Main menu

Craven spin on Prop. 30

Here's how the WSJ reported the passage of California's Proposition 30:

In approving a ballot measure sought by Gov. Jerry Brown to raise taxes for several years, Californians took a step toward improving the state's fiscal situation and avoiding education cuts.
The approval is a significant victory for Mr. Brown, a Democrat, who has staked his governorship on a campaign to raise taxes to ease the effects of the state's budget crunch.
"Last night, Californians made the courageous decision to protect our schools and colleges and strengthen the California dream," Mr. Brown said in prepared remarks. "The people of California have put their trust in a bold path forward and I intend to do everything in my power to honor that trust."

Here's the real, unvarnished truth:

In approving a ballot measure sought by Gov. Jerry Brown to raise taxes for several years, Californians relieved their governor of the need to impose much-needed fiscal discipline. 
Californians made the "courageous" decision to seize yet more money from upper-income earners, who already shoulder most of the burden of taxes, and give it to the educational system, which consumes unprecedented quantities of money yet delivers miserable results.

Yes, as Milton Friedman once said:

There’s been one underlying basic fallacy in this whole set of social security and welfare measures, and that is the fallacy - this is at the bottom of it – the fallacy that it is feasible and possible to do good with other people’s money. That view has two flaws. If I want to do good with other people’s money, I first have to take it away from them. That means that the welfare state philosophy of doing good with other people’s money, at it’s very bottom, is a philosophy of violence and coercion. It’s against freedom, because I have to use force to get the money. In the second place, very few people spend other people’s money as carefully as they spend their own.

It's hardly courageous for the majority of voters to decide to take money from a minority and spend it on another minority. Instead of patting ourselves on the back, we should be ashamed of our cravenness.  Will no one stand up to the teachers' union?

In any event, it should come as no surprise to supply-siders if, in fact, the money that Prop. 30 promises to raise fails to materialize. Prop. 30 is likely to encourage even more of the "rich" and small business owners to join the ongoing exodus from California to states with lower tax burdens and a more friendly business climate.

Australia is expensive, and the U.S. is cheap

For those considering an escape to a less-unfriendly business climate such as Australia's, an important caveat: the Australian dollar is very expensive and the U.S. dollar is very cheap. Selling here to move there is therefore an extremely expensive proposition.

The above chart compares the Aussie dollar exchange rate to my calculation of its Purchasing Power Parity with the US dollar. (PPP is the exchange rate that would cause US visitors to Australia, and Aussie visitors to the US, to conclude that most prices in the two countries were roughly the same.) I estimate that the PPP exchange rate today is about 0.66 dollars per Aussie dollar. But since the current exchange rate is 1.04, that implies that, from the point of view of a U.S. expat or a U.S. tourist, the average price level in Australia is more than 50% higher than in the U.S. Ouch. Moreover, the Aussie dollar has almost never been so strong. Lots of things are going to have to continue to go right for the Aussie dollar to remain at these lofty levels.

This next chart of spot commodity prices suggests that a big reason the Aussie dollar is so strong is that commodity prices—commodities are Australia's major export—are very strong. There is a very strong tendency for the Aussie/US exchange rate to track changes in commodity prices. Rising commodity prices bring a flood of new money into the Australian economy, and that tends to bid up the value of the Aussie dollar.

As this chart of the real, trade-weighted value of the dollar shows, the US dollar has almost never been so weak. It's not hard to understand why: monetary policy is extremely accommodative, the U.S. economy has never experienced a weaker, more disappointing recovery, federal deficits are extraordinarily large, entitlement programs are long overdue for reform, and regulatory burdens are very high and rising (e.g., ObamaCare). In contrast to conditions in Australia, lots of things need to continue to go wrong in the U.S. economy for the dollar to remain this weak.

For the time being, leaving the US for greener pastures overseas is in general a very expensive proposition.

Green shoots are still to be found

Fortunately, in contrast to my supply-side-induced gloom and doom this week, the evidence continues to support the view that the housing market is recovering. As this chart shows, the stocks of major home builders have more than doubled since September 2011.

