America's Fundamentals

A Fundamental Subprimer:

1938 - Fannie Mae was created under President Roosevelt as a government entity to provide liquidity to the housing market in the wake of the Great Depression.

1968 - Fannie Mae was pseudo-privatized by President Johnson to remove it from the federal budget. To make this privatization feasible, the company was made exempt from taxation and oversight. To ensure competitive market, Freddie Mac was created in 1970 to perform essentially the same role. Critics say they had no incentive to pay down debt because (1) they were exempt from reporting financial difficulties to the public, (2) they were backed by government as GSE's, and (3) house prices always go up. The effects of President Johnson's overall policy were swift and disastrous (link).

1970 - President Nixon continued tradition by signing the Emergency Bill on Housing, a bill designed to inject "as much as $10 billion a year into the sagging home construction industry." White house construction quotas were still not being met, so interest rates continued to be artificially subsidized. (St. Petersburg Times - July 25, 1970)

2002 - President Bush releases the Home Ownership Policy Book.

The stated mandates of this policy include

• home ownership targets, with a focus on minority home-ownership,
• a $440 billion increase in the financial commitment made by Fannie Mae and Freddie Mac to fund mortgages,
• incentives for other mortgage lenders and
• tax credits and down-payment assistance for new and prospective homeowners

2005 to 2008 - The growing American housing bubble bursts. Financial markets around the globe suffer as a result, especially in late 2007 and the first three quarters of 2008. Fannie Mae and Freddie Mac are put under conservatorship in September, 2008.

September 19, 2008 - In response to market turmoil, Treasury Secretary Henry Paulson announces a plan to buy the toxic assets that were plaguing markets. Critics say it emulates the tradition of creative accounting--moving garbage around in the hopes that it won't start to stink until it becomes somebody else's problem. They say Henry Paulson has just named himself CEO of a new enterprise called Hermie Max. Supporters say they have finally taken the first step in accepting responsibility for these problems.

Obviously, last week's developments in the mortgage crisis have been developing for some time. But it is by no means the only problem the U.S. Economy is facing. In fact, many of the problems have been exacerbated by others which are not mutually independent from the credit crisis.

=====================================================

John McCain has refined his position that the U.S. economy is fundamentally strong to saying that American workers are the fundamental strength of the economy. Many take issue with both claims. The following is a disquisition as to why.


The Myth of The Hardworking American
As a generalization, the hardest working Americans are actually the landed immigrants. They believe in working hard to obtain 'The American Dream'. Although they are often unable to reach this dream, because of either lack of education or lack of credential recognition, they continue to work hard to ensure their children can live out their dreams. Unfortunately though, n^th generation immigrants (children of landed immigrants and their children) often lose this value of hard work. They tend to feel they are entitled to the American Dream rather than believing it is something they have to work for. They believe the living in America is a birthright rather than a privilege. In a lot of ways, they are technically correct--but that doesn't help labour productivity.

How hard Americans work in absolute terms is not really all that important with respect to the fundamental economy. What really matters is how hard the American citizen works relative to citizens other countries around the world. There is no question that labour unions have done very great things for the working class. However, in well-established societies, unions have basically become an extension of government and their value at present is now rather questionable. In American society today, government already mandates minimum wages as well as reasonable and safe labour conditions. The only purpose left for unions is to squeeze every bit of corporate profits out of the corporation for more benefits and higher pay. Competitive compensation is good, but union practices now make western business uncompetitive in increasingly globalized markets. They have actually caused job loss rather than increased employment. Meanwhile, developing nations were able to produce goods and services without the excessive labour costs exasperated by entitlements and labour unions. There was a very lengthy period of time when this labour cost discrepancy did not matter much for the western world. That's because the west held something more valuable than work ethic: knowledge. The concentration of literacy, education and knowledge in the western world meant that while Dollar Store items were 'Made In Taiwan', expensive technological items like cars and computers were still 'Made In America'. With globalization, the Internet, and other technologies, knowledge is more widely accessible than ever before. Computer science jobs are now being outsourced to India. Japan has taken over the automobile manufacturing industry. In China, the automobile industry is rapidly gaining ground although it is currently still in the 'pathetic' phase at this point. Critics who think they will never be able to make cars suitable for the western world should note that the same thing was said of Japanese automobiles when they first entered the industry. Relative to the American worker, productivity of the developing nation labourer is closing in fast. This is part of the reason why U.S. GDP growth has been declining over the years, while it has been increasing rapidly in developing nations like China and India.


History Does Not Side With US
Many advisers are saying now is the time to make long-term investments in the U.S. economy because markets are undervalued. This is likely true, and markets are indeed likely to be higher in 12 months than they are today. These advisers are saying to look at history as proof that the markets will recover; that markets have always recovered from downturns in the long run. This idea that history is a key to the present is very important--but they are using a panoramic lens instead of taking the 360 degree view. The panoramic lens goes back to the start of the twentieth century; the 360 degree view goes back to the first dominant human civilizations. Dominant superpowers have always overextended themselves to the point that their decline of power becomes an inevitable conclusion. This doesn't necessarily mean the American Empire^* will go the way of the Roman or Ottoman Empires; but it may go the way of the diffused and diluted British Empire. Some historians think this happens because the intrinsic rigid nature of empires leaves them incapable of adapting to change.

