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Comments on Current Economic Issues

Prof. Peter Morici - 8/10/2011

I. Fixing Markets, the Economy Must Begin in the Oval Office


The U.S. economy and equity markets are being rocked by a crisis of confidence. Businesses, investors and ordinary Americans simply lack confidence in the ability of the Obama Administration to get the country growing and create jobs.

Apprehension about the future stems not merely from the constant bickering between Republicans and Democrats on spending and taxes, but more fundamentally on the growing realization that monetary policy is spent—the Federal Reserve has some ammunition left but is not likely to be very potent. And fiscal policy—huge stimulus spending and deficits championed by President Obama—has failed to jump start growth and jobs creation.

The Federal Reserve cannot lower further short-term interest rates. The overnight bank borrowing rate (federal funds rate) has been keep near zero since December 2008, and additional Fed purchases of U.S. securities to lower longer term Treasury and mortgage rates wouldn’t have much impact.

Fed purchases put additional funds at the disposal of banks but ordinary Americans can’t borrow because they lack collateral—their homes are simply not worth enough to warrant refinancing at lower rates. Too many older families are locked into properties valued at less than their mortgages and can’t sell to younger couples and get more capital in circulation.

Banks make loans to businesses on the basis of cash flow not collateral—after all the equipment and structures of businesses lose half their value if those fail and can’t pay their debts. Simply, most small and medium sized businesses lack the additional demand and cash flow necessary to justify expansion and qualify for credit.

Economists can quarrel about how many jobs the stimulus saved, but a $1.6 trillion dollar deficit can’t be increased any further. The bond market won’t tolerate it, and now the whole political dynamic is to push to deficit down.

Congress quarrelling with the S&P about the calculations supporting its downgrade of U.S. debt reminds of a class that went partying the night before an exam—it drank too much, got bad grades and now says the test is unfair.

Few rational observers would argue against the notion that the Congress is spending beyond the country’s means. Hence, little additional money can be found for additional stimulus from the public trough.

The third instrument of macroeconomic policy is exchange rates—the values the dollar trades at against other currencies. A cheaper dollar would boost exports; reduce imports in favor of domestic products; and increase demand, growth and jobs creation. Europe and North American countries have forsaken exchange rates as a policy tool and growth strategy, but not so China, Japan, India, and others, who use exchange rates aggressively to their benefit and the peril of western economies.

Asian superpowers intervene in currency markets—regulate transactions and sell their currencies for U.S. dollars—to keep their currencies cheap, boost their exports and growth, and deprive U.S. and EU businesses and workers of customers and jobs.

With monetary policy and fiscal policy spent, exchange rates are only tool the United States has left, and that is the province of Treasury Secretary Timothy Geithner and the President.

Mr. Geithner argues that China’s intransience on yuan pegging is not a problem, because China’s inflation is making its products more expensive. That is a sad apology for the failure of his diplomacy with Beijing to win changes in Chinese policies.

The yuan is undervalued by at least 40 percent, and its intrinsic value increases at least 6 percent each year because of Chinese productivity growth. With Chinese inflation exceeding U.S. inflation by only 3 percentage points, it is hard to see how Chinese inflation will provide any relief.

Decisive action is needed now to counter currency manipulation by China, Japan and others—these could include U.S. counter intervention in currency markets, currency conversion taxes and licensing currency transactions to offset similar practices by those mercantilists.

All this requires major shifts in U.S. policy, and for the President to articulate a clear path for Congress to support and for his Administration to implement.

Failing to make these changes would greatly imperil prospects for economic recovery and his reelection.

II. Tackle the Trade Deficit to Create Jobs


Tuesday, the Commerce Department is expected to report the deficit on international trade in goods and services was $48.0 billion in June. The trade deficit is the most significant barrier to jobs creation and growth in the U.S. economy.

Simply, the U.S. economy suffers from too little demand for what Americans make, and every dollar that goes abroad to purchase oil or Chinese consumer goods that does not return to purchase exports is lost purchasing power that could be creating jobs. Halving the nearly $600 billion annual trade deficit would create at least 5 million jobs.

Jobs Creation

Oil and Chinese imports account for virtually the entire trade deficit. The failure of both the Bush and Obama Administrations to develop abundant domestic oil and gas resources, and address subsidized Chinese imports are major barriers to pulling down unemployment to acceptable levels.

