If It’s Tuesday, It Must Be Belgium

Eurozoning Out

The eurozone’s outlook was the most grave since the slow motion train wreck of European sovereign debt began two years ago. The European Central Bank (“ECB”) still needed to show its resolve in backstopping member country debt. The crisis spread throughout the eurozone. Italian bonds went above 7%, causing longstanding Prime Minister Silvio Berlusconi to resign. Previously feeling immune, AAA countries Germany and France had to pay higher interest rates and had difficulty fully subscribing offerings. Belgium’s credit rating was lowered. Belgium looked to be the first domino at risk of falling amongst countries formerly considered safe bets.

Infectious Debt

Financial contagion was spreading amongst financial institutions owning European sovereign debt until steps were taken this week. Stock prices of many money center banks and brokerages had fallen back to their financial crisis lows, prompting “infected” firms and those seeking to avoid infection to unload their European sovereign debt holdings. Forced selling contributed to pushing European sovereign debt prices further down, throwing markets into dysfunction. European banks were finding it difficult to function in interbank lending and foreign exchange. At risk were successive failures of European sovereign debt offerings, banks, governments and finally, the euro.

ECB Reigns as Europe Wanes

Even though the European sovereign debt crisis was never worse than last week, investors are concluding that Europe’s woes are not as ruinous as had been feared. In response to the contagion, central banks reacted swiftly, jointly announcing a coordinated move to lower the cost of US dollar funding, triggering a worldwide stock market rally. Eurozone finance ministers have come to agreement on leveraging techniques of EFSF (the fund used to backstop European sovereign debt). Greece has received its next tranche of bailout money. The International Monetary Fund (“IMF”), which has had a recent history of good outcomes by successfully enforcing austerity measures, is getting actively involved. Importantly, the ECB is finally taking matters seriously and is preparing a one trillion euro cash injection for the eurozone and is “paving the way for a colossal market intervention in European sovereign debt” contingent on reforms. Details could come at the ECB’s meeting on Thursday. Confidence in European sovereign debt repayment should open up the markets for debt restructuring and avert future financial contagion.

Doing the Right Thing for the Wrong Reason

Policy makers prefer to flush economies with liquidity to dampen or stave off recession because austerity will actually make a recession worse, as has been shown by Greece’s experience. Failing European sovereign debt markets have made more difficult the issuance of additional debt, curtailing the aggressive spending of the weaker countries. Eurozone countries are being forced to become more fiscally responsible, adopt a stronger federalism and an empowered ECB, thus saving the euro and putting the eurozone into a position of economic hegemony and sustainability well into the future.

It’s the Economy

The US trade economy is able to withstand the recession brewing in Europe due to its diverse trading relationships, particularly with Canada, China, Mexico, Japan and a growing trade with South America. US economic data had turned ugly mid-year, sending double-dip shivers through the markets, but now the data are consistently surprising the markets with results above expectations. This past week pending home sales and employment reports were significantly above consensus expectation. Black Friday’s kick-off to the retail holiday season reflected that confidence had returned as consumers once again are spending more and saving less. Analysts are looking for a bottom in US housing prices due to several years of low housing starts against increasing demand, with home ownership levels down to lows. The overhang of foreclosures that are not being processed by banks seems to be the impediment to a recovery. The fundamentals of stocks have looked good all year, despite flat returns year-to-date and bruising bear-market losses in most of the world from recession and bank failure concerns. Stock earnings continue to consistently beat analyst expectations. Stock markets are poised to rally and finally blast through this year’s trading zone ceiling as concerns are discounted or addressed.

“Groundhog Day”

The sub-prime financial crisis was caused by excessive investment of bank capital in US mortgages which came crashing down as the US fell into the Great Recession. The financial crisis in Europe is being caused by excessive investment of bank capital in European sovereign debt as Europe falls into recession. Now China is showing signs of losing its characteristic economic robustness. The People’s Bank of China is reacting by increasing leverage on bank capital to increase bank lending. With recession, intervention and recovery going on all over the globe, investors wake up each morning and wonder if they are in the same situation all over again, except each day it’s another country.

