Cliff Diving and Wind Surfing

After another seven months on hiatus, I am attempting again to get back to a more regular writing schedule.  I had intended to start writing again after my exam in June (I did pass, thank you for silently asking), however, as is often the case, life got in the way.

And, a lot has happened in that time (more on that later), but now I want to get into discussing what is going on in the world as it pertains to the economy and the markets.  This will be a short (hopefully) account, focusing on translating the headlines and soundbites you may be hearing on the news, followed up by some personal developments just to get everyone up to speed.

Cliff Diving
The last few months of business news this year has been all about cliffs.  The most popular one being the Fiscal Cliff.  For those of you who may not know what this is, its a series of tax increases and government spending cuts scheduled to take place on the first of the year unless the President and Congress can agree to pass legislation which says otherwise. 

What makes this a potentially dangerous scenario is the immediate negative impact this would have on our very fragile, and modest economic recovery.  For instance, the average U.S. household could see a tax increase of over $2,000.  "But they could pass a bill in January or February that will have a retroactive effect of lowering taxes", you say; "so that taxpayers may never actually have to pay up on those higher rates".  While this is mostly true, one aspect of this equation is the payroll tax, which comes directly out of every one of your paychecks.  Therefore, people will see a material impact right away and this could effect their spending habits. 

The spending aspect of this cliff (known as the sequestration) could also have numerous negative effects.  The cutting of farm subsidies could double the price of milk at the grocery store, defense spending getting slashed could force contractors (companies like Boeing, Lockheed Martin, and Honeywell) to lay off workers, and worst of all, unemployment benefits could be shut off suddenly for thousands of people who are still out of work.  Many people have said that these negative effects are overstated and could be resolved even if no deal is made by simply enacting patches on a case by case basis.  Either way, I would still say that the outcome will not be a positive one for our economy.

As much press as this fiscal cliff is getting we've had a couple other cliffs in the news lately.  Unfortunately, I regret to report that we fell right off the Twinkie Cliff and crashed at the bottom.  Here, the Hostess Bakers Union could not come to terms with the owners of the company and they had to close up the whole operation as a result.  Brands like Twinkie, Ho-ho, and Wonder Bread are no longer in operation and although it is speculated that a competitor, or a private equity company will come and purchase some of these bigger name brands many people have lost their jobs which won't be coming back.

The final cliff, and the steepest one in my opinion, was the Cargo Cliff.  This was fortunately averted just before the weekend as an eleventh hour deal was made.  If the two sides in this debate did not come to terms all the dockworkers at ports from Houston to Boston would have gone on strike, and we could have seen a massive kink in the global supply chain, as all container cargo on the East coast stood still.  A similar strike in 1977 was estimated to have cost the economy close to $1 billion per day.  I am just glad we won't have to figure out what that would cost us today.

Wind Surfing
Despite markets being jittery from having to navigate all these cliffs, there are some very positive tailwinds that the economy has going for it.  The strongest of these is the housing market.  After all it was a housing bubble that sparked the financial crisis of 2008 and prices continued to move down even after we were supposed to be in recovery mode.  So why the optimism now?  Well prices for houses are finally starting to move higher.  There are more and more houses under construction, and we will need a lot more houses just to catch up with population and household formation growth.  Furthermore, due to the lack of construction for the last five years, we have also seen rents start going much higher, while housing affordability (measured by housing prices and cost of financing versus average family incomes) remains historically very low.  As home builders put more supply on the market they will finally have to start hiring more workers (backed up by the fact that average hours worked in the construction industry have gone higher the last couple of months.  There is only so much overtime workers can put in before you need more hands on deck).  This will have the secondary effect of having all these proud new homeowners have to go out and buy things to furnish their new pads. 

Other much smaller tailwinds exist in the economy as well, and can be seen just in the fact that things continue to improve.  Jobs and consumer confidence continue to go up.  Retail companies, while reporting a less than stellar holiday season, have continued to show solid profits, which appears to be a result of less aggressive pricing.  This shows that they aren't desperate to get people in the door but instead want to hold onto their margins.

The Bottom Line
The consensus right now is that if the government could get their act together and hammer out a deal to avoid the sharp sudden impact of the fiscal cliff, the markets could potentially move much higher.  Our overall economic backdrop is positive and improving and companies want to hire new workers and buy new equipment but many have been on pause to find out what happens in Washington.  It is hard for a business to invest for the future if they don't know what the rules of the road are going to be for things like taxes and regulation.

