“Continuity” At Fed, Not Best For Long-Term

October 31, 2017

The short-short list for new Fed Chair includes Janet Yellen, Fed Governor Jerome Powell and Stanford economist John Taylor, the author of the “Taylor Rule.”

Right now, Jerome Powell – a former Wall Street executive at Dillon Reed – is the runaway favorite.  Taylor and Yellen are a very distant second and third.

The Trump Administration apparently wants to put its mark on the Fed, but at the same time insure “continuity.”  After all, equities have been hitting record highs, jobs and growth are going well.  Why rock the boat?

But maybe the Fed needs some boat rocking, like both Paul Volcker and Alan Greenspan did.  Volcker stopped targeting interest rates and targeted money supply growth.  Greenspan initially focused more on inflation believing that unemployment was minimized over time if inflation was low and stable.

In Greenspan’s later years at the helm, and then under Ben Bernanke and Janet Yellen, the Fed adopted a kitchen sink approach to monetary policy.  The Fed worries about jobs, wages, equity prices, housing markets, long-term interest rates, and even inequality.  Fed regulators are now so powerful, banks manage their businesses to respond to regulators, not markets. 

The Panic of 2008, which was in part caused by Greenspan’s 1% interest rates, helped the Fed gather this new mandate to manage the economy.

Rather than accepting this broadened mandate, we think a new direction for the Fed might be best in the long-term.

The “Taylor Rule” would have avoided the inflation of the 1970s and helped avoid the 2000s housing bubble.  His rule would have allowed the Fed to lower rates sharply in the 2008 Panic, but avoided the prolonged period of super low rates ever since.

His rule would help create a modest and humble Fed, rather than a super-powerful Washington entity who some say has little accountability to elected officials.

Many worry that Taylor would jack up rates right now, but the leader of the Fed has only one vote.  A major change in Fed policy would take years of steady and patient leadership. By the time tides shifted, the “Taylor Rule” might signal even lower rates than current policy.

We don’t know who the President will pick.  But we know the current path of Fed policy will not change overnight, regardless of the next Fed Chair.  That’s fine for markets in the medium-term, but in the longer-term what’s best for the U.S. economy is not “continuity.”     

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
  

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Can We Afford a Tax Cut?

October 25, 2017

Congress took a big step last week toward enacting some sort of tax cuts and tax reform.

That big step was the US Senate passing a budget resolution creating the room for ten years of tax cuts totaling $1.5 trillion with a simple majority vote.  This procedure means there is no need to break a filibuster by getting to 60 votes.

So right about now is when self-styled “deficit hawks” will start to squawk.  They will claim the federal government simply can’t afford to boost the federal debt, which already exceeds $20 trillion, with no end in sight.

Let’s put aside the issue that between 2009-12 many of these deficit hawks were supporting new spending, when annual federal deficits were $1 trillion plus.  Let’s just take them at their word that they don’t think any policy that increases the deficit can be good for the economy.

One problem with their argument is that the $1.5 trillion is an increase in projected deficits over a span of ten years, not a definite increase in the debt.  If tax reform focuses on cutting marginal tax rates, particularly on overtaxed corporate capital and personal incomes, and can thereby generate faster economic growth, the actual loss of revenue could be substantially less than $1.5 trillion or maybe nothing at all.

The estimate of a $1.5 trillion revenue loss is based on “static” scoring, which means the budget scorekeepers on Capitol Hill make the ridiculous assumption that changes in tax policy can’t affect the growth rate of the overall economy.  Just a 1 percentage point increase in the average economic growth rate over the next ten years would reduce the deficit by $2.7 trillion, easily offsetting the supposed cost of the tax cut.

Another problem for the deficit hawks is that despite a record high federal debt, the servicing cost of the debt is still low relative to both the size of the economy and federal revenue.

Late last week, we got final numbers for Fiscal Year 2017 and net interest on the national debt was $263 billion – that’s just 1.4% of fiscal year GDP.  To put that in perspective, that’s lower than it ever was from 1974 to 2002.  The peak during that era was 3.2% of GDP in 1991.   The lowest point since 1974 was 1.2% in 2015, not far from where we are today.

The same is true for interest relative to federal revenue, which was 7.9% in Fiscal Year 2017, lower than any year from 1974 to 2013.  The high point during that era was 18.4% in 1991 and the recent low was 6.9% in 2015.  Again, we’re still pretty close to the recent low.

