- Market Commentary -

November 4, 2010 (FinancialWire) (Investrend Forums Syndicate) (By Steven H. Reynolds) (Go to http://www.financialwire.net/?s=cmmtry for all recent commentaries.) — As a result of the collapse of our modern financial system and a severe recession, beginning in 2008, the U.S. government embarked on a wide range of stimulative policies. They included massive injections of liquidity, extremely low interest rates, tax cuts, and a series of “innovative” programs such as TARP, TALP, and QE1.

Given the magnitude of the financial and economic problems and the profound loss of confidence, however, the policies were slow to take hold. By the 4Q 2008, GDP had bottomed at -6.8% and then recovered +5.0% in the 4Q 2009. Since then, the combination of the maturing inventory build and gradual run-off of the stimulus programs brought growth down to +3.7% in the 1Q 2010 and to +1.7% in 2Q 2010. Preliminary numbers show that growth continued anemic in 3Q 2010, advancing a modest +2.0%.

As a result, fears over an impending “double dip” or a slip back into recession have filled the financial media. Dire comparisons to Japan’s lost decade were discussed.  The worry was that the massive and unprecedented stimulus programs had merely stabilized the system and that sustainable growth in the private sector would be elusive.

Despite the government’s actions, the economy is not gaining important traction. The positive, reinforcing economic loop of stimulus, consumption, production, investment, and employment, feeding back to more income and consumption, is not working.

The “virtuous circle” is broken. How can it be repaired?

The Federal Reserve’s ability to provide additional traditional assistance is hampered by the near zero level of interest rates.  The prospect of meaningful fiscal help is unlikely because of the rising levels of government deficits and debt and political paralysis.

One of the few remaining options is a QE2, which is expected to be announced on November 3. The Fed would purchase further Treasury securities, which would provide additional liquidity to the banking system and push lower the cost of credit to borrowers. The hoped for benefits of the program would include a “psychological lift”; higher asset prices with a positive wealth effect; increased economic activity; and rising exports from a decline in the value of the dollar.

With interest rates already at extremely low levels and liquidity within the banking system ample, however, the anticipated positive effects of QE2 may be small and short-lived. Currently, monetary policy is limited in addressing structural economic problems. The success of the government’s efforts is hindered by the consumption of imported consumer goods, state and local deficits absorbing stimulus funds earmarked for job creation, the real estate overhang, and deleveraging of the household sector.

Thus, a major problem confronting policymakers is the inability to accelerate the velocity of money. The objective is to get lenders to lend, borrowers to borrow, new business activity to start, and employment to rise.  No velocity, no “virtuous circle.”

The banker, with a regulator looking over his shoulder, still undefined financial regulation on his desk, and foreclosure vigilantes massing, is reluctant to be a risk-taker in his lending activity. The small businessman, with unclear healthcare mandates, prospects of rising taxes, and an anti-business pall over Washington, is slow to borrow, expand, or hire.

Not only are the positive economic effects of QE2 questionable, but the possible unintended negative side effects are real. They may include excessive and cheap liquidity causing unwanted global asset bubbles, eventual domestic inflation, a weaker dollar leading to competitive currency devaluations and a hyper-inflated Federal Reserve balance sheet.

To accelerate the current, tepid pace of economic activity, the government needs a new program to overcome the psychological and real concerns. This must be addressed at the grass-roots level.

In February 2009, President Obama signed a law creating “Build America Bonds.” They are taxable, municipal bonds with above market interest rates that are subsidized by the federal government. The funds are to be used at the local level for infrastructure projects that provide employment opportunities.

So, in February 2011, the President, with a bi-partisan pro-business initiative, should attack the unemployment dilemma head-on.  He should propose a creative way of breaking the log-jam that is stifling economic activity. A private sector solution in lieu of continued dependence on public sector largesse should be put forward.

Instead of an impotent and potentially risky QE2, why not create a series of new securities at the state level, such as “Iowa Small Business Bonds?” In each state, banks would be “encouraged” to generate a minimum amount of small business loans.  These loans would be securitized, guaranteed by the government, carry an attractive coupon, and be sold to savers and institutions.  The favorable rate and federal backing would make them attractive for income-starved investors.

The risk aversion of banks and small businesses would abate and credit would flow to those so vital to job creation. The long awaited “virtuous circle” would begin.

Source: Steven H. Reynolds, Chief Investment Officer, Craig Drill Capital.  Go to http://www.financialwire.net/2010/05/01/craigdrill-capital/ for important disclosure/disclaimer information and more about Craig Drill Capital.

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