From the November 2011 issue of Investment Advisor • Subscribe!

November 1, 2011

Pull the Trigger

Several direct and indirect triggers affect GDP, but consumers are the hand holding the gun

A GDP trigger is something that has an effect on the rate of GDP. Moreover, a trigger can be direct or indirect. For example, direct triggers are the four components of GDP: consumer spending, industry spending, government spending and net exports. An indirect trigger is something that has an effect on a direct trigger and might include such items as interest rates or bank lending standards.

The most important direct trigger is consumer spending. When consumers spend, businesses hire, production rises to meet demand and the economy grows. Then, as the unemployment rate falls, more wage earners enter the fray and economic expansion gains traction.

To combat our weakened economy, the Fed has been highly accommodative. The problem, however, is that consumers are not taking the bait to any large degree. In fact, much of this monetary explosion is sitting at various Federal Reserve banks and commercial banks. Even though the cost of borrowing is at historic lows, lending activity is weak. Individual loans at commercial banks are down from their April 2010 peak and real estate loans have been trending downward since May 2009. One bright spot may be found in the level of refinancing activity. As consumers trade in their higher interest loans for a new lower interest model, positive cash flow results, which may encourage additional spending.

After 20-plus years of accumulating debt leading up to the Great Recession, consumers remain overleveraged. Before robust spending can return, they must reduce their debt, build up savings and feel good about the economy and the direction of this country. Until then, adding more money to the system or maintaining historically low interest rates will have little effect. Even if consumers were well-positioned to resume their borrowing binge, lending standards remain tight. The days of fogging up a mirror to qualify for a loan are over.

The most important economic issue we face is weak consumer demand. If we can stimulate this everything else will fall in place—assuming Washington regains some measure of fiscal discipline. Therefore, the key question is, “How do you stimulate consumer demand?” Until this happens, unemployment will remain stubbornly high.

Dollar Daze

One of the most often tweaked indirect triggers is the value of the U.S. dollar. When the dollar weakens, U.S. exports rise unless global demand is extremely weak. Therefore, a weak dollar policy provides support for the large U.S. multinational exporting companies, which in turn boosts GDP, assuming exports exceed imports. If the goal is to support these large corporations, then a weak dollar policy is good bait.

Recently, the U.S. dollar has been strengthening, which is a headwind to net exports. Conversely, a strong dollar is also anti-inflationary, which is good for the consumer. Could this policy revive the deflation discussion? It’s possible, especially if global demand continues to weaken.

Government: A Growth Buster?

Government regulation is a powerful indirect trigger that can stimulate or stymie business growth. The more regulatory burden placed on business, the greater the headwind. Historically, regulation has ebbed and flowed. However, since 2008 it has increased rather substantially. Proper regulation necessitates a balance between law and grace. Too much regulation hinders business growth, while too little may promote the wrong behavior. Government regulation has been out of control for years. As a result, many companies have opted to relocate operations outside the U.S. where the business climate is friendlier. Moreover, employers are understandably concerned about the additional costs related to Obamacare, Dodd-Frank, etc. Potential tax increases are only adding fuel to the fire.

It’s no secret that our government has been on a spending binge over the past few years. Clearly, the benefit of all of this economic “stimulus” has been tepid at best. When government allocates resources it frequently lacks focus and efficiency. For example, the government bailed out several failing banks in 2008. Today, these same banks are saddled with additional regulatory burdens and excess fees. Also, when the U.S. government enters into global agreements, it’s often to the chagrin of U.S. companies. A good case in point is the Basel accords. Recently, Jamie Dimon, CEO of JPMorgan Chase called Basel III “anti-American.” Many believe Basel I and II were not much better.

This has created an atmosphere of uncertainty and is a chief reason why owners of small businesses are reluctant to hire.

The Global Influence

I certainly don’t need to remind you of the seriousness of the problems facing Europe. Why are Europe’s problems so important to our economy? First, Europe is a large consumer block and one of our most important trading partners. When their economy slows, we feel the effect. Second, the subprime contagion between our financial institutions and their banks is largely unknown.

The eurozone faces many challenges beyond the extreme indebtedness of its members. Although they are united on paper, unlike the United States, Europe has a fragmented fiscal policy. Under this structure, there is no central authority to enforce fiscal prudency. Therefore, if a country believes they will be bailed out if they get in trouble, they may be inclined to assume more risk. Additionally, their labor force is less mobile than here at home. It’s much more difficult to move from Italy to Ireland than from California to Connecticut. Each country also has its own legal system. Finally, there’s the issue of the language barrier.

Japan, another developed country, is in serious trouble. They are struggling with massive government debt, an aging population and the aftermath of devastating natural disasters. At well over 200%, Japan has the highest debt-to-GDP ratio of any nation. It’s going to take a lot of time and money to restore economic prominence.

With the developed economies in slowdown mode, the role of global growth rests on the shoulders of the emerging countries. Although these economies have experienced robust growth over the past several years, many are showing signs of slowing. Besides, even if the engines of the emerging economies were humming along, would it be enough to power the rest of the world?

