-Caveat Lector- from: http://www.prudentbear.com/international.htm Click Here: <A HREF="http://www.prudentbear.com/international.htm"> PrudentBear.com - International Perspective - b…</A> ----- International Perspective - by Marshall Auerback Printer Friendly Version US ELECTION: ECONOMY LOSES NO MATTER WHO WINS 28 November 2000 It is has become an increasingly heard refrain amongst market pundits that “finality” and the elimination of political certainty is a more important determinant of future stock market health, than a victory for George W. Bush or Al Gore per se. Each day on CNBC countless portfolio managers and market strategists march before the cameras parroting the conventional optimism that stocks will resume their upward trajectory the moment we conclusively determine who the next President will be. Nor does the prospect of political paralysis frighten these Panglossians. Splits in the legislative branch will ensure the maintenance of the Washington gridlock that financial markets prefer, goes the argument. This line of reasoning largely assumes the status quo as far as economic policy making which, given their view of the current buoyant state of the US economy, means less scope for political activism that could undermine such prosperity. We wonder. In a recent International Perspective, we cited the example of Japan to illustrate that political gridlock can take on a much more malignant quality if it develops in the midst of a deteriorating economic environment in which more bold, pro-active policy making is required. Indeed, it has been our contention that the benign qualities ascribed to political gridlock rest on two faulty assumptions: first, that the United States economy is fundamentally sound, and, second, that the current expansion is largely unthreatened in the absence of a major change in fiscal and monetary policy (more likely in the context of political gridlock, according to this analysis). In these circumstances, the thinking goes, no new policy is good policy. We have long questioned the first assumption, instead characterising the United States as a bubble economy in which apparent prosperity has been largely fuelled by increasingly unsustainable credit expansion and record private sector debt accumulation. Given this inherently unstable condition, we have long felt it possible that a precipitating event (possibly the aftermath of the election itself) might be sufficient to engender a change in investor psychology which would begin to refocus attention on these vulnerabilities in the US economy, thereby creating a dynamic that adversely affects the economic framework in which the new administration has to operate. Columnist Jeff Madrick framed this issue very clearly in a recent New York Times report: “The presidential campaign was fought over how to distribute the spoils of prosperity, but the new president will face different economic conditions from those expected only a few months ago. The pace of economic growth is slowing significantly, and some economists are beginning to discuss the possibility of recession in 2001. The unemployment rate could rise, and the projected budget surplus could dissipate. Moreover, the record trade deficit and unusually high value of the dollar, which so many economists have brushed aside as unimportant, could well tie the hands of the nation's policy makers. The case for slower growth begins with falling stock prices and rising oil prices. Both are inhibiting consumer and corporate spending and raising the costs of doing business. But it does not end there. With individual and corporate debt so high, any slowdown in the growth of income can result in cutbacks in spending to meet debt service payments. After having invested so much in information technology, business may also be nearing the saturation point, and consumers appear to be slowing their buying of personal computers. The evidence is, of course, not conclusive, but retail sales in general, and auto sales in particular, weakened this fall; housing levelled off; capital spending slowed; and profits were disappointing at many companies, including high-technology leaders like Dell Computer.” Of course, the bulls counter, there is always Alan Greenspan, ready to cut rates at the first sign of market distress. But the sheer quantities of debt now outstanding in the US economy have rendered this instrument less effective as the cycle has matured. Aggressive monetary stimulus increasingly has had an effect akin to pumping air into a leaking tire, rather than expanding the overall economy. As Madrick notes, rate reductions had more impact when rates themselves were substantially higher, and debt levels much lower, setting off a process of substantial mortgage refinancing that provided so much buying power throughout the last decade. By contrast, Brian Reading of Lombard Associates has recently indicated that corporate debt to GDP ratios in America are now at the highest levels since 1816. Similarly, the US household sector has become so infatuated with the belief in the New Economy that it has become extremely illiquid in terms of its asset preferences. Savings are negative, and cash balances are close to record lows. Deteriorating corporate profitability, the threat of unemployment and/or a sharp fall in the stock market itself, any of these factors could trigger a sharp rise in liquidity preference, which would