Hope and Change We Can't Afford

This week, we've got Green Shoots...

Upside surprises for earnings and economic data have allowed equities and Treasury yields to rally. In the earnings arena, of the 16 reports out as of this writing, 12 beat expectations, including heavyweights CSX, J&J, Goldman, and Intel. The economic activity data was similarly positive, with overall retail sales, industrial production and the Empire Manufacturing survey reports all beating expectations. And yet for all this support for a positive outlook, the IBD/TIPP Economic Optimism and Bloomberg Global Confidence indexes both fell, and the weekly ABC Consumer Confidence survey remains mired near a record low.

This divergence likely reflects another divergence taking place. The private economy is looking good temporarily because it has been shielded by the Federal government from many of the shocks of the Great Deleveraging. However, investors and consumers realize at some level that the savior from Financial and Economic Armageddon, the federal government, is running up a tab that is not only unsustainable, but doing so at a pace that could prove crippling, if not outright ruinous, for the economy.

... but only as (or because) budget deficits are hitting records.

The federal government reported a June budget deficit of $94.3bn. The shortfall marked the first deficit in the month of June since 1991. Usually, individual and corporate quarterly tax filings ensure a surplus during the month. Unfortunately, receipts fell 17%y/y, even as spending surged 36.8%. Moreover, for the first nine months of the fiscal year, the deficit topped $1tn dollars for the first time, with revenues down 17.9% but expenditures up 20.5%.

The fiscal trajectory is simply "unsustainable"...

The Congressional Budget Office ["CBO"], in its June report, "The Federal Budget Outlook Over the Long Run", began with a rather stark assessment. "The federal budget is on an unsustainable path." The report highlighted the two key risks to the fiscal viability of the United States of America: Medicare/Medicaid and Social Security, with the vast majority of the threat emanating from rising healthcare costs. It discounted the effects of the current economic downturn on the long run fiscal viability of the United States, instead stressing that, "slowing the growth rate of outlays for Medicare and Medicaid is the central long-term challenge for federal fiscal policy." The CBO ruled out tax hikes, observing that "tax rates would have to reach levels never seen in the United States."

... so let's "double down" and spend more.

In the face of such a daunting situation, bold, decisive action is required, and that is the course the Federal government has chosen. This week, despite being unable to pay for its previous forays into national healthcare (Medicare/Medicaid), the House of Representatives passed legislation for a $1.5tn program that will ensure that healthcare becomes a right for all American citizens.

Of course, we'll have to raise taxes - on the rich ...

Perhaps realizing the irony of legislating yet more unfunded spending, the House proposed to raise taxes to pay for the new program. The House bill proposes a tiered surtax: 1% for households with AGIs of $350-500K; 1.5% for households with AGIs of $500-1,000K and 5.4% for households with AGIs greater than $1m. The support for a "soak the rich" tax program to finance health care has gained support with the general public. Whereas in March, a Rasmussen poll found 51% of respondents in favor of a "tax the rich" program, the support had swelled to 74% by April in a CBS/New York Times poll.

Despite the popularity of this course of action, there is real reason to question its wisdom. According to the non-partisan Tax Foundation, the added weight of this tax will increase the top marginal tax rate in 39 of the 50 states to above 50%. The smallest marginal rate would be Wyoming, at 47.25%, while the largest marginal rate would be Oregon, at 57.54%. If these sound like large percentages, they are. The average for OECD countries was only 42% (2006). Furthermore, consider that the top 10% earners (in terms of Adjusted Gross Income [AGI]) paid 68% of total Federal taxes collected, the top 20% paid 85%, and the top 50% paid almost 97%. Additionally, Congress' Joint Committee on Taxation forecasts that in 2009 47% of tax filers will owe no federal taxes, up from 35% in 2000.

In addition to appearing grossly skewed - even for a progressive tax system, a "tax the rich" program is likely to prove inefficient or even counterproductive. In November 2007, Congress' Joint Economic Committee issued a report observing that research had identified taxes particularly counterproductive to long-term economic growth as including higher individual income tax rates and "income tax surcharges on upper income households". Ironically, the paper extensively referenced a 2007 study by two academics that showed tax increases causing significant negative impacts on growth. One of the authors was none other than Christina Romer, Chairperson of the President's Council of Economic Advisors.

... but marginal tax rates were going up anyway...

Do not forget that the tax cuts from 2001 - 2003 are due to phase out next year. Ignoring politically charged semantics, the change from the phase out represents a relative tax increase that can already be counted on to create a drag on growth. Add to this weight the likelihood of increased taxes for the latest national foray into healthcare. And just in case anybody in the private sector is left standing, let's layer on the higher taxes the CBO has indicated will be necessary to fund prior big government projects: social security and Medicare/Medicaid.

... so enjoy today's Green Shoots - today.

Economists have pointed out that policymakers avoided a Great Depression in the past couple of years because they avoided raising interest rates and taxes, as happened in the early days of the Depression. Well, we're not out of this predicament by a long shot. And the Fed is out of interest rate ammo and our elected officials appear hell-bent on making the same policy mistakes as were made 80 years ago.

The situation could be retrieved by heroic asset purchases by the Federal Reserve, although such action could cost them their independence. A similar situation developed after WWII, and the potential for the loss of independence now is great enough that leading economic academics are spearheading a petition of Congress to maintain the integrity of an independent Fed.

If the Fed does not mount a rescue attempt, perhaps foreign governments could be counted on to use their excess savings gluts. No doubt, Treasury Secretary Geithner's recent travels to the Middle East involved that issue to no small degree. However, one wonders how much leverage he can obtain with the oil producing nations to finance US efforts to move away from oil consumption. Moreover, counting on foreign investment assumes other countries have excess savings they aren't currently plowing back into domestic stimulus programs.

What this all means for markets is that investors need to begin seriously considering the possibility of a double-dip recession (assuming H2'09 growth). And unfortunately, should this occur, the Fed will be left to stave off the slowdown with no opportunity to cut rates, which means the next dip could be even harder and long-lasting than the first.