Volume 63, Number 10
It is all up to the politicians now. That is certainly true in the US, and we would say that the Europeans are well on that path as well. Over the last ten days, three momentous events – from the Federal Reserve, The Supreme Court, and the EU ministers – have changed the outlook for policy and put the onus squarely on the politicians to do their jobs. They can no longer rely on monetary authorities or courts or global organizations like the IMF and World Bank to help them out. Now it is down to the democratically elected officials in the various countries around the world to tackle their many imbalances in the full light of their voting public – fix the problem or face the consequences, or in some cases fix the problem and face the consequences. Bottom line, politicians have run out of room to kick the can down the road and the next set of decisions – which may come before the next crucial election in each country – is more likely to be from a legislative authority.
We discussed last week the Federal Reserve’s move to extend Operation Twist through the end of the year – ending almost immediately after the election. This final leg of Twist leaves the Federal Reserve with virtually no short term securities and over 40% of the long term Treasuries. With interest rates already at zero and huge excess reserves in the system, the Fed is virtually out of bullets. It could engage in QE3, but even the doves on the FOMC are worried that it may have little economic effect and that it will complicate the Fed’s eventual exit from its huge balance sheet position. Chairman Bernanke stressed in his most recent testimony that monetary policy is not a panacea and that it was up to the legislative body to pass laws and regulations that might stimulate growth. We are not big believers in QE3 even if the economy weakens further. To do so might threaten the independence of the Federal Reserve if it is seen as interfering in the political process. At this point, it is up to the voters to decide who they want to guide the ship out of a deepening morass.
Supreme Court Chief Justice John Roberts, in a highly unexpected ruling in the 5-4 decision confirming that Obamacare is constitutional, clearly put the onus back on the Legislature. While the rest of the court split four-four on what appear to be political lines, Roberts argued that while the individual mandate was not constitutional under the Commerce clause, it was constitutional as a tax. This is an approach that had been rejected by lower courts and barely raised during oral arguments. However, Roberts’ reasoning was simple and clear. It does not matter what the Congress calls it, a penalty or fee or whatever paid to the Internal Revenue Service is a tax — and the Congress has the power to tax. He made clear that the Court’s job was not to approve a law, but only to rule whether it fit within the limits of the powers granted the Federal Government by the Constitution. In his view, this one does – if you don’t like it repeal it. While Roberts’ ruling has been widely criticized, he has largely removed the courts from the legislative process and put the onus back on Congress to support or reject its various taxes. Note that as a tax Obamacare is now part of the budgetary process and not subject to the Byrd rule, where 60 votes are needed to end debate. Bottom line, whoever is elected can enact tax laws that take a simple majority to pass – and bear the consequences in future elections as to their viability. The courts will not need to be called on to rule yea or nay on basis like the Commerce Clause. Rather than kicking the can down the road, Chief Justice Roberts has thrown the hot potato right back into the lap of the Congress and the Presidential election – where it belongs.
Finally, despite the gnashing of teeth over German Chancellor Angela Merkel’s defeat at the 19th meeting of the European minds in Rome, we think she extracted a heavy pound of flesh for her retreat. It was already clear to everyone in the debt markets that the highly undesirable requirement of government seniority on Spanish debt would be removed. It was also clear from last week’s Fab 4 confab that a 1% of GDP stimulus package would be approved. Even Merkel needed this to assure the support of the Reds and Green’s back home, where she needed a two-thirds majority to approve the fiscal pact and ESM. She rushed home from the summit to confirm the passage of those pacts on Friday, winning with a solid 491-111 vote – with little debate. Clearly, all the legislators in Germany, if not the general public, knew what was coming well ahead of her midnight negotiations.
So the big concession was that the ESM would be able to directly inject funds into banks without having to pass the funds through their sovereign – if, and only if, (that is a fancy economist term) these direct injections were subject to the overview of a central bank regulator. This is what Merkel has been after all along. In Europe, where the vast majority of lending – even to sovereigns — is through banks, a central banks regulator would for all intents and purposes become the single fiscal authority that everyone has been talking about. If the ECB is that central bank regulator, it effectively becomes both the monetary authority and the fiscal authority – and he who controls the ECB controls the Euro Zone. The ECB may have wandered some, but it is still largely a conservative, monetarist institution under the heavy influence of the Bundesbank. We think Merkel and most Germans would grudgingly pay off the current exorbitant excess borrowings of the Periphery if they could be assured that it would never happen again because of strict German oversight. The Left is even more ecstatic that future bailouts will only be subject to current European budget requirements and that, unlike Ireland and Greece, Spain and Italy would not be subject to the Troika – including the oversight of the French Led IMF and American led World Bank. No, instead they only would be subject to the oversight of the German dominated ECB – check and mate.
