Economics of Equality

I believe that equality is a state of being, one in which all people are given the same opportunities to live a life that is physically, mentally or spiritually stimulating. If one person chooses to squander an opportunity while another can take advantage, then equality is served because both persons had at least the option. Inequality arises when one group of people thrive at the expense of others; whether they are marginalized due to race, gender, or otherwise is inconsequential. The logistics of control as it relates to the public and private realms is a debate that is very important, however it is one that will be left for another time. In this post, I would like to discuss an article that was written by famed economist Walter Williams: http://www.gmu.edu/departments/economics/wew/articles/08/A%20Nation%20of%20Thieves.htm

Without regurgitating the column, Mr. Williams raises some questions regarding the practice of attempting to equalize income through taxation and redistribution of money amongst citizens. This action creates disincentives for hard work and the pursuit of success in ones career. Additionally, a substantial economic burden is created when the highest income earners are taxed at ‘unfair’ rates considering these income earners contribute to the majority of personal consumption figures. In a recent interview with CNBC’s Larry Kudlow, Walt Williams described redistribution of income in a nutshell by saying that “reaching into your own pockets to help your fellow man in need is praiseworthy and laudable… reaching into somebody else’s pockets to help your fellow man is despicable and worthy of condemnation”. Stealing is stealing, whether you are a man holding up a liquor store with a gun, or you are a member of a national government. Opportunity is Equality.

It is my hope that politicians in both Canada and the United States can see the benefits of a balanced tax and budget structure. Flat personal income tax, lowered consumption and corporate tax levels and an end to double taxation of dividends and capital gains are all net positives for economic growth. These policies would benefit the local currency, standard of living for all residents and increase trade and foreign investment. Any type of revenue collection and redistribution through government is fatally flawed because of the money drain arising through ineffective program management by the government ‘middleman’. Bureaucracy and lobbying are commonplace in government and if one thing is for certain, one dollar in revenues collected for an intended social program arrive as only a fraction of their initial value. Unfortunately, this type of reform may be a long way away, because as Mr. Williams stated in the aforementioned interview, taxation and redistribution in the name of fairness “sells with people who have the politics of envy”.

This Time it's (never) Different...

July 15, 2008 seems to have thus far marked a temporary bottom in the major US stock indices. I honestly did not believe that the low put in at the time of the Bear Stearns rescue would be broken so dramatically when it was retested. It seems that the major economic event to push the markets over the edge was the concern over the financial viability of the GSE’s: Fannie Mae and Freddie Mac. However, this was not really new information; These two companies have been on regulators radar screens as having a myriad of problems that only with a set of sweeping reforms could these institutions continue operating (with confidence) as a going concern. To be an institution in corporate purgatory stuck with the task of appearing to be profitable while at the beckon call of bureaucratic legislators and lobbyists is an exercise in futility. Nevertheless, Wall Street woke up to the troubles of Fannie and Freddie and the fact that the housing downturn and credit crunch could have a long way to go before it’s all over. Thus, financial stocks and the broader market were severely beaten down to the point of ridiculousness; some of the larger financial institutions that had a very limited chance of default (further confirmed by tight CDO spreads) were trading at fractions of their book value. When this type of old news hits the market so hard (and with very heavy volume on financials) a capitulation environment of forced selling is a very real possibility. In light of this information, it is my opinion that this low point in equities will hold, unless some sort of doomsday scenario (see last weeks post) actually comes to fruition.

A lot of talk in popular financial media has been the argument concerning the current market as being in a bear or bear-cub stage. The former indicates a more pronounced size and duration of declining equity values from peak to trough. Obviously the outcome will be determined by my favorite economic indicators: jobs, inflation (monetary tax), fiscal tax policy and the ever important home and credit lending conditions. Of course, this really can only be determined once we are through it all; but until that point, speculation will remain rampant… and I will participate whole-heartedly!

