Month: February 2010

• You would be within your rights if the economic and political events over the last several months have left you puzzled and uncertain.

• Is the economy getting better or worse? Do our political leaders understand the nature of our economic distress? As a nation, are we putting our priority, resources and focus in the right areas? Have we fully thought though the implications of those areas of focus, and whether they will strengthen us or imperil us? Are they working for genuine solutions or simple political or ideological victory?
• It is hard not to feel that we are at some form of crossroads, but what is the right way out?

The State of Play – Things are Not as They Appear:

• Certainly there has been good news recently. Unemployment dropped from 10% to 9.7% in January, and the Commerce Department reported that the American economy grew by an impressive 5.7% in the last quarter of 2009, building on a 2.2% gain in the third quarter.1 News reports consistently report on economists’ conclusion that the economy came out of recession last summer.

• But the welcome news on employment is tempered by the very methods that the government counts the unemployed. In a revision of unemployment from April 2008-March 2009, the Bureau of Labor Statistics calculated that 1.4 million fewer people were on payrolls. That means that during that period there were actually 8.4 million people unemployed, not 7 million.2

• In addition, when the Bureau of Labor Statistics counts people who have been unemployed, underemployed or simply given up looking for work, unemployment exceeds 15%. That is a huge amount of slack in the labor market.

• With regard to economic growth, the third quarter figure was revised down from its original estimate of 3.5%. The fourth quarter is subject to revision as well, but it is clear that the growth was almost completely reliant on retailers restocking inventory after the long 2009 drawdown.3

• Overall, the growth and employment numbers paint a picture of stagnation, with little genuine or organic ground work for sustained, private sector growth.

• For a bigger picture consider an analysis of Gross Domestic Product (GDP) and labor productivity, which provides an interesting guide to the geometric increases in GDP that will be required to jump start the economy.

• As it turns out, job gains associated with large increases of GDP are heavily influenced by labor productivity. In a high unemployment economy, labor productivity serves as an effective deflator of GDP, requiring even greater levels of growth to compensate and increase employment.

• For instance, if GDP grows by a healthy three percent, but labor productivity increases by 1.5%, then the job creation rate is effectively 1.5%.  Under the same scenario, if the labor force increases by two percent, then there will be a net increase in unemployment.
• Consider this formula as it is applied to data from the last two years:

	2007 (Year Total)	2008 QI	QII	QIII	QIV	Year	2009 QI	QII	QIII	QIV	Year
GDP	2.1	-0.7	1.5	-2.7	-5.4	-1.8	-6.4	-0.7	2.2	5.7	0.2
Productivity	1.8	-0.1	3.1	-0.1	0.8	1.0	0.3	6.9	7.2	6.2	5.15
						(-2.8)					(-4.95)
Estimated Net Unemploy’t Impact	0.3	-0.6	-1.6	-2.6	-6.2	-2.75	-6.9	-7.6	-5.9	-0.4	-5.2
Real Unemploy’t Rate	4.6	4.9	5.3	6.0	6.9	5.8	8.2	9.3	9.6	10	9.3
% Change (Year to Year)	Base Line										+100%

*Data from the Department of Labor/BLS and the Department of Commerce/BEA

• So what do we see?

• Clearly in three of the four quarters of Obama’s first year, labor productivity effectively erased any gains in GDP, a fact which tracks with increasing unemployment through 2009, despite positive economic growth in the third and fourth quarter.

• In good economic times, increased labor productivity is a positive development, increasing efficiencies and making goods and services more competitively priced.

• In a bad economy however, productivity serves two purposes; first, to compensate for lost revenues, it serves as a tool of internal belt tightening; laying off workers and making the remainder do more with less.

• But perhaps more importantly, over a measurable period of time, it serves as a pseudo-psychological tool to evaluate the mindset of the business community with regard to the risk to and the cost of capital in replacing workers or expanding production or services.

• To that end, note that as the downturn progressed in 2008, productivity gains were mostly slight, despite falling GDP. Once possible interpretation for this could be that business leaders collectively saw that with divided government in Washington, there would be no major changes in the tax structure or policy mandates from Washington that would complicated the cost of capital in doing business.