However, neither the stimulus from the growth pact nor the creation of a European bank regulator are likely to happen fast enough for the Spanish banks to survive – so we are likely to be seeing more concessions from the Left as they push Merkel to advance the calendar. The growth pact is a brilliant use of more European federalist funny money, which allows all national politicians to spend without significantly increasing sovereign debt. The key is the 120 billion euro package will be funded by the European Investment Bank. This is an organization capitalized by all 27 members of the EU, with 232 billion euros in callable capital (37.5 billion each from the UK, Germany, France and Italy) but so far only 12 billion euros paid in. On this thin capital base, the EIB has made 400 billion euros in loans – a 3% ratio, well below current international standards — with 61 billion euros in loans made last year. The plan is to call in another 10 billion euros of capital – already approved in most countries – which would allow for 60 billion euros in new projects as the EIB increases its borrowings. But that’s not all, the EIB will also release another 60 billion euros in shovel ready projects that have been considered, but not yet funded. Finally, many of these approvals require matching funds, so the net effect could be significantly larger than 1% of GDP. However, we have three concerns: 1) this tiering of capital leverage looks a lot like those bad old CMOs; and 2) the EIB invests mostly in infrastructure projects and small businesses, where the bang for the buck is years, not months, away; and 3) how will the EIB handle a doubling or more of its work load. Bottom line, European leaders are tapping another of the alphabet soup of federal programs to get out of trouble. The EIB says the projects will be targeted at needy countries. Sounds like a unified fiscal policy to us – or maybe even a Euro Bond. Ah, the power of semantics.
After so many policy initiatives, it is no wonder the equities bulls led the charge this week — but will it last? We see little real uncertainty erased by the various moves. Rather, they appear to concentrate the eventual solution on the legislative bodies, which have been the least trustworthy in carry through on their mandate. Obamacare may be legal, but a President Romney (currently ahead in most polls) would repeal it on day one – and replace it with what? Not a plus for businesses looking for clarity. Even under a second term for President Obama, Obamacare could face challenges in the budget process now that it is a tax and subject to only majority rule. The fight for or against Obamacare is also likely to weigh on the handling of the fiscal cliff. Most of our political contacts suggest this significantly reduces any chance of a lame duck solution or even one early in the next term – regardless of victor.
Bottom line, the US is still waiting on a Presidential election that is four months off, and the economy is already sliding toward recession. The soft consumer income and spending numbers for May released Friday have pushed most second quarter forecasts well under 2% real GDP growth. With moderating inflation, that argues for meager nominal growth, profits, and disposable income to pay down debts. Moreover, between the Olympics and the political conventions, we are headed into a dead spot where the ability of analysts to interpret the political polls and economic data will be clouded. We believe the lack of clarity that remains on the economic front will leave businesses sidelined in the US, and that the deepening economic weakness in both Europe and China will add to indecision on hiring and investment. Thus, the economy is likely to continue to slow into the election – raising the tenor of the rhetoric as to who is at fault and what is going to be done about it. In the end, November 6th will set the tone for the length and depth of a likely recession in early 2013.
At present, the US is still the fastest horse in the glue factory. America’s problems are more solvable than Europe’s, so on a relative basis, the US should outperform. It is hard to see China doing better with US import demand likely to cool over the next several quarters and Europe still awaiting a single bank regulator. In the short term, it looks like “All fall down”, but the bigger question is whose leaders will be most proactive in sparking the recovery that always comes after recession. For now, we see no grand solution, but rather a turning inward of each of the big three global economies – the US, Europe, and the China-led commodities bloc (including Canada, Australia, Brazil, Russia, etc.) Not quite beggar-thy- neighbor, more like just ignore him. Not historically a winning tactic.
For better or worse, how aggressive China is in its next round of stimulus and how effective it is at spurring a consumer led recovery, rather than simply another binge of infrastructure building, may determine the outlook for global economic growth and integration for years to come. They still hold the upper hand with respect to deployable capital. The question is how narrow might a Chinese funded Marshall Plan be? Just Asia? For all commodities producers everywhere, via direct investments? And what conditions will they demand for their aid? The post-war deal between the US and Europe was virtually unlimited lending for virtually unlimited control of the developing cold war. Critically, this happened in the single currency environment of the gold standard until 1973. Will China dictate their currency conversion rate in exchange for lending? Lots of uncertainty remains, and that suggests to us slower than maximum potential growth in an already low population growth and low productivity world. We remain in the low inflation/deflation, low interest rate/low investments yield camp for the foreseeable future.