A Little Statesmanship

We should all look to the Irish parliament (the Oireachtas in Gaelic) to see what a modicum of statesmanship looks like. The Irish Fianna Faill party is going to lose the next election largely because they didn’t stop the credit crisis from swamping the Irish economy. But, now that they are on the way out, they are at least trying to do what they think is right for the Irish state they were all elected to serve. Besides the simple fact that a lot of those parliamentarians will be back after the election, the party seems to feel a duty to the state and the population to try to mitigate the disaster that has unfolded on their watch.

The Irish government isn’t in the same boat as the Greeks or the Portuguese. They didn’t spend themselves into oblivion. Rather, Ireland is being consumed by a burst property bubble which was comparatively much larger than that felt here. The Celtic tiger had witnessed a huge revaluation of their property markets in the past decade from one of the cheapest places in Europe to buy to one of the more expensive. The debt that accompanied that explosion in property values is now hanging on the citizens, the banks and the government like a millstone.

A couple of years ago, the Irish government guaranteed all the liabilities of the leading Irish banks. This was to stop a run on those banks which would have overwhelmed them. So, having essentially nationalized the banks, Ireland was now faced with what to do with all the bad loans and other bad assets on the books of the banks. What they did was what any other government would do, they bought them and now hold them in a National Asset Management Agency (sort of like the old Resolution Trust Corp. that disposed of all the Savings and Loan’s bad assets back in the 1980’s). The next step is to rebuild the banking system with more guarantees and more capital and hope that the banks can get back to business.

So, the government of Fianna Faill agreed with the International Monetary Fund and the European Central Bank to cut spending and raise taxes and the IMF and ECB agreed to loan Ireland billions of Euros to tide them over until their economy starts growing again. The Irish Parliament is passing the needed legislation to hold up their end of the bargain. What is impressive is that many of the legislators who are not in the usual Fianna Faill coalition are also voting for it because they think it is the right thing to do for Ireland.

This is a hard pill for the Irish people to swallow. They still have a little revolutionary zeal in Ireland. Having been occupied as they see it until the 1920’s and having fought a guerilla war with Britain until the 90s in Northern Ireland, they are distrustful of multi-national agents and foreign intervention. This rescue package does not sit well with the typical Irishman. So, it takes a little guts to do what the Parliament thinks is right.

Issue of the Week

Taxes were an unresolved issue until last week, then Congressional Republicans and President Obama seemed to resolve it. They agreed to a two-year extension of the Bush tax cuts so that we aren’t raising taxes at a time of economic uncertainty (though we don’t see that much uncertainty, the powers that be seem to). Besides the tax rates for individuals, the capital gains rate will remain at current levels and the estate tax will revert to a 35% rate. That seems like a good deal for consumers, especially the richest, who will continue to not get their own ‘special’ rates.

We had long suspected that raising taxes wouldn’t play well even among more liberal Americans given the economic backdrop. There was always a solid majority of lawmakers who were willing to vote for some deal to keep rates from going up for most folks. The only real argument was about those taxpayers who make more than $200,000 or $250,000 for couples. The Democrats had pressed to let the Bush rates sunset for this group and so have their rate go to as much as 39.6% from either 33% or 35% today.

The deal includes an extension of extended unemployment benefits for another 13 months and a cut in the worker’s half of the payroll tax (FICA) by 2% from 6.2% to 4.2%.

There is the real risk that House Democrats will not allow a vote on the Obama/Republican compromise until the tax rates actually sunset. We could see the option of having to readdress all this next year. Even if the Congress makes the whole deal retroactive to January 1st and applies essentially the same deal worked-out Monday three weeks later, the delay will remind many Americans that this is not the most dependable environment for business.

Taking a page from the theatre that has become the highly partisan Congress, Democrats may just be grandstanding for their supporters, believing that a show of resistance will help win re-election a couple of years hence. Or, they may be trying to embarrass Republicans after their stunning electoral victory six weeks ago. Whatever the motive, whatever the result, one message comes through loud and clear – politics means more than governance in Washington, DC.

One of the beauties of the social sciences is that you can’t usually run controlled experiments. So, now that we have embarked on this policy, we will never know what the outcome of the alternative might have been. Maybe raising taxes on some people was the right thing to do? We’ll never know. We do however have an example in many of the European states that are now working on more austere budgets with tax increases and drastic cuts in services in order to bring their national books closer to balance. There are all sorts of ceteris paribus arguments as to why we can’t really use these other fiscal exercises as true comparisons, but it will be interesting to see what happens.

It is also interesting to note that even Lord Keynes saw the folly of giving governments massive sway in spending their way out of jams. In the last chapters of his classic “General Theory of Employment, Interest and Money” he noted the need for activist governments to cut spending and raise taxes during good times so as to pay-off the deficits run-up during recessions and prepare for their next intrusion into the economy. It seems that no politician has ever read those chapters, or at least taken them to heart.

Our own bias is for the government to largely stay out of the economy. Minimal fiscal policy initiatives may be needed from time to time, but by and large the government does a pretty bad job of most of it. It is a quiet joke among economists that once the Congress passes a jobs bill the recession must be already over. Seldom has the government ever done anything proactive about economic downturns. The actions are always reactive and tend to be really late. We’d all probably be better off if the government largely foreswore messing with the economy. It’s probably far too late to get that genie back in the bottle.

