Reality Check on the State of World Economics and Geo-Politics

Part 1: Europe

The world markets are volatile, the United States Congress broken, and Europe on the edge of a proverbial financial knife blade. The media loves those soundbites. The current market crisis does not have any new elements just new perceptions facilitated by the media and politicians. The world economy is not at a precipice and improvements have been ignored by investors' panic.

Current market turmoil is certainly blown out of proportion but however illogical the turmoil is it will have an effect on the economic and political structures of nations. The significance of market turmoil is subject to existing and established structural weakness in various world economies. This article will focus on how volatility will interact with the European zone of economic collaboration. The debt crisis in Europe has been evolving since the fall of Lehman Brothers and the focus of the new market upheaval has been directed towards the contagion of debt problems in countries such as Italy and Spain. Although Italy and Spain's debt problems should not be taken lightly there have been several developments towards a solution. In addition the specter of a new mortgage crisis in Central Europe has been entirely ignored by most market participants.

When market participants are infected with fear they will traditionally dump the riskier assets and flock to “safe” assets such as government paper or bank certificates of deposit. However, fixed income products are yielding almost nothing. Investors searching for safety have been storing their wealth by direct purchases of currency or indirectly through Electronically Traded Funds (ETF's). In Europe investors have flocked to the Swiss Franc and subsequently driven the currency much higher than the European Euro.

The Swiss banking system has long been held in high regards and Central European nations, namely Poland and Hungary, have taken home mortgages denominated by the Swiss-Franc. These mortgages have much lower rates and were very attractive to borrowers in the old Soviet-Bloc. Currently, 53 percent of mortgages in Poland and 60 percent of those in Hungary are denominated in Swiss-Francs. If the Franc continues to rise in value compared to the neighboring Euro the effect is essentially the same as a sharp interest increase of debts in Poland and Hungary. Because Poland and Hungary are part of the Euro-Zone they are at the mercy of how markets will value the Euro in relation to the Franc.

The Swiss Banking system has been buying Euro debt in an effort to stop the sharp increase in the value of its currency but it has had little effect on stopping the upward trend. On August 11th, the Swiss national bank made an announcement that they were considering a directive to peg the the Franc to the Euro. Shortly after the announcement the Franc fell 600 blips compared to the Euro but quickly regained most of that loss by the end of Friday. The Swiss find themselves in a difficult spot, if the Euro-zone continues to struggle with the debt crisis than Switzerland can not afford to attach its independent currency to a sinking ship. On the other hand, if it does not find a way to decrease its currency than its banks will surely suffer large losses due to waves of mortgage defaults in Central Europe.

The underlying issue is that the Euro-zone is at a debt crossroads but a solution has been signed that has escaped the markets. On July 24th the German Government agreed to sign as the underwriter for the newly reformed European Financial Security Facility (EFSF). The purpose of the EFSF was to provide loans to the indebted Mediterranean nations as a form of refinance. The issue the EFTF immediately faced was that the organization relied on funds from the northern and wealthier members of the Euro-zone to donate funds. Germany has the assets but giving money directly to the EFSF is politically unpalatable to German politicians who do not want to be viewed as bailing out member nations. Instead, the Germans have signed in a fashion that allows the organization to raise funds through the sale of bonds on Germany's credit rating.

This has accomplished two objectives. First, the EFSF can raise unlimited amounts of money to lend to the peripheral Euro-Zone nations at a rate far lower and on longer terms than could be issued otherwise. Second, The German population has not seen this move as a direct bailout, although that could change in the future. The catch to this whole EFSF deal is that Germany and Germany alone has the right to decide who can tap the EFSF for money. The EFSF has in effect created a central financial monetary leader and the leader of the Euro is the German State. Member nations do no have to gain permission from the European Central Bank to tap into the capital of the EFSF but member nations will have to understand that the Germans now hold the purse strings.

In all reality Germany is the only nation with the resources to save the Euro-Zone and Germany owes its economic success to the creation of the Euro-Zone. Germany decided to take responsibility and become the economic leader of Europe. The question becomes, is Europe ready to rally around Germany as it's leader?

