Stimulus 101

The word "stimulus" is defined in the dictionary as: something that incites to action or exertion or quicken action.... In economics, or the business world in general, the word stimulus is used to describe the act of government pumping money into the system to incite to action an otherwise sleepy economy where lenders are hesitant to lend and businesses and consumers are unwilling to borrow and or spend. The reasons an economy goes into contrition mode are many but chief among them is lack of credit/liquidity or the demand thereof. So the recent action by our government to pump nearly three trillion dollars into the economy no doubt was intended to alleviate the credit crunch and therefore cause a multiplier effect that is supposed to kick start the economy. This sounds great in theory but did not work and will not work for this current crisis.


First let me refute the opinion that the stimulus has actually worked. Those of that opinion basically site two examples of how or why the stimulus has been effective. Example one is that because of the stimulus we have saved roughly 650,000 jobs. This number is derived as the difference between the monthly job loss in January '09 of 779,000 and last month job loss of about 125,000. Example two is that without the stimulus we would be in much worse situation (or at least we could be). There is no doubt that the rate of job losses has fallen from its high and the administration has not wasted a moment to credit the stimulus package for that drop. Yet they can't tells us where or how these jobs were saved. I, on the other hand, will at least offer a theory as to why the decline in job losses has nothing to do with the stimulus. The theory is based on something known as the inventory buildup cycle. There is a natural process that takes place when economies are in recession. In that process are built in safety measures that may, later on, be breached but in an orderly manner (if there is such a thing in fast worsening economies). I am talking about the initial reaction of businesses at the beginning of this crisis, or any crisis, and that is the draw down of inventory to dangerously low levels. Once those levels are reached businesses face a critical decision even in the face of a still deteriorating economy. Unless they resume their activities (for which they were created) they risk going out of business, literally. So the natural act is to stop the firing and start building up their inventories for when the sun shines again. Hence the drop in job losses. However, unless those inventories make their way to the final consumer job losses could accelerate again. The stimulus money could not have had a positive impact on job losses because for the most part that money never made it to the segment of the economy that actually effect the kick start. As a matter of fact a large chunk of that money remains at the Fed and the Treasury where it was created in the first place stimulating nothing but political grandstanding.


The part that made its way to businesses or consumers was mostly a disaster. Billions were spent on propping up the housing market hoping to limit and reverse the foreclosure trend. At least that is what we were told. Funny thing is that the exact opposite has happened. Home prices are still declining and foreclosures are projected to be higher that the 4 million of 2009 . According to Forbes magazine as of July 1, 2010 one third of all homes for sale have seen their asking price lowered by an average of 10% (Phoenix being the worst at 13%). Some investment!!


As for the money that has so far kept the banking system afloat, I do have to say that at least some of it has actually been a great investment for the Treasury as evidenced by the return the government has received from the sale of various options that it had in some of the banks. But it did nothing to stimulate the economy because the banks are not lending. Here is the problem though: the government didn't actually have to print that money to get the interbank market pulsing again. All it had to do is come out and give its explicit guarantee as a backstop for the interbank market. Other stimulus programs such as cash for clunkers and the bailout of GM and Chrysler didn't fare any better.


There is another portion of this stimulus that simply shifted the losses from the private sector to the Fed's balance sheet. So instead of private shareholders taking the hit for the assumed risk now you and I have to pay for that, again doing nothing to stimulate the economy.


The suggestion that we could be in worse shape but for the stimulus may be right, although , again just like in saving jobs there is no evidence to support that. In fact, I argue that this is our way out of this mess. In other words our problem few years ago was too much liquidity and easily available credit to worthy and unworthy consumers alike. Of course I am not suggesting that all credit be cut off, but we also don't want to pump so much money into the system that the end result would be an inevitable return to the easy money of a decade or so ago. And that is exactly what will happen when that stash of cash makes its way to the economy.

Until we work through all the excesses we have and as long as the consumer is overwhelmed with debt (total households debt is 90% of GDP) the economy will not recover no matter how much money is pumped into the system. The simple fact is that government does not buy everyday essentials. The consumer is too busy deleveraging and businesses are weary of uncertainty and therefore are unwilling to plan ahead and spend when they see a retrenching consumer.



Another reason the stimulus (or additional stimulus) will not work is that the deleveraging phenomena is not confined to the U.S. As I have mentioned in previous blogs the two other main economic zones are either suffering through their deleveraging or are so dependent on the other two for their growth.


I know the effort is well intentioned but it simply cannot work in the face of all the headwinds domestically as well as internationally. So why throw good money after bad. You simply can't stimulate an over leveraged consumer by throwing more borrowed money at him. The consumer knows it will take him years before he feels the need and want to consume more. The same goes for businesses, and that is why this recession is not your garden variety one and traditional tools are ineffective.