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The Can Stops Here

Super Committee to the Rescue

Congress and the President agreed to a bipartisan Super Committee (the “Joint Select Committee on Deficit Reduction”) to work out the details of a deficit reduction of $1.5 trillion over ten years, averaging $150 billion a year. Put in context, the budget increase of 2011 over 2010 is $363 billion; the deficit this fiscal year is $1.3 trillion.  Effectively, the cut would just be a reduction in the rate of debt growth.  Significantly, the outcome of the Committee’s work will be symbolic of the ability of Congress to come up with a solution to the runaway US debt.  Just as eurozone is leaderless and struggles to demonstrate ability to make decisions and implement solutions, Congress could be suffering from the same systemic disorder. 

Splitting the Baby

Twelve members were selected for the Committee (three senators and three congressmen from each party).  Although their meetings have not been public, we know that Democrats will want additional revenues while Republicans will refuse tax increases and demand spending cuts. 

Disenabling the Children

The currently available $5 million estate, gift and generation-skipping transfer-tax exemption is purportedly on the chopping block, although most observers say nothing will come of it.  Instead of expiring on December 31, 2012 the rumor was that the exemption will be returning to a 55% federal tax rate for transfers above $1 million per person when the Committee makes its recommendations as of November 23.  Anyone who wants to make gifts at the current level (up to $5 million per person or $10 million per married couple) and has not already done so should consider making their gifts now. 

Muni Tunes

The Administration previously proposed a reduction in the tax exemption of municipal bonds retroactively, which could result in a significant drop in value in outstanding municipal bonds.  Before anyone sells their bonds, consider the current rumor that if there is a reduction of tax exemption it would be prospective.  This could result in a significant rally in existing municipal bonds in which case buying bonds is the thing to do. 

The Fix is In

If the Committee fails to agree on at least $1.2 trillion in reductions by November 23 (really, they need to decide by the end of this week so the Congressional Budget Office can run the numbers), or Congress fails to confirm the Committee’s reductions, then automatic spending cuts spread evenly over ten years starting in 2013 will be triggered to make up the difference. Half of the automatic cuts would be in defense spending.  There is talk that the Committee will only make recommendations and either leave the details up to Congress or else push the matter to after the election. Already, members of Congress on both sides of the aisle are scurrying to avoid any defense cuts by proposing workarounds before 2013.  President Obama has said he would veto any such moves. Unless this time it’s different, the Committee will push cuts towards the end of the ten-year period, which gives them time to be undone while reducing near-term fallout.  Perhaps some Committee cuts will be those that are likely to be cut anyway but are in the budget now, such as the budget for the wars in Afghanistan and Iraq.  Negotiations in the Committee are moving at a fast pace yet observers are holding out little hope for a successful outcome.  If real austerity is not an outcome, a Treasury debt credit downgrade by Moody’s and a further cut by S&P may result. Whatever happens, it will be a temporary fix.  The expiring tax cuts from the Bush-era and the statutory debt limit are looming.

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Advisor Intervention

If ever investors need investment advisors, it is now. The news, the economy, the market volatility combine to make everyone way too close to the action to have investment  perspective. Investors should not confuse sovereign debt failure , bank mismanagement or market exacerbations with the economic prospects of mankind. The top-down view is bleak when so many people are losing their jobs and economies are either at risk or are contracting as they adjust to the “new normal.” That so many stocks have sold-off in this environment is explicable and disheartening. Banks may indeed fail. The recovery has been short-lived. The growth driven by emerging markets is at risk. However, businesses which have tapped into growth markets are thriving. Given the bottom-up outlook for public companies that the analysts who follow them have, the current low level of stocks worldwide may represent a unique investment opportunity.

Spending Intervention

Policy makers are reacting to the economic slowdown gripping economies by enacting
austerity measures or by spending more, strategies which are diametrically opposed to each other. Austerity measures typically reduce spending and increase taxes while restructuring debt to manageable amounts over time. For 20 years, the US has recommended austerity measures for Japan, to mark-to-market the assets of its zombie banks and to clean up balance sheets and income statements generally in order for capital to be allocated to its most productive use. Japan has done little of this and 20 years into its own bank debacle, it is still at economic risk. Now that the US has the same issues, the Administration, Congress and the Fed have favored a free-spending policy for the US while increasing the debt ceiling and subsidizing banks, fearing the economic slowdown that austerity would bring, at a time when the economy is most vulnerable to collapse.

