Volume 63, Number 9
As economic data continues to roll in softer than expected, policy makers are on full alert with a wave of new ideas are being floated in the US, Europe and China. Flash PMIs in China and the Euro zone faltered again this month and the Philadelphia Federal Reserve Index plunged in the US, suggesting a deepening malaise as the real world waits for the policy makers to get a clue. Around the world, the initial stimulus from 2009 has worn off and businesses and their customers are slowly being strangled by a lack of access to credit. True, interest rates are low and falling. True, commodities prices are easing providing the equivalent of a tax cut. True, housing is starting to look a bit better in reaction to record low rates. Unfortunately, those are all traditional late cycle reactions due to weakening economic performance as stimulus ebbs. For the cycle to gain upside momentum, we need to see something proactive — like policy makers getting ahead of the curve, rather than just trying to stem the latest crisis, or businesses using their fortress balance sheets to take advantage of falling prices and interest rates. We see neither. Political leaders in Europe are still stuck in committee. In the US they are waiting for an election still over four months away. Even in China, ever the incrementalists, they are well behind the curve as the lack of a development surge this spring has resulted in surprisingly soft growth. Someone needs to step up. We expect more developments in Europe soon – but doubt they will do enough. We expect more in China imminently, and it should ramp up during the year as the numbers continue on the low side. Finally, in the US we expect nothing for four months – and perhaps even more confusion next week as the Supreme Court weighs in on Obamacare and then we try to figure out whose ox got gored.
First, Do No Harm
Ben Bernanke has a problem. He is worried about the US economy, but there is little or nothing he can do about it. QE1 and QE2 may have staved off imminent deflations and Operation Twist might be helping put in a bottom in the housing market – but so far, even his best stuff is all for defense. Effective moves to get ahead of the curve on US policy require dramatic changes in fiscal policy – stimulus now for altered entitlement plans later – as spelled out in Simpson-Bowles and Domenici-Rivlin. The Chairman has laid out his concerns to Congress several times, but that won’t change the fact that everyone is waiting on the election – and now that it is “just” four months away nothing is going to happen on the fiscal policy front.
So this week, faced with the fact that Operation Twist would wind down at the end of June, and remove the Federal Reserve as a buyer of $44.5 billion in long term Treasuries every month, he did the minimum. He extended Operation Twist through the end of the year – adding just one more brick in the wall for the fiscal cliff. By promising to convert another $267 billion in short term securities into long term securities on the Fed balance sheet, the Chairman basically replicated Operation Twist’s original nine month mandate for another six months. As it was widely expected, there was virtually no market reaction – but it did avoid a negative impact on the bond market at a time when finally housing is showing some progress. Unfortunately, it also means that the Federal Reserve has emptied its quiver short of QE3. At the end of the year, the Fed will have virtually no short term paper left on its balance sheet, and it will own over 40% of the 10 year or longer securities issued by the Treasury. Regardless of who is elected, they will need to act quickly as the Fed can no longer be relied on to kick the can down the road.
Any Change Rocks the Status Quo
Meanwhile, a new institution will add its say to the confusion in financial markets this week – the Supreme Court. While many feel that the court’s ruling will add finality to this debate we doubt it. If only the individual mandate is struck down, there will be a period of shuffling about to determine whether that is fatal to the entire program – and who loses if it does. If the entire program is killed, much of the adjustments the industry has made in recent years will be called into question. And if nothing is done so the program stands, small businesses are still left with the question of whether they should provide health care for their employees or not. While we would like to believe each will make up their own mind, we know that tricky invisible hand will be deciding for them as competition between those who do and those who don’t provide coverage alters labor supply to various industries. Obamacare as it stands provides little certainty to businesses, and changing the law only exacerbates the situation. We see more uncertainty after whatever the Supreme Court does.
As Romney’s chances for election rise with the weakening economy, we also wonder about the clarity a Republican sweep might bring. Yes, it will get everyone marching in one direction, but just how murky might that path be? A Republican sweep would eliminate much of the fiscal cliff, as the Bush tax cuts would be quickly extended and likely part of the defense sequester would be rolled back. However, that would leave huge deficits, which would be addressed supposedly by lower tax rates and a broadening of the base. While this sounds good in theory, the lower tax rates part is easy, the broadening the base not so much as every subsidy and tax expenditure has its defender. One of the dirty little secrets in Washington is that every dollar the government spends is revenue to a business, even when it is spending generated by entitlements and transfers. No one gives up their income stream easily – and the old chestnuts of efficiency and waste and eliminating out of date programs won’t generate the billions needed. Major changes in policy are painful and the public is not always happy about it – just ask the Greeks, Spanish, Italians, and maybe soon the Germans.
Defender of the Faith
In Europe, where important elections were just held in France and Greece, the fiscal authorities are back at the negotiating table discussing things they swore they never would discuss just weeks ago. The Big Four – Merkel, Hollande, Monti and Rajoy – have apparently agreed on a 1% of GDP (or 13 billion euro) growth package, with no details, but expected to be heavy on infrastructure projects. That sounds a lot like Obama’s early infrastructure tout, which took many quarters to gain momentum. Meanwhile, the ECB has lowered the quality requirements for securities that can be delivered in exchange for fresh loans. The lower quality debt faces bigger haircuts than earlier higher quality tranches – but it keeps the ECB’s tap open. In Spain, the Government’s latest stress test suggest that they will only need slightly more than half of the newly promised 100 billion euro set aside to save their banks. In Greece, they are asking for two more years to meet the austerity targets that everyone knows they cannot meet. Progress is expected on this front as well. However, Merkel is still digging in her heels on Euro Bonds, or a Sinking Fund, or even Euro Bills. She is adamant that credit extension must come with responsibility. She will not lend German taxpayer money without the right and ability to get it back.
In the end, we believe that Angela Merkel, like Ben Bernanke, will find it difficult to turn her back on a lifetime of institutional legacy. Merkel was known as “Kohl’s Girl” after her East German party merged with the CDU and she became part of his third, fourth and fifth cabinets. Yet, she alone was able to stand up to her mentor and demand that he leave the Party when he was caught up in a funding scandal. Still, Kohl and the CDU are integrally linked with the Pan-European concept, and we doubt Merkel will walk away from that position any more than we think Ben Bernanke will admit that the need for non-conventional monetary policy to fight deflation during a depression is wrong. Kohl was hampered in establishing a strong Euro, because he had to give into many other European leaders at the time to ensure acceptance of a newly unified Germany. Prior to unification, Germany, France, Italy and the UK were roughly equal in population, though Germany was even then more productive. Growing by 20% overnight –and to the East – threatened the post-War balance. One consequence was a Euro zone dominated not by German order, but by French bureaucrats. Merkel seeks to redress that wrong, and is dragging Europe toward banking and fiscal union – on German terms. Like Reagan and Thatcher, she stakes out absolute positions and then gives in only when the apparent maximum has been extracted from her intransigence. As Germany slips toward recession and inflation falls across the region, she is likely to become more flexible. No politician wants to face re-election during a downturn (ask Obama) and she is up again next year. Will she succeed? Much depends on the ECB. We have long argued that one solution to fiscal union, given Europe’s dependency on banks, would be if all banks were German banks. If the ECB regulates all European banks, as seems increasingly likely, only one question remains – are they going to use French rules or German? Historically, the Bundesbank has had great influence on the ECB, even under Trichet and Monti. Hmm….