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.

Politics Keep the Economic Crises Going

We are vividly reminded today that the economic crises bedeviling the world are political in nature.  The election deadlock in Italy, with leftists likely to control one house of the Italian Parliament, and rightists and leftists apparently in  a draw in the other house, is a vote against austerity and centralization of the EU's governance. Although the political nuances differ from Greece's initial anti-austerity vote last year, the Italian election, like Greece's, signals that numerous voters have yet to learn the words of the pan-European version Kumbaya.  Another election in Italy may well be needed, or the country will be unable to stay on track to meet the EU's expectations.

In America, sequestration now seems almost a certainty.  The arbitrary cuts imposed by sequestration were supposed to be unpalatable to either party, and would therefore incentivize both parties to cut a real deal.  Fat chance of that in these days of political dysfunction.  Truth is there won't be a real deal.  That's why the Dems and Republicans kicked the can down the road when the fiscal cliff loomed and the debt ceiling threatened to descend like the Sword of Damocles.  The government right now can do little more than bring its foot back for another kick.  The one silver lining in the clouds is that the economy seems to be recovering to some degree.  The better the economy does, the lower the deficit will be.  We should hope and work for economic growth, because that is the only politically feasible solution to the budget deficit.  The federal government needs to repair and upgrade infrastructure, adopt a pro-growth immigration policy, work hard to cut the growth of health care costs (perhaps the biggest expense in future federal budgets), and work toward supporting and expanding educational opportunities while reducing the cost of education.  (Internet-based instruction may be a great way to educate at much lower expense, and should be encouraged and supported.)  The current squabbling in Washington over budget cuts and tax increases is a game of musical chairs that no one can win.  We have to take a different approach.

Keep Your Investments Simple, Because the Alternatives Could Be Worse

As reported by the New York Times (and linked through CNBC.com:  http://www.cnbc.com/id/100449551), retail investors are once again being burned by complex alternative investments.  This is an old story in the annals of investment busts.  The more complex an investment, the less likely a retail investor will understand it, and the greater the advantage an unscrupulous broker will have in foisting it on the unsuspecting.  What's troubling is that many of the victims weren't seeking a fast, speculative buck.  They were often conservative investors who were pushed by the Federal Reserve's scorched earth policy against interest rates to hunt in dark, dank thickets for elusive, ethereal positive yields.  Desperate for investment income, they fell victim to sales people saying what they wanted to hear, but maybe not what they needed to understand.

An underappreciated element of saving and investing is the need to manage risk.  Manage doesn't mean avoiding all risk, and it certainly doesn't mean seeing greater risk as the path to greater rewards.  It means understanding that risk and reward are linked, and that not getting too greedy about rewards is the way to long term success.  Some risk is reasonable, as long as you don't expose yourself to so much volatility that you grab the little paper bag in the seatback in front of you and put all your money in a mattress.  The tortoise beats the hare when it comes to investing.  Searching for quick returns is like donning wings of paraffin and flying toward the Sun.  Don't invest in anything that you don't understand--and that means having a full appreciation for every way your hmmmm can be deep fried.  Simple, steady and average are a decidedly better bet for making you comfortable in retirement than the latest in glam financial fashions.  For more, see http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.

Dow 14,000: So What?

What does Dow Jones Industrial Average at 14,000 mean?  Not much, when you consider that it's to a large degree the product of the Fed's unremitting money printing policy.  A "value" achieved through government policies, rather than market forces, has little intrinsic value.  Witness the real estate markets of 2007-08:  decades of government subsidies through the mortgage markets, tax laws and Federal Reserve monetary laxity puffed up home values until they exploded in our faces.  Comparable subsidies (like quantitative easing) and more easy Fed money can do the same to financial assets. 

Right now, retail money has started flowing into stocks again.  That's deemed by many market pros to be a sign of an impending market peak.  If you want to get in and out of the market--i.e., trade it as if it were an asset bubble--there may be some greater fools who would buy from you.  That is, if you act quickly enough.  But investor, beware.  The Fed is making an enormous bet right now:  that enough monetary stimulus will somehow revive the economy to the point that it will independently resume sustained growth and return to full employment.  That such will occur is unusually uncertain.  Aside from the fact that economic revival has been painfully slow even with all the printed money, one has the sneaking suspicion that the Fed has quietly placed a side bet that its easy money policy would push down the value of the dollar enough that America might export its way to prosperity.  But other export-centric nations are fighting back.  Japan has effectively undermined the independence of its central bank in order to push the yen down. China has stopped levitating the renminbi. And the Germans are starting to grouse audibly about the revival of the Euro.  Currency wars tend to take on the look and feel of a circular firing squad, and the major economies of the world are charging their muskets.