Yes, interest rates should move up in the years to come, but it will take several years to rollover the debt at higher interest-rate levels.  Even if interest rates went to 4% across the entire yield curve, the interest burden would remain below historical peak levels relative to GDP and tax revenue.

The US certainly has serious long-term fiscal challenges.  The US government has over-promised future generations of retirees and should ratchet back these spending promises to encourage work, saving, and investment.  Meanwhile, we need the US Treasury Department to issue longer-dated maturities like 50-year and 100-year debt to lock-in low interest rates for longer.

However, the absence of these changes should not be an obstacle to boosting economic growth by cutting tax rates and reforming the tax code.  Plow Horse economic growth is certainly better than no growth at all, but turning the economy into a thoroughbred would make it easier to handle our long-term budget challenges, not harder.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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GDP Growth Looking Good

October 17, 2017

Next week, government statisticians will release the first estimate for third quarter real GDP growth.  In spite of hurricanes, and continued negativity by conventional wisdom, we expect 2.8% growth.   

If we’re right about the third quarter, real GDP will be up 2.2% from a year ago, which is exactly equal to the growth rate since the beginning of this recovery back in 2009.  Looking at these four-quarter or eight-year growth rates, many people argue that the economy is still stuck in the mud.

But, we think looking in the rearview mirror misses positive developments.  The economy hasn’t turned into a thoroughbred, but the plowing is easier.  Regulations are being reduced, federal employment growth has slowed (even declined) and monetary policy remains extremely loose with some evidence that a more friendly business environment is lifting monetary velocity.

Early signs suggest solid near 3% growth in the fourth quarter as well.  Put it all together and we may be seeing an acceleration toward the 2.5 – 3.0% range for underlying trend economic growth.  Less government interference frees up entrepreneurship and productivity growth powered by new technology.  Yes, the Fed is starting to normalize policy and, yes, Congress can’t seem to legislate itself out of a paper bag, but fiscal and monetary policy together are still pointing toward a good environment for growth.  

Here’s how we get to 2.8% for Q3.

Consumption:  Automakers reported car and light truck sales rose at a 7.6% annual rate in Q3.  “Real” (inflation-adjusted) retail sales outside the auto sector grew at a 2% rate, and growth in services was moderate.  Our models suggest  real personal consumption of goods and services, combined, grew at a 2.3% annual rate in Q3, contributing 1.6 points to the real GDP growth rate (2.3 times the consumption share of GDP, which is 69%, equals 1.6).

Business Investment:  Looks like another quarter of growth in overall business investment in Q3, with investment in equipment growing at about a 9% annual rate, investment in intellectual property growing at a trend rate of 5%, but with commercial constriction declining for the first time this year.  Combined, it looks like they grew at a 4.9% rate, which should add 0.6 points to the real GDP growth.  (4.9 times the 13% business investment share of GDP equals 0.6).

Home Building:  Home building was likely hurt by the major storms in Q3 and should bounce back in the fourth quarter and remain on an upward trend for at least the next couple of years.  In the meantime, we anticipate a drop at a 2.6% annual rate in Q3, which would subtract from the real GDP growth rate.  (-2.6 times the home building share of GDP, which is 4%, equals -0.1).

Government:  Military spending was up in Q3 but public construction projects were soft for the quarter.  On net, we’re estimating that real government purchases were down at a 1.2% annual rate in Q3, which would subtract 0.2 points from the real GDP growth rate.  (1.2 times the government purchase share of GDP, which is 17%, equals -0.2).

Trade:  At this point, we only have trade data through August.  Based on what we’ve seen so far, it looks like net exports should subtract 0.2 points from the real GDP growth rate in Q3.  

Inventories:  We have even less information on inventories than we do on trade, but what we have so far suggests companies are stocking shelves and showrooms at a much faster pace in Q3 than they were in Q2, which should add 1.1 points to the real GDP growth rate.

More data this week – on industrial production, durable goods, trade deficits, and inventories – could change our forecast.  But, for now, we get an estimate of 2.8%.  Not bad at all. 

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
  

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Longest Recovery Ever

October 10, 2017

If the current economic expansion lasts another year and a half, it’ll be the longest on record, even surpassing the expansion of the 1990s that ended in early 2001. 