Austerity Intervention

After decades of borrowing and easing, governments around the world are finding that spending policies only work when growth is imminent. The IMF and the ECB lend bail-out money to countries, but always with austerity measures attached. The misallocation of resources and the overhang of debt repayment resulting from spending programs are starting to yield to austerity measures. The fact is that putting countries on good fiscal standing is a positive and not a negative, although the markets are roiled with concern,
seemingly preferring to kick the can down the road. Ireland and Iceland were the first casualties of the most recent banking crises. Iceland seems to have fully recovered, under the auspices of the IMF, a few short years after complete system-wide collapse. Ireland has been working with the IMF and the ECB. In a few short months, Ireland’s government bonds have rallied from 55 in July to 83 today; clearly a turn-around is happening. 20% of the Greek labor force works for the government. Under austerity measures in exchange for ECB financial assistance, Greece is terminating 100,000 government jobs and cutting benefits and wages for those remaining. Greece is staging to turn itself around, although its GDP is contracting as it makes its adjustments. Virtually every analyst is expecting Greece to default and abandon the euro in favor of inflating its own currency.  That would be a shame when it is making such good efforts which could actually turn around Greece’s economy.

Central Bank Intervention

The history of central bank intervention shows that they tend to be reactionary, sometimes with disastrous consequences, such as the sub-prime mortgage collapse which was fostered by low interest rates resulting from Fed intervention. Worldwide, central banks are reacting to slow economies and bank weakness by interventions to lower interest rate, encouraging spending, and inflating money supplies. Central banks operate through the banking system, so for them, bank failure is tantamount to Armageddon. They are doing whatever they can to keep banks functional. For central banks, their only tool is money supply and interest rate intervention, either tightening (constraining spending) or easing (encouraging spending, which can be inflationary), one size fits all. For them, this tool is a hammer and all the economies of the world look like nails. The thought of constraining spending in a slow economy, as austerity does, is anathema to central banks. Dangerously, food is inflating worldwide but central banks continue to ease. China is experiencing 20% wage inflation and Europe’s inflation is now 3%, well above the 2% target, yet central banks continue to ease. Businesses continue to expand and unemployment is stabilized, yet central banks continue to ease, reacting to GDP figures, unemployment, bank risk and political pressure.

US Intervention

The US will ultimately need to follow other financially insolvent countries into regimes that favor austerity over spending into oblivion if spending programs don’t result in growth and higher tax collections. In order to attract, retain and encourage business, US corporate tax rates will need to be lowered yet tax receipts will need to go up. If corporate tax rates are lower than individual tax rates, then individuals will re-characterize their incomes as corporations. Thus, corporate tax rates and individual tax rates will need to be the same, so the individual tax rate will need to go down to the same level as the corporate tax rate. In order to increase tax receipts, individuals may lose deductions, such as mortgage interest and charitable donations, and may lose tax incentives, such as tax-free municipal bond income. Consumers may well end up paying a national sales tax, as is the case in most countries. Business costs for healthcare, retirement and education may be made taxable income equivalents to employees, which will drive down waste and empower the consumer. Many federal programs may be shifted to the states. The US will need to rationalize its spending on healthcare and defense, reduce headcount and benefits dramatically, and tightly manage spending programs generally while repaying debt.

It won’t be easy, as easing programs are. It will be austere, as austerity programs are.

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Stock markets have been volatile, plummeting on dismal economic signals, soaring on bargain hunting.  Yet, the wild gyrations seem to evidence overreaction. The US stock markets have been changing 1% to 5% more days than not, even though the news of the day may not be all that unexpected.


Stock market volume is dominated by automated execution programs and algorithmic trading strategies through exchange traded funds (1), high frequency trading (2) and index investments popularized by the “efficient market theory” (3). These strategies can force buys or sells of individual securities, overwhelming fundamental buyers or sellers, and thus exacerbating market volatility. Auction markets fail when there is forced selling in excess of buyers coming to market or forced buying in excess of sellers coming to market. The U.S. Securities and Exchange Commission found that “lacking sufficient demand from fundamental buyers or cross-market arbitrageurs … the  interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets” (4). Traders can also exacerbate volatile markets (5).


