Friday, September 17, 2010

Bernanke Obama and Yo’ Mama

Bernanke Obama and Yo’ Mama

This recovery has been very iffy. When times are hard you naturally ask what can the Fed do? What can government do? What about my family? (hence, the title Bernanke, Obama and yo’ Mama).

Out of options? In this cycle I think the Fed is tapped out. The government has fumbled the ball and then, to mix the metaphor, painted itself into a corner. Now it proposes an alternative to a Republican idea, an alternative that even after some thought seems pretty lame. No wonder confidence is slow in forming. It seems pretty clear when all is said and done that policy is dueling it out on a political battlefield not on an economic one. That means the economy is sure to lose out... again.

Why is confidence dropping? Ask yourself this: after everything the Fed and the Administration have done, why is sentiment sinking even as current conditions are improving? Therein lies a story of government that has lost its way and lost control and of a central bank with too much on its plate.

Obama hits rock bottom with Summers:

I recently saw Larry Summers on TV. It’s a bad sign, since Mr Summers is no pitchman. He stood there telling us, or trying to tell us, how much better investment expensing would be than making the Republican tax cuts stick for 10 years when they would send $750bln to the richest of Americans.

Republicans bad! Well, that’s one way to tell the story. But when Larry is talking we know to check our back pockets for our wallets. As usual he has presented us with a glaring and biased view of the trade-offs. Where has intellectual honesty gone? Is anybody stupid enough to believe what he said and take it at face value? I think even partisan Democrats must have choked as they chortled and listened to Larry.

The real deal - In the first place what most people seem to have put on the table is extending the Bush tax cuts for a couple of years not for the ten year period Summers used to inflate the cost. The idea is to extend the cuts until the economy gets on its feet.

The ‘why’ behind extending tax benefits - The reason for this idea is to shield small business from tax hikes. Many small businesses are not incorporated so their owners pay the personal tax rate. This means that if the personal tax rate goes up, the tax on business goes up and that will restrict activity. Congress has known about this for some time and has done nothing to solve the problem. It’s back! A tax hike on high wage earners is one thing; a tax on business is something else. That is what is really at stake and Mr Summers wants to hide that and prefers to sell policy on the basis of ideas rooted in class warfare which can never be good but do get the blood flowing. Summers is a much better economist than political spin-meister but his foray into politics via economics makes him look foolish.

Behind the tax deal - What’s worse is the idea that Summers proposes which is to make all investment spending tax deductible immediately. That would provide tax breaks for investment that responds to a tax incentive plan as well to all the investment that would have occurred anyway. That is a big giveaway. If the plan stimulates a 10% increase in investment spending then 90% of the break is a giveaway. But I guess giving money to big business is more palatable than giving it to ‘rich Americans’ even if some of them are small business owners. When it comes down to it I guess Summers likes capital better than labor. Did capital vote for Obama?

Small help for small business- This investment plan will not help small businesses since they do not invest to get tax breaks if they don’t have business. Large businesses can and do take advantage of such things. In addition there is the problem that a lot of capital investment is labor saving. So what Summers is doing is subsidizing the implementation of capital investment that will substitute for labor. That does not sound very helpful in creating jobs. Moreover, capital equipment is usually very capital intensive in its production. So even if capital goods output is stimulated it will not spur much hiring. The more you look into Summers’ idea, the less attractive it gets.

THE REAL TRADE-OFF- It comes down to this: Give money to rich firms to invest in high-end capital equipment and hope for a trickle of stimulus that will dominate the negative impact of this tax break, or give the tax break to the ‘rich’ knowing some of them are business owners and that a lower tax rate will impact how they manage their firm and deal with issues of economic expansion and hiring.

Different strokes for different folks - Stimulus plans for large well capitalized, well-lawyered up, and fully bureaucratized corporations Vs those for small business are very different things. The Administration does not seem to understand that after all this time. Small business will go with the flow. Large incorporated firms can swim against the current.

