Coronavirus and the Economy

It’s hard to imagine all the economic impacts of the current Coronavirus crisis.  A recession – official or unofficial – seems likely.  (An official recession is defined as two consecutive quarters of declining GDP.)  If the crisis lasts for only three months, there will be a “Newtonian” surge (an equal and opposite reaction) in demand in the third quarter that will even out the economy for the year.  

Government can and should play a role in managing the economic crisis.  But what is that role and how should they play it? 

Generally speaking, there are two kinds of shocks the economy can experience: a demand shock and a supply shock.  The first occurs when consumers develop some fear – rational or irrational – about their near-term economic future.  In that case, they hold back on purchases, first of durable items like cars and appliances and then more routine purchases like clothing and eating out.  A supply shock occurs when there is some disruption in the supply of essential goods and services driving prices up dramatically.  The Arab oil embargo of the 1970’s is a good example.  

A demand shock often can be effectively dealt with by the Federal Reserve lowering interest rates thereby lowering the cost of purchasing durable goods.  Supply shocks are tougher to deal with as they may be caused by factors outside the government’s control.  Again, the Arab oil embargo serves as a good example.  

The US economy was stable at the beginning of the year.  When demand and supply are balanced, the economy is said to be at potential real output.  But the coronavirus response may cause both a demand and a supply shock simultaneously.  Demand is down because people are staying indoors affecting large purchases like cars and homes as well as routine small purchases.  A supply shock might occur if supply chains providing essential products are disrupted -- if, for example, workers cannot go to work in domestic factories.  In the case of a supply disruption prices will rise at a time when many Americans are out of work.  It is not straightforward to recover from a recession clobbered from both sides. This is the worst possible case because neither Fed action (monetary) nor Congressional action (fiscal) can maintain a supply chain or get people back to work.  So, the Fed can react or do nothing.  Lowering interest rates keeps unemployment low but raises prices causing inflation.  Doing nothing keeps inflation low at the expense of higher unemployment. So, the best government can do is try to lay some foam on the runway to ensure a soft landing.  

Many government and health officials have been praised for their candor, decisive action and leadership in this crisis.  We need the same degree of honesty about the economy.  There will be an economic disruption lasting three to six months.  We should not overreact.  Inflation and deficit spending will increase, and we shouldn’t be too worried about it in the short term.  Remember: borrowing is cheap right now.  So, let’s do what we need to do without too much handwringing. 

The Fed is doing the right thing by lowering borrowing costs for government and businesses.  Congress and the President are doing the right thing by providing stimulus for the near term.  The stimulus should be targeted to those who really need it: low income families and small businesses who don’t have the cash reserves to survive a sustained drop in demand.  

I have seen more than a few memes suggesting buying gift cards from local businesses and over tipping service staff.  These are all good measures we can take as citizens to flatten the economic curve during this crisis.  Let’s hope that government action can also flatten the curve of the health crisis.  

WHO WILL LEAD?

Why both liberals and conservatives should hate the Fed

The Federal Reserve Bank

Most people don’t wake up in the morning thinking about the Federal Reserve System, the nation’s central bank.  Frankly, I don’t either.  But, when I think about it these days, I really hate what they’ve done to our economic prospects. 

Here’s why.

The Fed’s normal tools for modulating the economy – raising or lowering short-term interest rates – have exhausted their usefulness. Lower rates should stimulate the economy by reducing the cost of borrowing. But, when the economy wasn’t growing even with zero interest, what do you do?

Quantitative Easing (QE) was intended to stimulate the economy by supporting the acquisition of financeable assets through a policy of buying bonds like Treasuries and mortgage backed securities.  These purchases on a massive scale created low long-term interest rates with a goal of supporting the acquisition of financeable assets.  And it worked!

So, why do conservatives hate the program?  Because the increased supply of money hasn’t flowed through banks to increase the available capital for businesses to invest in growth.

Many blame the banks.  However, we should remember that we’ve told banks to cease the risky practices that led to the financial crisis.  Through the Dodd-Frank financial reform, we increased oversight of their lending activities. Also, international agreements negotiated in Basel, Switzerland required banks to increase the amount of capital they retain on their balance sheets, thereby decreasing capital available for lending. 