Crashing markets cause damage: collateral for loans disappears and then banks can fail; companies can fail when they can’t get refinanced by the banks or the markets; investors can lose confidence and pull their money out, forcing prices even lower. The downward spiral can be devastating and persistent. As investors flee to safe assets, they can push the prices of those assets high, as they buy  for safety instead of for intrinsic value, recently pushing gold up 300%, treasury bills to negative yields, and certain currencies, collectibles, commodities and some real estate to fantastic levels. These formerly secure asset classes are themselves now subject to a crash at any time, as their high prices ultimately cause a reduction in demand while at the same time incentivizing new supplies to the market.


Instead of maintaining orderly and rational markets, helping businesses grow, and building up confidence,  authorities are reacting by scare mongering to muster support for their agenda, artificially lowering interest rates which distort markets, and flushing money into an economy that is incapable of investing it.


Exchanges, large banks, brokerages and  investment firms are profiting from the high volumes, commissions, trading opportunities and management fees from computer trading, derivatives and index funds.  Despite a history of market failures leading to economic catastrophes, no new regulations are in sight, such as implementation of the Volker Rule (6).  Stock markets always need both a bid and an offer from fundamental investors; if either one is missing, not only can they fail, but markets can be abused.


(1)  As the name implies, exchange traded funds (“ETF’s”) are funds that can trade on exchanges. ETF’s hold specified investments, such as the securities that make up an index like the S&P 500. Trading their own capital, market makers are responsible for matching the supply of ETF’s to the demand, in ways that are usually very profitable. A Swiss bank recently reported a $2 billion loss and in 2008 a French bank lost $7 billion, both due to rogue traders in their ETF market making groups. The CEO’s of both banks had to resign, but there was never a thought of closing down the trading units, suggesting the profit was worth the risk.  When ETF’s are bought or sold, the underlying securities are subject to automated execution programs.

(2)  High frequency trading (“HFT”) is thought to account for over 70% of market volume. Run by computers, the orders are set to take the lowest offer or highest bid when there is an opportunity to make a gain of any size, constantly canceling and replacing orders as other buy and sell orders appear. The trading desks that run these systems are typically large brokerage firms or banks investing their own capital, just as they do with ETF trading. The HFT systems can trade the same financial instrument literally thousands of times a day and never keep the financial instrument overnight.

(3)  Efficient market theory (“EMT”) posits that all information on the markets is available rapidly to everyone and discounted immediately, leaving no opportunity for an informed investor to profit from knowledge or insight. EMT advocates prefer to invest in passive investment strategies, such as the S&P 500 index, and assume the underlying individual securities are properly priced by the market. When indexes are bought or sold, the underlying securities are subject to automated execution programs.

(4) In “Findings Regarding the Market Events of May 6, 2010” http://www.sec.gov/news/studies/2010/marketevents-report.pdf the CFTC and SEC
investigation found that the intraday stock market drop of 1000 points, now known as the “Flash Crash,” was due to one large S&P 500 related sell order wiping out every buy order while high frequency trading and exchange traded fund orders continued unabated, pushing the market down, with some stocks eventually trading for 1 cent before rebounding.

(5) In “Findings Regarding the Market Events of May 6, 2010”  market makers were blamed for not doing their job, effectively allowing the markets to crash. In 1938, Joseph P. Kennedy, Sr. implemented the uptick rule when he was SEC Chairman. He had observed short sellers profiting through market manipulation by massing  together stock sales in excess of market demand, contributing to the market  crashes leading into the Great Depression. The uptick rule restricted short  selling in a stock except if the stock had just had a trade at a higher price.  The rule was repealed in 2007.

(6)  Paul Volker, Jr., who knows the proclivities of banks only too well as the Chairman of the Federal Reserve under Presidents Carter and Reagan, proposed what became known as “The Volker Rule,” which would prohibit banks or related entities from engaging in proprietary trading (using their own capital to make investments), except as directed by clients. Initially receiving support from President Obama, the Volker Rule was never implemented.