Economic Levers

It’s important to understand that government does not produce or create. Government provides services for its people and can create an environment in which the private sector flourishes. Though we may debate the specific functions of government, when it comes to economic issues, the lines of demarcation are clear. Government has two primary levers with which they can stimulate an economy. These levers are monetary and fiscal policy.

Monetary policy is managed by the Federal Reserve. Established in 1913, this “central bank” has been tweaking the economy for nearly a century. Although its mandate calls for full employment and stable prices, it has recently ventured beyond this in an attempt to pull us back from the abyss.

The Fed has specific tools at its disposal, including adjusting the Fed funds rate, regulating the nation’s money supply and setting bank reserve requirements. Lowering reserve requirements is a method of expanding the money supply. Our economy operates under a fractional monetary system. This is highly relevant during periods of debt expansion. Here’s how it works: Let’s say you deposited $10,000 in your bank. If the reserve requirement was 10%, then the bank would be required to hold $1,000 in reserve, but could loan the excess $9,000. This loan would appear as a deposit and another 10%, or $900, would be held in reserve, leaving $8,100 to lend. This process is repeated over and over; from an initial deposit of $10,000, money could grow a total of 10 times. Although the topic of reserve requirements is beyond the scope of this article, reserve requirements today range between 0% and 10%.

The Fed: Did They Venture Out of Bounds?

Normally, the Fed only lends to member banks. However, as provided for in Section 13(3)—a rather obscure clause in the Federal Reserve Act—the Fed may lend to, “any individual, partnership or corporation” if five members of the Federal Reserve Board in Washington declare the circumstances to be “unusual and exigent.” This was the basis for the Fed’s actions in 2008 when it bailed out the auto manufacturers, banks, brokerage firms, etc.

QE III, IV or More?

Quantitative easing occurs when the Federal Open Market Committee (FOMC) purchases U.S. Treasury securities. As you are probably aware, the Fed has greatly expanded the money supply in recent years. However, much of this expansion remains on the sideline. Even though monetary expansion may help reduce interest rates, it also fosters inflation which has a negative effect on cash flow.

The Fed has recently lengthened the duration of its portfolio by selling short-term Treasuries and buying Treasuries with maturities of five years or greater. This could cause short-term rates to rise and long-term rates to fall. The result would be a flatter yield curve which would ostensibly put downward pressure on mortgage rates. All this translates to low savings rates and compels investors to seek riskier assets, a goal of the Fed. More bubbles and busts ahead? I’d say, “yes.”

To summarize monetary policy thus far, interest rates are essentially at 0%, the money supply has exploded (although much of it is on the sideline) and bank reserve requirements are very low. Additional quantitative easing would be like putting a pacemaker into a heart patient and then removing it—the problem is the weak heart. Thus, monetary policy has been exhausted and there is little more the Fed can do. It’s now up to Congress.

Fiscal policy is managed by Congress and may be divided into two categories: government expenditures and tax policy.

Government expenditures have reached record levels. Our nation’s debt, slightly under $15 trillion, increased by nearly $5 trillion under President Bush and another $5 trillion under President Obama. When you factor in the “off balance sheet” debt, the number is closer to $100 trillion. As a result, America’s credit rating was downgraded in August. As already discussed, due to inefficiencies and politics, much of this spending has been wasted. I suspect Americans will not embrace much additional spending, and Congress will be forced to make some tough choices. We’re well past the time for “shovel-ready” projects. Besides, if we could have done this effectively, would we be having this discussion?

Tax Policy

There have been a few small tax breaks enacted since 2008. We’ve witnessed the extension of the Bush tax cuts, the reduction of the Social Security payroll tax and a few other fringe tax breaks. However, this is like attempting to put out Nero’s fire with a squirt gun or bringing a knife to a gun fight.

What’s the solution? In the spirit of the game show “Let’s Make a Deal,” there are four doors from which to choose:

Door No. One: Reduce Interest Rates

Door No. Two: Expand the Money Supply

Door No. Three: Increase Government Spending to Create Jobs

Door No. Four: Reduce Taxes

Doors One and Two have been exhausted. Door No. Three has been attempted and has failed. The only remaining option is Door No. Four, which is precisely what President Reagan did following the economic malaise of the 1970s. By putting more money in taxpayers’ pockets, consumers will pay down their debt, increase their savings and investments and resume spending. We also need to create a business-friendly environment through reasonable regulation and lower corporate tax rates. Why? Because when jobs are plentiful somewhere, the unemployed move to those areas. And there are certainly a lot of unemployed people these days.

We are in a global competition. If America can become business friendly, we could attract companies from all over the globe. Then, instead of outsourcing jobs, we could experience the reverse. We need change, but not the change we have been experiencing. Winston Churchill once said, “Americans can always be counted on to do the right thing...after they have exhausted all other possibilities.” I hope his sentiment is proved wrong this time.

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