Economic News

Our trade balance shrank in October and that is a good thing. It shrank from both directions, our imports actually shrank a little but exports grew to near the highest levels on record. The weaker dollar in the fall probably helped our exports and may have impacted the imports as well. Having record oil inventories was also a big element in the equation. Trade will probably be a bigger piece of growth in the fourth quarter than had previously been thought.

Consumer sentiment rose to 74.2 from 71.6 in early December. The gain was largely driven by an improvement in the average consumer’s thoughts about current conditions. Their outlook for the future improved more modestly.

Weekly Stuff

For all the bond people in the audience, a moment of silence.

The great bond bull market that can be traced back to the end of 1981 is now over. This is according to none other than Bill Gross, who rode that bond bull for all it was worth and made one heck of a career out of it. Bonds have defied logic over the last several months despite evidence of a persistent recovery, huge supplies, some inflation and the adulation of the unlettered masses, they managed to continue to make grudging progress. No more.

The big story last week was the bloodletting in the bond market, especially Treasury bonds. The benchmark 10-year Treasury bond saw its yield rise from 3% on the nose to 3.32%. Given the mathematics of bonds that rise in rates was the counterpoint to a drop of about 3.5 percent in the price. All the new bond bulls that have emerged in the last couple of years have probably never seen the Treasuries fall so far, so fast. This may not be the end of the story either.

By our three rather loose rules of thumb for what interest rates ‘ought to be,’ rates could go quite a bit higher over the coming months. Essentially, the three ways we tend to look at bonds are: long-term rates essentially equivalent to nominal GDP growth; inflation plus about 3%; and about 150 basis points over Treasury bills. On two of the three metrics, we’re in bond market trouble. Nominal GDP over the last 12 months was right around of 4% (1.2% inflation plus 2.8% real growth). Inflation of 1.2% plus 3% equals 4.2%. And, not surprisingly 150 basis points of T-bills would be about 1.63%. So, with rates at 3.32% the path of least resistance still seems to be higher.

We don’t expect this to happen really quickly, but it might. There are all sorts of reasons that the bond bulls have for extraordinarily low interest rates that may give us pause as we mark down the bonds. We could get more dollar strength with the accompanying rise in price of all things dollar denominated. This usually comes as a response to some sort of crisis elsewhere. We could get bad news on the economy that would render the new bond bear more questionable. We could see the Fed trying mightily to keep rates low by artificial means. But, as we are won’t to say, when it comes to a race between economics and nearly anything else, economics usually wins.

Stock prices were generally higher last week in the good old USA, this despite a modestly higher dollar and generally good news in most of the rest of the world. There was real strength in the small cap end of the spectrum with gains of 2% or more. The more volatile NASDAQ gained nearly 2%. The large cap stocks of the S&P 500 and the Dow were up less.

Many foreign markets weren’t so lucky. Dollar strength offset modest gains in more European bourses. There was real weakness in many of the BRICs. Emerging markets were on edge with worries that China’s central bank (The People’s Bank of China) would raise interest rates in order to thwart inflation there. That risk passed without becoming a reality, but the anxiety was enough to clip those markets.

Foreign bond markets were generally lower and with the dollar strength were much worse in dollar terms. This situation underscores the silliness of trying to manage the dollar in real time. Ever since QE2 started, with its mandate to lower the dollar, the dollar has strengthened. The more the Fed tries to cut down the dollar’s strength, the faster it strengthens. Leave it alone and everything will be better off!

Real estate and commodities were also generally down on the week. The rising dollar cut into commodity prices and also hurt foreign real estate returns. Commodity prices were mostly lower but natural gas, copper and corn bucked the trend. Real estate prices here tended to follow bonds even though financial stocks were higher.

We have just passed the anniversary of Pearl Harbor and the sneak attack (which wasn’t supposed to be a sneak attack) that finally got the US into World War II. The parallel to the 9/11 attacks, which were supposed to be a surprise, is obvious. The difference to our minds is that the sense of violation, the fear, the hate and resolve to right this wrong, stuck with the US about nine months after 9/11 but for 4 long years in WWII.

It is hard to imagine the ‘me generation’ storming the beaches of Normandy or Okinawa. We can’t imagine the pluralistic, ‘let’s all get along’ mind-set accepting the sacrifice it would take to win a war on that scale again. Maybe we sell the new generation short, but our parents and grandparents faced these obstacles and surmounted them. There is no reason we couldn’t do it again.

The current wars in Iraq and Afghanistan are being fought by an all volunteer army (well actually mostly by Army Reservists with a few Special Forces here and there from the regular Army) and it shows. Recruitment rates have dwindled as the initial excitement after 9/11 has worn-off. As endless debate on the wars’ efficacy and strategy wear on the morale of the nation and the troops, we continue to fight to establish democratic nations in the Middle East. Just like in WWII, these are not wars of conquest or empire. Our nation was attacked and we fought back. Whether we picked the right target is another debate altogether.

But, we are getting more Europeanized as we go. Many Americans find it hard to contemplate anything really worth fighting for, unless we are individually at risk, we are not generally willing to take up arms and fight to oppose a distant threat. So, the answer to our enemies is obvious, don’t attack directly. Don’t blow up Christmas-tree lighting ceremonies in Portland, Oregon. Instead, blow-up the market at the edge of Fallujah, Iraq. You can kill Iraqis as often as you like without the US feeling like we really have to defeat you. Or, you could strike at our allies in Asia, killing Pakistani policemen or Indian parliamentarians or Korean soldiers without the US really meaning that we will help defend our allies.

Have a great week.

Karl Schroeder, RFC CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.