So, we succeeded in making banks less risky but decreased the capital flowing into the economy.  In terms an economist would use, we decreased the velocity of money. 

That’s why conservatives, read business people, hate theFed’s policy.  Growth has been floundering in the 2% range.  Take away the oil and gas boom and it would be closer to 1%.

Meanwhile, liberals -- led by the head cheerleader NY Times columnist Paul Krugman – embraced these policies.  More debt, more money in the economy the better, they said.  As for conservative fears about a collapsing dollar and inflation, we have seen no evidence.  Fools they must be, right?

Well, not exactly.  Sure inflation has been low for the last several years.  However, when viewed next to other currencies, the dollar has been weak.  And, a weak dollar increases the cost of buying foreign products.  In the last year, the Fed has ceased its bond-buying program while Europe and Japan have begun theirs.  Here’s what has happened to the dollar.

Dollar Index -- 5 year chart

What about the other effects of QE? 

The financeable assets that most benefited from the Fed’s policy have been real estate and the stock market.  Coupled with a tax code that rewards asset ownership, the policy has made the rich richer.  Liberal voices have decried income inequality without raising the connection between inequality and the Fed’s policies. 

If you want to find those most hurt by the Fed’s Zero Interest Rate Policy (ZIRP), look no further than savers who rely on interest for their income.  These include not just today’s retirees needing a low risk source of income but future retirees depending upon the success of those managing their pension funds in todays’ financial environment.

Further, policies that undermine business investment reduce employment opportunities, increase income inequality and reduce tax revenue to the government, thereby reducing its ability to fund programs that help those less fortunate. 

But, there is hope.  QE is over and ZIRP may be in its last days. And, as we emerge from a period of unprecedented Fed interference in the market, the government’s deficit has been reduced.  The end of the Bush tax cuts coupled with the cap on government spending pursuant to the budget deal struck by Congress and the President in 2011 have reduced the annual deficit.

Meanwhile, the Boston Consulting Group has projected that the US will be the manufacturing site of choice in the coming years owing to lower energy and transportation costs and favorable labor policies. 

It seems that the lesson here is: keep the government’s capital out of the market and our economy will soar.

WHO WILL LEAD?

If you can't score a touchdown, move the goal post

Have you bought any food lately?  How about gas?  Have you filled up your tank?  Of course you have.  And, it’s getting a bit more expensive, isn’t it? 

Take a look at this chart of inflation over the last 70 years.

So, why do we keep hearing that inflation is under control? 

Listen carefully the next time you hear it.  They’ll say, “Core inflation excluding volatile food and fuel prices” is under control or something like that.

If you can’t score a touchdown, move the goal post. 

There’s more.  The chart above shows the Consumer Price Index (CPI) which is the measure of inflation we have all grown up with.  However, the boys and girls over at the Federal Reserve have decided to use Personal Consumption Expenditures (PCE)as a measure of inflation (starting in 2000).   Here’s how the two compare.

So, what’s the difference?  In simple terms, the CPI measures the change in prices of a fixed set of goods and services – bread, clothing, gasoline, etc.  The PCE fiddles with that calculation a bit.  For example, if you bought a new computer a few years ago for $800, you got a certain amount of processing power, memory, ports to plug stuff into and so on.  If you spend $800 today for a new computer, you would get more of all that stuff.  Or, to put it another way, buying the same processing power etc. today as you did a few years ago costs less.  PCE averages that lower cost of the same features into its index holding down this particular measure of inflation. 

The Full Employment and Balanced Growth Act of 1978 established two goals for the Federal Reserve:  reducing unemployment and reducing inflation.

If your goals included holding down inflation like the Fed Chairman, wouldn’t you prefer to use PCE?

If you can’t score a touchdown, move the goal post. 

In fairness, a lot of economists think PCE is a better measure inflation.  But, out here in the real world where the cost of gasoline and food has been moving up steadily over the past five years or so, I don’t really care what they think.