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Over There

George M. Cohan Source: http://www.nndb.com/pe...

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Going Viral

Europe’s weakening economy is having profound impact worldwide due to the potential failure of European banks invested in slumping European sovereign debt.  Many European countries had borrowed aggressively based on growth projections that the marketplace believes will not happen.  Markets have been bracing for the risk that contagious systemic failure and recession could ensue. 


The European Central Bank (“ECB”) is funding the European Financial Stability Facility (“EFSF”), backstopping member country sovereign debt by buying it or guaranteeing it.  As long as investors are assured that there will always be a buyer, debt can be rolled over and default can be avoided.  However, the EFSF is too small and needs to be expanded.  US policy makers at least know how to shock and awe markets.  TARP and QE were spectacular in their size if not their implementation.   The ECB is failing to grasp the importance of investor confidence in maintaining orderly markets.

Euro Bonds

An even better solution than the EFSF would be euro bonds.  Euro bonds would be issued by the ECB and thus be something like the US treasury bonds in safety and liquidity.  They would provide member countries with financing at attractive levels.  The challenge will be to work out a way to get the member countries to be financially responsible.  If euro bonds are issued, and issued rapidly in significant size, the markets will take solace that the sovereign debt of some of the financially weak members of the eurozone is on the road to recovery.  The silver lining of euro bonds would be the euro could become an important reserve currency and the eurozone’s future as an economic power could be assured. 

Leaderless Union

A real leader in Europe needs to come to the fore to champion euro bonds.  Most Europeans do not want to pay to bail out irresponsible borrowing practices or take on austerity measures being foisted on them.  Eurozone politicians, most notably German Chancellor Andrea Merkel, are afraid of losing their jobs and are not willing to take a bold initiative, even as their own economies falter.  Defaults and abandonment of the euro are looming.  Well into the second year of the European sovereign debt crisis, to paraphrase George M. Cohan, Americans are wondering if the US economy won’t be safe until it’s over, over there.

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Curing Unemployment

Treating the Symptom

Tonight, President Obama will lay out his proposed legislation for increasing employment.  He is expected to renew the payroll tax cut and to extend unemployment benefits.  He will propose other programs and incentives to get jobs for the unemployed, raising concerns that employment programs can create a welfare state where there is little incentive or opportunity for permanent employment.  The early word is that President Obama’s program will increase the national debt by an additional $300 billion.

Labor is often the single largest cost by far for business.  The Fed actively slows down growth whenever there is a risk of full employment (3-5% unemployment).  The Fed believes full employment drives wages higher, which is inflationary and thus unhealthy for the economy.  Unemployment over 5% can create a large pool of flexible labor at low cost, which is good for business.  The concern is that the current unemployment range of 9-10% can be deflationary as companies lower wages to increase profits, only to lose their wage savings to competitive forces, putting further pressure to lower wages.

The number of people who have stayed unemployed is a lagging indicator.  The number of newly unemployed people and the trend of unemployment is a coincident indicator. Stock prices are a leading indicator.  The last 52 weeks, the S&P 500 has appreciated 11%, suggesting that businesses will do well in the future.  Businesses cut costs, increase productivity and go where growth and business opportunities abound, which while good for business could result in a weak economy where costs are high and growth prospects are low.  Treating the problem by creating an environment conducive for business may be a better solution than treating the symptom by artificially driving up employment.

Treating the Problem

Consultants at the big accounting firms teach US companies to hire offshore employees in offshore companies and to transfer US-based income to offset US taxes.  Under the current regime it can be cheaper to hire offshore and avoid taxes, even if employee costs are identical to that of a US employee.   

US businesses hold capital offshore where it avoids being taxed in the US and instead is being used to fund international growth, making it more profitable to invest overseas than in the US where it would be taxed, even if investment prospects are identical.  

To grow businesses in the US, and to attract back runaway employment, the environment needs to be cheaper and easier to do business.  The most obvious cost that policy makers can discretionarily cut is corporate taxes.  If more employees are then hired, and wages go up, state and federal income taxes from wages will go up to fill the void from corporate tax cuts.  If businesses have to pay high taxes and other costs, then pressure for businesses to go elsewhere or reduce their discretionary costs such as wages could inversely reduce tax revenue and hurt the economy.