Maybe the Fed Won't Sell Off Its Balance Sheet

A major question overhanging the financial markets is what will the Federal Reserve do with its $3 trillion and growing balance sheet?  The conventional wisdom is that, eventually, it will have to sell off much or most of its holdings, lest the Inflation Monster come roaring out of its lair.  The specter of $1 trillion, $2 trillion or perhaps more of Treasury and mortgage-backed securities hitting the bond markets would send a shiver down the spines of many a market player.  Even a suggestion that such sales are impending could induce interest rates to pop and stocks to drop.  All the Fed's hard work to stimulate the economy could circle down the drain as rising borrowing costs smack down home purchases, consumption and corporate investment. 

To avoid such a scenario, maybe the Fed will simply not sell off its balance sheet.  In the often strange alternative universe of the Fed, where massive money printing isn't perceived as an inflationary threat until the Monster is tearing into our throats, this might make sense.  Once the Fed stops purchasing Treasury securities and other debt in the open markets, it can simply hold the assets on its balance sheet until they are paid off.  It would remit the interest and principal payments to the U.S. Treasury.  This would reduce the amount of taxes that the Treasury would need to squeeze from harried citizens, aiding their ability to consume, while lessening the threat of its balance sheet to the stability of the financial markets.  If the Fed were to sell its assets in the open markets, it would compete against private interests for capital.  If it were to hold its assets and remit the proceeds to the Treasury, more capital would be available for private investment. 

Sounds too easy?  It would be too easy if the truckloads of printed money that the Fed has dumped into the economy inflates the dollar at substantially more than today's low rate.  But the velocity of money today seems driven by little more than a three-cylinder, two-cycle engine.  The economy is hardly growing any faster.  Unless economic growth rises above the fast side of brisk, selling off the Fed's balance sheet will threaten the recovery.  The Fed may well be tempted to take advantage of today's low inflation rate, and simply hold its balance sheet until maturity.  We'll see.

Consider a House To Hedge Against Inflation

The housing market, having walloped the bejesus out of tens of millions of Americans, may seem an unlikely hedge against inflation.  But history shows that home prices tend to move up briskly during inflationary times.  During the 1940s, inflation burst out, driven first by World War II rationing and then by pent up consumer demand after the war.  Consumer prices moved up about 72%.  Census Bureau data indicates that housing prices moved from a national average of $2,938 in 1940 to $7,354 in 1950 (unadjusted for inflation).  That's an increase of 150%.

During the stagflation of the 1970s, consumer prices rose 112%.  Housing prices rose from a national average of $17,000 in 1970 to $47,200 in 1980, an increase of 178% (unadjusted for inflation).  You can find Census Bureau data on housing at https://www.census.gov/hhes/www/housing/census/historic/values.html.

The data show that housing prices rose faster than inflation during two of the most inflationary decades in the past 75 years.  Of course, the sales prices of houses don't tell the entire story.  You can't directly compare prices of housing against prices of stocks or inflation-adjusted bonds like U.S. Treasury TIPS, because housing requires periodic lawn mowings, plumbing repairs, new roofs, maintenance of HVAC systems, and replacement of dishwashers.  It's also taxed locally every year, and sometimes hit up for special assessments if the water or sewer systems need to be gussied up.  But you'd directly or indirectly bear those expenses anyway if you rented.  So owning a house and capturing the upticks in value might work out well for you during inflationary flareups. 

Why would housing be such a good inflation hedge?  Professional economists might be tempted to wheel out a wagon load of regression analyses to demonstrate their erudition.  But the simple and obvious explanation is that a hard asset with substantial utility will have significant value no matter what the paper currency is doing.  A house provides shelter, warmth, indoor plumbing, and a private place to pig out on high fat, high sugar, low nutritional value junk foods while long-term parked in front of a 124-inch TV, parboiling your brain without the neighbors seeing what a couch burrito you really are.  Market forces will adjust the paper value of that hard asset upward when the fiat currency is going haywire.

At the moment, inflation seems to be spotted about as often as the ivory-billed woodpecker.  But that doesn't mean it's extinct.  History shows that inflation can be quiescent for long periods of time, and then burst forth like an oil well blowout.  Inflationary pressures right now are doing a fan dance, often out of sight but still faintly visible in profile.  Ultimately, unless the Fed and other central banks can repeal market forces, their massive money prints and asset purchases of recent years will eventually inflate paper currencies.

 Housing, like politics, is first and foremost local.  Some markets would make mediocre investments no matter what (like areas with high unemployment).  Some types of housing, like condos, may not be ideal for inflation hedging.  Their values tend to be less stable than that of the 4-bedroom, 2 1/2 bath Colonial with the white picket fence and English sheep dog.  A house isn't a substitute for sensible investment diversification.  Stocks, TIPS and perhaps other assets might also play a role as reasonable inflation hedges in a well-diversified portfolio. 

