It’s Not What You Spend It’s The Way That You Spend It

- And That’s What (Might) Get Results.

In Summary

The Obama administration is planning to execute a $775 billion fiscal stimulus package. Much of this will be in the form of tax cuts or expenditure on rebuilding infrastructure. Although this will give a temporary boost to the economy, it is likely that the benefits will be short lived. For the program to have a more lasting effect, spending should be directed to projects that stimulate or directly increase national productive capacity.

Why I say this is….

Keynes in his "General Theory" pointed to the fact that there are inefficiencies in Adam Smith's "invisible hand" that may lead to an economy operating at less than full employment. To overcome this he recommended counter cyclical government spending.

In one of his lighter moments he suggested burying money in a coal mines and then providing government licenses to dig. He suggested that the resulting influx of people and support businesses (those selling the picks and shovels, transportation services, accommodations etc) could create a vibrant economy where none existed before. He then went on to say that if such a plan could be effective, similar results could of course be achieved with more social benefit by spending the money on social programs: roads schools hospitals, housing, etc. i.e. on building and rebuilding infrastructure.

This philosophy, government spending with the objective of increasing demand, was the main driving force behind FDR's large expenditure programs in the 1930s which were arguably effective in ultimately pulling the US out of the "Great Depression".

Similar policies today are likely to be far less effective. In the 1930's there was very little national infrastructure relative to today. The improvements in roads, in the availability of electrical power, in rail, postal services, housing, health, communications, etc, that took place under FDR's New Deal created massive opportunities for entrepreneurs to engage in new lines of business. Projects that had previously not been viable suddenly became so. Essentially, the improvements in infrastructure vastly increased the capability of the economy to produce goods and services.

Today the situation is different. The roads may be bumpy and the bridges may be rusty. But the infrastructure is already in place. Repairing roads and bridges will not significantly add to productive capacity. Unlike in the 1930s, improving the roads, piping and wiring of the country is unlikely to create a single new business opportunity - other than to those temporarily involved in the construction efforts. (A dramatic improvement in rail services could perhaps have significant benefits). In the 1930s, building a new road created the possibility of business between 2 cities. Today, road improvements give us nothing more than a smoother ride.

Some parts of our infrastructure may present a serious safety risk, and clearly it should be a priority to fix these problems. In addition, doing so will of course create a temporary boost in employment and income, and will probably restore some economic confidence. However, once the improvement program is finished, we will be back where we started - admittedly with less bumpy roads and safer bridges.

Japan has implemented a number of fiscal stimulus packages over the last 2 decades. This seems to have resulted in little success in ending the stagnation of their economy. Most of these programs have focused on infrastructure development, comprising the usual suspects – roads, bridges, airports, and of course the bullet train system. However, by the mid 1980s Japan already had a very effective transportation and road network. As a result much of the spending has really just been “for its own sake” – rather than with the objective of making significant improvements in productive capacity. As one might expect, these fiscal programs have resulted in a brief blip in economic activity during and briefly following the time when the expenditures are made, subsequently falling back to previous levels.

Currently the U.S. faces serious underlying structural economic problems. The last 20 years have seen a significant decline in the manufacturing sector. The common myth is that this is not a problem as the economy has re-oriented to “services”. It turns out that this re-orientation was essentially to the Financial Industry. Between 2001 and 2006 Financial Industry profits accounted 37.38% of the total of US Domestic Industry profits. Much of these profits, however, were “phantoms” resulting from increasing asset prices and are now are being given back as asset prices plunge.

In brief the U.S. has a largely a broken manufacturing system and now a broken financial services system to boot. In order to pull the economy out of this morass the U.S. will require a major re-orientation of productive efforts from the current versions of our failing Financial and Manufacturing sectors to ……something else. The difficulty is knowing exactly what that “something else” should be. The U.S. is generally recognized as the world’s most successfully entrepreneurial nation, and it should probably be left largely to the world markets and to our legions of small, middle-size and large entrepreneurs to decide what the “next big thing” or things should be.

In the short term, a fiscal stimulus program will boost economic activity and confidence, but if we want this to be more than just a “financial bridge to nowhere” it is vital that, as it was in the 1930s, much of the expenditure should be focused on projects that increase productive capacity of individuals, of the economy and that increase opportunities for entrepreneurs. Exactly what programs should be supported would require considerable research and analysis. So the following are just a few “off the cuff” thoughts for starters:

A nation wide expansion of the California Hydrogen Highway concept, creating a network of filling stations to provide hydrogen or other alternative fuels, would dramatically increase the viability of producing alternative energy vehicles; universal government paid childcare would instantly free up millions of home bound parents and allow them to join the productive work force or start small businesses;
an expansion of funds available for part time college and technical skills programs could assist in retraining the work force to meet the new demands of the changing economy; and a large expansion of grants and loans to small entrepreneurs would create incentives and opportunities to explore new areas of business.

In conclusion, a large fiscal stimulus package is probably vital to prevent further deterioration of the U.S. economy. However, if this is mainly directed towards refurbishment of existing infrastructure and other unproductive projects, the benefits will be short lived. In order for the stimulus to be the effective in truly generating long term revival, the focus should be on projects which can be expected to provide new business opportunities and improve productive capacity rather than just on spending for its own sake.

The Credit Crunch is Only a Symptom

Summary

The conventional wisdom seems to be that there is only one problem..- "the credit squeeze, sub prime crisis, the - if it wasn’t for these lousy bankers we'd all be OK problem".....this is not really true. The credit crisis is really a symptom rather than the underlying disease. The underlying problem is that the USA does not have the productive capacity to support current levels of consumption.

