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At Arm's Length: 08.22.05

Question is should our approach be less fearful and more open? Not necessarily. Our wariness is well-founded and should be used to keep our wits about us in any negotiations with the Chinese.

The full article.

Today's Commentary: 08.22.05
America the Leveraged

Every year in the Portland, Oregon area, builders and contractors display their wares in a showcase of homes called the Street of Dreams. Every year, thousands of regular folks like my wife and I shell out $15 to tour these mansions of overindulgence, wasted space, and new fangled gadgetry all designed to give the modern wealthy a more comfortable place to live and us a glimpse how they struggle day-to-day. All of these homes ­ although none have what might be called a homey feel ­ are for sale. This year, six of the eight seven-figure homes were sold prior to opening and a rumored five of those were paid with cash.

But the rest of America is living a drastically different lifestyle. Our economy is in trouble on many fronts. In spite of recent reports suggesting that economy is still growing, which it is, and that we can continue borrowing exactly as we have, which we canıt, there seems to be a slow shift from giddy expansion to a fuel-forced conservatism.

We have done what Washington suggested we do, and by their example, we borrowed our way to prosperity. In a post-9/11 landscape, the bill for such expansion often comes due for generations in the future. Both Washington and Main Street have racked up huge debts that do not seem repayable in the near future. Both Washington and Main Street have not calculated the cost of servicing those obligations into their short-term thinking until recently.

Washingtonıs reaction to the deficit will not be the same as their partner on Main Street but the mindset is similar. Washington will claim that taxes provided by growth will keep those debts in check. Main Street will simply stop spending. The biggest question is which reaction will bring the economy down first.

To hear the Heritage Foundation, a right wing think tank, tell the story, the proper way to measure the governmentıs debt is not by simply pointing to the amount of debt but how that debt affects the overall ability of the government to honor those obligations. Using debt-to-income ratios as a template ­ the same one prudent bankers have used in the past to determine ability for Main Street to repay borrowed money - falls short of reality. Unlike you and I. when the government's obligations exceed ability it simply issues more debt offerings on the open market.

To buy their argument, it is important to first embrace the belief the economy is doing well. To believe in that you must make a few assumptions about growth and the health of the third player in this fragile scenario, Wall Street. Growth based on borrowing is a sound economic principle for business. And if companies can successfully grow their business, then the tax revenues will solve all problems.

The use of borrowed funds allows companies to expand their footprint, retool their factories or even better, build new ones. Cheap money encourages capital spending and this increases productivity. That is usually followed by increases in jobs and accompanying wages, which, in turn get spent on goods and services. Taxes are collected and the deficit level drops.

Except for one little problem. Business is not really a part of this recovery. They have grown leaner and more inventory efficient using capital purchases of years gone past to achieve their new productivity levels. They have not spent their profits on improvements but instead have embarked on huge stock buybacks along with increased dividend payouts in a tax friendly environment.

That productivity has given many companies the boost they needed to stay solvent, tout their efficiency to shareholders and produce profits based almost solely on pricing power. This, of course, is based on the willingness of the Main Street and often Washington to continue to consume at the rate they has over the last four years.

This, of course led to encouraging news coming from the nonpartisan Congressional Budget Office last week. Their latest report suggests that federal deficit would decline by 20% because of tax revenues collected from this profitable business environment. Even with profits soaring and Wall Street giddy at the strength of corporate earnings, the markets have moved mostly sideways which has given many a Main Streeter something to be worried about.

Business still sees something Washington is loath to admit ­ growth based on artificial stimulation. Willingness to accept monetary accommodation is not the same as actually using it with the designed intent.

That stimulation is going away and no one feels it more than the consumer. Main Street is now faced with reality that the one source for available cash, their home, is slipping away in a higher interest environment.

The current economic successes that Washington is congratulating itself for are supported by low interest rates, cheap commodities (until recently) and willing consumers. It is this unholy triumvirate that has provided much of the short-term boost credited to higher tax revenues.

Although the real economic absorption rate of higher oil prices, the point at which they begin to have a drag on the economy, has yet to be determined, the influence of higher energy prices will act as a tax unto itself. Unfortunately, the problem will work its way up the economic ladder rather than the other way around. So Washington can honestly forecast a GDP growth of 3.4% on up to 3.7% for the coming twelve months with relative certainty. Beyond that point is anyoneıs guess.

The consumer however has already begun to react to the pinch of those higher fuel prices. The costs of producing food and the transportation of all other goods is beginning to trickle down to the consumer and without the home-as-an-ATM available to finance these increased costs, look for Main Street to back off quickly. Any shift in spending away from current, highly leveraged trends will negatively impact the marketplace.

Many of the jobs created over the last three years have been as a result of housing. Not only were jobs created in construction, but the new found equity in many regions spurred a spending spree of sorts on entertainment, restaurants, and other service driven businesses pushing the need for lower paying workers, the second highest area of job growth. Without manufacturing, the economy turned itself around on the backs of American homes which created low paying jobs in construction and services. Essentially, we have created an economy that sells and resells stuff to itself.

Once again, we are back to the ability of Main Street to borrow and to do so with the hope that one day they will be able repay those debts. The Heritage Foundation does not think that repayment is necessary as long as income remains vibrant enough to cover not only the principal but the debt service as well.

Too bad the Federal Reserve thinks otherwise. I mentioned earlier that the increase in low cost, wage resistant productivity earlier was one of the main reasons businesses have been so profitable. Expect that to change. Alan Greenspan is now looking at the pool of available workers and is quite concerned. He is, of course not counting the disparaged worker or the one who was forced into many of the newly created service sector jobs to fill the basic need for economic survival. To do that would be akin to acknowledging that the real unemployment rate as closer to 9% than the 5.1% currently reported.

Greenspan is looking at the current pool of laborers and when he does, he sees something of a shortfall. A small pool of potential workers creates wage pressures which slow productivity, which pushes prices higher.

Productivity has slowed on its own over the last year and that has the so-to-be-retired Fed chief worried that two possible scenarios will ensue. The first is the need for these lean companies to keep productivity moving forward. But outward signs are beginning to indicate that this might not be possible at least at the current pace. Because of those trimmed-to-the-bones operations, business has reported a 4% increase year over year since 2001. But in late 2004, that pace began to slow suggesting that former gains through the late nineties ­ with the best possible scenario of growth at 3% - will return, or worse, the slowdown could become exaggerated to pre-1995 levels of 1.5% annual increases.

The odd result of strong productivity numbers is anemic job growth and slow wage gains. As productivity slows, wage gains are increased, as the few jobs available become the source of increased competition. Recent Fed reports are pointing at a post-technology productivity gains at 2.5%. This may not be good enough for Wall Street and will certainly not provide adequate incentive for Main Street to look for other investments beyond their own backyard.

The second problem facing Greenspan as he looks for the exit is the money. What-if possibilities are already surfacing as investors wonder who will foot the bill for any market expansion, wage growth, or increased productivity. Foreign investment has shrunk in recent months. Equity in homes has become more expensive to extract and Washington has not found a cure for their free-spending ways.

In order to keep things rolling, even hobbling, along, something has got to give. Business seems disinterested in growing their markets in the US. Washington seems hell-bent on borrowing as much as they need from whomever will lend them the cash. And Main Street is feeling the pinch of higher interest rates, increased prices, and slower job growth. Throw the cost of fuel into the mix and all three players face a somewhat unpredictable future in terms of operating capital.

The corner we have backed ourselves into is quite unique in the history of the United States. As we search for the way out, one thing can be counted on: the answer to all of these economic issues will no longer be housing.

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