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Easy Money


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2001: A Money Odyssey

Former Fed Chairman Alan Greenspan focused on the “irrational exuberance” of the stock market.  When ultimately the Dot Com stock market bubble burst, with the NASDAQ Composite Index eventually dropping 80%, Mr. Greenspan went into action with an easing program.  The easing went into high gear after 9/11.  On September 11, we mark not only the 10-year anniversary of that seminal event, but also a decade of easing.

A debt spiral of international irrational exuberance would consume the next decade, encouraged by the Fed lowering of interest rates all the way down to zero.  An attempt to raise rates in the middle of the decade may merely have been the tipping point for the credit crisis.  Even with rates at zero, attempting to extend even further its debt model, The Fed has committed to leave rates low for another two years and has embarked on a “Quantitative Easing” strategy to buy long-term debt in order to lower long-term rates, so governments can borrow at even lower rates and so that more money gets flushed into the economy. 

Irrational Money

Perhaps if Mr. Greenspan had focused as much on ending the exuberance of the mortgage and government debt market as he did on the exuberance of the stock market, he would have done more good.  US Stocks are now at the same valuation they were in 2001 despite the US GDP growing in that decade from $10 trillion to $14 trillion, a 40% increase in ten years.  During the same period the percentage of those employed in the US population has fallen from 64% to 58%. By 2007, when the first credit crisis hit as a result of the excessive leverage, 40% of the S&P 500 valuation was in financial stocks.  Financial stocks of course don’t make anything, they just provide financial services, yet the robust earnings in companies involved in the finance boom (rather than in businesses that would contribute to the long-term health of the country) dominated stock valuations.

Lending Yourself Money

The Glass-Steagall Act, a depression era law that disallowed banks from investment banking, was repealed in 1999 by the Gramm-Leach-Bliley Act.  Apparently Senator Glass and Congressman Steagall had concluded that a cause of the Depression had been the banks’ excessive gambling of their own capital on non-bank activities.  The Glass-Steagall Act was intended to remove the conflict of interest of both the granting of credit and its use by the same institution.

Show Me the Money

 The Fed supported the repeal, believing the Depression was due to policies that tightened credit when a policy of easing credit should have been used. We don’t know how well an easing policy would have worked in the Depression had it been implemented immediately.  Inversely, we don’t know how the economy would have fared had Mr. Greenspan not ushered in a decade of easing now. What we do know is the Depression ended when business and government started expanding and employing aggressively as World War II began, not because consumers and banks were given handouts.

Paying Yourself Money

The Federal Reserve is a private bank, owned by its member banks.  With lower interest rates, banks continue to make lots of loans, generating fees.   The Fed allows banks to leverage depositor capital at a ratio of 12 times, which had been increased 50% from 8 times, the regulatory maximum in 1968.   With their newfound ability to invest for their own account and lower capital reserve requirements, banks invested heavily in mortgages and government debt in order to arbitrage their low-cost of capital.  Big profits were dispersed to employees.  Financial stocks enjoyed strong growth.  Governments, feeding at the trough of low-interest debt and conveniently believing that borrowing was enhancing economic vitality, were complicit. 

Money Makes the World Go Around

Meanwhile, the amount of money that US non-bank businesses were borrowing dropped as a percentage of equity, even though the costs went down.  The lack of business borrowing suggests that either they could not qualify for loans or else their economic growth prospects could not stand the risk, neither of which is portentous for a prosperous underlying economy. The low-interest rates only helped the most financially secure business get lower cost funding that they didn’t need, putting them at a competitive advantage over new and smaller businesses, which is the sector driving employment and economic expansion.

A Fool and his Money

The low-interest rates also benefited consumers who borrowed up to 100% of the cost of home purchases they otherwise could not afford, and governments who are now borrowing at such a torrid pace that they could never afford to pay it back, particularly if rates ever return from current average rates of less than 2% to the historical average of 6%. 