I would like to turn now to the topic of inflation, as it is a troubling factor whose cause has of late been a mystery to me. As a friend and colleague at my work, Paul Tabak, pointed out to me recently “Inflation is always and everywhere a monetary phenomenon”; those are of course the words of the legendary liberal economist, the late Milton Friedman. As too much money chases too little goods, prices are bid up as inflation accelerates. Friedman advocated a slow and steady growth rate in the money supply that was tied to some formulae accounting for GDP growth (as well as other factors). The most important feature of this regimen is that a steady and predictable monetary base would provide an anchor for prices allowing businesses to make decisions based on more reliable and known pricing information. I am a great believer in this philosophy; however, careful examination of current data seems to point to contradictory causes of the current inflation position. Firstly, growth in M1 since 2006, and most importantly through the Fed’s latest easing period has shown no signs of increasing. How should one interpret easy money policy on the part of the Federal Reserve when growth in the monetary base has been stagnant? In light of this information I would tend to focus on two pieces of information that could help in uncovering inflation causality: growth in a wider measure of the money supply (such as M3), and the cost-push inflation scenario. Unfortunately the Fed no longer tracks M3, which would make it difficult to speculate how this wider money aggregate (which includes the total amount of money held by both bank and non-bank institutions) is currently behaving. Perhaps the velocity of money is consistently declining as hard commodity and inflation speculation has caused cash hoarding among the most influential institutions (thankfully, this is a topic that is outside of the realm of this blog and reserved mostly for academia).

Cost- push inflation occurs when a set of important goods (such as food and oil) increase in price while there is no close substitute for consumers. This theory has been largely debunked citing that a central bank would have to accommodate this scenario by increasing the stock of money available to the public to chase the price of these goods. Without an increase in the money supply, the price rise in these goods would simply eat up a greater proportion of spending ultimately resulting in either behavioral shifts in production or consumption or it would give rise to recessionary conditions. Since the stock of M1 has not increased during this time, inflation from this source would seem to be an unlikely occurrence. Similarly, there seems to be no hangover effects from past inflationary periods causing a wage/price spiral putting upward pressure on the price level. More to the contrary, a low level of inflation coupled with mounting data pointing towards a weak job market should put to bed any concerns over a wage effect on prices. So what are we left with??? The only thing I can surmise from this stockpile of ambiguity is that broader measures of the monetary base, such as M3, are likely to be trending upwards, which is causing a steady increase in the core level of inflation. Volatile commodity and food prices are likely to have short-term impacts on the aggregate CPI basket of goods, which should however be mitigated over time as expectations are adjusted for the price appreciation of these goods.

Inflation is a significant concern to both the economy and the health of the ongoing long-term secular bull market in US equities. Inflation is the most significant tax on growth, can be a destroyer of currencies and therefore should be of the utmost concern to policy makers at all levels of government.

Uncertain Times

Volatility has ruled as of late, now is the time to be a trader and certainly not the time to be a long-term investor who checks his portfolio on a daily basis. I still maintain that given the bottom that was put in both the financial sector and the stock market on July 15, 2008 could hold over the short to medium term and definitely provides a good entry point for a focused investor with a long time horizon. The amount of negativity, fear and panic that was felt at that time has not been seen since the dot-com bubble, making it very difficult to break that floor on anything less than horrible economic or geo-political news. Lucky for us, I may have just the thing to take the market through that low and on down to some very nasty territory….