largely override the impact of any monetary stimulus introduced by the Federal Reserve. It is true that increased government spending would offset some of this decline in household spending and corporate investment, and government transfers via tax cuts would tend to bolster household incomes in the first instance. But it is here that the issue of gridlock and the legacy of bitterness engendered by a highly contested controversial election result (regardless of the ultimate winner) might inhibit aggressive pump priming. Normally, the first two years of a Presidential term is characterised by a burst of legislative activity, largely predicated on the view that the executive has won a national mandate from the people, thereby conferring on Congress some political obligation to implement part of his manifesto. However, regardless of who wins this time, the sheer ferocity of the conflict and lingering acrimony left in the aftermath of highly pitched legal battles will largely dissipate this traditional reservoir of goodwill for the new President; his “honeymoon” period could instead become a nightmare period. Regardless of who obtains control of the White House, we argued recently that the sheer narrowness of the Republican majority in the House, and the tie in the Senate, meant that the next set of Congressional mid-term elections would assume an almost Presidential-like importance. Is it in the vested interest of either party to co-operate with the other, given these political conditions? Let us consider the possibilities. A recession spawned by a downturn in private sector consumption and investment can be somewhat offset in the first instance by corresponding government dis-saving. In this context, the more aggressive tax cuts proposed by Governor Bush might be viewed as an approp riate policy response even if it dissipates the budget surplus. Economic circumstances might create a heightened political expectation for the government “to do something”, but it is worthwhile asking whether an embittered opposition party, the Democrats in this case, would be prepared to co-operate in the implementation of such a program, given that its success might ensure the re-election of a President whose victory (in many of their eyes) has come amidst extremely contentious circumstances AND in the absence of a majority of the national popular vote where Gore is some 300,000 votes ahead? (Historians and political scientists might argue that the Electoral College is all that matters and that the popular vote is irrelevant in such circumstances, although we doubt that such constitutional niceties will carry much weight with constituencies already inflamed by highly partisan political rhetoric.) It is also questionable whether the Democrats would countenance a tax cut whose prime beneficiaries (in their eyes) would be core Republican constituencies. Wouldn’t it be better to gear up, oppose, and try to seize control of the House and/or Senate in two years’ time? The composition of the 50/50 Senate in particular leaves ample scope for effective and highly partisan opposition to such tax cuts. (By way of historic parallel, consider the effective means by which Republicans in the Senate of 1992, also split 50/50, were able to derail Clinton’s fiscal stimulus package in the first months of his Presidency, as well as eviscerating his health care proposals later on.) A Gore Presidency would face similar, perhaps even more intractable problems, in light of the widespread conviction amongst Republican legislators that he has sought to “steal” the election (and polls indicate that this sentiment is much more prevalent amongst Republicans with respect to a Gore Presidency, than Democrats in relation to a Bush Presidency). Part of the explanation for the apparently increased rancour on the Republican side lies in the fact that for many Republicans, the current conflict is merely an extension of 8 years of bitter partisan warfare with a Democrat administration, in which the GOP has usually found itself politically outmanoeuvred – the budget battle that led to the shutdown of the government in 1995, the 1998 impeachment proceedings and, now, the Presidency itself should Gore emerge victorious. Gore himself might feel politically constrained against arguing for an aggressive tax cut when he campaigned so aggressively against the Bush proposals. But in an environment in which the pace of economic growth might well be slowing significantly, the country will require a President who can reach out to both sides of the aisle, as well as exercising the sort of political dynamism and bipartisan leadership largely lacking in the Vice President thus far. According to Madrick: “At this point, presidential leadership of a high order will be required. A nation long educated to fear federal budget deficits may resist fiscal stimulus when it is needed. The bond markets may also punish any fiscally oriented president with higher rates. The new president will have to convince the public, the financial markets, and the Federal Reserve chairman, Alan Greenspan, that fiscal stimulus is in order.” Personally we feel that Madrick overstates the problems with respect to the public, the markets, and Chairman Greenspan. In our view, it will not be so much a case of President Gore needing to exert leadership to convince the public or the financial markets, as both will likely be baying