Client Q&A - Social Security, Iraq, China & the Fed
Q. Would the compromise of private social security investment accounts along with a slight increase in the payroll tax, be a net positive for the stock market?
A. No. Chairman Bill Thomas of Ways&Means is right, a payroll-tax increase is a job-killer, and it would only postpone the financing problem.
Q. We got the tax cuts, we got a great jobs report one month in the spring (you celebrated with champagne at Poly, you said), what`s keeping the “jobless recovery” going? Or, why aren't more jobs being created?
A. We were happy at Poly because we had predicted the 2003 tax cuts would not show job improvement until the spring of 2004, and we were on the button. If you recall, I’ve not been as concerned with job growth because a rising stock market by itself would enable the retired and near-retired to live without having to work. An ever-higher capital/labor ratio would enable growth to continue with a declining work force. One breadwinner per family should be enough to support it. At this point, we don’t need sustained improvement in employment for economic growth to be more than modest.
Q. Are the fiscal, regulatory and tort reforms you see on the horizon enough to get the Dow significantly above 12000 within the next 12-18 months?
A. I’d consider it a triumph if we got to 12000, let alone “significantly above.” It will be difficult pulling off the tax and SSI reforms, but any positives on that front will run into the Fed’s perverse monetary policy of raising rates to counter economic growth considered to be inflationary. Of course, personnel changes could move the yardsticks one way or another.
Q. Greg Ip in Thursday`s WSJ noted that the Fed will be considering an inflation target. Since you have always argued that the Fed must promote a stable dollar policy, wouldn`t a stable inflation rate of 2% fix our monetary problem by stabilizing the volatility of the dollar?
A. No. There is no good index of inflation that can be used as a policy guide when the forces moving the general price level are real as well as monetary. And the idea of moving any flawed index up or down by raising or lowering the funds rate, which in itself is a flawed operating mechanism, merely compounds errors. A gold target is as close to perfection as you can get. Second best would be a small basket of commodities including gold, oil and one or two other internationally traded commodities that strip out local or regional demand conditions.
Q. The problems in Iraq seem to be weighing down the markets, at least indirectly by increasing our federal deficit and making it politically more difficult for Congress to pass further tax reductions. So, isn`t it bullish for the markets when the President says that US troops will be pulled out of Iraq if asked by the newly elected Iraqi government?
A. We’ll know more in a week or so, but I am afraid the elections were rigged to produce a national assembly that will be beholden to the administration and ask us to remain while a constitution is written. The insurgency could drag on through the balance of the year and drain the President’s political capital at home, which he needs to accomplish his worthy domestic goals.
Q. Larry Kudlow last week said the capture of an important insurgent in Baghdad caused the stock market rally that day. Is what’s going on in Iraq that significant in your thinking?
A. I don’t think the capture of any “bad guy” moves the market. Even if we bagged Osama bin Laden, the markets would not budge because the major geopolitical forces affecting global commerce don’t turn on the existence of a single individual. We caught Saddam Hussein and it didn’t mean a thing to the financial markets of the world. What’s important is how much the continued violence in the Middle East drains the financial and intellectual resources of the U.S. and the political capital of the President. Good news from Baghdad or Tel Aviv adds to those resources and that political capital. We need more of the latter, less of the former.
Q. Yield curve. Spreads inverted before the last four recessions. According to your model, is this a predictor or just coincidence?
A. The yield curve doesn’t invert when the dollar is pegged to gold because gold never “backwardizes,” which means the currency tied to it doesn’t invert with interest-rate spreads. This means the inversion is caused by errors by the monetary authority, which may think raising rates will stop inflation. This causes the inversion at some point, as the market knows the long rates are true reflections of inflation, and when the economy gets weak enough, the Fed will backtrack, as it always does. It’s a goofy way to manage the dollar.
Q. We think the ongoing expansion is sound, but we always consider the quality of growth. To what degree do you think asset inflation has generated improved financial earnings?
A. After several years of deflation, where business could not pass on costs of production, it has been a relief to be able to do so with the modest inflation to date, but it would have been much healthier for the Fed to have stabilized gold at $350 oz, and at least below $400. The little inflation feels good, but the costs show up eventually in the rise in the general price level and the taxation of inflationary capital gains.
Q. Does debt growth lead to asset inflation?
A. Only if the market sees that conditions have arisen that will mean the debt cannot be repaid. Under a gold standard, where inflation cannot occur, the central bank can only prevent a collapse in the willingness of the market to hold growing debt under such conditions by issuing bonds to mop up surplus liquidity at ever-higher interest rates. If the government can’t correct the conditions, it will have to break the gold link and repudiate its sovereign debt by pure monetary inflation. When the market saw the Confederate States of America losing the war, there was no interest rate that could attract bond purchases. The same happened during the American Revolution, when “the continental” became nearly worthless, but was revived by victory and Alexander Hamilton’s genius.
Q. At Davos, the director of the National Economic Research Institute at the China Reform Foundation insinuated that the Chinese government was considering unpegging the yuan from the dollar and fixing it to a basket of currencies. Would this fix China`s inflation problem?
A. China will stay pegged to the dollar unless the dollar/gold price climbs. At some point above $450 oz, I’d guess there would be a shift to a dollar/euro/yen basket to limit the monetary inflation within China.
Q. Will fear that the dollar keeps falling frighten foreigners from U.S. stocks, and if so, where would they go?
A. We shouldn’t worry about what foreigners do with the dollars they acquire when they sell us goods, services and assets. They have no choice but to buy goods, services or assets from us. If they decide to buy dollar financial assets and change their minds, they will have to buy goods or services or real property. Worrying about the U.S. current-account deficit is a waste of time. It takes care of itself. All I am concerned with are the actions of our government and central bank in making it easier for Americans to produce more and better goods with less effort.
Q. With the central banks of Russia, India, and China announcing their intention to decrease their dollar holdings in their forex baskets in favor of the euro, do you expect OPEC might be able to get oil contracts priced in euros or a basket of currencies this year? Would there be any impact on the dollar from this, or would it merely reflect the declining utility of the currency?
A. I doubt there will be a move away from the dollar unless it really goes haywire against gold and the euro. I mean gold at $500 oz. And I don’t see that in 2005. Nor do I expect OPEC to price in euros. It only needs to raise dollar targets as the dollar inflates, which it does anyway.
Q. Who do you think will replace Greenspan as Chair? Do you have a preference?
A. Someone the President knows and someone who Greenspan likes. He does like Glenn Hubbard and so do I, but I’m not sure he’s Greenspan’s preference. There’s talk of Fed Gov Ben Bernanke replacing CEA Chairman Greg Mankiw in a few months, so the White House will be able to see him close up with the idea of having him step back into Greenspan’s shoes next year. I like both men, although Hubbard is more comfortable with gold.
Q. 13 years I`ve been with you, but you know I also follow a couple of the young Turks. They hold to the consensus supply-sider stand that the Fed`s move since jawboning and rate raising started is on the right track, and that this will remove the excess liquidity added since 2000. And with that, the dollar will rise. What are they missing that you are not?
A. My guess is that one of them decided that the federal funds rate was too low and causing inflation and it had to be raised to some “natural rate,” and the rest of the pack followed along. I almost drifted along myself, but realized it went against everything I’d learned from Bob Mundell about money and all I’d learned by following policy and the markets since 1974. The Young Turks, as you call them, will eventually realize their error and be able to deal with it next time it comes up. Or at least the best of them will.