The Coming Storm

by Alfred Lagan - July 15, 2009

Reprinted with permission.

Years ago when our children were young we had a summer cabin on a lake in the mountains of upstate New York. Every now and then, an idyllic summer day would be interrupted by a violent storm. Typically the storm was preannounced by the sudden appearance of dark clouds that gave way to torrents of rain, deafening crashes of thunder, and dramatic flashes of lightning. The storm would pass after a while, but it occasionally would leave in its wake fallen telephone poles, downed electrical wires, and blackouts. In time, repair crews would appear on the scene and soon return things to working order.

At some point over the next two years, the United States will be threatened by the economic equivalent of a violent summer storm. How policy makers prepare for its coming – and react when it strikes – will determine the length and depth of the damage and how quickly recovery will set in.

The first five months of the new administration have seen a tectonic shift in the government's approach to recessions and involvement in the economic machinery of the country. For a host of private-sector industries deemed "too big to fail," central government planning has assumed managerial responsibility. Government influence over major portions of corporate America has been accompanied by an explosion of spending intended to keep troubled companies operating and a host of regulations designed to govern behavior of offending industries. This is all in addition to the $789 billion stimulus package, and because these corporate rescues are ongoing, they are difficult to sum up.

The case of American International Group is illustrative. AIG has received $182 billion in bailout money, more than the total capitalization of the company in 2005. Its rescue has spurred other insurance companies to obtain government financing, though their survival was never threatened. The domestic automobile industry has received $110 billion so far – with more to come, according to news sources. And yet despite this bailout, belief in General Motors as a viable, independent automobile company remains shaky. Even excluding the banks, which were the first to succumb to the financial crisis, the amounts committed to other companies via bailouts, temporary loans, or other means are massive. Numerous companies are now wards of their rich Uncle Sam.

Still to come are the financing costs of the administration's new initiatives that are now being debated in the Congress. Assuming congressional approval, the costs of the new health-care effort will be staggeringly expensive. The so-called cap-and-trade bill, an approach to carbon emissions favored by the European community, is effectively a tax levied on consumers. Not often mentioned is the need to shore up the projected deficits of the Social Security and Medicare trust funds. These, however, will be left for another day.

Speculation about the size of the growing deficit and the tax increases that are surely coming has added to the already burdened psyche of consumers and investors. There are legitimate reasons to be concerned: The Congressional Budget Office has estimated that the federal deficit will rise from 41 percent of gross domestic product at year end 2008 to 87 percent in 2020. The deficit for the current fiscal year is estimated at $2 trillion, based on optimistic assumptions for growth.

Increases in government spending via annual deficits of $2 trillion or more will ultimately result in lower sustainable growth and fewer new private sector jobs. Government deficit spending does nothing for productivity and hampers creativity and personal initiative. Ed Yardeni points out that government transfer payments to individuals have grown to over 31 percent of total wages and salaries. The rate in the mid 1960s was less than 10 percent. As more people rely on government funding for their livelihood, the burden for paying for it falls on fewer people.

The liquidity created by the Federal Reserve's attempts to revive bank lending and economic growth will have to be withdrawn at some point. Most of the liquidity is in excess reserves at banks. Excess reserves jumped from $2 billion in August 2008 to $844 billion in May. The funds are invested mainly in U.S. Treasury and Agency securities, and bank lending has remained constrained. Nevertheless, the liquidity has pushed short-term interest rates to zero and is at least partly responsible for the rise in commodity and stock prices in the first half. The excess liquidity must be removed before loan growth revives and the recovery gains traction in order to forestall a new burst of inflation. But a need for monetary restraint may clash with the government's insatiable funding needs.

Lack of spending restraint by Congress is at the heart of the current skepticism and fear, and discipline is required to restore the confidence of the financial markets. The $787 billion American Recovery and Reinvestment Act is directed largely at increases in social programs and is loaded with special interest. In reality, it is a hastily enacted and a seriously flawed bill that will provide little real stimulus and very few new jobs.

Eventually something must give. The history of congressional spending orgies is poor. The easy (and worst) option is to print the money, thereby causing serious inflation, destroying the savings of millions of retired Americans, and further damaging the dollar in international markets.

These anxieties may pass without incident. Despite current jitters, the short-term outlook for the American economy is still for recovery to get underway in the second half of the year. Production will benefit from inventory rebuilding as final sales stabilize and slowly creep up. Inflation will remain muted, as there is plenty of unused capacity to absorb any increase in production. The recent summer collapse of oil will provide a real benefit to the consumer, equivalent to an immediate tax cut.

Still, sometime in 2010 choices will have to be made affecting both monetary and fiscal policy, the goals of which may well prove politically incompatible.

Alfred A. Lagan is founder and chairman of the Congress Asset Management Company.