Notice how we didn’t say it’ll be the “best” expansion of all-time, just the longest; it’s not the best by a long shot.  From the recession bottom to the expansion peak, real GDP expanded 39% in the 1980s and 43% in the 1990s.  So far, eight years in, this one is only up 19%.  That’s why we’ve been calling it the Plow Horse Economy. 

Still, the length of the current expansion is pretty remarkable given how doubtful most were that it would even get started back in 2009, as well as all the predictions since then that it would end in spectacular fashion during the past eight years.

And we think the odds of going at least another 18 months are very high.  Nowhere do we see the kinds of policy shifts or imbalances that could curtail economic growth enough to throw us back in recession.

In terms of policies, tight monetary policy, a major shift toward protectionism, or large tax hikes could all hurt growth. 

In the past, tight money has usually been the key factor behind recessions.  But, for now, short-term interest rates are about 125 basis points below the yield on the 10-year Treasury, roughly 200 basis points below the growth trend in nominal GDP (real GDP growth plus inflation), and the banking system remains stuffed with excess reserves.    

Yes, President Trump has talked tough on some trade issues, but has yet to follow through in any major way compared to previous presidents.  Meanwhile, geopolitical issues regarding North Korea may limit his ability to antagonize China with the sort of protectionist policies he suggested during the presidential campaign. 

As far as tax hikes go, recent tax proposals would cut key marginal tax rates, not raise them. 

In other words, public policy isn’t going to be the source of recession anytime soon.

Meanwhile, home builders haven’t overbuilt, consumer financial obligations are still hovering near the lowest share of income since the early 1980s, and bank capital ratios are substantially higher than before the financial crisis.  Moreover, market-to-market accounting rules were tamed so that there’s less likely to be a sudden drop in monetary velocity.  

Will there be another recession?  Certainly!  It’s just very unlikely to start any time before Spring 2019, which means the current expansion looks set to become the longest on record.  And if Congress and the President get their acts together and find a way to pass tax cuts or tax reform (or both!), that should postpone the next recession even further into the future.  

Just another reason why equity investors have good reason to remain bullish.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
  

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Stocks Won

October 3, 2017

Next Monday (October 9th) will be exactly ten years from the stock market peak before the Financial Panic of 2008.

Imagine that Doctor Doom, the perceived “best analyst in the business,” told you on that night, when markets peaked, that financial authorities would allow mark-to-market accounting rules to burn the banking system to the ground, with many well-known financial firms failing or being taken over by the government.  You knew the unemployment rate was going to soar to 10% and the economy would experience the deepest recession since the 1930s.  You also knew the US would soon elect a president that would socialize much more of the health care system, raise top income tax rates, and push the Medicare tax for high income earners up by an additional 3.8%.  Finally, you knew that ten years later all of those new taxes and expanded health care policies would still be in place.

Then imagine you knew the federal debt would be more than 100% of GDP, with massive annual deficits predicted as far as the eye could see.

Then, imagine you were allowed one investment choice, a choice you had to stick to for the next ten years, through thick and thin, no reallocation allowed.  Put all your investable assets in the S&P 500, a 10-year Treasury Note, gold, oil, housing, or cash.  Pick just one of these assets and let your investment ride.

Which asset would you have picked?  Be honest!  In that environment, with that kind of foresight, right at a stock market peak, it would have been awfully tough to pick stocks.

And yet, on the basis of total return, over the last ten years, that’s the asset that did the best.  Assuming no major shift in the next week, the S&P 500 has generated a total return (capital gains plus reinvested dividends) of 7.2% per year, essentially doubling in value in ten years.

Gold did well, but lagged stocks, increasing 5.7% per year.  A 10-year Treasury Note purchased that night (now coming due), would have generated a yield of 4.7%.  Oil was a laggard, down 4.3% per year.  Home prices increased about 1% per year, on average, and “cash” averaged 0.4%, both trailing the 1.6% average gain in the consumer price index.

You might have slept better by investing in 4.7% Treasury Notes.  Certainly the volatility of stocks, and the cascade of financial news headlines predicting doom and gloom over the past ten years, wouldn’t have bothered you as much.  But you’d have fewer total assets today than if you would have kept the faith and stayed long stocks.  And if you wanted to reinvest, now, for the next ten years, your rate would be roughly 2.3%.

If you knew exactly when to buy and sell each of these investments over the years, you could have done better, but no one did that and no one knew how to do that.

