An Explanation of the State of our Economy

By: Alex Harris

First of all, I’d like to say that I personally apologize to those of you who do actually enjoy reading this blog periodically. Clearly, it’s been a while since I’ve taken the time to write; apparently college takes its toll.  But, that’s neither here nor there, because right now there are a lot of economic developments taking place that will seriously impact each and every one of us at some point or another and they certainly deserve some attention.  This article will delve into a few critical issues, and I will do my best to explain them from a layman (or perhaps a college student’s) perspective.

The most obvious of these critical issues is the current run-up of a wide array of significant equity indexes, namely the S & P 500.  On March 6, 2009, the S & P reached its low of 666.  Today, it closed over 1,100 representing a nearly 70% increase over an 8-month period.  Government measures, such as Cash-for-Clunkers, a first time home-buyer tax credit, and aggressive bailout measures, coupled with unexpectedly high GDP growth (a result of the government measures) and a federal funds target rate of 0 - 0.25%  (the rate at which banks lend to each other) has outmatched the highest level of unemployment in nearly three decades to instill confidence in risky asset classes (particularly equities).

Furthermore, an issue that doesn’t get nearly enough attention from the mainstream media, the value of the U.S. dollar continues to deteriorate on a daily basis.  The dollar index closed today at approximately 75, a level that is both lower than its 50 and 200-day moving averages, which is typically regarded as a bearish signal.  Why has this occurred?  First and foremost, the institution that controls our nation’s monetary policy, The Federal Reserve, has continually pledged to maintain extremely low interest rates for an “extended” period of time.

This type of policy allows money to be easily accessible because it is cheap. As a result, more and more money flows into the economy, making everybody’s dollars less and less valuable.  Makes sense.

Now, the Fed believes that flooding the system with dollars will help bring the United States out of this recession, however, it is more important to look at the long-term implications, some of which are already coming to fruition.  When dollars are cheap, big time market players are inclined to borrow large sums of dollars to purchase riskier assets, such as equities and fixed income securities in emerging markets, such as China and Brazil.  This is commonly referred to as “the dollar carry trade” and will inevitably, although not necessarily tomorrow, cause asset-bubbles to form, however this time it won’t be in the U.S., it will be throughout the world.  So unlike Alan Greenspan who pledged to keep rates inexplicably low for an entire year (2003-2004), causing the domestic real estate bubble of 2007 to burst, current Fed Chairmen Ben Bernanke will pledge to keep rates inexplicably low for an entire year (if not longer), causing asset-bubbles to form within a breadth of international economies (all of which are extremely important to our long-term growth).  This easy money policy is most likely a spirited attempt from the Federal Reserve and the government alike to bloat stock prices and therefore instill greater confidence in our economy.

They got the first part right, but the second part will not work.  Why?  Just think about it.  I can almost guarantee that a close relative of yours, or perhaps your own mother or father has recently been laid off and is having a difficult time finding another job.  With the real unemployment rate hovering around 20%, household incomes will continue to decline making it harder and harder to pay off personal debts, or more importantly, increase personal savings which is the only true path to economic recovery.

More importantly, the credit crunch hasn’t seemed to have dissipated nearly as much as previously believed.  Small business owners continue to struggle gaining access to credit, even if they are credit-worthy, resulting in the stymying of entrepreneurial growth.  Beyond that, continued political activity (specifically the universal health care debate) creates overwhelming confusion among executives, forcing them to hold off on hiring and additional investment.  So, even though there has certainly been an uptick in M&A activity across many sectors (representing a newfound appetite for risk and access to credit markets) many Americans continue to lose their jobs making the proverbial task of keeping their heads above water more and more difficult.

To conclude, it is important to note that The Federal Reserve’s main goal is to promote maximum employment and price stability.  So far, they have done neither.  What they have done is failed to increase the value of our money, push the S & P to extremely unattractive levels (currently the S & P’s earnings are at around 130; it’s historical average from 1988 to 2008 is right around 20), and create unsustainable commodity prices, particularly gold which today reached another record high of 1,138 dollars an ounce.

Basically, it’s safe to say that this policy/unintentional result (look at it as you will) cannot continue.  Economic growth will not occur if we don’t realize our mistakes, and face the consequences; no matter how difficult that may be.  Our financial institutions need to recognize losses on their loans, rather than hiding them with scrupulous accounting measures.  Our government needs to recognize reality and stop hiding these bad loans on the Federal Reserve’s balance sheet.  And most importantly, we need to educate ourselves about the implications of kicking the can down the road.