Dead Money

This happy collusion between banks and the Fed with the US government has allowed politicians to extend debt-backed growth rather than by supporting organic business growth.  By using the debt markets for their own needs, banks and governments might have even crowded business out.

 As the credit crisis continues with the unwinding of mortgage debt, soon to be followed by the unwinding of government debt, the weakness of the real US economy is being exposed.  The markets are girding for the crisis to get worse.  The policy of easing may have backfired.

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Voodoo Economics

Disrupting Mom and Pop

What happens if growth stops?  Sometimes growth is not required for prosperity or for a good life.  A husband and wife operating a grocery store might still make a sufficient living without growing the store, opening other stores and starting an online delivery service.  They might even be happier just selling their fruits and vegetables by day, and enjoying time with their family in their home above the store by evening, without worrying that the rat race outside their window will result in higher costs they can no longer afford, caused by new wealth which competes for limited resources.  As long as mom and pop provide for their needs, growth of their earnings might come at a cost they don’t want to pay.  For mom and pop, what really matters is an economy for which demand for their product stays in place.  Competitors chasing growth by moving into mom and pop’s neighborhood or consumers cutting back because of debt-induced recessions is disruptive.

Stimuli Lie

Prosperity and quality of life are not necessarily synonymous with growth.  Economic policies that are based on continued economic growth risk destabilizing an economy if anticipated growth ends.  Stimulus spending results in a short-term economic pick-up by artificially increasing demand, but does nothing to keep the demand high long-term when the stimulus effect wears off, which can then perversely result in demand sagging from its stimulated level.  Increased debt the government incurs to pay for stimuli will suck that same capital plus interest from the economy in the future if it is to be repaid, depressing demand. 

Those Who Can’t, Teach

Some economists teach that by borrowing, governments can fund near-term needs while avoiding increasing taxes that could undermine growth. Then, the anticipated economic growth will result in increased tax revenues that would pay for the borrowings.  George H. W. Bush called this “Voodoo Economics.”  It never worked.  The increased tax revenues from the economic growth resulted in room to increase government spending, and thus further increasing borrowing based on the assumption that the economy would always grow and tax revenues would always increase.  Recessions were just excuses to spend more money.  No one ever stopped to wonder what would happen if an economy ever matured.

Mature Economies

Companies are prospering and investment opportunities abound.  Yet, investors and policy makers are terrified that the economy will fall into recession.  Economic figures are being revised downwards as the economy fails to grow.  Perhaps fear of recession might morph into a realization that certain developed economies are simply mature.  For those economies, domestic policies need to be shifted to sustenance rather than growth.

Perhaps the most meaningful change in economics that has occurred in our lifetimes is that populations have stopped growing in developed economies, and are at risk of contracting. Worldwide, as countries become wealthier, even in developing countries, births decline. No longer is increasing demand a given.  Perhaps the second most meaningful change in economics in our lifetimes is the unbridled growth that developing countries are experiencing in their huge, undeveloped markets.  At the present rate of economic expansion and population growth contraction, ultimately all economies may mature.

Fortunately, there is a way that the mature developed countries can continue to grow, just as they did before the industrial age ushered in our current era of increased productivity.  That solution was to establish trade with developing countries and to bring those earnings back home.  Governments of mature economies need to manage their domestic economies for sustainability while their businesses and private capital can benefit from the surging international demand.   The trick will be to avoid losing their businesses and private capital to more accommodative climates.   

Lead, Follow or Get Out of the Way

Governments can oversee sustainable economic policies that provide for a quality of life for everyone.  They can provide resources to administer the rule of law.  They can protect and help recover the world’s environment, explore space, allow for free trade and capital flows, and make sure that markets operate functionally. They can help protect their cultures and foster development of the arts and sciences.  Obviously, by definition, a non-sustainable economy will ultimately not provide sufficient resources for its government.  If governments don’t adapt to the new paradigm, they risk their ability to manage the very services and benefits we expect from an enlightened and prosperous population. 

Developed country governments need to become part of the solution instead of the cause of the problem.  The economy of the United States rests on the ability of business to provide its workers wages, healthcare and retirement savings.  The tax revenue generated funds the overhead.  In order for this type of economy to work, the needs of business must be paramount.  The sustainable way to compete and still enjoy prosperity is to keep costs down so more money can go into productive resources, to keep government debt down so that long term the cost of that debt will not undermine the country when it can least afford it, and to create an environment where all businesses, big and small, have access to the resources they need in a sustainable way. 

