Around the World in 90 Days Part I: The U.S.

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by Victor A. Canto,  La Jolla Economics (Guest Contributor)

MARCH 29, 2010

The signature issue of Obama’s presidential campaign was the health care initiative proposed by the then candidate. The passage of the legislation may very well be the crowning achievement of his administration. The long term effects of the legislation are unknown, but years into the future we may look back and see this piece of legislation as a major economic turning point.

During the events leading up to the bill’s signature, opposing sides made very different claims and forecasts about the long run and short run impact of the legislation. Polls showed that the majority of the American people were opposed to the bill. Republicans were arguing that voter discontent with the legislation and the process leading up to the passage would sour the voters on incumbents who voted for the legislation. Proponents argued that once the bill passed, the public would come around. Recent polls suggest that they are. Does this mean that the Democrats won’t pay as high a price as Republicans expect? We tend to agree with that view, but for different reasons. Our outlook is based on our economic forecast.

We believe that the economic data will continue to improve as the year progresses. We look for the inflation rate to remain low and even decline as the economy improves. In such an environment, with unemployment improving slowly, the administration will argue that the economic improvements are evidence that their economic program is working as they said it would. They would also argue that the data vindicates the administration’s views and that enacting its economic program was the right thing to do. This is a persuasive argument and we don’t see Democrats losing as many seats as Republicans expect.

One issue that concerns us from an investment perspective is the following, what if the economic improvements are due to reasons other than those espoused by the administration? Obviously, one would like to know the reasons or rationale for the alternative explanations and a key question for investors is whether the outlook would be as bullish as the administration is likely to argue.

The Alternative Scenario

We are big proponents of the view that preannounced tax rate increases tend to lead to a false prosperity. We frequently use the analogy of what happens to a store when it preannounces a major price hike? Needless to say, it will result in brisk sales with the sales volume rising in the period leading up to the price increase as the dreaded day approaches. But that is not all. When the new price hike take effect, the sales of the store will slow down until people consume or use all the inventory they had built up in order to take advantage of the price hike. The volume of the inventory built up depends on the ease of storage, carrying costs and other factors. The main point being that some of the increased sales are nothing more than a timing issue where current sales are, in effect, stealing future sales. This is some sort of price arbitrage across time.

The parallels with a tax increase are obvious. We know the Bush tax rate cuts are set to expire. Corporations will not be affected by the law change since their tax rates will remain unaffected by the expiration of the Bush tax rate increase. Hence any action on the advancement front will have to come from individual behavior. People laugh at this suggestion. They argue how can wage earners accelerate their income? The answer is simple, work more hours even if the pay is at a regular non-overtime rate. Viewed this way one can see that the employer would benefit from this by not having to pay overtime and/or hire an additional worker. The employee benefits by earning the income now. How much will they do that? Well here the progressivity of the tax rate schedule will come into play, working harder could push the individual employee into a higher tax bracket. That will limit the amount of income advancement by the employee. The bottom line here is that workers working longer hours will lead to a slower recovery of the unemployment rate in relation to the increase in the level of economic activity.

Investors will also be affected by the expiration of the Bush tax rate cuts. Dividend and capital gains tax rates are set to increase and, that again induces an incentive to accelerate income recognition. An astute investor would like to increase its cost basis in order to avoid an increase in the capital gains it has already locked in. The simplest way to do this is to sell the stock and buy it back later on. Doing so allows the investor to recognize all its capital gains at current rates and then purchase later the same or a similar asset, which allows the investor to increase its cost basis for future capital gains. The costs of the transaction may be the inability to generate additional gains from the previously locked in gains. The benefit to the government is that the realizations will lead to a “one time” higher revenue collection. Politically this will be favorable to the administration. They will argue that their economic program is working as evidenced by the higher revenue. Yet if we are correct in our argument, these will be one time revenue gains that will reduce future revenue collections.

The effective tax rate on dividends is also set to increase. Again we ask ourselves, how can people advance their dividends? Well Mike Milken taught us how. Recall that corporate debt is deductible to a corporation and taxable to the individuals, while retained earnings are taxed at the corporate and individual tax rates. This means that dividends and capital gains are subject to double taxation while corporate debt is not. The increased tax rates on dividends and capital gains will increase the attractiveness of corporate debt as a return delivery mechanism. The ideal strategy is to increase corporate debt and pay a one-time special dividend to shareholders. Have them pay the current low tax rate. For the corporation, use the future cash flows to pay for corporate debt instead of paying the future dividends that they would have paid if they had not issued the one-time special dividend.