As I write now, tomorrow is New Years Eve and I have still not heard anything coming out of Washington suggesting a deal is getting done.  Things could get dicey for the first few weeks of January and maybe the first part of the year, however, strong tailwinds could help the economy glide even after going over a cliff or two.  I would look past the cliffs and suggest that the U.S. economy will be in better shape next year than we are now, but then again I am ever the optimist.

On a Personal Note
As I mentioned things have been a little hectic since my last post.  My intention to keep up with writing always seems to get sidetracked by one thing or the other and lately there has been a lot to work on.  After the exam, I took a little extra time to get caught up on some reading that I had been neglecting during my study time.  (If anyone is interested in the economic history of the United States, I can recommend John Steele Gordon's Empire of Wealth which is a fascinating account about how our economic progress shaped the country.)  The kids started getting to more and more activities now, so I spent some weekends going to things like cross country meets (I did not know they had cross-country for 6 year olds, but my daughter loves it), and I also moved to a new employer where now my office is located much closer to home.  My commute was reduced by 95%, which has given me a little extra time to get some much needed projects done around the house.  Time well spent certainly, but busy none the less.

Alas, with New Years just a day away, I will again make my one annual resolution, which is to do a better job at time management.  The thing is that there are a bunch of important things that I want to get done for 2013, like kicking butt in my new job, writing regularly, reading more, etc.... but they will need to get done without taking away from the even more important things (like yelling myself hoarse at cross country meets).  And the trick is that it can all get done, as long as I use my time well.  I'm definitely not great at it, but a willing effort will get you halfway there; and, I get better every year.

- "Time is what we want most, but what we use worst" - William Penn

On that note, I wish all of you a joyous and prosperous 2013.  Thanks for reading and please feel free to share your thoughts.

KJA

The Future of Europe

We have all heard the range of opinions on the effects of the sovereign debt crisis in the European Union.  Greece has gotten the most press as their crushing debt load and rapidly declining economy has their citizens up in arms.  We have all seen the footage of peaceful protests on the Greek Parliament building turning suddenly violent and scary.  Portugal and Ireland are the next worse off in terms of their balance sheets.  Both have large overall debt loads and large current deficits that need to be addressed.  The most recent fear is that of Italy and Spain who have each much larger economies and therefore pose a drastically greater threat to the global financial system. 

The question then is how does this whole situation get resolved?  To answer that question we look a little deeper into the situation and ask further questions.  Who are making these decisions?  What are their primary interests?  Who are their constituents and what do they feel about it?  All in all its a messy situation but one that I think has a logical outcome.  One that is not nearly as scary as some people might think.

The Problem
Greece is a failed economy at the moment.  Every ounce of austerity that gets passed is causing massive civil unrest.  The Greeks have been used to a certain lifestyle, and now because of excess spending by the government, who paid investment bankers lots of money to keep their large amounts of leverage hidden, its time to pay the piper, and everyone has empty pockets.  While some commentators call out the Greek people by saying they were living beyond their means with very generous government benefits which they did not pay for, (in Greece you are considered a sucker if you pay your taxes), I think the Greeks have a legitimate beef.  Their government told them that this way of life was ok and that it was sustainable.  Now the government pulls back the curtain and says "sorry, we were wrong and the party is over".  Its understandable to be a little upset at that situation.

What revealed all these problems, of course, was the 2008 financial crisis.  The only thing that keeps the party going for a country like Greece is the ability to keep borrowing, and keep hiding the liabilities.  Once that merry-go-round stops, the game is up.  Now the risk is that by defaulting on its obligations, Greece brings into question all the other financially challenged nations in the Euro-zone.  Creditors think "If Greece defaults, what is to stop Portugal and Ireland?" and therefore demand higher interest rates to continue to lend to these countries.  This higher interest rate increases the cost of funds, and thereby makes a difficult financial situation even harder, making it a vicious circle of decline.  The endgame being the default of Italy and Spain, which would hamstring the entire European economy and throw the entire global economic system into a funk for many years.