*Many Americans are reluctant to call the America an empire, and prefer the term 'superpower'. I suspect this is because of stigma surrounding the fact that no empire in history has ever maintained its hegemony status for more than several centuries. Ultimately though, it will be up to historians to decide on an appropriate title for America's global influence.

The Swinging Pendulum
Turning the focus back to the economy at present, most analysts estimate there is still another 6-18 months before the fundamentals of the United States housing market hit bottom. The reason, they say, is an excess inventory of homes and historically low federal lending rates poised to rise in the coming months when the economic outlook improves. Confidence in U.S. markets has been shattered and it will take some time to repair. Money is on the sidelines and everyone is blaming it on the regulators, greed, and white-collar criminals. By 'everyone', I include those who would normally call themselves libertarians and 'ultra-free-market-capitalists'. They concede that Freddie Mac, Fannie Mae and AIG were too big to fail and in need of a government bailout. They will give very serious consideration to Paulson's plan for two reasons:

1. By not moving toxic assets to the taxpayer balance sheet, it could cause a depression. All but the most idealist free-marketeers will accept government intervention if this scenario proves realistic.


2. The credit rating of the U.S. is being eroded. If the government doesn't bail out China and the other creditors that hold the bad debt, then the foreign creditors will stop lending the U.S. money. It would be like trying to refinance a mortgage after declaring bankruptcy--creditors don't lend to clients who don't repay prior debts.

This is a sign that the ideological pendulum is swinging from right to left, and it is now poised to swing too far to the left. Regulation is a necessary part of markets; but only to provide stability and sustainability in an otherwise chaotic 'free-market'.

Under-regulated markets lead to volatility and unpredictability, while over-regulated markets lead to predictability and stagnation. Growth is good, and so is predictability; it's just a matter of finding the desired balance of the two. The swinging pendulum should be stopped somewhere closer to the center rather than the extremes where it was, and where it is now headed. When the Republican presidential nominee says "the regulators were asleep" and wants to dismiss the SEC commissioner for not regulating markets more, this is rather disturbing for the growth side of the equation.


Debt and Deficits
In defence of George W. Bush--the 9/11 hero that has now fallen out of favour with the American public--his policies are now, like those of most presidents at the end of their terms--more responsible since he doesn't have to worry as much about political backlash. He has threatened or tried to veto virtually all of the fiscally irresponsible bills put forth by a democratically-controlled congress (mostly to no avail). None of the recent bailouts were part of the budget.

Bail Out Recipient	Guaranteed (Public) Debt
Bear Sterns	$30 billion
Freddie, Fannie	$200 billion1
AIG	$85 billion2
'Toxic' Mortgage Nationalization	$700 billion
Big 3 (GM, Ford, Chrysler)	$25 billion3
Total	$1.04 trillion

Notes:

1. Freddie Mac and Fannie Mae could cost taxpayers much more or less, no one really knows yet as this depends on how many more defaults there are.
2. AIG was made to sound like a great deal for taxpayers. The balance sheets of AIG aren't public but there is an unlikely scenario that taxpayers could profit and actually get a good deal. Note that free market enterprises would not capitalize on this potential 'bargain' given the high degree of risk. $27 billion of the 'loan' was reportedly used within a day of the takeover.
3. The big 3 deal is currently being lobbied to U.S. congress. GM is most desperately in need of these funds and some think the figure could be as much as $50 billion.

The U.S. Government Accountability Office states in a 2007 fiscal report that "The government is on an unsustainable fiscal path." It is their job to be alarmist, as this department is meant to hold congress accountable. But even if the debt projections are reduced by an order of magnitude, the picture still doesn't look pretty. This is on top of government deficits that are expected to be US $500 billion (excluding bailouts) for 2008 and only slightly less in 2009.
Neither presidential candidate has a realistic policy platform. Both tax increases and spending cuts are required just to stop the deficit, let alone reduce the $10 trillion federal debt. This figure excludes health care and social security entitlements that are expected to increase in the coming years.

In Canada the health care entitlements are an even bigger problem because of a public health care system. The baby boomers will begin reaching the standard retirement age of 65 in 2011. Health care costs will continue to rise as they have been in recent years and perhaps this rise will become exponential with the aging population blip. At some point in the very near future, Canadians will need to decide between privatizing health care and raising taxes. As the fiscal surplus is gone, there is simply no alternative; but at least in Canada the problem is not compounded by an increasing trade deficit as it is in the United States.


GDP Against Black Gold
America is addicted to oil. Furthermore, it's domestic supply continues to decline meaning it needs to export an increasing amount of wealth to feed it's addiction (see 500 billion dollar problem). As this happens, the U.S. GDP begins to work like the mirror image of oil prices. There aren't too many people left that believe the price of crude oil will go back to $40 a barrel. Given the current level of energy dependence, a sustained price of $40/bbl or less is the only likely way for the American GDP to grow at the same average annualized percentage this century that it has over the last century. This doesn't mean I think the economy can't still grow, but the higher the oil price, the more stagnant it will become. And right now at least, oil prices and the economy are in lock-step--as the economic outlook of the largest oil consumer appears strong, oil prices rise; when economic outlook is weak, prices fall. I can't see how the United States economy can be considered fundamentally strong with oil priced over $100 for each barrel.