With a business friendly climate, as the safest place in the world to do business with the most powerful economy and the strongest rule of law, the United States can quickly become once again the best place in the world for businesses to be based.

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Animal Spirits

Money is not circulating as rapidly as it would if business and consumers had more confidence.  After policy leaders scared the public by declaring that the US was teetering on depression, spending and hiring was instantly reduced.  Reacting to the economic slowdown, the government gave cash rebates, tax credits, tax breaks, unemployment benefit extensions, unbelievable amounts of money in infrastructure spending, grew many programs, gave banks free credit and funded massive “quantitative easing” in order to jumpstart the economy with additional capital flows.  After all that, business is still not hiring and consumers are still saving their money.

“You can lead a horse to water but you can’t make it drink.”

If you don’t know if you are going to be making money in the future, you will be extra careful not to spend the money that you have.  It does not matter that you have enough money to continue spending as you had been spending.  What matters is your perception that you might not have money in the future.  Human behavior, or “animal spirits” as it is called in by some academics, is an essential component in markets and in the economy.  In the markets, animal spirits can be reflected by fear and greed.  In the economy, perception of wealth and confidence in the economy are animal spirits that drives demand.

Perception becomes reality in human behavior.  For example, reputation may be more important than someone’s actual character.  Developing a brand seems to be as essential as executing a business plan.  Communications experts counsel that it’s not what someone says or how they say it that matters as much as how they engage with their audience.  Animal spirits are all about feelings.

Animal spirits are ultimately reflected in the need to survive.  Politicians will do what it takes to get re-elected rather than be controversial and cut spending.  Consumers will save their money in case they may not earn enough in the future.  Companies will avoid borrowing money and hiring employees in case the economy does not improve.

“It don’t mean a thing if you ain’t got that swing.”

Policy makers need to appreciate the critical role of animal spirits in markets and the economy.  People need to trust and believe in strong markets and a strong economy in order to have the confidence to get money circulating rapidly again, which will keep the economy prosperous.   To draw on a scene from “Animal House,” the iconic movie about animal spirits, when everything seems as bad as it can get, it’s time for a toga party.  It’s time to get in the right spirit.

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Buy US

The European sovereign debt crisis could quickly spread into a worldwide epidemic as banks lose their capital from sovereign debt exposure. Germany is looked to as the leader in Europe to show commitment that failure of this debt is not an option. The German people, on the other hand, are starting to worry they are not only bailing out the rest of Europe’s profligacy, but that it may not even be a successful strategy without fiscally responsible governments in place.

Congress forestalled a US debt crisis by putting off the need to deal with it. However, just as in Germany, the people are tired of government fiscal irresponsibility and are looking to constrain government spending. As a result, fiscal policy is tending towards tightening when an easing policy has been heretofore aggressively pursued. For example, the payroll tax cut and unemployment benefits appear unlikely to be extended, at least after the election.

Many analysts are now predicting that the US economy will either sputter along or stall and plummet into recession. The Federal Open Market Committee, with few tools left to use, let the market know that it was going to hold its fund rates at its low level until mid 2013, so as to increase confidence in their commitment to their policy.

In the past, when the US sneezed, the rest of the world caught a cold. Now US population growth is leveling and its economy is shrinking as a percentage of the world economy while developing market economies are growing. As a result, much US corporate growth is coming from international demand and the vulnerability of the international economies to the US economy is decreasing.

Despite the poor economy in the US, the US stock market is amongst the best performing worldwide in this environment, reflecting the value and growth prospects of US companies as well as the capital markets capabilities and relative safety of the US for business. With the rapid exchange of information and capital, international and domestic stock markets have shown a great deal of correlation in recent years, potentially reducing the value of investing internationally in order to diversify an equity portfolio, though international diversification remains sensible. Where suitable, Stonnington Group clients are being counseled to invest in US companies that have high earnings growth prospects. Fortunately, there is no shortage of such companies.

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