So, what should we make of all this?

Perhaps the best perspective is provided Dylan Grice, author of the Edelweiss Journal.  He tells us “inflation is not measurable”.  He tells policy makers that “trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen”. 

And, when was the last time the government’s forecast for economic growth came true?

WHO WILL LEAD?

GM, Ford, Chrysler… Does the end justify the means?

Have you heard?  People everywhere (except Europe) are buying cars again.  Automotive News reports that June’s U.S. auto sales are up for six consecutive years. They project 16 million for the full year.  Further, they report that each of the Detroit Big 3 gained market share in the first six months of 2013. 

That’s a far cry from the reports out of Detroit a few years ago.

More interesting is that foreign manufacturers are locating more factories here in the U.S.  Is that a good thing?  You bet.  When companies from another country invest here it creates jobs no matter what the nameplate on the car.  Indeed, Nissan, Mercedes, Toyota, Honda, BMW and the rest are exporting cars from their U.S. factories to the rest of the world.

Bloomberg recently ranked the U.S. as the third most attractive country to locate a business behind Hong Kong and the Netherlands.  China? They’re number 19. 

How can that be?  Here’s how.  While it’s true that the weaker dollar has caused the effective labor cost to drop, what’s more important is that the U.S. is well integrated into the global economy through its transportation and communications systems, has the wealthiest consumer base and is a rules-based economy. 

Global investors – business owners, corporate executives, shareholders -- are more likely to put their money into a venture governed by a reliable set of regulations, taxes, policies, etc.  “The rule of law” is very important to them.

Rule of law is a confusing term and, used in other than economic contexts, can be construed as “rule according to law” or “rule under the law”.  Dictionary.com provides a concise definition thusly:  “the principle that all people and institutions are subject to and accountable to law that is fairly applied and enforced; the principle of government by law.”

Was the rule of law abandoned a few years ago when the automakers were circling the toilet for the third time?  Fearful that hundreds of thousands of jobs would be flushed along with the shareholders money, the government intervened, first under the Bush administration, to loan TARP money the automakers and, then under the Obama administration, to engineer a restructuring of both GM and Chrysler through bankruptcy proceedings.

Critics howled but fear ruled the day.  So, what would have happened if the government hadn’t stepped in?  Many of my friends and colleagues have speculated that private investors would have acquired the assets through a Section 363 sale in bankruptcy court.  GM could probably have been had for about $10 billion, chump change for the private equity industry. 

But, I am not so sure.  We were all in a panic in the first half of 2009.  No one was quite sure what would happen next.  Investors like a stable environment in which they can place their bets.  2009 was anything but stable.   Mike Jackson, CEO of AutoNation (NYSE:AN) the nation’s largest auto dealer, has often said, “it’s pains me as a conservative Republican to say this…” but the U.S automakers would not have survived if the government hadn’t taken action.  He goes on to support the oft-reported view that the a GM liquidation would have unraveled the supply chain and brought down many other companies in the industry, causing not only job losses but also disruption of the global economy.  And, this was at a time when the U.S. Federal Reserve was still putting the Humpty-Dumpty financial services industry together again.

Principles are important.  Our leaders, both Republicans and Democrats, violated so many sound principles of capitalism during the nine-month span between the Lehman bankruptcy and the GM bankruptcy that it’s hard to keep track.  The most prolific of the Austrian school of economics, Friedrich Hayek, in his most important work The Road to Serfdom, said, “nothing distinguishes more clearly conditions in a free country from those in a country under arbitrary government than the observance in the former of the great principles known as the Rule of Law”.

But, there is no line in the sand that can distinguish between actions that satisfy the principles of the rule of law.  Both the President and the Chair of the Federal Reserve are given a great deal of discretion.  Here’s what George W. Bush told CNN in December 2008, a month before he turned the reins of government over to his successor.  "I've abandoned free-market principles to save the free-market system, to make sure the economy doesn't collapse."

We’ll never know what might have happened if the government hadn’t exercised its discretion.  But, no President wants to preside over the collapse of the economy.