• Now look at President Obama’s first year. Even as growth began to recover after the first quarter, the increases in productivity were exponential and sustained.  This not only responds to the depths of the economic crisis as it trickled from Wall Street to Main Street, but it is also a concrete business reaction to Obama policy initiatives under unified Democratic control of Washington.

• Said simply, the private market does not have confidence in Obama governance as an ally in organic, private sector led economic growth.

• By way of quick comparison, look at the same analysis from the Reagan years, when unemployment actually exceeded the high point so far reached by President Obama. In contrast, Reagan’s low tax/regulation paradigm created private market certainty, which led to remarkable employment results over his term.

	1981	1982	1983	1984	1985	1986	1987	1988
GDP	2.5	-1.9	4.5	7.2	4.1	3.5	3.2	4.1	3.4
Productivity	1.1	-1.1	4.4	2.0	1.6	3.1	0.3	1.6	1.6
									1.8
Estimated Net Employ’t Impact	1.4	-0.8	0.1	5.2	2.5	0.4	2.9	2.5	1.7
Unemploy’t	(7.6)	9.7	9.6	7.5	7.2	7.0	6.2	5.5
% Change									-42%

*Data from the Department of Labor/BLS and the Department of Commerce/BEA

• With that data in mind, consider the Obama 2009 Year in Review.

• It began with nearly $1 trillion in economic stimulus.  While the President is correct that a portion of the package was dedicated to individual tax credits (so that those who do not pay tax would be eligible), the “Happy Meal” tax relief, was both too small and paid in weekly paychecks instead of a lump sum, providing little benefit to the economy as recipients did not recognize the tax credit as a demonstrable increase in their disposable income.

• Beyond extension of unemployment benefits and health insurance for the unemployed, which enjoyed mostly bipartisan support, the rest of the package was a truly colossal government-to-government transfer of wealth.

• Aid to state governments hid what was effectively a massive transfer of public funds to Democrat-favored constituencies at the expense of the private sector unemployed- the public employee unions. These government workers were put first in the waterfall of federal funds to back stop states that were experiencing their own massive shortfalls and risked significant government lay-offs, as the private sector was doing.

• Remember, the President promised that if the package passed, unemployment would not go above 8.5%. The package passed a year ago, and unemployment skyrocketed to more than 10% before dipping slightly in January.

• Business confidence in the package never materialized and was rapidly joined by the skepticism of the American people, 60% of whom believed at the end of 2009 that the Stimulus had no impact or a negative impact.4

• From a regulatory point of view, the Obama administration’s breathtaking interventions in the economy proper, and its legislative plan for wholesale changes in health care, energy policy and financial reform, formed a foundation of tangible uncertainty for the business community.

• Consider the Administration’s direct intervention in auto industry, forcing arbitrary bankruptcy settlements on private shareholders in favor of reordered ownership which, again, included favored constituencies; this time the UAW.

• An infusion of $70 billion in TARP monies guaranteed de facto government ownership of two of the big three. The Administration’s intervention in the auto industry was closely followed by new CAFÉ standards for cars, issued by the EPA, which will force a crippled industry to create cars that don’t currently exist, without regard to market acceptance or cost analysis by federal diktat.

• The punitive efforts by the Administration to micromanage compensation in financial firms, first in those companies accepting TARP monies and then more broadly in the financial sector, was a disturbing departure from past government practice, and found voice at the end of the year with the Administration proposing a new tax on the still fragile financial industry to pay for the TARP bailout.

• That the tax will fall most heavily on those firms which have already paid back their TARP loans with interest – and not the firms that still owe tens of billions (including the auto industry) does not dampen Democrat enthusiasm for a revenue generation mechanism that happily punishes the wealthy and wealth creation.

• And though they did not pass Congress in his first year, Obama-sponsored legislation on health care and energy policy – his Cap N’ Trade plan were equally dire for business.

• In the pending, final compromise on health care, there are an array of personal and business mandates and increased taxes and penalties that impact not just the health care sector of insurance and pharmaceutical companies, but each American and most every business.  It creates new bureaucracies with sobering and arbitrary powers to regulate the cost of providing medical care, unleashing government investigative units to probe “unfair” or “anti-competitive” pricing by the government’s definition.