It's hard to have confidence in housing after the free fall in prices of recent years.  But investment success can often come from buying disfavored assets.  Buying bubbly assets like bonds (especially junk bonds) isn't likely to be the epitome of financial perspicacity.  Home sweet home, be it ever so humble, may work out better if inflation rears its ugly head.

Reducing the Deficit: Should the Fed Monetize the Federal Debt?

Desperate times call for desperate measures.  We've seen yet another dysfunctional mess from the political process, and have to think expansively.

The recent fiscal cliff deal was largely a failure.  It raised taxes on most Americans, while doing virtually nothing to reduce federal spending.  While income taxes were not increased for the middle class, Social Security taxes were increased for all workers at all income levels.  The well-off (the $400,000 plus crowd) face a higher income tax rate of 39.6% (20% on qualified dividends and capital gains) and wealthy dead people now pay a 40% tax rate (instead of 35%) on the portions of their estates exceeding $5 million ($10 million for married couples).  The automatic spending cuts required by the cliff were deferred for two months (except for $24 billion in cuts that do go into effect), so spending largely continues apace.  Presumably, there will be a second face off over spending cuts when the President asks Congress to increase the debt ceiling in the next few weeks (even though the White House insists it won't negotiate over the debt ceiling).

One thing to take away from the cliff deal is that spending cuts are really hard to agree on--so hard that the Dems and Republicans simply kicked the can down the road.  But they will be even harder to agree on two months from now.  The Republicans have lost significant leverage by agreeing to tax increases now.  The tax side of the fiscal cliff has been resolved, more or less favorably to the Democrats (although some liberal Dems are still unhappy).  What incentive do the Dems, who control the Senate, now have to agree to spending cuts?  Of course, the Dems would agree to some spending cuts (the defense budget would be their target number one).  But Republicans are focused on hurting core constituencies of the Democratic Party through Social Security, Medicare and Medicaid cuts.  With the Dems having largely won on the tax issues, they have little reason to make concessions on the social safety net.  Even if the President is willing to give the Republicans some of what they want (which he seems to be), he may have a problem in the Senate, where Social Security, Medicare and Medicaid were stoutly ring-fenced and defended during the fiscal cliff talks.

Realistically speaking, we shouldn't expect our dysfunctional elected government to find grand solutions to the fiscal deficits.  Due to a variety of bad and intractable political dynamics, that simply won't happen.  We have to look elsewhere for solutions.

The next logical candidate to get the hot potato would be the Fed.  The central bank has played a central role in combating the Great Recession, not without some success.  In the course of its massive quantitative easing programs, it's accumulated a balance sheet of close to $3 trillion.  This total is likely to grow as the Fed continues to purchase debt on the open markets.  Slightly over half of the balance sheet consists of U.S. Treasury securities.  Total federal debt is about $16 trillion.  Thus, the Fed holds about 10% of all federal debt.

Why not have the Fed simply forgive some or even all of the U.S. Treasury debt it holds?  In other words, it would declare that the Treasury wouldn't be required to pay the debt.  That, by definition, would reduce the federal deficit by reducing the amount of federal debt outstanding.  And it's what happens anyway.  When the Fed receives debt payments from the Treasury (usually consisting of interest payments), it simply remits those funds back to the Treasury Dept. (except for a small amount retained to finance the Fed's budget).  Debt forgiveness by the Fed would simply expand on what happens in the ordinary course.   

Of course, such debt forgiveness would be tantamount to monetizing the debt, and has the potential to be inflationary.  But precisely what the heck do we think is going on now?  When the Fed launches repeated quantitative easing programs, with ever more asset purchases but not the tiniest hint of when, if ever, it would unwind its Brontosaurian balance sheet, it has functionally monetized the debt.  With the economy expected to be a sick puppy for years, reality is the Fed may hold a lot of its current inventory of U.S. Treasury securities until they mature.  When they mature, it will remit the principal payment it receives from the Treasury back to the Treasury (or use the funds to make more open market purchases of Treasury securities).  The federal debt has been monetized, even though no one on the government's payroll is going to admit it. 

Such debt forgiveness wouldn't fully resolve all the deficit problems.  But it could reduce the scope of the crisis, and would amount to little more than accurately accounting for what is actually going on.  If inflation flared, the Fed could suspend debt forgiveness and raise short term interest rates, combating inflation as it traditionally would.  But as long as inflation is subdued, debt forgiveness could contribute to resolving a problem that politicians clearly won't be able to solve, at least not comprehensively.