Interpreting the Economic Recovery

The tax rate story is very compelling and quite feasible as we have argued in the previous paragraphs. It clearly suggests that the economy is likely to be stronger this year because of an acceleration of income. In effect, this means that we are stealing some economic activity from the future. Voters and investors will have to decide how much of the increase in economic activity is due to the policies of the Obama administration, how much is due to a natural cyclical recovery of the economy and how much is due to an advancement of income in anticipation of higher tax rate increases. Each of the components has vastly different implications for investors and the future path of the economy. If the recovery is due to the stimulus, then we can expect more government spending and government intervention in the future in order to keep the economy going. If the growth is due to a cyclical recovery the government spending/stimulus may have been a waste and future stimulus programs may also be a waste. Evidence in favor of this view is the fact that the unemployment rate is much closer to what the administration predicted the unemployment rate would be if no stimulus package was adopted than what they forecasted it to be with the stimulus.

If we conclude that the stimulus was ineffective, the only remaining explanations for the recovery are the cyclical recovery and tax induced shifts away from the future into the current lower tax rate year. This is very important. A simple numerical example will illustrate the point. Suppose that the economy’s natural growth rate is 3.5% in real terms and the economy grows at 3.5% this year and next year. This numerical example would indicate a normal cyclical recovery where the economy would return to its long term growth rate. However, what if the income shift accounted to a 1.5% shift in income from future years to the current lower tax rate year. This would suggest a couple of things. First, that the economy is still recovering and has not reached its long term growth path. The second point is that 1.5% of the growth rate is being stolen from the future, say next year. Now if the economy returns was on schedule to return to its long run growth path we know what next year’s growth rate will be the long term natural growth rate less the amount shifted to this year, or 3.5% less 1.5%. Hence, we would forecast a 2% real GDP growth. Now if the economy was not on schedule to reach its natural growth rate, subtracting the income shift to this year will leave a less than 2% growth rate.

The previous calculations show something very important to us, that if the income advanced to this year exceeds the economy’s adjustment process to its long run growth rate, next year’s real GDP growth rate will be lower than the current year’s GDP growth. In the current economic parlance, a W recovery would be in the offing. Now whether the W leads to a double dip or negative growth rate depends on two factors: the larger the income advancement and the slower the process of adjustment to the long run growth rate, the more likely the double dip.

Unintended Consequences and Other Insights

The passage and enactment of the Obama health care bill will reinforce many of the effects that we have talked about in the previous paragraphs. Needless to say, in order to get the necessary votes, some compromises and deals had to be cut. Also, the political environment forced the legislative process to develop at least a budget neutral or budget positive package. However, as many economists know, the scoring of the legislation is based on static analysis and on a set of assumptions made by the administration regarding features of the program. If people do in fact respond to incentives and change their behavior accordingly, we know that the scoring of the program will underestimate the spending and overestimate the revenue collection. Whether these dynamic effects are large enough to erase the static savings is a strong possibility, but that is not the aspect of the dynamic effects that we want to focus on. We just want to point out that the legislation will increase the marginal tax rate of higher income taxpayers and that will reinforce the substitution effects or income advancement that we mentioned in the previous section. This may be particular important for the dividend and capital gains income that will be faced not only with a higher marginal tax rate, but also with a 3.8% Medicare tax rate. Therefore, we look for the income advancement measures and capital gains realizations to accelerate during the remainder of the year.

Now, changing gears, we want to focus on the insights gained by the behavior of the different players during the process leading to the passage of the health care legislation. While some of the press focused on some of the promises the president made during the campaign about transparency and inclusion, criticism that we agree with but not what we want to focus on. To us what was very revealing about the process was the feeling that, to the administration and Congress, the end justifies the means. It suggests an ideological bent where the players in charge are willing to use any tool at their disposal to achieve their objectives. Let us be clear, we are not impugning the sincerity of the administration or congressional leaders. We take the president at his word and believe that he is trying to do the right thing. What we are focused on is anticipating what changes may come in the future that will affect the markets and specific sectors of the economy.

If, as Republicans claim, voters will be mad in November and the Democrats know that they are going to be punished, then the logical strategy will be to enact as much of the president’s agenda between now and then. The only way Republicans would be able to repeal Obama’s legislative gains would be if they get a veto proof majority. Such an outcome implies an across the board and overwhelming repudiation of Obama’s legislative victories. Based on the economic forecast that we are envisioning, we consider this outcome a highly unlikely event. The likelihood of modest losses suggests that the implementation of the Obama agenda should continue with gusto even after the elections. Now in the event that the congressional losses are large and the Democrats lose the majority, recent events show that the administration will push its agenda in other ways. For example, it may very well try to implement many of the cap and trade legislation provisions administratively through the EPA.