With the action of the European central governments, the credit crisis has eased and this will probably lead to short term rises in the stock market. Over the longer term fundamentals will re-assert themselves and I expect to see a drawn out recession and lower stock market levels in the US.

What I Mean to Say Is…..

The deal out of the EU over the weekend is pretty incredible. Essentially as I understand it all bank debt up to 5 years guaranteed by the respective governments.

Which of course means, at least in theory, that the bank credit crisis in Europe is over. Suddenly there is no reason at all for banks in the specified countries (Group of 7 less UK I believe) not to lend to each other, and this gives them funds that they can on-lend to others and therefore very significantly reduces the pressures on the US banks as well.

The plunge in the stock market has been caused by two factors:
(1) The credit crisis. The lack of available loanable funds has driven banks and corporations close to, or in some cases into, bankruptcy. As the situation worsened the probability of further bankruptcies increased – as a result (stating the obvious here) the future value of expected earnings fell - and therefore stock prices followed. If the supply of loanable funds recovers, this problem simply disappears and the so of course, if this were the only issue, the stock market should shoot right back up to its previous highs.
(2) Economic fundamentals. Many U.S. corporations are struggling because they are simply unable to find markets for their goods. The near bankruptcy of GM, for example, has nothing (or at least very little) to do with the credit squeeze, simply their revenues do not support their ongoing expenses. As more and more companies have seen falls in their earnings results this has led to a decrease in stock values – as market stock valuations are of course based on expected future streams of earnings and dividends. This second problem is not fixed, at least not directly, by an increase in the availability of loanable funds.

Over the next few days the initial and rapidly drafted statements of the G7 will probably be revised, there will be squabbling and quibbling about exactly what was meant and who will get the loan guarantees. But regardless, the credit crisis has eased – at least partially reversing the first cause cited above of the market decline. As a result I expect to see dramatic rises (even after today’s huge move) in the market over the next few days - of course with very significant volatility.

However, over the longer term the fundamental problem is that a large part of US aggregate demand for goods and services has been lost, and is unlikely to come back in the near future.

Consumer expenditure has been the driver of aggregate demand in recent years in the US. Aggregate demand also includes, corporate investment in productive capacity, government expenditure and exports. However, corporate investment demand is itself driven by current and future estimates of consumption. Government expenditures are also affected, as strong consumption expenditures result in greater levels of income and corporate profits, leading to greater tax revenues, and therefore a greater willingness of government to expand their expenditures as well.

Consumption expenditures have in turn been driven by increases in asset prices, mainly real estate, but also stock prices (the Dow rising from around 8000 at the end of 2002 to 14,000 at the end of 2007).

This filtered through in two ways. Firstly as asset prices rose, individuals and corporations felt wealthier and spent a portion of their increase in net worth, either by dipping into cash savings, or by borrowing. Secondly Wall Street generated huge phantom profits (40% of corporate US profits in recent years according to an Economist article) relying on continuously increasing real estate prices, and passed on these profits to their employees and shareholders – who also increased their consumption expenditures.

This created a temporary upward feedback cycle. Asset prices rises caused increases in consumption expenditures, resulting in increases in incomes and wealth and further willingness to purchase assets (equities and real estate) and so further pushing up asset prices.

The important point is that this was sustainable only as long as asset prices were rising. Individuals were spending at levels that they could only maintain as long as the values of their stock and property continued to rise. In many cases we know that sub prime borrowers could in fact only maintain loan payments as long as prices continued to rise. The moment that prices stopped rising therefore, demand had to fall, and that in turn lead to a reverse feedback cycle of falls in asset prices and further falls in demand. In other words there was no stable equilibrium at the top. Either asset prices were rising with high demand, or falling with low demand – which is were we are now.

When asset prices ceased to rise and started back down, suddenly collateral did not cover loan values, banks started to be squeezed, and this has of course caused the credit crunch.

Asset prices are not increasing anymore, and the recent extraordinary Wall Street profits, it turns out, also came largely from the speculative bubble in property prices, and now that this is gone we, will not see these levels of profit again in the foreseeable future. As a result, the situation is continuing to worsen as more and more people find that they have run out of scrapings at the bottom of their barrels of cash and credit. In short a huge chunk has been taken out of demand with no immediate prospect of coming back.

In addition, the illusion of profitability of the financial sector resulted in a huge diversion of capital and human capital to what in retrospect turns out to have been a largely unproductive sector for the last several years.

In summary, our current situation is an economy with considerably reduced demand levels and a large amount of our resources invested in the financial industry which is likely to see severely reduced profitability.

As a result, after the brief exuberance that the markets and the economy will certainly experience as a result of the easing of the credit crisis, I believe we will suffer a protracted period of a severe recession, reduced corporate earnings and lower stock prices.

What Next For the USA?

Few commentators seem to have focused on that fact that such a large proportion of US income and (apparent) wealth have been based on the profits of the financial industry. Now that these profits seem to have gone up in smoke it is difficult to see what will support the US economy in the future.
According to a report in the Economist, profits from the financial sector have in recent times accounted for 40% of the US total. Much of these profits turn out to have been nothing more than phantoms, effectively based on a speculative inflation in real estate and financial assets.
In the short term the financial industry has been, and will continue, to give these profits back as assets fall to lower levels. But this is not a short term problem. The economy will not bounce back as soon as the "liquidity crisis" is resolved or when housing prices stabilize. Levels of profit that we have seen in the financial industry will not be repeated in the foreseeable future.
It has long been said that the decline in US manufacturing is not a serious problem as we have become a successful "service economy" - this really just being a euphemism for surviving from profits of the financial industry.
The USA no longer has the production of goods and non-financial services to support our current living standards. As a result, the recession will be long and painful and MAY only ultimately terminated by a major re-orientation of industry.