Our steroidally challenged economy
The second in a 3-part series on the steroidization of our economy.
By Vitaliy N. Katsenelson, CFA
This presentation covers the main concepts discussed in the series and shows how we are positioning for this very different economy.
Our economy suffered severe injuries last year, and to keep it going massive amounts of steroids were and are being injected – they’re what economists call stimulus (or government intervention).
Let’s take a closer look at the extent of the steroidization (to coin a new word) of our economy, and its side effects.
I’ll focus on the US economy, but similar arguments to varying degrees are true for many countries around the world. In the US, things appear to be stabilizing and improving on the surface, but beware, there is a giant IV hooked up to the veins of the economy, through which billions of dollars are constantly being pumped in.
The stimulus is everywhere:
- To help the auto industry taxpayers were subsidizing the price of autos through the “cash for clunkers” program and thus were creating artificial demand.
- The housing market, the epicenter of this crisis, is propped up from different directions. On one side there is a buyer (it used to be the just first-time buyer, now it is any buyer) tax credit. From a different direction interest rates are kept low by the Fed’s quantitative easing, fancy econ-speak for the Federal Reserve buying long-term bonds and thus keeping long-term rates artificially low. Finally we have the (now) defunct government-controlled Fannie and Freddie, which are the mortgage market of our economy, since they account for the bulk of mortgages originated today.
- Since banks are the conduits through which the government pumps stimulus into the economy, the aforementioned government involvement in the housing market helps them generate enormous fees. In addition, profitability is boosted (at the expense of savers) by the near zero short-term interest rates, again thanks to the friendly Fed, that allows banks to earn a healthy interest-rate spread.
- Last, and certainly not least, the giant, multi-hundred-billion-dollar infrastructure projects are coming on line as you read this. Yes, steroided we are.
Now let’s look at the side effects:
- Our economy’s true, unsteroided, unstimulated performance is a lot lower than the one we observe. Though the government can spend money at a high rate for longer than one would rationally expect, stimulus is a finite endeavor that comes with a heavy price tag. In most cases the stimuli have been financed with higher future taxes and rising government debt, thus higher future interest rates.
- Steroids and stimulus share addictive properties, and the longer we take them the less effective they become; but once we’re used to them it’s hard to give them up. The $8,000 tax credit started as a temporary measure. However, the politicians found it difficult to let go, and the program was extended and supersized by providing the tax credit to anyone with the patriotic ambition to buy a house.
- Japan was on the stimulus bandwagon for more than a decade and, with the exception of its government debt-to-GDP ratio tripling, Japan has nothing to show for it. Their economy is mired in the same rut it was in when its stimulus marathon started. It had a hard time giving up stimulus because the short-term consequences were too painful. Also, Japan is proof that a low (zero) interest-rate policy loses its stimulating ability over time and turns into a death trap for the economy as leverage ratios are geared to low interest rates. Now, even a small increase in interest rates (say, from 1% to 2%) would be devastating for Japan’s economy.
- In many cases the simulative measures just accelerate future sales to an earlier date, at the taxpayer’s expense. After ”cash for clunkers” ran its course, demand for autos fell into the abyss. The same will be the fate of industries exposed to infrastructure projects.
- Finally, stimuli result in long-term damage. Politicians and central bankers have good intentions; they hope that the stimulus will tide us over the bad times and buy some time for the economy to heal itself. It’s a logical argument. For instance, as much as we hate banks to be making a lot of money today, it allows them to patch up holes in their balance sheets from past and future losses.
However, for the most part stimuli just kick the can down the road and result in higher debt and higher taxes. But the harm doesn’t stop there: stimuli cause bubbles. The fix for the 2002 recession involved interest rates staying at extremely low levels for a long time, which resulted in the housing/liquidity bubbles we’re paying for today. The present stimuli will leave us with even more serious damage somewhere down the line.
Vitaliy N. Katsenelson, CFA, is a portfolio manager and director of research at Investment Management Associates in Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007). To receive Vitaliy's future articles by e-mail, click here.
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