The point of all this is that the administrative measures and the administration’s desire for “fairness” will lead to targeted measures aimed at taxing the “rich” and redistributing income to lower income groups. But these measures with their mean testing, exclusions and exceptions will lead to an increase in the regulatory burden. This would have a couple of effects on the economy. First, the smaller companies will be able to morph themselves to minimize the impact of government regulations. Also, many of the provisions tend to exempt smaller companies. This and the fact that revenue collectors like to hunt big game, means that the larger companies will have a tax target on their back. However, once the dust settles, these larger guys will be able to plan ahead in order to reduce their tax liabilities. In conclusion, we are looking for the small caps to outperform the larger cap stocks in the U.S. and assuming that Asia and the emerging markets do not follow the U.S. and Europe’s lead, we look for them to lead the way and outperform the U.S. market.

Monetary Policy

In theory, the Fed is supposed to be independent of the executive branch. However, proposed changes in legislation may blur the line a bit. Also, the fact that there are a number of vacancies means that the president, as is his right, will appoint people he thinks can do a good job and who share some of his economic views. Based on this reasoning we presume that he will appoint competent economists steeped in Keynesian tradition. A clear example of this is his nomination of Janet Yellen to become Vice-Chairperson of the Fed. A distinguished academic, former Fed member and president of the San Francisco Fed, it is clear that Yellen is well qualified. Her long career and academic writings leave no doubt about her orientation. She will be clearly in the Keynesian-Phillips-curve camp. The Fed will gradually shift its focus away from a domestic price rule to one that incorporates the Phillips curve view of the world that slow growth leads to lower inflation and higher growth leads to higher inflation. A world in which stagflation is difficult to explain and unlikely to happen. Within such a framework we expect the Fed to continue its easy money policy as long as the economy is recovering.

Monetarists take a different view. They argue that inflation is too much money chasing too few goods. The monetarist framework suggests that excess money creation leads to higher inflation. They are quite worried about the Fed’s easy money policy. It is fair to mention that these critics were worried about the Fed’s policies well before the crisis. The subsequent expansion of the Fed balance sheet and the Fed’s changes in operating procedures only added to these critics’ inflation fears. Looking at Figure 1, the base explosion surrounding the crisis is undeniable. An issue of concern is whether the Fed will be able to reverse the explosion in the base when the economy returns to normal. If that is the case, the Fed will have acted just right and criticism of the Fed was unwarranted. On the other hand, if the Fed fails to withdraw the excess base fast enough, inflation will rise and the Fed would have failed. Looking at the numbers that the Fed watches (the PCE inflation rate ex-food and energy), one has to conclude that the Fed has not failed. In fact, it seems to be doing a pretty good job. The current inflation rate is well below the Fed’s widely reported 2% target range.

If things are going well according to the previous numbers, why worry? In order to answer the question we need to explain why the explosion of the monetary base has not caused a rise in the inflation rate. Our view is that MZM or transaction money reflects the interaction of demand and supply conditions while the monetary base mostly reflect the Fed’s decision or supply conditions. Hence, by comparing the growth rate of MZM to the monetary base we can make inferences as to whether there is an excess demand or supply condition. Looking at the data it is apparent that during the first decade of the new millennium, MZM grew faster than the monetary base and, thus, an excess supply condition existed (Figure 3). Not surprisingly, the inflation rate began to creep up (Figure 2). Notice that in the advent of the crisis the inflation rate declined abruptly and has remained low while at the same time the monetary base surged relative to MZM.

The explosion of the monetary base did not cause a rise in the inflation rate. Why? The answer is that during that time, credit collapsed. In the crisis aftermath, lending standards changed. Banks were unwilling to lend because they did not have capital and/or because borrowers were not credit worthy. That unwillingness to lend led to a collapse of bank created credit and given the mechanics of money and banking combined with double entry book keeping where assets and liabilities have to match, the credit collapse also resulted in a decline in both credit creation and endogenous money creation (i.e. deposits). Figure 4 illustrates the collapse in the multiplier. Now we have a simple explanation as to why the inflation rate did not surge when the Fed expanded the monetary base. In fact, one can argue that the Fed was doing a great job of providing liquidity. It was offsetting almost dollar for dollar the impact of the collapse of credit creation on the money/transaction market. The Fed provided the liquidity necessary to keep the economy going. In fact, the data shows that the Fed did it just about right, the inflation rate remained positive and we never fell to the dreaded deflation range.