• Consider, as a business owner or investor, would you want to put capital at risk where the costs and penalties were extreme?  More specifically, with taxes levied on medical device manufactures, how excited are you to invest in and invent the next medical breakthrough here in the US?  Why not simply move the operation to Costa Rica?

• In Cap N’ Trade legislation, the Democrats effectively monetize carbon emissions to create the greatest direct and indirect tax in American history. If you explore, refine, produce or use fossil fuels, directly or indirectly, you will be taxed.  It is gargantuan and regressive, touching every facet of life.

• The legislation effectively defers national energy independence by ignoring the plentiful energy stores here in the United States, including clean coal, natural gas and environmentally responsible off-shore oil development. By punishing fossil fuel emitters, the legislation will force disruption, rationing and exponential price increases for existing forms of power, in the hope that commercialized, competitively priced clean technologies will eventually take their place.

• But energy literally powers economic recoveries.

• The intentional creation of scarcity by the government to promote clean technologies, which under the most optimistic forecast will have a negligible impact on the increasingly discredited existing science of climate change, is critical to businesses as they evaluate the costs of creating or expanding commerce.

• That the Obama administration has effectively tasked the EPA to implement an emissions cap system by executive fiat, as opposed to legislative action, demonstrates the extent to which the Democrats and the Administration will go to fulfill an ideological agenda.

• In sum, during the first year, Team Obama and the Democrats have provided the private sector with little if any confidence that is the life blood of a sustained, private market, economic expansion. The productivity numbers for the first year simply bear it out.

• But even in an adverse and uncertain policy environment, the business cycle will eventually force a nascent if suppressed spurt of growth.

• Having absorbed the intrusions of government in 2009, and seen signature legislation fall on the shoals of general public discontent, what structural challenges are ahead for the US in 2010?

• In fact, there are two disturbing developments that are intertwined with potentially cascading impacts that will further disrupt the business cycle.

• Foreclosure Crisis II

• • Nationally, 13.3% of mortgages are in the process of foreclosure, including 7.2 million Americans behind in payments and one million properties already repossessed.

• • Further, within the cohort of loans that were current as of 2008, the percentage of “new” serious delinquencies is 4.64%, the highest of any year analyzed.  Moreover, prime loans are deteriorating at a worse pace than subprime loans.5

• • In addition, the percentage of defaults or delinquencies on Federal Housing Administration (FHA) loans rose by 30% in 2009, to almost ten percent of FHA borrowers.  The spike portends a second foreclosure crisis this year.6

• • A fresh dimension to the pending foreclosure crisis is found in GDP measurements in commercial and residential structures. Investment in non-residential structures was down 15% in Q4 of 2009, on top of a loss of 18% in Q3.  As for residential units, investment peaked in Q3 at 18.9% with the first time home owner’s tax credit, and dropped to 5.7% in Q4, after the tax credit’s expiration.

• • In sum, people aren’t building or buying in a sustainable fashion, and those that currently own structures are struggling. The federal government is strangely conflicted, pressing banks to lend money, but insisting on conservative guidelines to hedge against future losses that all but cut out those in the most need under the current economic environment; otherwise safe credit risks that are dealing with unprecedented economic dislocation.

• State Budget Deficits

• • In FY 2010, individual states cumulatively closed $145 billion in red ink. In almost all cases, states used monies provided by the Obama Stimulus bill to plug the holes in their budgets.7

• • Now, half way through calendar year 2010, with Stimulus funds expended, states that used the Stimulus as stop-gap instead of a life line to prepare for leaner times, are having fresh “cash calls” and budget challenges. State budget officials call it the “cliff effect,” where revenues drop precipitously and deficits balloon out of any sense of proportion based on declining revenues and continued demand for increased services.

• Consider the cascade impact here. Stubborn unemployment or underemployment forces more home owners into foreclosure. That puts pressure on banks in the still-recovering financial sector that hold the mortgages, or their backstop, Freddie and Fannie.

• Foreclosure not only arbitrarily revalues the foreclosed property, but it also has a “knock on” effect that devalues the properties that abut the foreclosures in neighborhoods nationwide, placing additional homeowners at risk as home values with sinking values.