So, what’s our point?  You would have been better off by ignoring all those pessimists who became famous in 2008-09.  Investing in companies, and allowing world class business managers to use your money to build wealth, was once again the best investment strategy.  Ten years on, we still think that’s true.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Low Inflation Is No “Mystery”

September 27, 2017

Last week, at her press conference, Federal Reserve Chair, Janet Yellen said continued low inflation was a “mystery.”

She’s referring to Quantitative Easing (QE) and the lack of the economic evidence that it worked.  The Fed bought $3.5 trillion of bonds with money it created out of thin air in an extraordinary “experiment” to avoid repeating the mistakes of the deflationary Great Depression.  Milton Friedman was the leading scholar in this arena, proving the damage done by a shrinking money supply during the 1930s.

The money supply is a “demand-side” economic tool.  A lack of money inhibits demand, while a surplus of money (more than the economy needs to grow) can cause inflation.  The idea of QE (which has been tried unfruitfully for more than a decade in Japan) was to boost “demand-side” growth.  And, yet, inflation and economic growth have both been weak.  In other words, demand did not accelerate.

So forgive us for asking, but after unprecedented expansion of banking reserves and the Fed balance sheet, with little inflation, is it really a “mystery?”  Or, is it proof of what we believed all along: QE didn’t work?

We get it.  Just the fact that the US economic recovery started in 2009 and stock prices went higher is all some need to convince themselves that QE worked.  But no one knows what would have happened without QE.

Back in 2008, even Janet Yellen knew there were problems with QE.  During a December 2008 Fed meeting, she said there were “no discernible economic effects” from Japanese QE.  Back then she was a Fed Governor and this was said during internal debates about whether to do QE.  Today she leads the Fed and bureaucracies can never admit failure.  So, the lack of inflation becomes a “mystery.”

Conventional Wisdom is so convinced that QE worked, it can’t see anything as a failure.  QE supposedly pushed up stock prices and drove down interest rates, while at the same time boosting jobs.

As for the lack of demand-side growth, the explanations are confusing.  Yellen says low inflation is a mystery, others say it’s because of new technologies, global trade, and rising productivity.  Slow real GDP growth is blamed on global trade, a Great Stagnation in productivity and the lack of investment by private companies.  QE gets credit for the things that went up, but things that didn’t are explained away, denied, or determined to be mysteries.

We have promoted an alternative narrative that agrees with the 2008 Janet Yellen – QE didn’t work.  It flooded the banking system with cash.  But instead of boosting Milton Friedman’s key money number (M2), the excess monetary base growth went into “excess reserves” – money the banks hold as deposits, but don’t lend out.  Money in the warehouse (or in this case, credits on a computer) doesn’t boost demand!  This is why real GDP and inflation (nominal GDP) never accelerated in line with monetary base growth.

The Fed boosted bank reserves, but the banks never lent out and multiplied it like they had in previous decades.  In fact, the M2 money supply (bank deposits) grew at roughly 6% since 2008, which is the same rate it grew in the second half of the 1990s.

So, why did stock prices rise and unemployment fall?  Our answer: Once changes to mark-to-market accounting brought the Panic of 2008 to an end, which was five months after QE started, entrepreneurial activity accelerated.  New technology (fracking, the cloud, Smartphones, Apps, the Genome, and 3-D printing) boosted efficiency and productivity in the private sector.  In fact, if we look back we are astounded by the new technologies that have come of age in just the past decade.  These new technologies boosted corporate profits and stock prices and, yes, the economy grew too.

The one thing that did change from the 1990s was the size of the government.  Tax rates, regulation and redistribution all went up significantly.  This weighed on the economy and real GDP growth never got back to 3.5% to 4%.

Occam’s Razor – a theory about problem solving – says, when there are competing hypothesis, the one with the “fewest assumptions” is most likely the correct one.

The Fed narrative assumes QE worked and then uses questionable economics to explain away anything that does not fit that theory.  It blames “mysterious” forces, both strong and weak productivity and claims business under-invested. We’ve never understood the weak investment argument; why would business leave opportunities on the table by not investing?

Our narrative is far simpler.  It looks at M2 growth, gives credit to entrepreneurs, and blames big government.  After all, the US economy grew rapidly before 1913 when there was no Fed, and during the 1980s and 90s, when Volcker and Greenspan were not doing QE.  And history shows that inventions boost growth, while big government and redistribution harm it.    Because it has the fewest assumptions, Occam’s Razor suggests this is the more likely hypothesis.

