One of the (many) problems with using big increases in federal government spending as an economic stimulus tool is timing. You can’t appropriate and spend it fast enough to matter much during the downturn. Spending it years later, after the economy has already begun to recover on it own, then becomes an inflation worry.
There is a new CBO study, Implementation Lags of Fiscal Policy, that details the path of the money this time around. In spite of all tyhe talk we have seen about shovel ready projects not much of the money has actually made its way into the economy yet. As you can see in the figure above, except for HHS and the Dept. of Labor, less than 2% of the money appropriated to all other departments (Education, Transportation, Energy, …) has been spent. The total spent so far is just $24.6 billion out of $379 billion.
This chart details how much of the $787 billion in stimulus money will hit the economy each year over the next three years. As you can see, only 11% of the $308 billion appropriated to discretionary spending like highways, mass transit, energy and education will be spent by the end of this year. Overall, less than a quarter of total funds will be spent in 2009.
Why is this s problem? Because there are early signs of recovery coming in now every day. By the end of this year the recovery will be undeniably underway. That means next year (2010) and the year after will be periods of rapid growth and rising inflationary worries. That’s why bond yields have increased by more than a full percentage point in recent weeks with more to come over the coming months. And that’s one of the reasons why commodity prices have been rising so fast.
Investors should be very careful to avoid long-term Treasury bonds today
The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.
The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.
This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.
Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.
My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.
The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.
The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.
Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.
If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.
Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.
It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.
California’s budget mess is front page news. Some are trying to figure out whether they can (or will) cut spending enough to live within their means. Others are looking for new revenue enhancers–we don’t call them taxes anymore or people will vote them down in elections. Both are missing the point. It’s not only the budget, but the balance sheet that needs attention.
California does not only have a tax and spend problem; it has a balance sheet problem. There are too many promises of future cash flow to pay for pensions and the like. California needs a balance sheet solution. Not the one that failed in last week’s election—borrowing more money and accounting with mirrors. California needs to sell assets and shrink liabilities in order to regain financial health. When a person or a company declares bankruptcy the judge takes your house, your car, your toys and your other ‘stuff.’ Although state governments cannot, formally, declare bankruptcy, the same medicine will work for them as well. Easier said than done.
Yesterday I wrote about the strange accounting practices for government entities used by the Federal Reserve Board in preparing their quarterly Z1: Flow of Funds of the United States reports. They provide detailed information about cash receipts and cash disbursements for federal, state and local governments, consolidated on p. 110 for all levels of government. They include the information on current receipts (tax collections) and current expenditures as well as information on government purchases and sales of all sorts of assets including spending to buy fixed assets (buildings etc., $513.1 billion annual rate in Q4/08). But in the consolidated balance sheet, which I have reproduced above, they conveniently forget to mention that governments own real assets.
According to the table, All levels of government owned $3280.4 billion in financial assets and had total liabilities of $10,171.3 billion on 12/31/08, which seems to imply that governments had a negative net worth position of nearly 7 trillion dollars (-$6,890.9 billion). But where are the $513.1 billion in fixed assets they reported governments buying in the flow of funds table? Indeed, where are all the other tangible assets–the land, the buildings, the machines, the trucks and buses) the governments purchased in all the previous periods? If they had included government holdings of tangible assets the statements would look much different. Indeed, they would reveal the immense stockpile of real assets on government balance sheets that are available for sale to meet the government obligations everyone is writing about. The federal government, for example, owns more than 700 million acres of land (not reported on their balance sheet either). These assets can be sold outright or they can be sold and leased-back. Either way the cash is available to pay obligations. Either way we would have more honest financial statements.
You don’t need a very sharp eye to detect the number of speeches in Washington taking aim at “the rich” and the number of new policies that aim to redistribute wealth from “the wealthy” to “the middle class.” Like all wars in Washington this one is being fought with symbols and rhetoric. People argue about who is, or is not, middle class and whether each policy will, or won’t, impact that ill-defined middle class.
I have been writing and talking about the reasons why this class war had to happen for a number of years. To me it is the unavoidable side-effect of the same change in capital markets that created the fast-growing global economy and lifted three billion people around the world out of poverty.
First, let’s clarify who is attacking whom. It is the capital market and the people who make their living in the capital markets, not “the rich”, that are under attack. That’s because, since 1980, the capital markets have both facilitated and enjoyed three decades of growth.
The chart, above, shows the change that precipitated the class war. In 1981, Reagan was elected after a decade of rising inflation and rising interest rates that had all but destroyed the capital markets. In 1980, inflation was 15%, CD rates were over 20%, the 30 year Treasury yield was 15%, and the top (federal) marginal tax rate was 70%. Inflation had driven investors out of stocks and bonds and into hard assets like gold and silver–50% of total assets were held as hard assets. Growth was zero. The stock market was trading at single-digit multiples of earnings; the Dow was 860 in mid-1981.
Tax cuts and falling inflation over the next 2 decades forced investors to gradually move their wealth from hard assets to stocks and bonds. During the same period there were further change–deregulating brokerage markets and the spread of high speed telecom networks around the world–that made it easier, cheaper and faster to move capital from one use to another or from one location to another. Moving capital from a low-return use to a higher-return use increasses its value. You have to pay someone to move it.
Stock and bond prices soared, as did the amount of work to be done in the capital markets. Moving all that capital took a lot of people. And people working in fast-growing industries make a lot of money. As the chart above shows, the compensation of financial market workers roughly doubled compared with everyone else.
Everyone else includes the people NOT working in the financial sector. It also includes people left behind when capital owners moved it from where it was (say, a manufacturing business in Michigan) to where it would earn a higher return in a different industry or a different country.
This shift in relative income and wealth is the principal driver behind the shift in politics that elected Obama. It is increasingly clear that he believes he was elected with a mandate to redistribute wealth and income through government spending, tax rates and regulations. Recent experiments have included price and wage controls. I have seen this movie before; it doesn’t work.
The problem is that, whatever your political objectives, we need markets and market prices if we want to stay rich. Market economies are much, much more efficient at producing goods and services than other forms of economic organization. At its core is a vast parallel-processing information network that transmits information about scarcities and wants ONLY to the people who need it so they can make decisions. We transmit that information in little packets we call prices. Any policy that interrupts those transfers by interfering with market prices will lead to a dramatic drop in productivity and output.
Policies to control prices and wages, taxes subsidies to encourage politically correct businesses and a tsunami of taxes and spending are extremely destructive to growth and average living standards. But that does not mean they are going away. The change in income and wealth distribution that created the class was are real and lasting. I am concerned that the growing class war may end up as the defining characteristic of the U.S. economy this decade.
NOTE: Senior moment alert. I pulled the charts in this piece from a recent article but can’t remember the right person to cite. If you know, please let me know so I can give proper credit. Thanks.