The Likely Solution
The only way to stop this kind of negative feed-back loop is to get out in front and make a credible back-stop at some point in the Domino chain.  Its obvious to everyone in the financial markets that Italy and Spain are "Too Big to Fail" and need to be included in that backstop.  The question is, where do they get the funds to make this kind of back stop?

That's also the main question with the recent resolution that was passed.  Sure the European Financial Stability Facility (EFSF) has been boosted on paper to around one trillion Euros, but where is that money coming from?  The banks are being asked to take "voluntary" (key to avoid a "credit event" default) haircut on Greek debt of 50%.  Where do they get the extra capital to keep their balance sheets in good shape?  Assuming 50% mark-down on Greek debt is one thing, being that its a small amount, but now we have Ireland and Portugal getting in line to get some "voluntary" forgiveness as well.  The amounts of losses and the drain on bank capital is growing.  Where does it stop?

The most likely resolution is going to have to include a global coalition to support bank debt.  The Europeans have enough capital on paper to address the potential losses, but not enough to sufficiently "shock and awe" the credit markets into believing that a resolution will hold up.  And, much like the "Lehman Moment" of 2008, as confidence continues to falter, the losses continue to mount.  It becomes a problem of chasing a moving target, where you cant aim at the size of the problem where it is now.  You have to lead out a sufficient distance and tackle the problem as it could grow to, much you like a quarterback has to lead a receiver downfield.

I regret to inform everyone here in the US, that we will all be a part of this solution eventually.  In a time of increasing austerity, and suspicion of bail-outs, it will be a political nightmare to announce any kind of assistance to this problem.  We had enough trouble bailing out our own financial system.  But I don't think it will be all that bad, and people will need to realize the necessity of this situation.  First of all, China will NEED to be included for this all to work, however, China will definitely not go it alone.  They will need the assurances of the US that they will cooperate as well.  How big this eventually gets in terms of the commitments needed, I have no way of knowing.  But they are coming, and hopefully with a combined effort between the two largest economies in the world, no actual capital will have to be deployed, but merely placed on the table to reassure the markets.

Will the EU Hold Together Under the Weight of this Crisis?
The answer to this question is unequivocally yes.  Very quickly there are two main reasons for my confidence in this.  The first is that the Maastricht Treaty which formed the EU holds no provisions for countries to exit.  Just like the Hotel California, you can check in, but you can never leave.  Therefore, there would need to be an amendment passed by all member countries to arrange for some type of exit strategy.  Euro leaders have made it abundantly clear that this is not currently on the table.  Some would say this is posturing and that they are looking into behind the scenes, but I am not so sure.  That leads us to the second reason, which is incentives.

What happens if Greece leaves the EU from the perspective of just Greece and Germany.  For Greece, they would go back to using the Drachma as their currency.  This currency immediately becomes worthless as it is backed by a failed economy.  All their debtors have to work out some form of payment in a combination of Drachma and Euros.  This doesnt just go for the sovereign debt, but every single foreign financial obligation from every business in Greece.  The logistics of working that out are nightmare-ish at best, and (I would guess) impossible at worst.

For Germany, they would also be adversely effected by such an event.  Germany is an exporter of high-value specialized manufactured goods.  If Greece leaves the Euro-currency it instantly becomes stronger, and therefore makes all of these German goods more expensive.  In an environment where growth is hard to come by as it is, the Euro becoming more expensive is a headwind that the Germans can ill afford.

The Bottom Line
I am optimistic at the end of the day, despite the fact that every analysis I have read from every analyst out there, says otherwise.  The solution agreed upon last week was a start, and greatly exceeded market expectations, but is clearly not a long-term solution.  It has shown that the leaders in Europe have a political will to keep this European experiment moving forward.  The simple fact is that these countries need each other, and despite the line from all the doubting pessimists "calls to China for money are not going to work", the rest of the world needs a functional Europe.  China will go along if it can get the US, Japan, and other governments to put some skin in the game.

We have to all look at this situation through the lens of the costs and incentives of possible outcomes.  Euro Area Depression and destruction is not good for anyone, and a chaotic destruction of their financial system will un-hinge the global economy.  So while analysts correctly predict that a solution will be difficult, the alternative is unacceptable, and avoidable with global coordination.