The amount of debt the government is piling on is going to be a factor in delaying the recovery and making America's product less competitive in world market. This is not your father's America anymore and therefore what may (emphasis on "may") have worked back then will not work today. Back then America was an island with a huge domestic market whose products were pretty much unchallenged. Today the world does not need America's products, actually Americans don't need America's products. Back then America was exporting capital. Today America not only has to compete for money to fund its deficit it actually has to plead for it. In other words America finds itself in most need of liquidity to finance its overextended way of life at a most unfortunate time that the rest of the world is demanding, and in some cases actually supplying, more and more of that limited pie of financial resources.


All is not lost quite yet. But the sooner we acknowledge our deficiencies the sooner we can be ahead of the world in capturing a larger portion of that pie. But this cannot happen until we bring down our standard of living. This can either be planned and carefully thought out resulting in minimum shock or it can be forced on us with dire consequences, but it sure cannot included the paralysing effect of more debt.


What we have is not stimulus. Rather it is a transfer payment. In short, shifting money around creating the illusion of a stimulus.

If I sound a pessimist it is because I am a realist. We should be politically strong enough to tell the nation what needs to be done and not offer politically acceptable solutions that only kick the day of reckoning down the road.


You can email the author at gnasr59@yahoo.com

A Tug of War

Today we had two earnings reports that paint different picture of the state of the economy and its future direction. Earnings results from Yum and Intel pulls the economy in opposing directions. Yum, an end consumer oriented company, posted second quarter results that were below expectations. But the more telling numbers are those of its forecast for the rest of the year. Those projections tell a story of a retrenching consumer that will be a drag on the recovery (see my post about the consumer psyche published on 5/8/10). Intel on the other hand reported great results and increased its year- end forecast. But Intel's success may be short lived because Intel's results are more a sign of IT spending by corporations. In other words it is the result of an inventory build up cycle which may have ended with the second quarter (see my post about inventory recovery published on 5/18/10). For the recovery to be sustained we have to see the Intel products make their way to the end consumer. I just can't see this happening yet because , among other reasons, of the lack of credit available to the consumer and the unwillingness of that consumer to pile on more debt at this time. So the tug of war goes on for now with a bias in favor of Yum's directions. The full impact of this war may be felt in few weeks following the end of earnings season.



You can email me at gnasr59@yahoo.com

Where Are We Headed?

Under the directions of the government banks in China are recapitalizing at a fast rate. At times, when private interest was lacking these banks have turned to sovereign funds to ensure the success of their IPOs. This follows an unprecedented lending by Chinese banks over the last two years, again under the encouragement of the government. I can only think of three reasons this urgent and large capitalization is taking place. The first would be an equally large expansion that would require increased lending activities. I am not sure this is what the Chinese government had in mind when it ordered this massive recapitalization, not when it took steps to cool down the economy and its own lower GDP projected growth rate. The second, and more likely reason, is that the Chinese government expects an increase in the banks' nonperforming loans portfolio and therefore the need to have enough capital on hand to meet the necessary reserve requirements. The third, which is closely related to the second reason, is to hurry up and recapitalize before the capital markets shut them out.

Today (7/7/10) the Financial Times reported that European banks are using their gold holdings to raise cash in swap agreements with the Bank for International Settlements. This can't be a good sign, not at a time when Europe is still experiencing a severe debt problem. This move is very negative for the European economy because it indicates deteriorating values of European debts, especially those on the banks books. On the other hand, depending on the magnitude of these swap agreements, this may be bullish for gold prices.

We are certainly facing huge uncertainties with respect to the global economy but the above mentioned examples add an element of urgency and increase the odds that we are headed toward something truly big that will leave a deep impact on our lives. I don't know when or what but I am not very optimistic about the state of the economy.

What's Yours Is Ours

If I told you I have a gambling addiction and asked you to lend me money to pay off some debt would you? The answer is most likely no, because any reasonable person would not believe the money would go to settle debt. Rather, I am more likely to gamble it away. Why? because I am addicted. The solution to my addiction and debt is not to give me more money. Rather, it is by making me realize and understand that "my world" of gambling is not an entitlement just because I got used to it. The same can be said about the state of our economy. Just because we got used to easy and cheap money doesn't mean we are entitled to it. Worse yet, is taking other people's money to satisfy our addiction. Yet this is exactly what our government is doing with private as well as public money in the name of curing our addiction. I say private money because that is exactly what happened with the bondholders of Chrysler and GM. They were forced to accept a fraction of what they are entitled to legally under our existing business laws. The public part is the endless printing and spending of money by the federal government as well as the Fed. Both fall under the Robin Hood syndrome, taking from the rich to help the poor. This is a very dangerous precedent that will hamper the ability of the economy to recover. The Robin Hood syndrome also extends to the banking industry, the energy industry and the health care industry but seems to exclude the politically sensitive unions, Fannie Mae and Freddie Mac. I guess Robin Hood took only from a select group of rich people.