The current analysis suggests that the demand for and supply shocks to money and credit markets will have different impacts on the inflation rate, price of credit (i.e. the fed funds rate) and money and credit creation. That is a mouthful, but we do need to keep track of the changes. A rising demand for money relative to its supply will, all else the same, lead to a higher money multiplier and lower inflation without impacting the real rate of returns, resulting in a similar decline in the inflation rate and the fed funds rate. On the other hand, a rise in the demand for credit will lead to a rise in the fed funds rate relative to the inflation rate. From Figures 5a and 5b, we can make retrospective inferences as to the nature of the various shocks during the past 30 years. Rising inflating during the 1970s were accompanied by a decline in the multiplier as we expected. Similarly, the fall in the inflation rate to the 2% price rule range led to an initial rise in the multiplier during the early 1980s and then stabilized. The multiplier did not begin to rise until the so called Greenspan golden years. The maestro did find the golden wand as far as inflation was concerned. The sin of the Greenspan Fed was its manipulation of the credit markets. One can see that from 1995 on, the fed funds rate, our proxy for the price of credit, rose relative to the inflation rate, our proxy for the purchasing power of money. The process culminated with the bursting of the tech bubble. A much smaller, but noticeable divergence can also be found during the events leading to the recent financial crisis.

When we get back to normalcy, the credit markets will recover and the money multiplier will rise. The question is whether the Fed will withdraw the monetary base from the economy fast enough? If the past is any guide, we doubt it. Consider the Greenspan Fed. In the events leading up to Y2K, the Fed flooded the market with base money in anticipation of Y2K. When nothing happened, it withdrew the money quite quickly. That may have helped push the economy into a mild recession. We don’t think Mr. Bernanke will risk that. So our outlook is for a repeat of the events early in the millennium. A rising multiplier led to a rise in the inflation rate. The question is how much the inflation rate will rise when that happens. That is our longer term outlook. In the mean time, the shorter term outlook is for the credit crunch to continue and we look for the inflation rate to decline in the near term.

Implications

The election of Barack Obama and the passage of the health care legislation marks a turning point in the economy. We believe that, rightly or wrongly, we are in for a long term cycle of government intervention in the economy where tax rates, regulations and the share of government provided services will steadily increase over the next several years. The only question is where that trend will take us. In our view the worst case scenario is that of Greece or California. The best case scenario is one where we approach a continental Europe type of economy and suffer a bout of Euroescelrosis. Our forecast is for the economy to grow below the long term trend for a few years. On the monetary policy front we believe that the Fed will move to dismantle what we have called the domestic price rule and will switch to a more active monetary policy focused on inflation, real GDP growth and the growth of monetary aggregates. We believe that over the long term the inflation rate will rise steadily. Given this longer term environment, we would expect the small cap stocks to outperform the larger cap stocks, the U.S. to underperform Asia and the emerging markets and, depending on how the tax rates are increased, we look for corporate debt to become relatively more attractive as a return delivery mechanism.

The transition to the longer term is a bit tricky. The fact that tax rates are going to increase suggests to us that people are going to have an incentive to accelerate income recognition. So part of the real GDP growth that we are experiencing is nothing more than the present stealing from the future. We look for next year’s real GDP growth to slow down and we expect the same for corporate profits. In addition, the passage of the health care bill with the increase on the tax rate on capital gains will further accelerate the impetus to recognize gains and increase the tax basis in order to minimize future tax liabilities. If history is a guide, we expect to see what some will call selling pressures some time during the fourth quarter. The issue is whether such selling pressure will have a negative impact on the U.S. equity market as we approach year’s end.

In the short run, the monetary side will be different than the long run outlook. The surge in economic activity and the rush to realize capital gains and to establish a higher cost basis for investments will result in an increase in the demand for MZM. This combined with a continuation of the lackluster credit creation by the banks means that the multiplier will not rise enough to provide liquidity. As a result, we look for the inflation rate to come in below the consensus. This is a big plus for fixed income instruments. But government bonds have a couple of strikes against them. One is the increasing concern about credit issues. The second one being the forecasted strong economic performance, both tend to have a negative impact on the valuation of the government bonds. In contrast, corporate bonds have a couple issues going for them. The increase in tax rates will benefit them on a relative basis. Higher capital gains and dividend tax rates and the unchanged corporate tax rate, mean that corporate debt will improve their attractiveness relative to dividends and capital gains. Finally, companies with access to credit markets and/or large cash holdings may be able to arbitrage future tax increases by issuing one time special dividends in principle equivalent to the net present value of future earnings thereby reducing the effective tax rates on those future earnings. We look for corporate bonds of these companies to outperform government bonds.

Victor A. Canto
La Jolla Economics
www.lajollaeconomics.com

If you have any questions/comments on this article feel free to email Erik Walters of La Jolla Economics at ewalters@lajollaeconomics.com.