Faramir
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Joined: 2/12/2005
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Below is the first draft of my newsletter to clients on current economic conditions in the US.
I posted it here in case there are any other economic policy wonks at collar.me
An Economic Update – October 19, 2005
Of the four main factors that affect the US economy, and in turn the value of your investments, two are critically in play: monetary policy and tax policy. We are currently in monetary error (inflation), and future tax policy is uncertain, leading to significant stock market uncertainty. Tariff policy and regulatory policy have been fairly steady in their direction, and are not critical at this time.
Monetary Policy: We are currently suffering from inflation in the US. Inflation is monetary error – too many dollar bills in circulation relative to the existing economy. This is a problem inherent to having a fiat money system – a system where you guess how much money to print/have in circulation, vice an external standard like a gold standard.
Whether we say too large a money supply, or too small an economy, the money supply relative to the size of the economy has been expanding since Dec of 2000 (the bottom of the Greenspan Deflation). From that time until April of 2004 you could call that increase “reflation” – getting back to the former relative money pool size, getting back to the old value of a dollar, which had been fairly steady from about 1982 to 1997, our longest period of monetary stability since President Nixon unilaterally ended the Bretton Woods agreement. Now though we are experiencing real, monetary inflation. Not rising prices (which is a symptom, not a cause) but a surfeit of dollars relative to the pool of goods and services to be denominated. Simply put, in a 10-apple economy, with a $10 money supply, apples are $1 a piece. If you add a dollar, so your money supply is $11 relative to a 10 apple economy, apples must re-denominate at $1.10, which is a big problem if you have negotiated a contract to purchase apples at a future date, or sell apples at a future date at the current price. A deal that made sense when you first made it is now a windfall profit for one side, and a windfall loss for another, destroying trade. A 30-year mortgage is a contract in effect to borrow a house, and pay back a house plus some interest to compensate the lender for their risk. Inflation means you might borrow a house, and pay back 9/10ths of a house with no interest. Windfall profit for you, windfall loss for the lender, and on a large scale, as in the 70s, this leads to things like the Savings and Loans crisis, an echo of massive monetary error a decade later.
Inflation is currently destroying a few marginal businesses, destroying some jobs, and hurting your investments as markets react to the fear that the modest inflation we have now will become crippling inflation. There are two ways out of inflation: correcting monetary policy, or growing the economy to match the size of the money supply. Alan Greenspan, the current Fed Chairman is the man responsible for inflation, and must by statute be replaced in 2006. The leading candidate to replace him is Fed Governor Ben Bernanke, a demand-side economist who articulates an economic model very similar to Mr. Greenspan’s, which is disheartening. However, even a blind squirrel finds a nut now and again. This same Gov. Bernanke, in remarks before the National Economists Club, Washington, D.C. on November 21, 2002, perfectly explained the monetary mechanism behind inflation and deflation, and explicitly said he would print more dollar bills to cure deflation (which implies printing less dollar bills to cure inflation). He is the front-runner to replace Mr. Greenspan and I think he would be a huge improvement.
Tax Policy: The growth in the stock market and your investments in 2003 and 2004 started the day the 2003 Jobs Growth Tax Act was agreed to in principle in the Senate. That law expires in 2008, and if it expires it will be bad for the economy, and bad for your stock investments (taxes on investing will jump from 15% to 25% or 15% to 35% depending on whether it is a stock sale or a dividend). This is the biggest issue before the economy, and uncertainty about the future of tax policy, along with current inflation, is making the stock market retreat. Further compounding this uncertainty, the Advisory Panel on Federal Tax Reform has again delayed their final report (to Nov 1), but they did vote yesterday on their final policy recommendation, and will now work on the finished report. White House spokesman Scott McClellan has said that tax reform remains a priority of the President, but that it will not be addressed this year – the Supreme Court nomination of Harriet Miers and post Katrina spending bills are the focus for the rest of the year.
The Advisory Panel on Federal Tax Reform couldn’t come to a consensus on bold reform vice a more modest reform, and so they settled by making two, parallel recommendations. One is for a modified consumption tax – I don’t think that has any chance of passing so I will not comment on it. The more modest “One Page” reform proposal (most filers would fill out a single page return) does sound possible. It’s pretty long and complicated, and it by no means makes the code simple, but it does simplify some, and the important part is that they make a political trade-off. This is just the heart of the proposal: some of the biggest tax-breaks for the very wealthiest Americans would be scaled back (the up to $1 million a year mortgage interest deduction and the unlimited deduction on employer health insurance), and in return the double taxation of corporate earnings would end at the corporate level, the Alternative Minimum Tax would be repealed, and capital gains taxes would fall to 8.25% on long term capital gains.
I don’t know if this proposal will be implemented as is – it is significant though that the thrust of the proposal is tax simplification, and a lowering of the taxes on investing in exchange for a raise in taxation on some of the wealthiest Americans. This policy proposal would be a huge boon to the stock market and the value of your investments.
So the future of tax policy is somewhat uncertain, pushed off until next year, and the Fed Board replacement is pushed off to next year as well. How does this affect you as an investor – what should you do?
Because we don’t know what the final policy decisions will be, I think this time of uncertainty and lower prices in the stock market can be used profitably by those who have a long term time horizon. Every month the stock market is down is a chance for people making systematic investments (like in a 401k) to buy low and profit. On the other hand, someone who has real near term liquidity needs may need to make sure they have enough money in cash and bonds to balance out short term volatility in their portfolio – call me or set up an appointment to discuss your portfolio if you think you will have a real change in your liquidity needs (for example if you were about to retire).
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