The credit market, at this point in history, is the most important factor in determining business activity, which in turn establishes the health of the labour market. On the other side, the credit market is integral in the housing sector, which not only has an effect on personal consumption and consumer confidence, but also carries a direct link to the asset values of structured debt instruments on the books of large financial institutions. It is easy to see how the borrowing and lending environment for consumers and businesses connect the pieces of the economy and how small disruptions in that market can have large impacts on broader economic growth. I don’t want to paint a doomsday scenario, but conditions exist today that could precipitate sub-prime credit woes to spread into so-called prime and upper-tranche level assets. Both the major North American auto manufacturers, as well as credit card giant American Express, have told us lately that customer defaults on credit obligations are showing no signs of abating. Leases may become a thing of the past because the values of the asset (SUV, truck, or car) are worth substantially less at expiration, which is affecting resale values of the assets and the ability of these companies to break even on such a transaction. American Express also warned in its latest earnings release that defaults on consumer debt remain high and spending by even the most affluent of consumers has begun to curb. Auto loan and credit card receivable structured debt is a significant portion of the CDO market and if weakness extends to these assets, as it so famously has with MBS, this may spark a whole new round of asset write-downs and fears of general economic weakness. Institutional buyers of these assets, commercial banks and financing companies would most likely feel the brunt of this pain as it spreads throughout the economy.

Mortgage lending remains very tense; as the combination of tightened credit standards and heightened inflation expectations have pushed up long-term lending rates. The Fed in its statement today tried as best it could to balance the need for real inflationary concerns with a watchful eye on risks to the downside as generated in the credit market. The Fed, through it’s policy instruments, can only affect the short end of the yield curve; however, through it’s hawkish rhetoric on inflation it has the power to affect future inflationary expectations of the bond market and thus, long term yields. The only thing the Fed can do at this point is to talk tough on inflation, and be vigilant on credit lending conditions and the health of the banking system. Hopefully time will mend the credit market, at which point the Fed can concentrate it’s efforts on restoring confidence in the long-term stability of prices. If things don’t turn out so rosy, meaning credit defaults spread and inflation is again put on the backburner… the sky is the limit for commodities, inflation and an all out crappy economy.

Interestingly enough, the stock market has responded quite positively to the precipitous drop in crude oil prices as of late. However, optimism should be met with great trepidation. The initial rally in equities caused by the price drop in oil was broad in nature and on very high volume; as oil has continued to drop, volume has dried up and some sectors have stopped responding all together. I think the market realizes that the increase in commodity prices came with a loosening of monetary policy; now, no catalyst exists to bring prices down to acceptable levels, except for the recently popular (and even more fragile) ‘demand destruction’ theory. The trend in commodities, as of now, seems to be broken. However, I foresee a consolidation at some level in the near future as traders run out of reasons to sell. Now if the dollar holds this temporary bottom and gains ground against other major currencies, this may be another mechanism to press down on commodity prices in general. With the ECB and the UK central banks convening policy meeting this week, they may favour risks to economic growth as inflationary pressures seem to be taking a back seat to surprising weakness in some of the more resilient eurozone economies (ie. Germany).

I would like to end this post with a short commentary on the possibility of the U.S.A. turning red. Yes, being a ‘greenie’ (or environmentalist) is a thing of the past; the new wave in popular American politics is socialism. Let’s review some of the recent events on both the political and economic fronts: FHA bailout legislation, government rebate stimulus package, Bear Stearns bailout, provisions and increased guarantees for Fannie and Freddie, restrictions on short selling and the popular support for regulating ‘speculators’ in oil futures. Add to this list the fact that the presidential candidate leading the polls is a severe left leaning liberal who publicly states that his economic platform revolves around taxation and redistribution of income. Mr. Obama’s latest stunt aimed at appeasing voters at the expense of free market economics is to tax oil companies and give the proceeds to consumers in the form of an ‘energy rebate’. The most surprising thing is that such a radical policy of taxing a private entity to support a social agenda would likely be met with support from the middle class who are largely uneducated on the dire consequences of such an egregiously disrespectful and socially irresponsible policy. Unfortunately there is not enough space on this blog for me to discuss the buffoonery of Congress, and specifically Nancy Pilosi, to adjourn to a summer holiday without even a vote on critical energy policy issues. It is a slap in the face to the voting public for elected officials to be so unproductive and subsequently complacent in the face of a national crisis. For the last word, I will digress to the wisdom and supreme importance of the Kudlow Creed…

"We believe that free market capitalism is the best path to prosperity"!