Ultimately, the best solution to the deficit problem is to boost economic growth.  Greater growth means higher employment levels and more income and corporate profits to be taxed.  If the economy were growing briskly and unemployment were around 5%, we probably wouldn't feel we have a deficit crisis.  Housing seems to be stabilizing, although its long term prospects remain clouded.  So we can't count on housing to be the engine for growth.  Measures the government could take include:  (a) rebuilding infrastructure--this is something the government has historically done well, and should do more of given the crumbling state of our infrastructure; (b) loosen up immigration restrictions for well-educated people and people who can invest substantial capital in America to create jobs--we need more innovators and entrepreneurs; (c) improve education, not by handing out loans to anyone who has a pulse and a signature (there's way too much student debt already, and it will be the next big debt bubble), but with measures to make education more efficient and inexpensive, like expanding Internet-based educational programs.  Achieving greater economic growth will take time, but it's a lot easier than trying to use the political process to agree on budget cuts. 

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.

The Fiscal Cliff Negotiations: Just Who Is Barack Obama?

Recent negotiations over the fiscal cliff, which seem to be faltering after initial signs of progress, raise a persistent question about Barack Obama:  has he any political principles?  After campaigning this fall to protect the poor and middle class, he agreed in fiscal cliff negotiations to changes to the income tax structure and Social Security that are more damaging to the poor and middle class than the prosperous segments of American society.  By accepting Republican demands for the Social Security inflation adjustment to be the Chained Consumer Price Index, Obama has effectively reduced inflation protection for Social Security recipients, military retirees and federal civilian retirees, the vast majority of whom are low or middle income.  At the same time, because the same inflation adjustment would be made to income tax brackets, the brackets would rise more slowly during inflationary times.  That would effectively result in heavier taxation across the board, a seemingly regressive result.  Additionally, Obama agreed to raise the threshold for higher tax brackets from his original position of $250,000 to $400,000.  To be cynical, this might be viewed as a gift to the upper middle class professionals who often are his supporters and contributors.  And to be more cynical, it can be observed that many lower income folks, especially older whites heavily reliant on Social Security and/or military pensions, tend to be Republican more often than Democrat.  Perhaps the President sees little to lose in imposing austerity on them.

One wonders if Obama, after four years of dealing with the Great Recession, understands even the basic structure of the U.S. economy.  Our economy is 70% consumption.  Money in the hands of the poor and middle class gets spent.  They don't have enough to save hardly a penny.  This spending stimulates the economy.  Money in the hands of the upper middle and upper classes is frequently saved, allowing the rich to get richer relative to other income categories.  By raising taxes on the poor and middle class while cutting benefits to Social Security recipients, and military and federal civilian retirees, the President is reducing consumption and its stimulative impact on the economy, while exacerbating the inequality in wealth distribution.  What policy sense does this make?

During his first term, Obama demonstrated time and time again at critical junctures that he is a clever politician and dealmaker much more than a leader.  He craftily co-opted his most serious Democratic rival, Hillary Clinton, by making her secretary of state.  And he kept the liberal wing of the Democratic Party at bay by putting one of their number, Joe Biden, in the Vice President's residence.  But he has few loyal constituencies.  His one signal achievement, the Affordable Care Act, may transform life in America.  But transformational legislation doesn't necessarily bestow greatness on a President.  Lyndon Johnson's Great Society programs transformed America far more than anything Barack Obama has done or will do.  Indeed, the Voting Rights Act of 1965 enfranchised black and other disadvantaged Americans, paving the way for Obama to win the White House.  But Johnson has been denied the mantel of greatness.  While this is due in large part to his foreign policy catastrophe in Vietnam, it's also because Johnson, like Obama, was a consummate politician without any large loyal constituencies.  There's no one running around singing Johnson's praises.  Obama will always be remembered as the first nonwhite President, and there's a measure of greatness in that.  But John Kennedy was America's first non-Protestant President, and in 1960 that was an achievement not far from Obama's achievement in 2008.  Kennedy is remembered today for his charisma and charm.  But he doesn't rank among the great Presidents.  And, because Obama seems to value a deal more than principles or loyalty to constituents, neither will he. 

How Will the Fed Deal With Speculation on the Fed?

The Federal Reserve's historic announcement today of specific benchmarks for changes in monetary policy--no positive short term interest rates permitted until unemployment is 6.5% or lower, or inflation exceeds 2.5%--got a resounding shrug from the stock market, which closed flat.  Or maybe it wasn't a shrug, but puzzlement.  This policy takes the Fed into uncharted territory, and the truth is no one really knows what will happen next. 

One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go.  For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market.  Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to. 

Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large.  Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately.  Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck. 

With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world.  After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right).  The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited.  Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on.  The specter of systemic risk could lurk. 

If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways.  If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark).  In such an instance, the very policy that the Fed is attempting to implement could be undermined. 

But there is no practical way for the Fed to prevent benchmark betting.  Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take.  If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem. 

The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable.  That's nice theory.  But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works.