- Editorial Market Commentary -

March 19, 2010 (FinancialWire) (Investrend Information Syndicate) (By Dr. Albert M. Wojnilower) (Via Craig Drill Capital)  — The American economy continues in its slow and spiritless up-drift.  The world-wide turnabout from huge inventory liquidation to modest accumulation, which has produced a large rise in foreign trade, is nearly over.  After rebounding from the crisis lows of last spring, U.S. automotive sales and output are leveling off.  Construction activity of all sorts, whether private or public, residential or nonresidential, is depressed.  The only significant fresh stimulus in sight is the imminent employment of hundreds of thousands of part-time census-takers, most of whom will be laid off in a matter of months.  In sum, the outlook for real GDP growth in 2010, and probably some time beyond, remains around 2 1/2%, implying that reductions in unemployment will be slow.  And the downside risks to this modest outlook are considerable, reflecting policy inertia here and abroad.

Fiscal-policy “fatigue” from mounting budget deficits and political deadlock has overtaken many legislatures, national and local.  Nevertheless, central-government deficits remain indispensable to a revival of economic growth.  Normally, even as particular credits mature and are repaid, aggregate credit outstanding continues to grow through the extension of new loans.  These days, however, private credit and debt have continued to shrink (except for loans by financial institutions to one another).  To compensate for the lack of private credit growth, federal deficits have had to expand.  Had they not, the public’s saving would not have been recycled into new income, greatly accelerating the vicious circle of declining GDP and income.  No matter how well justified it might be for other reasons, fiscal restraint in a weak U.S. economy enlarges rather than shrinks budget deficits.

Monetary stimulus, too, as reflected in the Fed’s enlarged balance sheet, is also being questioned more openly.  In this regard, one needs to distinguish between the size of the balance sheet and its composition.  Clearly the composition of the Fed’s balance-sheet would be “cleaner” if the $1.4 trillion dollars in direct and indirect debts of “Fannie” and “Freddie” could be replaced by U.S. Treasury obligations.  Recognizing this, the Fed is to cease buying mortgage-related securities at the end of this month.  If residential mortgage rates hold essentially unchanged as this happens, which is what the Fed and the markets currently presume, it would demonstrate that Fed purchases are no longer necessary to hold mortgage rates down.  This would allow the mortgage-related securities accumulated by the Fed to be gradually retired by the debtors, to be replaced on the Fed balance sheet by ordinary Treasury securities.

Should it turn out, however, for whatever reason, that mortgage rates rise at month-end, the Fed will have to resume promptly its buying of mortgage securities, because the repercussions for the housing market and the Fed would be disastrous.  The Fed would almost certainly be punished by being deprived of its supervisory role and authority in many of its present jurisdictions.

As to the size of the Fed’s balance sheet, that can be reduced only through net asset sales.  For the most part, these are feasible only during an economic boom, when the resulting rise in interest rates and “crowding out” of private borrowers is acceptable and may actually be welcome.  Such steps, if taken now, would replicate the Fed errors of 1936-1937 which deepened and lengthened the Great Depression.  That they are even being discussed illustrates how divorced from reality some policy-makers are.  Nevertheless, despite these discussions and regardless of Chairman Bernanke’s underlying views on these matters, the troubles of the economy and political vulnerability of the Fed virtually rule out any significant short- or long-term interest rate rise in 2010.  The appointees to the vacancies on the Federal Reserve Board will be “doves” (although Senate shenanigans may stall their taking office).

Paradoxically, at the same time as many leaders of the major economic powers are urging budgetary retrenchment, they would also like personal consumption outlays in their own and other countries to grow faster.  The world shows little hesitation in paying tribute to the American empire by electing the dollar and US Treasury securities as its key monetary and financial assets.  We are taking advantage of this by running huge internal and external deficits, and foreigners do not seem to mind at all.  Indeed, they would like us to buy and invest more abroad.  None of our major trading partners is pleased when its currency rises against the dollar and some (most notably China) take measures to prevent this from happening.  The bottom line is that foreign central banks, as well as foreign oligarchs and ordinary citizens, are voluntarily adding substantially to their holdings of Treasury securities, notwithstanding the low interest rates.

The sluggishness of the U.S. economy is not a response to discipline from abroad.  It is self-inflicted.  We let finance run wild.  And yet the legislative future of financial regulation seems as muddled and uncertain as that of health care.  Countries like Australia, Canada, Israel, and Sweden, which have learned from ugly experience to compel their major financial institutions to behave like regulated public utilities, are where the economic outlook in the developed world is brightest.

In ancient Rome, the rulers, to perpetuate their reign and empire, are said to have provided the public with bread and games (circuses).  We have games aplenty, but cheap food (employment) is scarce.  Since we can’t agree to enact the stronger policies needed for faster growth and more jobs, more people will be living on the dole:  unemployment compensation and Medicaid.  Not an auspicious environment for parents and children…or the future of the empire.

Source: Craig Drill Capital (http://www.secinfo.com/$/SEC/Name.asp?X=craig+drill+capital%2C+l%2El%2Ec%2E)  

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