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Friday November 6, 2009 - 17:37:15 GMT
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US Fiscal Policy Conundrum

US Fiscal Policy Conundrum


In the wake of the defeat for Democrats in races for US governors in Virginia (where there has been a Democrat in charge for 8 years) and in New Jersey (where incumbent Corzine was defeated despite a heavily Democratic state) showed a loss of support for the politics of big government to the independent voter.  Recall it was the independent voter who voted decisively for Obama and Democrats in Congress in 2008.  While the vote may not change the agenda of the White House and liberal leadership in Congress in a significant way, it will leave moderate Democrats (Blue Dogs) less inclined to run up deficits to stimulate demand.  The election result makes a second fiscal stimulus (really fourth stimulus if we count Bush admin’s TARP and first fiscal stimulus as one and two) from the Obama admin highly unlikely in the current environment. 


Okay the $787bln fiscal stimulus plan now in place is only 40% spent and TARP has been significantly replenished as banks pay back the government (so more funds in place to support banks ahead – probably will end up supporting regional banks when commercial real estate loans put many on the ropes).  Meanwhile Congress is in the process of passing a bill to extend unemployment insurance another 14 weeks (through the holidays) and extend the first-time homebuyer $8000 tax credit (key prop for lower priced home sales which is skewing overall sales and prices higher).   But in a $14trln a year economy, the fiscal stimulus and related subsidies for consumers is a drop in the bucket and outside these programs and a base effect from housing investment (q/q off depressed level annualized) there is little evidence of a recovery in household demand and business investment. Moreover, today’s employment data for October showed job losses continue if at a reduced rate while the unemployment rate trends higher.  The worst case scenario for bank stress tests used by US Treasury and Fed earlier this year was 8%.  We are now at 10.2% and unemployment is still rising even as long-term unemployed exit the workforce (not actively seeking) in light of the poor chances of finding a job (post secondary school enrollment, especially at junior colleges is soaring…and in cash poor California where state cutbacks are shrinking funding for junior and four-year state colleges). 


I find it stunning that anyone thinks there is enough stimuli in place to assure a recovery in the private sector ahead.  Barrons recently, so confident of the recovery accelerating that inflation is imminent, urged the Fed to hike the funds rate to 2% in short order.  Yes the Fed has rates at an exceptionally low level and is pumping all sorts of cash into the banking system for little or questionable collateral.  However, banks are not lending this cash to private sector agents outside of real and leveraged money managers who are accumulating risk assets rapidly on a cheap funding basis which is driving asset prices (including commodities) with little else.  Bank lending to commercial customers is depressed, though so too is demand (with so much idol capacity why would a firm borrow to expand capacity?).  With CIT in bankruptcy, loans for small- and medium-sized firms, where there is demand, are scarce (were scare before CIT filed).  The only bright note ahead for limited regions of the country is that Wall Street is planning on paying record bonuses to executives for record or near record earnings, another outcome of a near zero funding cost for banks, even banks that aren’t really banks assuming Congress does not stop this in its tracks.  But what banker who gets paid this year (most bonuses are paid in Q1) will spend like it is 2006?  Claw back risk, retroactive taxes and potential relapse in the banking crisis from elevated unemployment and souring loans suggest these monies will be saved not spent.  In Connecticut, the state legislature (Democrats) and Governor (Republican) have increased the state income tax for those earning over $500,000 a year to 6.5% from 5.0% effective January 01, 2005 which means many in this range are way under what withholding should be for the year now that it is November, and to catch up on withholding employees are paying little to highest paid workers for the rest of the year.  If wealthy CT residents are suddenly getting no take home pay, I suspect there will be some change in consumption behavior for the upper end of the income earners, especially in Fairfield County where the bulk of these earners live. 


Simply both ends of the income spectrum are feeling it.  Fairfield County’s wealthy won’t be to NY metro area economy what China is now to Australia’s economy.


Unless exports soar ahead behind a weak dollar and an unforeseen shift in savings behavior in Asia, I can’t see where private sector demand starts to recover in any real and sustained way. 


So what is the conundrum?  Well the economy needs a much larger stimulus to turn confidence in the face of record (in my lifetime) unemployment and underemployment before we see a second wave of asset deflation.  Yet politically the winds are blowing in a very different direction making a far more serious fiscal stimulus ahead unlikely.  At most, I see the White House and Democratic leadership in Congress finding support from centrists and even conservatives of both parties for a tax credit-based stimulus ahead which might well end up including tax cuts (delay in Bush tax cut expiration in 2010).  But any progress on a “second”(really fourth) stimulus ahead will only come later than it is needed and only ups the chance of the economy falling off a cliff again in 2010…in Q2.  Oh l almost forgot…2010 is a Congressional election year with all the seats in the House and a third of the seats in the Senate up for a vote.  


If you think the drumbeat now for fiscal restraint is loud, one can only imagine the deafening roar as the 2010 Congressional campaigning gets going in full glory.  I think the Fed has insured large banks against failure and put a major subsidy in the hands of bankers (profits).  But it has had little impact in generating private demand.  The only game in town (main game outside of exports) is fiscal stimulus and this has lifted private demand via programs like cash for clunkers and fist-time homebuyer tax credits.  Beyond this there has been some success in stemming layoffs at state and local government levels as federal money has moved relatively quickly down the food chain of governments.  The much heralded infrastructure spending train has yet to leave the station for the most part sadly.  This channel for jobs may kick in later in 2010…too late to prevent the cliff dive.


And lastly, the success to counter cyclical monetary and fiscal policy depends on winning the hearts and minds of individuals. People need to feel better about their job prospects, income growth and credit availability (banks are taking care of the latter with usurious interest rates and cuts in credit lines from HELOCS to credit card limits…even for best customers).  I give the Fed and Washington as much chance of winning the hearts and minds of US consumers and businesses as I do NATO in winning the hearts and minds of Afghanistan’s rural poor.  It is possible yes, but not probable.


Lastly, this is a time in our history when gridlock is bad, very bad and yet almost assured. 


David Gilmore




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