range of $300 billion to $450 billion. It will help create some jobs, but not enough to dramatically reduce unemployment levels. Net impact: not much for the economy, plenty of grist for the political blame game.

The big stakes are over in Europe. The betting now is pretty much for the entire ranch. Proposals for a United States of Europe, on the one hand, compete with proposals for booting Greece (and perhaps other profligate EU members) out of the European Union. Europeans are facing up to the fact that muddling around with bond exchanges and other kicks of the can down the road won't fend off the swarming bond and derivatives vigilantes.

Neither option is attractive. A United States of Europe would appear to foster stability. But stabilizing its debt problems would soak up a lot of the wealth of the northern EU, leaving less capital available to finance future growth. The unexpectedly large burdens of sovereign and bank debt in Europe could cripple growth for years in a region that already suffers from low growth. Europe's per capita income is on average about a third lower than America's. The costs of unifying may widen that gap (a scary thought for Europeans, considering how stagnant America's economy has become). With the rest of the world's economy slowing, there's no powerful economic engine anywhere for the Europeans to latch onto. (China's economy is only one-third the size of America's, and everyone in the entire world wants a piece of it, so Europe can't count on China.)

Besides, it's unclear that unity would last. It didn't for the Soviet Union. Hell, it didn't for Czechoslovakia and Yugoslavia. Why would it last for the entirety of continental Europe (plus, maybe, the U.K.)? Certainly, unity would last as long as Germany and a few other well-off nations wrote checks to poorer member nations. But that's a gravy train that will run dry, perhaps sooner rather than later. Then what? Singing Kumbaya lasts only for a few minutes.

Splitting up the EU could trigger a financial crisis. Europe's banks have been financing the EU's growth, by making many loans to countries that turn out to be dodgy debtors. The bonds of as many as a third of the EU's members are now suspect. Booting Greece and other libertine nations would likely trigger domino defaults. Banks across the Continent might blow up one after the other, like a string of firecrackers on the Fourth. The well-off countries of Europe would have to commit their national wealth to propping the European banking system. The U.S. financial system would falter as well. But then the big American banks would line up at the Fed to receive their bailouts, which would be forthcoming in nanoseconds with an extra large helping of fries.

Whichever way they go, EU nations may well be damned if they do and damned if they don't. But that won't stop them from doing something, because the status quo is untenable. Whatever they do, the impact in America will likely be big. So read those impenetrable news stories about the EU in the middle of the third section of the newspaper. They're important.

Will Wall Street Weaken America's National Security?

The defense budget will shrink. That's inevitable, given the toxic swirl of today's federal budget/debt ceiling/tax laws politics. A lousy economy generates less tax revenue. Social Security, Medicare and Medicaid are hard to cut because you'd have to hurt a lot of voters. The federal payroll and the non-Defense, non-entitlement portions of the federal budget are relatively small. Cuts to them won't have much numerical impact. The Defense budget is large, and wears an obvious bullseye on its back.

Outgoing Secretary of Defense Robert Gates has already warned of cuts. He also gave our NATO allies a deserved lecture on increasing their defense capabilities so they can contribute more effectively to the alliance. When America stepped into the background, NATO's air campaign against Muammar Gaddafi sagged, and almost left the Libyan rebels high and dry. The major powers of Europe, unable to effectively spank a crummy tinpot dictator on the other side of the Mediterranean? Gates' admonishment to NATO is another signal that America won't have the resources to be the world's full-time peace officer.

Let's remember that all this goes back to the financial crisis of 2007-08, which originated from greed, recklessness, idiocy, and appallingly bad risk management on Wall Street. However much one might blame Presidents Bush and Obama for proposing taxpayer funded bailouts, however much one might criticize Alan Greenspan, Ben Bernanke and their colleagues at the Fed for printing money and creating asset bubbles and inflation, the root of the problem lies with the big banks. When executives from the major banks now whine about the costs of regulation and heightened capital requirements, bear in mind that America's international stature suffered gravely and will continue to suffer gravely because of the bank-spawned financial crisis. And America's ability to defend itself has been and will be reduced because the big banks weren't kept in line. This is a threat that shouldn't be allowed to recur.

Demote GDP and Enhance Economic Well-Being

The most frequently used measure of economic well-being is Gross Domestic Product. Government and private sector leaders, economists, commentators and polemicists fixate over GDP. Its upward movements prompt celebrations and congratulations (usually, self-congratulations). Its downward movements provoke calls for resignation, electoral ouster, and tea parties, and fuel no end of tiresome cable TV commentary. Whether the country is in an economic downturn or upturn is defined by movements in GDP.

Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.

The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.

GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.

Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.

A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.

A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.

Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.

The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.