WHO WILL LEAD?

What’s NEXT for Florida? Ask Alex Sink

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Alex Sink

I love former politicians.  They learn to fly once their political parties no longer tether them to the ground.  In the case of Alex Sink, it’s more like soaring than flying.  Ms. Sink is the former CFO of the State of Florida and ran an unsuccessful campaign for governor two years ago.  Before politics, she was a banker and a really good one at that.  She enjoyed a reputation as someone who truly got to know her clients’ business.

With that as a background, it surprised no one when she founded the Florida NEXT Foundation last year.  It’s mission?  To “empower young people, entrepreneurs and small businesses so they can drive the innovation needed to enhance Florida’s economy and quality of life”.

I had the pleasure of hosting a luncheon at which Alex was in attendance last week along with my partners at The SCA Group. The attendees included business owners, professionals and executives.  It was interesting to watch Alex hold court.  Like all great leaders, she listens more than she talks.

We had a far ranging conversation covering education, business incubation and, most of all, how we keep our best talent from relocating to another state. 

This last topic was of great interest to one of our guests, Dan Madden.  Dan is COO/CIO of Lake Worth based Eastern Metal Supply.  He is also a Ph.D. candidate at Nova Southeastern University and is in the process of founding a non-profit of his own.  The “95 Research Corridor Alliance” would nurture technology businesses in Southeast Florida.

With everything he is involved with, I wondered why he would make time for this new initiative.  “Because I don’t want to have to travel to Texas or California to visit my kids when they graduate from college,” he told me. 

Those are two very interesting states when you think of nurturing business.  California, of course, is home to Silicon Valley, highly concentrated with venture capitalists and tech entrepreneurs.  Texas’ claim to fame in this regard is Austin, home to the University of Texas and a burgeoning tech incubator in its own right. 

But, beyond that, the two states are very different.  California – the Golden State – has been a center of innovation and cultural leadership for over a century.  But, the emphasis here should be on the words “has been”.  A recent report of the Federal Reserve Bank of San Francisco concluded, “economies of states ranked high on tax-and-cost indexes [meaning lower taxes and costs]…  tended to grow faster than the states ranked lower”. 

Meanwhile, low tax and low cost Texas – with its low propensity to provide social services and quality public education – is thriving.  Now, before you conclude it’s all because of oil, I’ll tell you that the Dallas Federal Reserve Bank has reported that only 2.4% of Texas employment is in the oil and gas industry.  And, Texas’ job growth has been more than triple that of California over the last 20 years.

So, how should Florida respond to Dan Madden’s desire to keep his kids closer to home?  Should we become California with its first class public schools and infrastructure?  Or Texas with its 19^th Century pioneer spirit? 

Well, my answer is neither.  We shouldn’t pursue job growth so single-mindedly that we sacrifice efforts to improve public education.  The workforce of the future will be better educated than past or even current employees or else they’ll be waiting tables.

In other words, the fundamentals of attracting businesses and high content jobs to Florida are low cost and low taxes coupled with a well-educated workforce.  In a micro sense, Dan Madden’s 95 Research Corridor Alliance is focused on incubating businesses, especially high technology businesses – info, bio or nano.  In the macro sense, Alex Sink’s Florida NEXT is about mixing the right cocktail of entrepreneurial energy, government policy and infrastructure. 

Florida is a small business state.  In the tri-county area that makes up the Miami metropolis, there are about 3000 businesses with more than $10 Million annual revenue.  Of those, only 300 exceed $100 Million. 

We keep hearing that small businesses drive job growth and that’s true.  But, it’s not universally true.  A November report by McKinsey & Company identified the top tier of job creators by industry – heavy construction, social services, industrial instrumentation, chemicals and utilities.  So, should Florida focus on attracting those industries?  And, how should we take into account the wave of mobile technology that is destroying jobs in airports, publishing and banking?  What jobs will be created?  What companies will thrive?

Whatever the answers are – and, I don’t think there is only one right answer – the LEADERSHIP provided by both Ms. Sink and Mr. Madden will be critical to our success.