Stop Saying the Stimulus Didn't Work

The tag-line of many hard-line conservatives this year, as the economy continues to struggle, is that the stimulus package was a failure.  They say "the Democrats promised that this stimulus spending would bring the unemployment rate down to 8%."  Since this did not come to pass, they say that it was "a colossal waste of money."  While the democrats may be guilty of bad forecasting, to say that the stimulus did not work shows a complete lack of basic economic understanding.  You will also notice, if you pay attention, that none of these tag-line parroting hard-liners ever follow up this claim with what they feel would have been a better solution.

For those of you out there brave enough to take an economics course in college, and unfortunate enough to not have been able to sell back your textbook at the end of the semester, you can look back at a couple of equations that represent the most fundamental relationships for an economy.  The first is as follows:

GDP = private consumption + gross investment + government spending + (exports − imports)

Ok, so now lets take a look at what happened in 2008.  A recession of massive proportions drove down consumption and investment to the point where GDP was shrinking by 6% at its worst point.  So when you have a total absence of consumption and investment, and we all know that the U.S. has imported far more than we have exported (aka running a negative trade balance), then the only hope to get an economy to stop shrinking is to increase the government spending variable.  We have to increase spending and increase the overall debt level in order to prevent the recession from worsening.  If the economy continued to fall at a 6% clip, what would have happened to employment levels?  What would have happened to tax revenues and unemployment and social entitlement costs, if the economy continued to shrink?  Steadily falling revenues and continually increasing costs would have been worse for the debt situation than a one time shot aimed at preventing those effects.

The other important equation to consider is the following:

M * V = P * Q

What does this translate into?  Money * Velocity = Price * Quantity, or even more simply, the supply of money in the system times the speed at which it turns over, is equal to price times quantity, aka GDP.  While this is a little more convoluted for a non-economist, here is how it breaks down in real terms.  In 2008 the credit markets froze up as banks were afraid of lending any money out.  The supply of money was shrinking (which is actually a pretty rare occurrence for the US).  The money that was in the system was not being turned over as fast because consumers were not spending it.  So banks not lending, consumers not spending, will lead to a lower GDP as well.  What the government hopes to do by increasing their spending is to increase the supply of money and credit, and hope that the extra supply will turn-over (read, get spent) at a fairly rapid clip.  The absence of government spending in that situation could lead to a continuing decrease in both and thus, continuing decrease of GDP.

The choice that the government has is to allow the country to spiral dangerously close to a depression type scenario, or to add another slug of money to our debt level in order to float the economy, and also then "stimulate" the private economy back into a growth mode.  The question is not whether or not we have recovered from recession, but rather where would we be absent this critical level of government spending?

The second argument is that this money was "wasted" on bad projects that did not have the pay-off they should have.  The most famous tag-line for opponents of stimulus in this argument is pointing out a line from President Obama where he said "maybe some of these shovel-ready projects were not as shovel-ready as we thought."  Now we can argue all day and night about the stimulative effects of one congressman's pet projects vs. the others, but the bottom-line is that the difference between the two is nowhere near as important as the actual level of the funds being spent.  Further more, if you log onto to recovery.gov you can actually see what the break-down of the spending really is.  Curiously, well over a third is represented in by tax-cuts, which I thought many conservatives tend to favor.

I realize that politicians never let facts get in the way of a good argument so, with this next election season coming up, I am bound to suffer through all of the republican candidates regurgitating the stimulus package argument.  I just hope that we can make our decisions based on facts and figures instead of convenient sound-bites.  The worst mistake the democrats could have made was trying to tag a target rate of 8% unemployment to this bill.  Their big underestimation was on the productivity of Americans who are nervous about the possibility of losing their job.  Companies have not hired more workers because they have been able to get more and more out of their current skeleton staffs.  In my January prediction piece I also quoted a forecast of 7.5% unemployment by the end of the year because of the same mistake.  Today we are still seeing a 9.1% rate and this is not expected to drop much further by year end.

Bottom-line is that the stimulus was a necessary step from the government to prevent our recession from devolving into a full blown depression.  Am I satisfied with where we are in terms of our recovery?  Of course not.  It will take time to work through our malaise, and unfortunately require some action from our action-phobic congress.  In the end, I am optimistic that our country will continue to prosper... it just might not be at the level many of us were used to in the last two bubble economies of the 90's and early 2000's.