The economy added only 117,000 jobs in June; whereas, 386,000 jobs must be added each month for the next 36 months to bring unemployment down to 6 percent. With federal and state government cutting payrolls, the private sector must add about 410,000 per month to accomplish this goal.

Too many dollars spent by Americans go abroad to purchase Middle East oil and Chinese consumer goods that do not return to buy U.S. exports. This leaves U.S. businesses with too little demand to justify new investments and hiring, too many Americans jobless and wages stagnant, and state and municipal governments with chronic budget woes.

Economic Growth

The first half of 2011, GDP growth has averaged about 0.8 percent, well below the 3 percent needed just to keep up with productivity and labor force growth and keep unemployment from rising.

In 2010, consumer spending, business technology and auto sales added strongly to demand and growth, and exports have done quite well. However in 2011, the soaring cost of imported oil and subsidized Chinese manufactures into U.S. markets pushed up the trade deficit and offset those positive trends. Now consumer pessimism is pushing down retail sales and home prices, and discouraging new home construction and business investment.

Administration imposed regulatory limits on conventional oil and gas development are premised on false assumptions about the immediate potential of electric cars and alternative energy sources, such as solar panels and windmills. In combination, Administration energy policies are pushing up the cost of driving, making the United States even more dependent on imported oil and overseas creditors to pay for it, and impeding growth and jobs creation.

Oil imports could be cut in half by boosting U.S. petroleum production by 4 million barrels a day, and cutting gasoline consumption by 10 percent through better use of conventional internal combustion engines and fleet use of natural gas in major cities.

To keep Chinese products artificially inexpensive on U.S. store shelves, Beijing undervalues the yuan by 40 percent. It accomplishes this by printing yuan and selling those for dollars and other currencies in foreign exchange markets.

Presidents Bush and Obama have sought to alter Chinese policies through negotiations, but Beijing offers only token gestures and cultivates political support among U.S. multinationals producing in China and large banks seeking business there.

The United States should impose a tax on dollar-yuan conversions in an amount equal to China’s currency market intervention divided by its exports—about 35 percent. That would neutralize China’s currency subsidies that steal U.S. factories and jobs. It would not be protectionism; rather, in the face of virulent Chinese currency manipulation and mercantilism, it would be self defense.

Cutting the trade deficit in half, through domestic energy development and conservation, and offsetting Chinese exchange rate subsidies would increase GDP by about $600 billion and create at least 5 million jobs.

III. S&P Downgrade Will Little Affect Interest Rates or President Obama’s Policies


The Standard & Poor’s downgrade of U.S. government debt can only have lasting economic consequences if it significantly affects the interest rates U.S. government pays or political machinations in Washington.

Global investors have little alternative but to continue to do business in dollars and store wealth in Treasuries. The bonds denominated in other reserve currencies—the yen and euro—are simply unavailable in suitable quantities.

Japanese institutions hold most of Japan’s privately-held sovereign debt—simply the Japanese have too high a savings rate, and their government borrows from them, through banks and funds, to finance deficits that keep its economy going. As the long term prospects are for the yen to rise against the dollar, global investors are holding about all the yen-denominated sovereign debt they can get their hands on.

The euro zone has no central government that can levy taxes, spend significant sums, and issue bonds. Instead, investors must purchase euro-denominated debt issued by the member states.

The largest issuer of euro bonds is Italy, and it is doubtful that investors would swap U.S. Treasuries for Rome’s paper. Even if more German and French sovereign bonds were available, the future of the euro is so much in doubt—and likely to stay in doubt for many years—that the long term stability of even the strongest euro-zone economies is uncertain.

U.S. bonds are subject to the risk of unanticipated inflation if the U.S. government keeps printing too many bonds and greenbacks but that risk pales in comparison to the risk that the euro-zone will disintegrate and seriously impair the German and French economies.

The fact is Washington prints the world’s currency, and will likely do so for a very long time to come.

China, the biggest purchaser of U.S. debt, likes to carp about U.S. fiscal affairs but will keep on buying dollars to maintain an undervalued yuan and convert those into Treasuries. Otherwise, Beijing must finally let the yuan rise significantly against the dollar, and that would end China’s export boom and bubble economy.

Longer term, all the debt Uncle Sam is piling up is bad for the United States but the problem won’t be resolved anytime soon.