It is for this reason of course, that energy independence (or more accurately reduced foreign oil dependence) is now such a hot topic. From this perspective, offshore drilling will help. Though as parties debate how much it will help, oil from this source won't hit markets for at least another ten years. Contrary to popular belief, there is no technological fix to America's energy dependence problem. Any realistic political fix to this problem would need to focus on facilitating revolutionary social change. Most of this required change relates to an incredibly powerful and convenient device called the automobile. There are 250 million registered passenger vehicles in the U.S., more than 8 for every 10 people. The transportation industry consumes half of America's oil, yet no feasible fuel exists to replace gasoline as oil prices rise. The much-hyped alternatives have some potential, but none will result in a seamless transition from oil.

Natural gas
If a T. Boone Pickens-type plan were implemented, NYMEX natural gas prices on the continent would double to approach or exceed prices in Europe. Driving range between refuelling of natural gas-powered vehicles is considerably reduced. While the U.S. has more recoverable reserves of natural gas, they are not that much more, and it would also turn Russia into the new Saudi Arabia.

Ethanol
Brazil's sugarcane-based biofuel model can't be scaled up to meet the transportation requirements of the United States, especially using corn-based ethanol. This fact only became apparent to some legislators when corn and grain prices began to skyrocket to unprecedented levels due to artificial biofuel subsidies.

Hydrogen
This fuel is not an abundant natural resource as it does not exist in its elemental form anywhere on Earth. Currently, most industrial-use hydrogen is generated from steam reforming of natural gas (CH₄ + 2H₂O → CO₂ + 4H₂). Hydrogen can also be split from water using electricity but the process is thermodynamically inefficient--it requires considerably more energy input than a fuel cell will ultimately output. This is why hydrogen fuel cell development has been slow.

Conservation and Fuel Efficiency
Gains here are limited, and the more significant gains come at a price--automobiles that are more expensive and unaffordable. First-generation hybrids (those that don't plug in), are a good example of this.

Electricity
The electric car in its current form can't replace the automobile. They simply don't have the speed or range to meet the current social requisites of America. Batteries just aren't amenable to energy storage the way liquid fuels are. No one had to kill the electric car in the conspirator sense some have suggested. The Chevy Volt is a plug-in hybrid that will to come close to meeting social requirements with an optimistic 2010 production date, but at an estimated cost of $30-40 thousand apiece. GM's Vice Chairman Robert Lutz says that hybrids will never be as cheap as gas-powered vehicles for one simple reason: they require two power-trains instead of one. Instead of trying to meet the social requisites, the auto industry should focus their efforts on creating and marketing electric cars as 'urban utility vehicles' rather than as standard cars.

Given that technology will not provide a seamless transition from oil to other fuels in the transportation industry, Americans will be required to undertake social change. In terms of social lifestyles, what energy independence means is not that air travel, trucks and gasoline-powered cars will disappear completely. However, it does mean that the "soccer mom" who drives three kids to extra-curricular activities in different corners of the city in an H3 Hummer will cease to exist. She will find different activities closer to home without compromising the developmental opportunities of her children. Many people, including policymakers, find this new reduced dependency on the automobile very difficult to visualize because it requires a change in the way we think about transportation. This is why it will likely take 40-50 years before any significant degree of U.S. energy independence is reached, perhaps a decade or two less with political facilitation. And yet, the wheels for this have already been set in motion with the collapse in the sales of gas guzzlers and material reductions in air travel (the gas guzzlers of the skies). High gas prices also served as a catalyst in the collapsed assumption that 'house prices always go up', particularly in distant suburbs requiring excessive commute times. In time, the white picket fence will fall out of the American Dream. Unless the world can continue to produce oil at well over a thousand barrels a second, these changes will continue. Unfortunately for the United States, it continues to lose its grip on oil production, which means the change must be financed from within, and this will hurt GDP and growth as a result.


In Brief
As the western countries continue to lose their monopoly on knowledge, the higher work ethic will allow developing nations to continue to steal market share in terms of productivity for goods and services. As America's domestic supply of natural resources continue to decline, and the overpopulated world continues to consume them at an unsustainable rate. An incredible amount of energy will need to go into a structural change in the American way of life. As this happens, the U.S. will continue to lose its grip on control of strategic resources in countries like Venezuela, Iraq and Nigeria. Even domestically, resistance exists to the exploitation of coal and offshore oil reserves because of concerns about the environment. All of this means America's public and private debt is likely to continue increasing to the point where America will not own itself anymore, its foreign creditors will. Government will become incapable of acting on behalf of its citizens as it will become forced to appease its creditors. Useful work will go towards change, and repaying debt, and it is this that will circumvent growth. This is why the fundamentals of the U.S. economy are not all that good.