The False Concept of Tax Cuts

There seems to be a rule of thumb among many Republicans lately that has caused me large amounts of confusion. Apparently, cutting taxes will increase government revenue when the economy improves due to the tax cuts. Republicans hold Ronald Regan up as a shining example of the success tax cuts have as economic stimulus. However, this simple explanation of success falls short of historical accuracy.

This belief of tax cuts to encourage economic growth is known as “supply side economics”. The economic theory postulates an increase of government revenue at a lower tax percentage due to a growing economy. This theory is dependent on economic expansion resulting from new tax cuts yet if an economic contraction occurs, government deficits increase drastically. This risky maneuver has backfired every time since 1980 but the belief tax cuts help the economy stems from false concepts of what has caused economic recoveries in the past thirty years.

Ronald Regan implemented supply side economics during his first year in office by cutting $39 billion from the federal budget; created a 25% tax cut over three years, and faster write-offs for capital investments. The gamble was that such a huge tax cut would shock the economy from its stagnant state and the result would be a growing economy which would cover the cost of the government tax cuts. Instead of economic expansion the country fell into a recession and a mounting federal deficit forced Regan to increase budget cuts and increase taxes.

During the recession in 1982 the Federal Reserve Chairmen Paul Volker had worked to decrease the double digit inflation and lower the double digit interest rates that were crippling the economy. When Volker’s many painful reforms started to lower inflation and interest rates the economy boomed while Regan was increasing taxes and cutting spending to handle the federal deficit. The economy flourished during Regan’s Presidency but the federal debt was growing at a frightening pace. The promised increased government revenue was not materializing.

Republicans claimed that supply side economics had created the economic boom of the 1980’s although lower inflation and lower interest rates were the real drivers of the economic expansion. This Republican propaganda spin allowed George H.W Bush to win the election in 1988, fortunately, Bush did not hold to the “Voodoo” economic policies of Regan.

President Bush felt that America could not grow and prosper with the growing federal debt. Bush pushed for more federal spending cuts but the Republican congress also wanted to cut taxes again which would have increased the deficit in 1989 to $500 billion. Instead of increasing the debt levels, Bush signed a Democratic bill that raised taxes to battle the deficit left by Regan. The Republican voters felt betrayed by Bush who had promised “no new taxes.” Bush’s political career was killed when he signed the bill. Although Bush’s broken promise cost the Republican Party the election in 1992, the tax increases halted the budget deficit and helped Bill Clinton and the conservative congress to create a large federal surplus in the 1990’s. The 1990’s saw a long economic expansion with no tax cuts, instead, low interest rates and low inflation once again spurred economic growth.

This decade of prosperity came to an end when George W. Bush won the election in 1999 and returned the political agenda to supply side economics. In his first year Bush passed a slew of new tax cuts and championed many new financial reforms focused on easing the accounting standards of large corporations. At the same time he increased welfare programs with no balancing tax increase to cover the spending. The country entered the Tec and Telecom recession which reversed the federal surplus in two years. By 2005 the country was engaged in two military conflicts while more tax cuts took place.

During this period of increasing debt levels the US economy recovered from the 2001 recession but this success was not due to the many Bush tax cuts. The new fed chairman Alan Greenspan kept interest rates artificially low to stimulate economic recovery and this was mixed with Bush’s increased mortgage spending through Fannie and Freddie Mac. The mixture led to an economic recovery which eventually caused the housing bubble burst in October of 2008. Faced with economic depression due to his tax cuts and increased mortgage borrowing, Bush passed the $700 billion TARP bill to rescue the nation’s credit markets further increasing the national debt.
By looking at the historical timeline since 1980 it seems that cutting taxes did little to stimulate the economy and increased the federal debt levels astronomically. In addition, entitlement programs such as social security, welfare, and Medicare were expanded with no tax increases to balance the new entitlement spending. Every major tax cut since 1980 happened before or during an economic contraction. Each recovery was due to a combination of lower inflation or low interest rates and not from large tax cuts.

For me to say that lower tax rates are bad for the economy would be a false statement. Lower tax rates over long time periods encourage less government spending and increases a strong and vibrant economy. That said, large tax cuts in short periods of time while increasing spending has led the large debt America has created.

