Sunday, December 30, 2012

Over the Fiscal Cliff and Through the Woods

Over the cliff and through the woods,
To a grand recession we go.
Congress knows the way to waste its last day,
raising taxes and adding woe.

Over the cliff and through the woods,
To a grand recession we go.
The Fed is on deck, printing money like heck,
Investors are losing dough.

Over the cliff and through the woods,
To a grand recession we go.
The Dems go their way to make the rich pay,
Republicans say no no.

Over the cliff and through the woods,
To a grand recession we go.
Where the deficit shrinks, while the jobless drink,
Eating cake is for the po'.

Happy New Year.

Wednesday, December 19, 2012

The Fiscal Cliff Negotiations: Just Who Is Barack Obama?

Recent negotiations over the fiscal cliff, which seem to be faltering after initial signs of progress, raise a persistent question about Barack Obama:  has he any political principles?  After campaigning this fall to protect the poor and middle class, he agreed in fiscal cliff negotiations to changes to the income tax structure and Social Security that are more damaging to the poor and middle class than the prosperous segments of American society.  By accepting Republican demands for the Social Security inflation adjustment to be the Chained Consumer Price Index, Obama has effectively reduced inflation protection for Social Security recipients, military retirees and federal civilian retirees, the vast majority of whom are low or middle income.  At the same time, because the same inflation adjustment would be made to income tax brackets, the brackets would rise more slowly during inflationary times.  That would effectively result in heavier taxation across the board, a seemingly regressive result.  Additionally, Obama agreed to raise the threshold for higher tax brackets from his original position of $250,000 to $400,000.  To be cynical, this might be viewed as a gift to the upper middle class professionals who often are his supporters and contributors.  And to be more cynical, it can be observed that many lower income folks, especially older whites heavily reliant on Social Security and/or military pensions, tend to be Republican more often than Democrat.  Perhaps the President sees little to lose in imposing austerity on them.

One wonders if Obama, after four years of dealing with the Great Recession, understands even the basic structure of the U.S. economy.  Our economy is 70% consumption.  Money in the hands of the poor and middle class gets spent.  They don't have enough to save hardly a penny.  This spending stimulates the economy.  Money in the hands of the upper middle and upper classes is frequently saved, allowing the rich to get richer relative to other income categories.  By raising taxes on the poor and middle class while cutting benefits to Social Security recipients, and military and federal civilian retirees, the President is reducing consumption and its stimulative impact on the economy, while exacerbating the inequality in wealth distribution.  What policy sense does this make?

During his first term, Obama demonstrated time and time again at critical junctures that he is a clever politician and dealmaker much more than a leader.  He craftily co-opted his most serious Democratic rival, Hillary Clinton, by making her secretary of state.  And he kept the liberal wing of the Democratic Party at bay by putting one of their number, Joe Biden, in the Vice President's residence.  But he has few loyal constituencies.  His one signal achievement, the Affordable Care Act, may transform life in America.  But transformational legislation doesn't necessarily bestow greatness on a President.  Lyndon Johnson's Great Society programs transformed America far more than anything Barack Obama has done or will do.  Indeed, the Voting Rights Act of 1965 enfranchised black and other disadvantaged Americans, paving the way for Obama to win the White House.  But Johnson has been denied the mantel of greatness.  While this is due in large part to his foreign policy catastrophe in Vietnam, it's also because Johnson, like Obama, was a consummate politician without any large loyal constituencies.  There's no one running around singing Johnson's praises.  Obama will always be remembered as the first nonwhite President, and there's a measure of greatness in that.  But John Kennedy was America's first non-Protestant President, and in 1960 that was an achievement not far from Obama's achievement in 2008.  Kennedy is remembered today for his charisma and charm.  But he doesn't rank among the great Presidents.  And, because Obama seems to value a deal more than principles or loyalty to constituents, neither will he. 

Wednesday, December 12, 2012

How Will the Fed Deal With Speculation on the Fed?

The Federal Reserve's historic announcement today of specific benchmarks for changes in monetary policy--no positive short term interest rates permitted until unemployment is 6.5% or lower, or inflation exceeds 2.5%--got a resounding shrug from the stock market, which closed flat.  Or maybe it wasn't a shrug, but puzzlement.  This policy takes the Fed into uncharted territory, and the truth is no one really knows what will happen next. 

One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go.  For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market.  Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to. 

Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large.  Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately.  Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck. 

With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world.  After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right).  The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited.  Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on.  The specter of systemic risk could lurk. 

If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways.  If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark).  In such an instance, the very policy that the Fed is attempting to implement could be undermined. 

But there is no practical way for the Fed to prevent benchmark betting.  Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take.  If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem. 

The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable.  That's nice theory.  But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works. 

Friday, December 7, 2012

Will Stocks Drop Over the Cliff?

The stock market has been eerily calm in spite of all the sturm und drang over the fiscal cliff.  After a brief sell-off following President Obama's re-election, the Dow Jones Industrial Average has treaded water right around the 13,000 mark.  Evidently, the market believes the anonymously leaked assurances from both the Republican and Democratic sides that a deal on the fiscal cliff will be reached.  And, rationally speaking, that should happen.  So maybe the market is justified in its equanimity.

But is it?  Looking back at the most recent comparable instance of fiscal dysfunction, the 2011 debt ceiling scrum, we find that "resolution" of the political problem was followed by a drop in the market.

The debt ceiling fight simmered until June and July 2011, when all hell broke loose and records were set for political dysfunction in Washington.  Only at the last minute, on August 2, 2011, was a deal to lift the debt ceiling finalized and approved by Congress.  The Dow, which floated around in the 12,000s during July, fell below 11,000 within a week.  One might have thought that resolution of the debt ceiling battle would produce a market rally.  But, no, just the reverse happened.

The debt ceiling fight revealed the depths of America's political dysfunction.  Standard & Poor's cut America's credit rating on August 5, 2011.  The future looked, if anything, more uncertain than before the debt ceiling crisis.  The resolution to the debt ceiling problem was to kick the can down the road, and defer confronting the government's tax and spending issues until after the November 2012 elections.  Stalling and delaying isn't the kind of thing to inspire investors.  The market's frothiness before the deal and its drop after the deal seemed like a classic case of buy on the rumor and sell on the news.

Well, that may be where we are headed today.  There are plenty of nice sounding rumors being floated by politicians who have plenty of incentive to shade the truth.  Reality is that whatever compromise the Republicans and Democrats reach on the fiscal cliff will surely be ugly.  The pie is too small to be apportioned in a way that will make many, if any, happy.  With the "resolution" to the fiscal cliff likely to make most of the nation grumpy, stocks aren't likely to be exuberant.  Whatever you do, don't bet on politics to produce investment gains.