Fighting the Economic Headwinds

I have written many blogs about the faltering U.S. economy and the continuing headwinds that will prevail for the next few years.  The headwinds include:

• A consumer balance sheet loaded with debt with flat to falling income;
• The  consumer’s major asset, the home, continues to fall in value with approximately 25% of homeowners with mortgages now underwater;
• A banking system whose lenders to small business, community banks, are constrained by lack of capital and which are under attack by their government regulators insuring a continuing small business credit crunch;
• The support of the “Too Big To Fail” with cheap capital injections, a bonanza in the arbitrage of borrowing at 0% and purchasing Treasury Notes at a 3.00 percentage point profit margin, while shrinking their lending each and every month.  Meanwhile, they’ve paid themselves outrageous bonuses while Main Street remains mired in Depression;
• Federal Government economic policies which make the future so uncertain that businesses are reluctant to hire, including:
  • The adoption of healthcare reform against the will of the vast majority of the population with the unintended consequence of a significant increase in the cost of health care and, perhaps, a much poorer delivery system;
  • Interference in, and control of, private sector business including:
    • The government takeover of GM, forcing the firing of its CEO, and protecting 100% of Chrysler’s union pensions at the expense of the bondholders;
    • The passing of a financial reform bill that completely ignored the institutions (FNMA & FHLMC) and Congressional policies responsible for the sub-prime housing bubble, and the establishment of a new government bureaucracy which will, no doubt, make it much more difficult and costly for consumers and businesses to access credit;
    • The use by President Obama of Presidential fiat, against the advice of his own panel of experts, to stop all oil drilling in the Gulf of Mexico which, in my view, will have much more devastating and lasting economic impacts on the region than the oil spill itself;
  • The continuing threat to economic growth of cap-n-trade legislation which has the potential to significantly increase the price of energy.

Americans have now begun to realize that unemployment will be a significant issue for many years.  At the same time, they see that the folks in Washington either will not, or cannot, figure out how to really stimulate private sector job growth.  The U.S. economy cannot expand, and jobs will not be created until investors feel it is safe to invest and businesses feel confident they know the rules of the game and that those rules won’t soon change.

So let’s look at what policy changes are possible to eliminate the uncertainties and bring confidence back.  This will encourage business to take the risk of expansion and result in job creation.  There are 7 such policy changes listed below, 3 of which I will comment on extensively.  As each of these issues are addressed, if, indeed, there is the political will to do so, business confidence will improve and there will be a concomitant improvement in the equity markets:

1. The Bush Tax Cuts:  It is not a well publicized fact that the net effect of the Bush tax cuts was actually an increase in the marginal tax rates for the wealthy from what they had paid previously.  Yes, the marginal tax rates in the table were reduced, but incomes expanded such that the “rich” (the top 1% of taxpayers) moved up to higher table brackets and actually ended up paying a higher proportion of their income in taxes than they had during the Clinton years (38% vs. 33%) (see Bill Frezza, http://www.realclearmarkets.com/articles/2010/08/16/the_hidden_truth_about_the_bush_tax_increases_98625.html).  The real issue, which has always been obscured by the way the arguments are presented, is not that there isn’t enough tax revenue, it is the explosion in government spending.  Since 1950, federal tax revenues have fluctuated between 16% and 19% of GDP.  And, during the Clinton years, we actually ran a substantial surplus.  Balancing of the federal budget is more about spending control than about lack of revenue.  It’s just easier for the Congress and the politicians to pretend it is a revenue issue and to obscure the real issue by concentrating on the tax issue.
2. The Credit Crunch – Call off the Regulators: America’s small businesses are in the midst of a credit crunch.  The large, publicly traded corporations, have access to the national debt markets through Wall Street, and have recently taken advantage.  We’ve even seen 100 year bond issues.  Small businesses, on the other hand, don’t have such access and have traditionally relied on community banks and the shadow banking system (non-bank financial institutions) for their borrowing and working capital needs.  It is widely recognized that small businesses in the U.S. create the majority of jobs.  To break the credit crunch, small banks must be able to lend again, or at least be able to make credit available when businesses once again have enough confidence to expand. Under today’s conditions, even if small business wanted to expand, there is no credit available.  In July, Bloomberg News learned that in the case of the Corus Bank (FL) assets (and in 14 other similar cases), the FDIC gave Wall Street firms long-term 0% interest loans.  The FDIC indicated to Bloomberg that they did this to give those Wall Street firms “the time they needed for the Real Estate markets to heal”.  To relieve the credit crunch, why doesn’t the FDIC give the same consideration to small banks, i.e., give them 0% long-term loans to increase their capital, which will give them the same precious time for the Real Estate markets to heal as they are giving to the fat cat Wall Street firms?  A policy of TARP like injections into small banks which will give them both the capital and the time will go a long way to alleviate the credit crunch to small business, making economic expansion and job creation possible when businesses have gained back the confidence they need to expand.
3. Fix the housing finance system:

• The first issue is the number of underwater mortgages.  A reduction in the number of foreclosures is critical, yet every month we see these continue to expand.  Using tax policy, mortgage institutions must be encouraged to rework such loans both by lowering the interest rate and by extending the amortization period, even to 40 or 50 years, making these permanent if the homeowner remains current for a specified period.  While this won’t stop all foreclosures (e.g., households without employment), it may lessen them enough to restrict supply such that home prices eventually stop falling;
• FNMA & FHLMC: These two, alone, have already cost the American taxpayer $150 billion, and the total bill is likely to be north of $500 billion (perhaps, even $1 trillion).  These two entities operated for many years with significant profitability until they were forced by the Congress to enter the sub-prime markets in the late 1990s.  Their original business model isn’t broken, it was changed by Congress.  A return to a public-private partnership with private capital, rational underwriting, a prohibition on lobbying and Congressional political appointments and interference, and run like a business with a board elected by shareholders would go a long way to restoring the housing industry to health;
• As for the existing FNMA & FHLMC, shut them down and appoint a receiver to wind down their assets (maybe a 20 or 25 year endeavor).  Yes, this will be at great expense to the taxpayer.

Other actions that will have a positive impact on business confidence and on the equity markets (listed without further comments):

1. Address the Social Security and Medicare unfunded liability issue;
2. Develop a real energy policy that makes the U.S. energy independent in 15 years;
3. Stop being the world’s policeman;
4. Adopt a real immigration plan that stops illegals and encourages foreigners with the skills we need to be competitive in the world to immigrate here and become productive U.S. citizens (who will likely help create jobs).

Each of the above actions will restore some business confidence; several of the actions together will make a significant dent into the unemployment situation; any of these actions will garner a positive reaction from equity investors.

Robert Barone, Ph.D.

August 29, 2010