for rate cuts at the first sign of market distress, like a heroin junkie needing his next fix. Nor will the Federal Reserve Chairman require much convincing, given Greenspan’s historic and asymmetric proclivity to ease monetary policy at the first sign of trouble in the markets. But we have already highlighted the limitations in respect of further monetary ease, which is likely to be further constrained by the existence of so many foreign holders of US debt. In respect of fiscal policy, however, the potential problems of gridlock would come to the fore. Gore would have to make his case to an extremely hostile Congress many of its members who will regard his Presidency as “stolen” and who will therefore be largely committed to his political demise as expeditiously as possible. Gore’s task will be further complicated by the fact that he will have to push for such fiscal stimulus months after adamantly asserting the primacy of balancing the federal budget and paying off part of the national debt every year. At this point it is worthwhile noting that there is a body of work, the so-called Austrian school of economics, which casts doubt on the efficacy of any kind of monetary and fiscal action adopted by public sector officials in the context of a period of widespread debt liquidation and economic retrenchment. Such economists argue that market-clearing mechanisms must be allowed to function as quickly as possible, in order to purge the economy of its existing debt burdens, and that any moves by government to counteract the effects of this process of debt liquidation merely serves to prolong and exacerbate prevailing deflationary problems. Economists from this school would no doubt view any type of political gridlock in the American government, be it benign or malignant, as a positive insofar as it would frustrate the ability of activist policy makers to frustrate this debt-purging mechanism. We do not wish to turn this analysis into a debate on the relative merits of Keynes vs. Ropke or Von Mises. For our purposes here, we simply wonder how foreign investors, so crucial to the maintenance of the current buoyant state of the economy, would react in the event that the US economy became a testing ground for these competing economic theories as a consequence of government paralysis. Investors do not generally react well to political uncertainty and policy paralysis. Recently, the Japanese yen has broken out of a multi-year trading range and has started to weaken against the dollar. Japan’s deteriorating political environment and the consequent impasse between advocates of faster restructuring against those who wish to persist with massive fiscal stimulus to keep the economy afloat are the grounds cited for this recent weakness in the currency. Here, it is not a question of the markets passing considered judgements on the relative economic merits of the two competing camps: the capital has exited instantaneously as if to say, “See you later, we’ll come back when you can sort out your problems.” Is this not an equally plausible response in the event of a deteriorating American political situation in which gridlock and policy paralysis become more characteristic and more long-lasting features of the economic landscape? Might this not engender a change in overseas investor psychology? Bridgewater Associates estimates that the US economy is now absorbing roughly 70 per cent of the world’s available capital. In the aftermath of a record monthly trade deficit, the current imbalance is reaching levels that will put increasing strain on the world financial system to come up with the almost $400bn the US will require on an annualised basis. Thus far, endless analyses of “hanging chads”, “dimpled ballots”, and protracted legal disputes have been viewed by foreigners with detached bemusement and a touch of schadenfreude, not alarm. The dollar has actually strengthened marginally against the yen, sterling, the euro, and the Swiss franc indicating little in the way of foreign disenchantment yet with the entire imbroglio. But this might change in the event of protracted political conflict which calls into question the very legitimacy of the leader of the free world, and circumscribes his ability to act effectively on a national or international scale. Then bemusement could very well turn to panic as investors come to focus on long-standing imbalances in the US economy. Given the sheer size of these monthly deficits, it is not even a case of foreigners needing to SELL US dollars; all that is required for a fall in the external value is for them to BUY LESS each month as the deficits continue to accumulate. Ever increasing monthly deficits require ever increasing quantities of external savings simply to maintain the greenback’s external value against other currencies. To us, the most recent monthly trade deficit of $34.5 billion has particularly worrisome implications. Growth has picked up in both Asia and Europe from the depressed levels of 1998/99, yet contrary to many expectations made at the time, the US deficit has proved even more intractable. We recall in 1998 that a number of Wall Street commentators confidently predicted that greater growth from abroad would rekindle consumption for more American exports. But the lagged effect of a persistently strong dollar and the resultant deterioration of American trade competitiveness has more than