This may be the most miserable recovery in modern times, but it nevertheless remains a recovery, and that is very important. The U.S. economy doesn't need the ministrations of policy to recovery; it's fully capable of recovering by itself. In fact, if policy were less blatantly stimulative, we would probably have a much healthier economy today.

Still no sign of labor market deterioration

As disappointed as I am with the reelection of Obama, I don't think the economy is likely to underperform the market's dismal expectations. Misguided monetary and fiscal policy have been behind the economy's sluggish growth, and I don't see that getting worse. Some argue that very slow growth such as we've had increases the risk of a recession, using the analogy of an airplane that approaches "stall speed" being at risk of falling out of the sky, but I don't believe that analogy works for an economy. Recessions happen when unexpected and unpleasant things happen; they don't happen just because growth is disappointingly slow. Besides, the U.S. economy has an inherent dynamism which you underestimate at your peril. Most people want to advance by working harder, smarter, and by taking on extra risk. Americans by nature are problem solvers, and love to overcome obstacles and undertake challenges. And boy do we live in challenging times: successful entrepreneurs and businesses today are more likely to be demonized than appreciated, while some who fail to succeed are bailed out. That's not fair, in my view, but it hasn't stopped people from working harder.

I've argued for years that even though the recovery would be sub-par, the economy was likely to outperform the market's expectations, and for the most part that has been exactly what has happened. Although it is hard for me to be optimistic about another four years of Obama, I still think the economy can generate enough growth (even if it's only 2% per year) to beat the expectations that drive people to buy 10-yr Treasuries with a measly 1.7% yield, and to eschew equities with an earnings yield of 7% in favor of cash yielding zero.

For those who hold cash to be rewarded, the economy has to deteriorate significantly. However, so far there is no sign of any deterioration. Sandy may have caused claims to be a bit lower than expected, but even if they were higher the story would still be the same: seasonally adjusted claims have been flat for almost the entire year.

The above chart takes the numbers from the first chart and compares them to the size of the workforce. What this tells us is that in the past 60 years there have been only about 10 years in which a smaller percent of those working were at risk of losing their job. The economy isn't adding a whole of jobs, but neither is it firing very many. The problem is not layoffs, it's the lack of new jobs.

As this next two charts show, the one thing that has been very different about the last recession and the current recovery is the unprecedented number of people who have received unemployment insurance, thanks to Congress' decision in mid-2008 to create an "Emergency Claims" benefit. That is now winding down, with the result that there are 20% fewer people today receiving unemployment insurance than there were a year ago. This is one of the biggest changes on the margin in today's economy, and it doesn't get the attention it deserves. It's a perfect example of how the influence of government in the labor market is declining to a meaningful degree. Whenever government intervenes in a market, it almost always creates unintended consequences: disincentives to work, corruption, crony capitalism, and bureaucratic waste. As government pulls back, market forces come more into play and things improve. More people now have a greater incentive to find and accept jobs, even though they don't pay as much as they would have liked to get. This isn't fun, but that is the best way for excess labor to be reabsorbed. This is a good indicator that jobs are likely to continue to grow, if only because government is no longer making it easy for people to stay home.

The election could be a positive surprise for the market

I'm a fiscal conservative and a supply sider, so naturally I think that a Romney win in tomorrow's elections would be better than an Obama win. Romney would most likely steer the economy in a direction that would reduce the size and influence of government (thus increasing individual liberty) and increase the after-tax rewards to work, investment and risk-taking (thus boosting growth). Obama, as he has demonstrated in the past four years, would work hard to do just the opposite. A Romney victory would improve the outlook for the economy, whereas an Obama victory would just mean more of the same disappointing growth that we've seen in recent years.

Yet when I look at the market, I see no sign that the market is enthusiastic about the election results. Perhaps this is because the intrade odds say that Obama has a 67% of winning. Perhaps it's because the polls are inconclusive, and some polls show that Obama has a good chance of winning. Perhaps it's because the market for a long time has been reluctant to believe that things will get better. For whatever reason, I don't see signs of optimism, so I must conclude that the market is braced for an Obama victory.