Interest rate distortion - Look at Microsoft. This week it announced a bond offering. Why? This firm is loaded with capital, and in the form of extra cash, too. Yet, it has a bond offering. It finds money so cheap it just had to stockpile more. It has no good use for it, but if money is almost free I may as well get some- that’s what they think at Microsoft. If a corporation is huge it can do stock buy backs or something else. At this cost large firms will find some use for the cheap money. A small business never would do that. Not all the corporate borrowing will stimulate jobs some will just dress up the balance sheet.

Rate incentives - More to the point, this behavior shifts our focus to monetary policy. Microsoft, certainly, is not the only firm that finds long term rates very low and very attractive. So if you are on the other side of that trade, say a bank, are you very eager to lend at these rates? I’d say no. It’s one of the reasons I think the Fed is tapped out on policy. Rates are already so low bankers probably do not really want to pile on any more long term fixed rate assets.

Rate disincentives - If a banker makes a 30-Yr loan at a 30-yr fixed rate two ‘bad’ things can happen. The loan can default causing the bank to incur loss. Or, the loan can remain on its books for 30-Yrs causing its investments to underperform. Few expect long term rates to stay this low. All this makes a mockery of the economic theory of the determination of long term interest rates. Banks are dragging their feet in mortgage lending precisely because they are skeptical that rates can stay here for very long. They are being picky about documentation and are setting high standards in terms of credit scores for access to the best rates for mortgage borrowers. In short, they act like they really do not want to do this business. They don’t.

The Truth - Rates that are ‘too low’ will not stimulate the economy, to the extent that demand increases supply pulls back. Low rates may have the opposite impact form what’s intended. As for the Fed’s quantitative easing, if it does not work through interest rates, how does it work? Do we really want another round of the Fed sloshing in reserves hoping they will have some impact on market rates or market spreads? Worsening the excess reserve situation will only make unwinding the process all the harder. If the idea is to stimulate the economy by shifting expectations to see more inflation I’m not sure that is a good route to go. Indeed, at some point too much bloating of the Fed’s balance sheet is not good for the Fed’s reputation or for the dollar. We do not want to flirt with that route. That would be the biggest mistake of all. We did not have such a thing to worry about in the Great Depression Bernanke studied. The dollar is now the principle international reserve asset; it changes the game.

Policy will reveal the Fed’s preferences - What the Fed chooses to do will tell us a lot about what it really thinks. When times get tough, when it is hard to do what is best, it is often best to avoid doing what’s worst. This is the mini-max approach. The aim under this doctrine is to take the path which, if it is wrong, will do the least damage. So what will the Fed do? That will tell us what it really fears. The Fed claims to see the economy doing better. It has cut its outlook but it still sees growth. If the Fed engages in another round of Q-easing we can only conclude that it sees a slippage into a double dip as the most severe risk. If it avoids a second Q–easing we can conclude it believes its own forecast for growth and sees excessive stimulus as the biggest risk. Ironically the more aggressively the Fed behaves the more pessimistic it should make us feel. Since the Fed’s ability to stimulate with quantitative easing is so suspect, it should be reticent about doing something that will trigger negative feedback.

What transparency does - Basically the Fed is stuck making policy in a fish bowl. We can all see what it is doing. We also can assess the impact of what it is doing. When the feedback effect might dominate the stimulus effect, something I believe is true, the Fed should very wary of adopting a new round of stimulus.

Summing up - To sum up, the economy is in recovery. The Fed has cut its view of recovery. Private sector economists have just cut their outlook. Yet, recent economic data have just been showing a bit more upside. We do not know what the Fed thinks will happen or how seriously it fears what ‘might happen.’ But we can infer these thoughts from the Fed’s next move.

The Fork in the road - We do know that there is a deep schism within the Fed. Some members feel their view has been ridden over roughshod. Bernanke keeps testifying that the Fed can do more and is not out of bullets. This is exactly what he should do/say if the Fed is out of bullets and cannot do any more. But at some point we will leave this world of posturing and the Fed will do something. Will it do more stimulus? Or will it try to convince us that it believes the economy really is on the road to recovery? It can’t have it both ways. Its forecast of recovery is undermined by its actions if we get a new Q-easing plan. Withholding a new plan gives the Fed’s forecast of continued growth more credibility. The Fed has reached the fork in the road. It’s time for it to take it.

But which one Yogi?