offset any positive impact that might have been derived from stronger overseas domestic consumption. Now both Europe and Asia appear to be slowing down markedly, so it is likely that both blocs are less able to accommodate increased imports from America in the future, implying further trade deterioration. If a fall in US consumption provided yet another growth shock to these already slowing regions, the US could have the worst of all possible worlds: a slowdown in domestic consumption which sets off larger percentage declines in business inventory and fixed investment without alleviating the current account deficit. At some point, the full implications of this scenario must become alarming to foreign investors. The world will go into a slump in the aftermath of a bursting of the US credit bubble, and the US will remain saddled with its chronic deficit. Only if a recession in the US is so deep that it depresses demand at home significantly relative to weakening demand abroad, will the bursting of the US stock market bubble significantly close the current account deficit, but this will be extremely time-consuming and hardly likely to create conditions supportive of the dollar. Consider that a rise in the US savings rate from its current negative level to pre-bubble levels of disposable income of around 4% requires a contraction in US consumption equal to around 4 per cent of GDP. Except for the 1930s, that is a virtually unprecedented decline for US household sector spending. Political paralysis will simply exacerbate this problem in much the same way as it has done in Japan precisely because such gridlock might preclude the adoption of sufficient levels of government spending to offset some of the expected decline in household spending and corporate profits. We have seen recent articles suggesting that the centrist cast of the new Congress would facilitate a modicum of bipartisan compromise, thereby creating the conditions under which a raft of stimulatory legislation could be passed. Strategists and scholars who express this view suggest that the Clinton era itself has provided a vivid illustration of the legislative possibilities open to a President even when beset by scandal and doubts about his political legitimacy. But we would argue that despite America’s apparent prosperity and success during the Clinton administration, it is difficult to point to one major domestic accomplishment to the President’s credit. His welfare reform essentially co-opted the Republican proposal, and his one major social policy initiative, the promise of comprehensive national health insurance, was mishandled badly and defeated. His subsequent programs were essentially minimalist and reactive; hardly the sort that might be required had economic circumstances been more severe. Our predictions are not written in stone by any means. But we feel compelled to offer a competing interpretation of the election aftermath in light of the now prevailing conventional wisdom that financial markets will prefer the Washington gridlock that a close presidential election will bring. When finality is reached in respect of the next occupant of the White House, we have no doubt that investors will be increasingly bombarded with this optimistic spin. Perhaps against considerable odds, one of the two Presidential candidates will demonstrate as yet unseen statesmanlike qualities so as to unify the country and facilitate the operation of a successful functioning republic along bipartisan, centrist lines. But there is little evidence to support this scenario; this appears to be a case of hope trumping the existing facts as we know them. We also feel that the Clinton analogy is invalid given that the current President had the great fortune of never having to deal with a severe domestic recession. True, the “Committee to Save the World” did act in the midst of the 1998 emerging markets financial crisis to prevent these overseas problems from impinging on US shores, but consider the cost: an extension of moral hazard to as yet undefined limits (undercutting much of the criticism levelled against the emerging world by both Greenspan and Summers), the perpetuation of record corporate and household debt levels and the concomitant dissipation of private sector savings, a growing and record current account imbalance and a continuation of many of the speculative practices that continue to render the country prone to tremendous financial fragility. All that President Clinton and his “committee” did was keep the US economy on the path toward debt trap dynamics, a path whose eventual outcome grows ever worse as time passes. Political gridlock is hardly the best environment in which to summon up the best resources of the country in order to deal with the serious economic challenges that lie ahead for the United States. We believe that more and more investors are going to come to appreciate this fact in the months ahead, no matter how great is the positive spin laid out to the contrary. ----- Aloha, He'Ping, Om, Shalom, Salaam. Em Hotep, Peace Be, All My Relations. Omnia Bona Bonis, Adieu, Adios, Aloha. Amen. Roads End <A HREF="http://www.ctrl.org/">www.ctrl.org</A> DECLARATION & DISCLAIMER ========== CTRL is a discussion & informational exchange list. Proselytizing propagandic screeds are unwelcomed. Substance—not soap-boxing—please! 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