Nancy Pelosi and the Dismal Science

Arguably the most interesting quote springing from our nation's capitol over the past several years was the now infamous Nancy Pelosi's remark on Obamacare:  "We have to pass the bill to find out what's in it".  Poor Nancy was ridiculed for a comment that, ironically, may have shown great insight into the inner workings of our federal government.

She's now at it again, but in a more subtle context in offering her guidance on the Fiscal Cliff.  We're paraphrasing, but it was something to the effect of "we all know what needs to be done: raise taxes, promote growth and cut spending".  We could hear the snickers from economists as this seemingly bipartisan but economically paradoxical statement was offered.  What Nancy failed to grasp is what every Econ 101 student learns, that higher taxes and lower spending do not produce growth, at least not in the short term.

The fiscal cliff, as we are calling it, is thus a choice between austerity and stimulus.  Since our fiscal stimulus cannot be paid for from revenue, it is also a choice between austerity and debt.  To avoid the cliff in its fullest sense, would therefore require postponing (yet again) the measures to which gave its rise.  This would mean reauthorizing the Bush era tax cuts, the payroll tax cut, capital gains and estate tax provisions, while kicking the can down the road further on spending cuts, by postponing the sequestration measures. 

This solution would cause the least fiscal drag in the short run.  Essentially, the fiscal cliff would be resolved with no more fanfare than the Y2K problem.  The concern, though, is that by punting our fiscal issues down the road it will magnify them in the long run, as deficits continue to spiral out of control.  The equity markets would like rally on the news, however, as many have suspected the market to be trading for quite some time more on government intervention than economic fundamentals.

The other extreme solution is to do nothing.  This would produce the greatest short term negative impact on the economy, but also slice the federal deficit in half in one-year.  This would also likely cause a deeply negative reaction in the stock market.

The argument that's ensuing in Washington, then, is between taking on some fiscal discipline in the form of higher taxes, per the Democrats' position, or in lower spending, per the Republican platform.  Our bet is that the cliff gets resolved in favor of neither.  Responsibility will give way to practicality.  Politicians despise austerity: even if they know it to be prudent, no one has ever been reelected on it.

The problem is, Nancy, you simply can't have it both ways.

The Fiscal Cliff

Ben Bernanke's ominous metaphor of a fiscal cliff to describe the pending economic contraction brought on by expiring tax cuts and mandated spending cuts has now embedded itself in the lexicon.  We've heard the beltway buzz surrounding the fiscal cliff described as "cliff diving", we've heard the cliff characterized as "more of a fiscal slope" and by one Citigroup equity strategist even as a "bungee jump".  Leave it to the ingenuity of Americans to turn a phrase.

The concern, however, is that many Americans are confusing the issues that may impact the economy in the very near term, with prudent fiscal policy in the longer term.  The markets, for their part, are largely discounting the whole affair, believing that at the 11th hour the politicians will "compromise" and, therefore, avoid the cliff.

But let's take stock as to what is on the table and what it means to compromise.  At year end, absent any political tinkering, roughly $600 billion of fiscal tightening is scheduled to trigger in the federal budget.  Approximately $100 billion of this total will come from sequestration of expenditures and the balance from the expiration of the Bush era tax cuts, the payroll tax, estate, AMT and capital gains taxes. In a word: austerity.  This is the do-nothing scenario, the dreaded fiscal cliff.

With politicians being as they are, however, the do-nothing scenario is largely discredited to the muddle-along.  Each party has drawn lines in the sand, and then another and another.  The question is what does it really mean to compromise.  The "grand bargain" as it's been discussed (there's that turning of the phrase, again) would involve the Republicans conceding to tax increases on the wealthy and Democrats agreeing to some level of spending cuts.  Should this come about, both measures will place fiscal drag on the economy, just less than the do-nothing scenario, rendering the cliff into something more of a fiscal slope.

And this is precisely our dilemma.  We all recognize that the government cannot go on endlessly racking up $1 trillion plus annual deficits, yet any measures to narrow the deficit or impose austerity, contribute to the cliff.  In the do-nothing scenario, the annual budget deficit would be cut in half in one year, but the fiscal drag on the economy would amount to as much as 4% of GDP.  This takes us then to the very nub of the problem: with the current level of federal deficit spending amounting to 8% of GDP any effort to rein in the deficit, poses a significant drag on the economy.  In essence, our economy is on life support and we are between a rock and a hard place.

Now, what's most curious about this is the Obama position.  Immediately following the election he came out swinging:  any proposals to resolve the fiscal cliff must involve higher taxes on the wealthy.  Ok, we get it.  He's Robin Hood and we're all living in the Sherwood Forest.  While this approach might hold populist appeal, it's curious in terms of its economic impact.

The CBO estimates that allowing the Bush era tax cuts to expire on the wealthy would raise approximately $42 billion per year - or roughly 4% of the budget deficit.  Four percent.  So, Obama is willing to endure $42 billion of fiscal drag because he's now preoccupied with fiscal prudence? And if it's an insignificant level of drag, at 4% of the deficit isn't it also an insignificant amount of budget savings?