• And as this vicious cycle continues, it places states and municipalities that rely on property taxes for revenue even further at risk, unable to provide basic services.

• Where does it stop?

• All roads lead back to a place where Washington is not focused; the nexus between Wall Street and Main Street which was sealed when mortgages were securitized as debt instruments, their value not calculated individually, but in tranches of quality, collectively, which allowed for ever more lending, which pleased both Barney Frank and Goldman Sachs.

• This allowed bad debt to be priced at an artificial and faulty premium, and with the creation of exotic and untested financial instruments, created the break point for the epic crash in values experienced by both Wall Street and Main Street that have still not recovered.

• Consider that we are awash in debt tied to the value of land that has depreciated precipitously; as an act of market correction, and/or as an act of unqualified borrowers, in both cases driving down the value.

• The toxic debt is stashed away; in Freddie and Fannie, freshly guaranteed in perpetuity, or on the balance sheets of government guaranteed banks, but it is toxic and it exists, serving as a burden that will continue to dog economic recovery and threaten an even starker double-dip recession.

• It has placed the very fabric of our economy at risk.

• And we are not doing anything about it.

• Yes, the Obama administration has created the Making Homes More Affordable program – out of TARP monies – but the program is widely judged as a failure for two reasons. First, it only concentrates on the highest risk mortgages, people who unfortunately should not have gotten into the homes they have now in the first place, and are at least as likely to default on the revised terms as a result.

• Second, Team Obama has not solved the riddle of how to impose stricter lending guidelines and still get more money out the door to in-need borrowers.

• Indeed, the next wave of trouble will not be with people who fell in the sub-prime category, but credit worthy borrowers who have fallen on hard times. Team Obama’s innate ideological hostility to higher income earners is frankly creating a potentially larger and steeper economic challenge when mortgage holders who have paid on time, despite plummeting home values, are now facing additional pressure due to the fallout in the job market.

• In his State of the Union, President Obama failed to identify the core problem, and essentially dressed up his priorities from 2009 in the cloth of bipartisanship and outreach for 2010.

• There was talk about potential off shore oil drilling and tax cuts for small business. But dig a bit and you see that the President focused on passage of a “jobs bill,” which is essentially the younger brother of the failed Stimulus bill from last February.  He also called for passage of health care and his Cap N’ Trade legislation, identical to his priorities from last year.

• Indeed, if the President added anything noteworthy to the economic debate in his address or in his budget submission to Congress, it was his support for the new tax on financial firms, and his long standing promise to allow the Bush tax cuts on the “wealthy” to expire. These policies violate the iron rule of economic downturns; never raise taxes in a recession.

• It is hard not to see that the continuing conundrum for Democrats is that their all-purpose elixir for problems large and small – vastly increased public spending, wealth redistribution, excessive regulation and expanded government control – hasn’t created recovery.

• More fundamentally and profoundly, it has not tackled the core problem that instigated the financial meltdown 17 months ago.

• However, through excessive federal spending, the Democrats have exacerbated and multiplied the financial challenges to the nation by threatening unsustainable national debt and the potential for ruinous inflation. According to Moody’s, even America’s stellar credit rating, core to our ability to borrow, is in potential jeopardy.

• It is hard not to conclude that we have sadly lost a year, fiddling in a variety of ideological policy experiments, while the real economy teeters.

• The fact is that there were no easy solutions in 2009; solutions that could protect all Americans from consequences. But in an effort to spare most everyone, we are now collectively and exponentially at greater risk.

• The policy tinkering from Washington, as intrusive and growth inhibiting as it is, represents only a diversion from the debt bomb, held together by a public-private Ponzi scheme, that is heading our way.

• Does anyone really believe that the corrupted health care bill or the growth inhibiting and scarcity inducing Cap N’ Trade bill will solve the financial crisis? Will a slimmed down government stimulus under a different name succeed where a much larger bill failed?

• That we have seemingly not learned from the mistakes and inaction of 2009 is a wake-up call for concerned Americans.

• A government worthy of its people?
• Not yet. By some measures, not even close.  For the team in charge, buyer’s remorse is going to be ugly in November – more so if the crisis unwinds first.