The Fed has never fracked a well or written an app.  We understand that government bureaucracies want to take credit for everything.  But, in spite of record-setting money printing, inflation did not rise.  Prices are measured in dollars, so if those dollars had actually entered the economy, prices in dollar terms would have gone up.  They didn’t, which clearly says that money didn’t enter the economy and QE didn’t work as advertised.

Some say that’s because the money went into financial assets, but if that was the case the P-E ratio for the S&P 500 would be through the roof.  But because earnings have risen so sharply, the P-E ratio is well within historical averages based on trailing 12-month earnings and relative to bond yields.

We also understand that entrepreneurship is a “mystery” to some people because they can’t do it.  Most people can’t change the world the way entrepreneurs can, but that doesn’t mean that by rearranging the assets of an economy in a different way, entrepreneurs don’t create new wealth.

By claiming that low inflation is a “mystery” the Fed is admitting it doesn’t understand the mechanics of QE.  Yet, it is perfectly willing to allow people to think QE is what saved the economy.  This is teaching an entire generation of young people, who in many cases don’t study economic history, that growth requires government intervention.  The only “mystery” is why they would allow this to happen. 

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
  

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Fed Preview

September 20, 2017

No one expects the Federal Reserve to raise rates at the meeting this week.  A rate change of any kind, either up or down, would be a complete stunner.  Instead, the big news on monetary policy this week is very likely to be the Federal Reserve announcing it will begin gradually trimming its balance sheet at the start of October.

The process of unwinding Quantitative Easing (QE) is going to take time, too much time in our opinion.  The Fed has said that whenever it starts, it’s going to trim the balance sheet by $10 billion a month for the first three months, $20 billion per month for the next three, and on and on until it hits a pace of $50 billion per month.  So, if it starts cutting in October it would take until about 2021 for the balance sheet to reach what we believe is a normalized level.

We think the Fed could get away with being much more aggressive about reducing the balance sheet.  We don’t think QE helped the economy in the first place; all it did was stuff the banking system full of excess reserves that the banks didn’t lend.

However, the Fed is cautious by nature; it hates getting blamed when anything goes wrong.  Think about it from their perspective:  Let’s say they were more aggressive about trimming the balance sheet and suddenly the stock market had one of its inevitable corrections.  No matter the actual connection to the Fed’s actions, many would blame the Fed.

Meanwhile, the Fed will also drop some hints about a potential rate hike at the end of the year.  Those hints could come from both the official statement following the meeting as well as Fed Chief Yellen’s press conference afterward, but will certainly come from the “dot plot.”

Four times a year, every member of the Fed’s Open Market Committee submits a forecast of where interest rates will be at the end of each of the next few years.  The Fed then publishes a chart showing these forecasts as anonymous “dots.”  This dot plot is used by the market to assess the likelihood of interest rate changes.

Back in June, twelve of the sixteen dots showed at least one more rate hike by the end of 2017.  Now that a September rate hike isn’t going to happen, and given the Fed’s reluctance to move at meetings without a scheduled press conference (like on November 1), the number of Fed policymakers projecting at least one rate hike is very likely fewer than twelve.  But how many fewer?  We’re guessing it’ll show something like nine or ten (still a majority!) projecting a December rate hike.

If so, that would be a relatively hawkish sign considering the investor consensus embedded in the federal funds futures market at Friday’s close showed a slightly less than 50% chance of another rate hike this year.  That’s up from about a 20% chance a week and a half ago, but still below our view that a December rate hike has about 65% odds.

The Fed isn’t the only central bank tilting toward a less loose monetary policy.  The Bank of England (BoE) and European Central Bank (ECB) also seem determined to start trimming back on some of the aggressive measures of the past decade.  The BoE looks like it will soon move rates up after having cut them to 0.25% in the aftermath of the Brexit vote last year.  Meanwhile, the ECB will start tapering its asset purchases.  We wish the ECB would also end its experiment with negative short-term rates, but that will likely take more time.