America has to decide if we will pay off our debt and cut spending or cut taxes in political retaliation to a liberal president which will place a tombstone over our fiscal grave. When will America put aside our political differences and realize we have a responsibility right now to pay for our borrowing? I guarantee if we cut taxes more our nation will be forced to default before end of the decade. The discussion should not be about taxes but about entitlement spending that is bankrupting this nation. I personally choose responsible taxes and spending cuts rather than a second great depression.



Some Sources:

http://www.reagan.utexas.edu/archives/reference/reference.html
http://www.reagan.utexas.edu/archives/reference/pressketch.html
http://www.investopedia.com/terms/v/voodooeconomics.asp
http://yellowroad.wallstreetexaminer.com/blogs/files/2008/06/inflation.gif

The Financial Crisis: More than One to Blame.

The Crisis Commission started its yearlong investigation on what caused the financial collapse in the fall of 2008 and major Bank CEO’s were the first to sit in the hot seat. Members of the commission quizzed these men vigorously for several hours on the issue of leveraged grouped mortgage securities and insurance on those grouped debts. However; it seemed the commission focused little on how the crises happened and more about taxpayer vengeance on these banks. The attention on bank bonuses proved the commission is a political stunt to demonstrate to citizens of the United States action is be being taken against TARP recipients. Politicians have incentives to act in ways that are not conductive to the financial health of the country, can America find a singular cause to the crash, or do the leaders of the country need a scapegoat?

The answer is there is no one entity that caused the crash. I state that opinion not because I have a conservative agenda or enjoy the merits of unhindered capitalism but because a market as diverse as the United States’, does not fall from bad banks, evil government, or uneducated homebuyers. It took all three. In addition, we (US citizens) are not collectively responsible for what happened in 2008 and early 2009. Many were responsible with finances and refused to buy into the Adjustable Rate Mortgages (ARMS) and finance a high luxury lifestyle on borrowed money. The problem the economy has now is what role should the government take in the recovering economy?

There are many suggested answers what the government should do; conservatives want federal money rolled back, liberals want banks to pay for the crisis, the Federal Reserve wants to protect home prices, and people want more jobs. The common belief among all of these groups is the federal government can solve the many economic issues in the United States. In reality, the federal government has very little ability to handle these issues, for several reasons.

First, the federal government cannot remove the financial aid it has given over the last year. The reason is the elected officials (including conservatives) will lose in the fall elections if they cut any programs. Incentives for government officials to spend are higher than the incentive to do the correct economic action of slowly removing aid and focusing on its job of regulation. Second, adding new taxes targeting big banks will not raise money to stem government debt. The finger pointing by the White House and congress is a political stunt to try to appease angry citizens due to bank bonuses. The problem with this approach is the reason banks have the money to pay the big bonuses is directly related to the government allowing banks to barrow money for free from the treasury and then investing that money in foreign currencies.

Which brings us to a third reason the government cannot help the economy. The Federal Reserve is keeping rates at near 0% supposedly protects home prices and job creation. However, it is hard for small banks and businesses to make any money at a 0% policy, hurts responsible savers, and fixed income citizens. Big banks are making big money off 0% but the small businesses, which create most of the jobs, are having a hard time with their investments and cannot hire new employees. Lastly, people that want jobs cannot look to Washington for help because Washington cannot create 10 million jobs itself.
There is a silenced majority, of financially responsible citizens in the United States, frustrated by federal government policies. The source of this frustration stems from the fact these citizens did not barrow more then they could afford, saved their money when houses were expensive, and built balanced portfolios that survived the crash. As home prices fell, these people started to buy the now affordable houses but then the federal government dropped interest rates so low, it has held up home prices. In addition, because rates are zero, the responsible savers are no longer making money on saved assets. The question they ask is why irresponsible barrowers getting mortgage breaks for making loans they could not afford?

The government has pinned its hopes for economic success on the citizens that have spent all their borrowed money in the past. The reasons for this decision are many but are based on political calculation rather than economic success. Low rates mean three things. First, the market never fully corrected and new asset bubbles are forming quickly. Second, savers that would have become buyers, creating economic growth and new jobs, are sitting on the sidelines trying to survive in a market dominated by 0% rates. Lastly, the people at the bottom will now suffer longer because of lack of jobs, expensive homes, and rising government costs. More of the middle, will start to slip into the bottom and the gap between super rich, and the rest of us, will continue to grow. Can we point at finger at banks to make all our problems go away? No, there are far more people to blame.