It hardly sounds reasonable.  Rather, it seems Obama is searching for a grand political statement cloaked as a grand bargain.  He is saying that America is unfair.  Income disparity is unfair.  The tax system is unfair. The rich are unfair.  Capitalism is unfair.  It's all just so stinking unfair.  And we have to do something about it.  Little, but something.  Perhaps insignificant in the scheme of things, with little hope of tackling America's real economic issues, but something.  

Is the Federal Reserve Evil?

We ask this question facetiously, but with the most recent actions of the Federal Reserve Bank, the argument for nefarious activity and hidden agendas certainly increases.  It has long been speculated throughout this economic recovery that the Fed's four year policy of zero interest rates (ZIRP) and Quantitative Easing (QE) is really designed to debase the dollar and, in so doing, lessen the burden of the Federal Government in paying off the mountain of Treasury indebtedness, growing larger each day.  Commonly referred to as "monetizing" the debt or a "soft default", the argument is that paying back the Treasury debt in dollars of lesser value, forces a "haircut" on holders of the debt.

The Fed, as you might expect, vehemently denies this charge.  And, of course, Treasury Secretary Geithner is a proud proponent of a strong dollar policy (at least in speech).  But it has long been known that a strong dollar favors creditors and a weak dollar, debtors.  It's the solution of choice in most third world debt crises:  devalue the currency, diminish the debt.

Yesterday's action by the Fed to purchase an "unlimited amount of mortgage bonds", however, ratchets up the QE stakes to new bounds.  With no evidence, academic or anecdotal, that QE has had any effect whatsoever on job creation, Bernanke's argument that this new policy is designed to meet the Fed's mandate of full employment, is suspect at best, diabolical, at worst.  In his statement, Chairman Bernanke said that the Fed will continue to purchase mortgage back securities each month until there is evidence of "substantial improvement" in the labor markets. How will we know?

We think it's time for Americans to stand up and question just what the heck the Fed is up to. This much we know: last fiscal year, the Fed purchased 80% of net new Treasury debt. It then rebated 100% of the debt service the Treasury paid on those securities back to the US Treasury. That means the Government only shouldered 20% of the burden of funding the Government's huge $1.3 billion budget deficit.  Not bad.  Can you imagine if your mortgage interest was not only deductible, but if you were given an 80% direct credit?

The Fed's new plan to purchase an unlimited amount of mortgage backed debt comes suspiciously close on the heels of a recent Treasury policy directive that forces 100% of all Fannie and Freddie profits to the US Treasury. In so doing, in one stroke of the pen, the Treasury jumped ahead of Fannie and Freddie's private sector creditors and effectively nationalized the two mortgage lenders. WIth the Fed now purchasing an unlimited amount of Agency mortgages, they will undoubtedly funnel these interest payments similarly back to the GSEs (to be remitted to Treasury) or to the UST directly. In substance, the Fed has just announced that it will be monetizing Fannie and Freddie debt, in addition to direct UST debt. Lucky us, the taxpayers.

But for the Fed to take these actions under the guise of lowering unemployment, or to not make public its plans to remit the interest expense on these mortgages back to the Treasury, it is an inescapable fact that the Fed is being deceitful.

So now we return to our original question:  is the Federal Reserve Evil?

A New Democratic Party Elite?

Last night like millions of Americans, we watched the opening speeches at the Democratic National Convention:  Julian Castro, Mayor of the City of San Antonio and Michelle Obama were undeniably eloquent.  Castro was introduced by his brother, also a rising star in the party and like Julian, also a graduate of Stanford University and Harvard Law School.  This fact was mentioned several times, both in introductions and then in Julian’s speech, as it was similarly mentioned by Michelle that she was Princeton undergrad and Harvard Law.  Barack, we know, is Columbia University and Harvard Law (as well as a graduate of the elite prep school, Ponahou School in Hawaii).

This all seems kind of odd.  On the one hand, each politician emphasizes their dire poverty in upbringing in an effort to connect with the mass constituencies that they are courting for votes:  blacks, Hispanics, the middle class and the poor.  Yet at the same time, it's hard for us to associate Princeton, Harvard and Stanford with anything but the most privileged elements of American society.  So which is it, are they poor or privileged, or both at the same time?

According to the Harvard Law School website, tuition and the estimated cost of living in today’s dollars is approximately $75,000 per year.  Adjusted for inflation, it wasn’t any bargain when Michelle, Barack, or the Castro brothers attended.  Not many people can afford to send their kids to Harvard Law School and most would consider a graduate, a person of great privilege in our society.

But this is the pedigree of the new Democratic Party elite.  We were compelled to do a bit of digging to see where and when this all started. We guess with Bill Clinton, a Georgetown, Oxford and Yale Law grad. Kennedy and Roosevelt were both Harvard men, but were privileged beyond modern imagination, so our sense is that this phenomena is more recent and best traces back to Bill Clinton.  

To confirm our suspicions, we were prompted to check on other recent Democrats to see if they too were members of the society of elite university graduates:  Jimmy Carter, Georgia Southwest College and the US Naval Academy;  Lyndon Johnson, Texas State University; Harry Truman, Spalding Commercial College (dropped out).  Now, this is the stuff of the party of the common man!

But watching the DNC last night, there's an undeniable shift in the Democratic elite these days.  How well this new elite will connect with the constituencies they most desire will remain to be seen.