So if Romney wins tomorrow, that could end up being a very positive surprise for the market.

Let's review the key market indicators that reflect the market's view on tomorrow's election results.

This chart of the implied volatility of equity options (the VIX index) tells us that the market is not nearly as nervous or fearful on the eve of a major presidential election as it has been at the depths of the Great Recession and the flareups of Eurozone sovereign debt default angst. At 18.3 today, the Vix is above the levels that are associated with periods of relative tranquility (10-15), but orders of magnitude lower than the levels that have been associated with crises (30-100. The market is concerned, but not terrified; worried, but not extremely so. Could this be complacency? I'm not sure. But it's not a sign of a market expecting a big positive surprise tomorrow. It's a market braced for more bad news, of the same variety we've had.

2-yr swap spreads are excellent indicators of systemic risk as well as excellent predictors of the financial and economic health of the economy. Today, swap spreads are about as low as they have ever been, and this is a good sign that the economic and financial fundamentals are healthy. Financial markets have no lack of liquidity; people can exchange risk with almost no friction. Nobody is locked into uncomfortable positions for lack of liquidity; those who were uncomfortable with the risk they were bearing have had ample opportunity to get out of their positions.

As the second chart shows, all of the above applies also to the Eurozone. There are still lingering problems, to be sure, but Eurozone swap spreads are low enough to be considered reasonably healthy. There's nothing fundamentally wrong with the economy, the problem is that the market doesn't see any reason to believe that things will get better.

Consistent with my view that this has been a reluctant recovery, the equity market continues to believe that earnings will decline, and perhaps significantly. There's more pessimism out there than optimism. That's why PE ratios are below average, even though corporate earnings are close to all-time highs both nominally and relative to GDP. The market is braced for bad news.

10-yr Treasury yields are almost as low as they have ever been. It's not because inflation is extremely low—it's because growth expectations are extremely weak. Inflation expectations are at the high end of their historical range, to judge from the spread between TIPS and Treasury yields. But with most TIPS real yields trading in negative territory, the only conclusion to be drawn here is that expectations for real growth are dismal.

Credit Default Swap spreads are roughly unchanged over the past few years, but they are still substantially higher than they were prior to the onset of the Great Recession. As with the VIX index, this is a sign of a market that is concerned, but not terrified. It's consistent with a market that is braced for more of the same disappointing news: weak growth, high deficits, Congressional gridlock, you name it.

When the market is braced for bad news, all an investor needs to win is for the news to be a little better than bad. If we indeed get a Romney win tomorrow, the news could eventually be much better than bad, and that's what leaves me optimistic.

(One major caveat: Romney's position on China is dreadfully wrong. I can only hope that he is shamelessly pandering in order to win over some independents, and that when he is actually in charge he will, as Obama has done, conclude that engaging in a trade war with China is in no one's interest.)

Who do I think will win? Romney, by a comfortable margin. I think the polls are systematically overestimating Democratic turnout, and underestimating Republican turnout. Thus they are underestimating Romney's strength by enough to put him comfortably over the top. I like Peggy Noonan's most recent take, "Monday Morning."

Service sector sluggish but still growing

The ISM Service Sector Business Activity Index fell last month, but remains comfortably above 50, suggesting that the sector continues to expand, albeit slowly.

This next chart compares the ISM Service Sector Composite index for the U.S. to that of the Eurozone. The U.S. continues to grow, but the Eurozone continues to contract. Weakness in Europe may be contributing to sluggish activity here, but the U.S. has not contracted the Eurozone flu.

The relatively high level of the prices paid index suggests that the U.S. is more likely to be suffering from too much money than too little. Despite sluggish economic activity, there is clear evidence of inflation. The Fed may be overstaying its welcome in QE territory; we're more likely to see higher inflation than lower inflation in the years to come.

The one bright spot in today's ISM release was the employment index, which showed a decent gain. This suggests that economic activity is still likely to expand in the future.

Altogether, not much in the way of new news here. It's steady as she goes, at a relatively slow pace. A disappointingly weak recovery, but still a recovery.