Regardless of what happens in the near future, central banks around the world remain extremely accommodative.  None of them are remotely close to running a “tight” monetary policy.  Yes, we’ve discussed the Fed here, but for investors, at this point it’s best to ignore the noise.  Stocks are still cheap, the Fed is still loose, and the economy is still growing.  As long as there are “excess reserves” in the system, monetary policy will not threaten the recovery.  If it takes the Fed as long as we think to fully tighten, this recovery will end up being the longest ever.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Time To Drain The Fed Swamp

September 12, 2017

The Panic of 2008 was damaging in more ways than people think.  Yes, there were dramatic losses for investors and homeowners, but these markets have recovered.  What hasn’t gone back to normal is the size and scope of Washington DC, especially the Federal Reserve.  It’s time for that to change.

D.C. institutions got away with blaming the crisis on the private sector, and used this narrative to grow their influence, budgets, and size.  They also created the narrative that government saved the US economy, but that is highly questionable.

Without going too much in depth, one thing no one talks about is that Fannie Mae and Freddie Mac, at the direction of HUD, were forced to buy subprime loans in order to meet politically-driven, social policy objectives.  In 2007, they owned 76% of all subprime paper (See Peter Wallison: Hidden in Plain Sight).

At the same time, the real reason the crisis spread so rapidly and expanded so greatly was not derivatives, but mark-to-market accounting.

It wasn’t government that saved the economy.  Quantitative Easing was started in September 2008.  TARP was passed on October 3, 2008.  Yet, for the next five months markets continued to implode, the economy plummeted and private money did not flow to private banks.

On March 9, 2009, with the announcement that insanely rigid mark-to-market accounting rules would be changed, the markets stopped falling, the economy turned toward growth and private investors started investing in banks.  All this happened immediately when the accounting rule was changed.  No longer could these crazy rules wipe out bank capital by marking down asset values despite little to no change in cash flows.  Changing this rule was the key to recovery, not QE, TARP or “stress tests.”

The Fed, and supporters of government intervention, ignore all these facts.  They never address them.  Why?  First, institutions protect themselves even if it’s at the expense of the truth.  Second, human nature doesn’t like to admit mistakes.  Third, Washington DC always uses crises to grow.  Admitting that their policies haven’t worked would lead to a smaller government with less power.

The Fed has become massive.  Its balance sheet is nearly 25% of GDP.  Never before has it been this large.  And yet, the economy has grown relatively slowly.  Back in the 1980s and 1990s, with a much smaller Fed balance sheet, the economy grew far more rapidly.

So how do you drain the Fed?  By not appointing anyone that is already waiting in D.C.’s revolving door of career elites.  We need someone willing to challenge Fed and D.C. orthodoxy.  If we had our pick to fill the chair and vice chair positions (with Stanley Fischer announcing his departure) we would be focused on the likes of John Taylor, Peter Wallison, or Bill Isaac.

They would bring new blood to the Fed and hold it to account for its mistakes. It’s time for the Fed to own up and stop defending the nonsensical story that government, and not entrepreneurs, saved the US economy.  Ben Bernanke and Janet Yellen have never fracked a well or written an App.  We need a government that is willing to support the private sector and stop acting as if the “swamp” itself creates wealth.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Hurricane Economics

September 7, 2017

The hits keep coming.  Hurricane Harvey left destruction in its wake, and now, Hurricane Irma has Florida in its sights.

It’s been five years since Hurricane Sandy, nine years since Ike and twelve years since Katrina.  As with all major weather events, personal tragedy, pain, suffering, and loss are left in their wake.  We have prayed, and continue to pray, for those affected.  But at the same time, in our job as economists we look toward rebuilding and economic restoration.  This is where investors often make two different mistakes about how these massive weather events will affect the economy and markets.

Some might think that, as did Nouriel Roubini after Katrina, the damage itself will cause a recession.  Others take the opposite tack and think rebuilding efforts might actually help the economy.  Neither are correct.  By themselves, the storms will not push the economy off its Plow Horse path.

In the face of disasters, we should all be thankful for the (mostly) free markets that help the U.S. respond.  These markets allow accumulated wealth and know-how to focus on recovery.  The losses will never be fully replaced, but the sheer size and flexibility of the U.S.’s capitalist system allows resources to be shifted and directed toward recovery.  The price system makes this happen.  While some think no profit should be made from a disaster, it is those profits which allow overall “economic” recovery to occur in relatively quick order.

Some estimate that damage from Harvey could be close to the $108 billion estimate for Katrina (2005), certainly above the $75 billion cost of Hurricane Sandy (2012).