The idea of government spending, on the scale we have seen lately and in an economic state we are experiencing now, acting as a stimulus is flawed for the main reason that the American consumers' psyche (as well as that of businesses) is shaken to its foundation. This is not to be taken lightly. Spending is not on the mind of many Americans, but deleveraging is. Hence the government can print all the money it wants without any real results. The government does not buy everyday essentials like the consumer does. The only stimulus will come from the consumer once he/she has deleveraged and is confident enough in our fiscal and taxing policies. In addition, I think we can all agree that government does not create jobs. Thus that money the government is spending is money that is not available to the job creating private sector, thus delaying recovery. Second, for that money to be stimulative it has to bring something new to the table but this can't be because the money is borrowed money that increases our already huge deficit and hinders our ability to borrow more or even service our existing debt. In other words taking money from my left pocket and putting it in my right pocket does not add to my net worth, and therefore does nothing to make me want to spend and by extension create a job or two. It is a waste of expanded energy (wasteful spending) that creates a short term illusion of economic activities (my right pocket has more money now). The first quarter GDP was reduced from 3.2% to 3% and finally to 2.7%. The GDP for the second half of the year is projected to be even lower. The jobless rate is still at 9.5% and likely to stay there for several years. So where is all that stimulus that is supposed to take place? where were these promised jobs created? in China? which poor people were helped by raiding the coffers of the rich? The starving in Africa? the answer may be in the "now you see it now you don't" pick up in the housing market thanks to all the incentives that pulled in from future demand (no net increase) at a huge expense that will burden us for years to come.

What we are witnessing in terms of public policy is nothing short of madness targeted at a segment of our economy. I say that because by now it is well known that creating economic equality among the population does not work. Hence the ex Soviet Union and the new Russia, China and a host of newly created nations that have embraced the concept of capitalism even in the midst of this crisis. Big government, even if just perceived, sends anti-growth vibes through the economy as well as unsettling uncertainties of a centrally planned economy. Big government does not have to be involved in the day to day business decisions. It is enough to set a tone and make an example of an industry or two and the message is received.

The premise of taking what belongs to the successful ones and spread it more equally among the rest of the population in the hope of instilling a sense of government responsibility or creating a sense of equality does nothing to stimulate creativity and risk taking which are necessary to create jobs. It actually has the opposite effect. It sends the message that either there is no need to, or we are incapable of being creative or productive; the government will do it for us. History, as well as common sense, shows otherwise.

China is widely held as a model of modern day capitalism. To a certain extent I agree. However, I caution that China is still to a large extent a centrally planned economy as evidenced by its control of the banks and other state owned entities that are responsible for the larger share of GDP. China had to embrace certain principles of capitalism because it knew it will not be able to take care of its population, and risked falling behind the rest of the world. The difference between China and the current U.S. administration way of thinking is that the two come from opposing backgrounds and are heading in opposing directions. That is why China is very mindful of the ineffectiveness of the Robin Hood syndrome while the U.S. seems to think that restoring economic power and prosperity is not only to take from the rich and provide for the poor but to also borrow from the Chinese to fix our many social ills. I am not promoting a Chinese style economy either (see previous blog). I still think that China's economy is not what it seems to be. But at least China seems to be forward looking in terms of its business practices (not enough) and in terms of its acknowledgment of the power of lower taxes ( no capital gains tax in China) while the U.S. seems to want to revive an old worthless system (by the way the U.S. has one of he highest corporate tax rate in the world in addition to the soon to be 40% capital gains and dividend tax rate).

There are signs that policymakers are beginning to realize their misguided efforts. Today's job report and the slowing economic activities as well as the urging of some of our European friends to cut back on spending and stimulus may help speed that realization. Let's hope it doesn't take a European style debt crisis to awaken us because by then it may be too late and the consequences will be severe indeed.

Robin Hood may have been an entertaining legend and character but never the savior. On the other hand we are facing reality and our responses have to be equally realistic and future looking. That is not to say there are easy and painless solutions, to the contrary, the solutions are difficult and quiet painful (not literally), but absolutely necessary and should not include a Robin Hood style solution.



Coming soon: What An Investor To Do?