The Administration treated the S&P downgrade like it does all other bad economic news—it sought to blame others, circumstances and the messenger. The Tea Party, bad luck like the Japanese earthquake and the competence of the S&P staff—who used CBO numbers to assess the future of the U.S. debt burden—were all cited by the President’s surrogates in interviews and the Sunday talk show circuit.

Communications in the White House are such a closed loop that the Administration does not even recognize help when it gets it from critics. The S&P report gave the President ammunition to push for higher taxes—ill-advised as that might be.

The S&P report pointed to political dysfunction in Washington, fingered Republican reluctance to raise taxes and cited skyrocketing health care costs. It did not single out Democrats resistance to cutting Medicaid and Medicare, and this despite spending is more the problem than taxes. Simply, spending is up $1.1 trillion over the last four years, when only $200 billion was needed to cover inflation, whereas reinstituting the Bush tax cuts for all brackets would raise revenues by only $300 billion.

The report went on at some length about how different taxing scenarios would affect the situation. It said little about what curbing U.S. health care spending to German levels—also a private system—would do to future U.S. debt, or even adopting Congressman Paul Ryan’s reforms would effect.

After a temporary disruption in stock and bond markets, this report is likely to little affect what the U.S. government, companies or consumers pay for debt.

At the time of the downgrade, the stock market was in an adjustment owing to concerns about the economy. Neither those nor the deficit worries will abate until the President offers the country a plan to get the economy going—other than blaming others, hoping for a favorable turn of events or criticizing those that keep score on the economy and government’s performance.

IV. Why to Buy Stocks Now


The U.S. economy and equities are worth more than current prices indicate. This is a good time to buy companies with strong brands and decent cash positions—those are ones that weather tough times better and grow nicely when conditions improve.

The Standard & Poor’s downgrade did not cause the selloff the first trading day after its announcement—the market slide began on July 22, some 18 days earlier. That was the day negotiations between Speaker Boehner and President Obama to accomplish a grand deficit reduction bargain collapsed.

Those talks failed because the President incorrectly insisted on more taxes—over the last four years, the deficit is up ten-fold, annual spending in excess of inflation is up $900 billion, but eliminating the Bush tax cuts for all tax brackets would yield less than $300 billion in new revenue.

The President’s insistence on taxes to permanently increase the size of government—and his absolute refusal to act on business and investor complaints about rising costs imposed by health care reforms and incomprehensible new industrial regulations—have instigated doubt about the President’s ability to grasp the challenges facing the economy, and come up with reasonable policies to jump start growth and avert a second recession.

Over the last two months, the economic data has been generally bad—weak retail sales and industrial production, jobs creation, GDP growth and other distressing news.

Business leaders—unlike Ivy League economists and Noble Laureates the Administration consults—don’t believe big deficits—followed by more taxes and permanently bigger government—spur growth.

Most recent Presidential missteps have aggravated business and investor mistrust. These include an announced bus tour through the Midwest to address the jobs situation—when the crisis is not one of communications but a lack of U.S. and global demand for what Americans can make—and his failure to personally address the S&P downgrade for three days after his knowledge of the fact.

When the President finally spoke, he rehashed old ideas that will do little to improve the situation—extending unemployment benefits and the payroll tax cuts only sustain the status quo—and strengthening universities and free trade agreements offer uncertain positive outcomes only years into the future.

The President offered no recognition that the lack of demand, which business economists believe is paramount, is caused by a huge trade deficit and in turn by reliance on oil imports and distorted trade with Asia. He said nothing about regulatory burdens that are causing American businesses to take purchases and investment abroad.

The good news is a President and Congress can only do so much damage—they are too rigid in their positions to agree on much further to distress the economy.

In the second half, economic growth should pick up, and the odds are better than even that a recession will be avoided.

Asia, laughing at Follies Americana, will continue to grow like gang busters and the S&P 500 companies—who comprise 80 percent of U.S. publicly traded companies by assets—earn more than half their profits abroad and many are well situated across the Pacific.

Moderate growth at home and robust growth in Asia spell continued good earnings reports. Those will ultimately drive a recovery in stock prices.

At 62, I maintain a healthy cash position as a hedge against an unplanned retirement, but as I always do when things go sour, I am putting money into the market.

The investors will be feeling much better on New Year’s Eve than it does in the August dog days of displeasure. Don’t miss the party.