Neither of these previous storms caused a recession, and at the same time, the data show no real acceleration in growth either.   Real GDP grew 4.9% at an annual rate in the first quarter of 2006 after Katrina, but never accelerated above 3% in the first two quarters after Sandy.  For six and nine month periods before and after these storms, growth rates were similar.  In other words, it’s hard to separate the impact of Katrina or Sandy from normal statistical noise.  The U.S. grew over 4% annualized in Q1 2005 and in Q3 2014, with no major weather impact.

But even if the bump in real GDP growth in the first quarter of 2006 was due to Katrina, that doesn’t mean it was good news.  It would be what Henry Hazlitt in his book “Economics in One Lesson” called the “fallacy of the broken window” – which we recommend all investors read.

Hazlitt told a story about a vandal who broke a shopkeeper’s window, which caused a glassmaker to get an additional order.  But the shopkeeper was planning on eventually using that same money to buy a new suit, so the tailor lost an order.  In other words, even though rebuilding appears to create new economic activity, fixing things that have been destroyed actually robs an economy over time of the benefits of growth.  Repairing physical capital does not generate new wealth, it only replaces old wealth.

Before Harvey, the market consensus was that automakers would sell cars and light trucks at a 16.6 million annual rate in August.  Instead, automakers reported late on Friday that they only sold at a 16.1 million rate.  Harvey hit an area that represents about 5% of US auto demand and it did so for about 20% of August.  This suggests Harvey cut roughly 1% off of August sales nationwide, or that autos would have sold at a 16.3 million annual pace in the absence of the storm.

Automakers should make those sales back up in the next few months.  In addition, reports suggest the storms destroyed about 500,000 autos, which will also generate additional sales in the months ahead.

These sales might help make the GDP numbers look better late this year or early next year, but it just represents demand that would have eventually appeared elsewhere in other sectors.

The lesson is that these disasters, while a tragedy in so many ways, do not shift the fundamental path of the U.S. economy.  Some think socialist economies can respond better, but this is not true; markets are the most efficient system for guiding resources to areas in need.  Free people that get hit with a disaster will overcome and reach new highs, because that’s what people do when they’re free, disaster or not.  Godspeed to all those affected directly, and to those helping in recovery.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Don’t Fret DC Debt Drama

August 29, 2017

Think that title sounds familiar?  It is.  We’ve been here before.  And, as before, the “debt ceiling” is a gold mine for some politicians, journalists and analysts.  A possible government shutdown, or reaching a “hard” debt ceiling, are both fun for pessimists to talk about.

It seems to happen every couple of years and, as we’ve always said in the past, any dire warnings you’re hearing are completely overblown.

Just to make it clear up front, it’s important to recognize that a government shutdown and a debt default are not the same.  Although it’s theoretically possible for both to happen at the same time, they really are different kinds of events.

A government shutdown happens when a president and Congress fail to agree on a budget, or a “continuing resolution” – which funds government agencies until a budget is passed.

But much of government is on autopilot.  Even with no budget, taxes still get paid (unfortunately) and debt payments still get made.  The military still operates, as does Border Control and air traffic control.  “Essential” government workers still go to work and get paid.  Checks still get churned out for Social Security, Medicare, Medicaid, Food Stamps, and other entitlements.  And “non-essential” government workers usually get paid back for the time they didn’t come to work.  In other words, a government shutdown is not catastrophic.

Hitting a hard debt ceiling and missing payments to bond holders is a more serious issue.  But, it’s highly unlikely to happen and we’re confident the Treasury Department would find a way to prioritize payments.

Tax receipts are more than enough to cover debt payments; instead, Treasury can delay payment to federal government vendors.  Some liberals say delaying payments to vendors is the equivalent of a “default” but they’re just playing word games.  If this were true, Illinois would already be in “default” since it has billions of dollars of unpaid bills.

All this being said, we think in the end that the debt limit will be raised by late September.  Ideally it would include policy changes that limit future government spending, but we’re guessing that’s a hope that won’t materialize this time around, at least through the debt limit process.

After eight years of recovery, the government should be arguing about what to do with its surplus.  The real problem isn’t hitting the debt ceiling, it’s the fact that government is too darn big.  What really matters is policy changes on taxes, spending, and regulation.  The political class won’t let the money run out.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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