With the Economy, Perception is Reality: 2008 US Open of Surfing

This past weekend, the finals of the U.S. Open of Surfing, a six star World Qualifying Series event, graced the south side of Huntington Beach pier. Amidst the world class men’s and women’s surfing, skateboarding, BMX, and freestyle motocross, one could not ignore the babble that erupted from the loudspeakers as the announcers narrated over the lulls in the surf.

In one impulsive outburst, the announcer denounced high oil prices and their impact on the economy, declaring that a recession in the U.S. has impacted everyone based on his anecdotal evidence of more surfers spending their daily lives at the beach. A quick glance around the venue, however, painted a much different picture. Dozens of sponsors had erected large tents and displays to promote their products.

Honda, the headline sponsor, had no less than ten vehicles and personal watercraft conspicuously arranged around the venue. Other companies distributed free clothing, energy drinks, hotdogs, and natural food bars to more than 100,000 fans that crowded the beach to enjoy the free events. The U.S. economy, it seems, is resilient in the face of bank failures, high oil prices, and rising inflation.

Despite the challenges facing the economy, the U.S. has not experienced even one quarter of negative economic growth, with the first quarter of 2008 registering a 1% increase in gross domestic product. Thursday’s release of second quarter GDP growth data will likely show similar signs of modest growth, refuting projections of a recession. When it comes to economic matters, however, perception is reality.

Weakness in housing has affected both banks and consumers, which continue to entrench themselves fearing further economic distress. Unemployment has risen with continuing claims rising 21% to 3.1 million people over the past year. The diversity of the American economy combined with extensive global integration has provided support, however, to an economy afflicted by pockets of weakness. Major investments by Asian and Middle Eastern funds have bolstered the capital positions of U.S. financial institutions while Congress and the Federal Reserve have enacted a seemingly endless array of stimulus and bailout packages designed to alleviate weakness in housing and financial institutions. The ability of the U.S. economy to avert a full blown recession will depend largely on the restoration of public confidence in the financial system and an expansion of the availability of credit. Public consternation over high oil prices and news of bank failures may dominate the media, but the spectacle of the U.S. Open of Surfing suggests that both the U.S. economy and the Huntington Beach south swell will keep on rolling.

A Slippery Slope towards Socialism

The United States has become a society of overly coddled children that demand all of their whims be satiated while absconding any personal responsibility. Consumerism, fostered by an endless barrage of product marketing, has permeated the psyche of Americans compelling an unsustainable accumulation of material goods and an obsession with image and status. The innovative U.S. financial system facilitates this excessive consumption by readily extending credit to anyone who can sign their name, giving little consideration to such factors as income, debt outstanding, or ability to repay. America has become a society of debtors.

Entranced by a desire to project an image of success and accomplishment, Americans indulge in the luxuries of the world, leveraging their assets and mortgaging their future income in the process. Ultimately, these debts come to bear and the overly extended populace cries foul, claiming they were duped by unscrupulous lenders, shifty salesman, and greedy corporations. U.S. political leaders, who previously embraced the housing boom and pervasive availability of mortgages, now rail against the excesses by casting a net of blame far from their shores. In order to assuage their guilty conscience, Congress recklessly proposes an endless array of bailouts, “stimulus” packages, tax credits, and socialization of privately incurred financial risk. Government intervention encourages the excesses that foster risky behavior and a misallocation of capital, preventing the market from properly revaluing assets and imposing a discipline on both consumers and investors.

A market economy functions properly when it is free of government intervention. Paternalistic bureaucrats, in an effort to rescue their constituents from self inflicted hardship and misfortune, constantly propose policies that incent “desirable” behaviors and distort market driven corrections. When the market imposes a severe punishment for misdeeds, politicians react in earnest by legislating sweeping “reforms” and regulation. As any parent knows, one cannot always protect his children from harm, but instead should provide constructive advice and guidance to foster good decision making. By providing exorbitant tax incentives for home ownership while concurrently promoting consumption as a patriotic duty, the government has encouraged overconsumption and excessive accumulation of debt, especially in the housing market. For many, this burden has become unmanageable, resulting in financial failure and personal hardship. Congressional paternalism, however, absolves personal excesses and reckless behavior while burdening the responsible and cautious with the obligations of others. Until philosophies of responsibility, accountability, and individual choice emerge as guiding principals of the democracy, the United States will continue on a slippery slope towards socialism.

The End of U.S. Economic Supremacy

For more than a quarter century, the United States has been mired in a global trade imbalance that has led to a consistently rising current account deficit. An overwhelming dependence on foreign oil combined with insatiable consumer demand has driven the trade deficit to record heights. Despite significant declines in the value of the dollar and steady export growth, the U.S. current account deficit has grown from $140 billion to $739 billion, a 426% increase in the past ten years. The accretion of nominal deficits, however, does not tell the whole story. The U.S. current account deficit as a share GDP has risen from 1.7% to 5.3% over the past decade, further exemplifying a growing dependence on foreign goods and an inability of the U.S. economy to meet the demands of the consumer.



Trade imbalances emerge when domestic demand exceeds the productive capacity of the economy. Consumers resort to imports in order to alleviate deficiencies in domestic production resulting from an insufficient investment in capital or an inadequate labor supply. In the short run, the productive capacity of an economy is constrained by its endowment of capital and labor. Incremental short term improvements in labor productivity can be attained through longer working hours, but these gains are generally temporary in nature. Capital, on the other hand, requires long term planning as it takes years to design and construct new office buildings, production equipment, and manufacturing facilities. While differences in consumer preferences and comparative advantages lead to trade among nations, large persistent trade imbalances point to excess consumption and insufficient investment.

A trade deficit should not, on its face, be considered unfavorable, but one that finances consumption demand as opposed to investment portends an inevitable day of reckoning. For the U.S., that time may have come. Years of inadequate domestic investment in energy exploration and production has resulted in a dangerous dependence on foreign sources of energy. Whether it is opposition to offshore drilling, a reluctance to build new refineries, aversion to coal fired power plants, or trepidation about nuclear energy, the United States energy policy has been held hostage by lobbyists and opposition groups that have derailed efforts to craft a national energy policy. The environmentalist lobby prevented meaningful debate about a comprehensive energy policy and squashed President Bush’s proposals in 2002 that would have substantially increased domestic energy production, alleviating much of the current global supply inadequacy. More than six years of inaction have been marked by discarded plans for multiple coal fired power plants and oil prices that have increased more than 500% since the national energy debate was suppressed.

The United States spends between $600-700 billion per year on imported oil, representing virtually the entire trade deficit. Oil imports do not increase domestic productive capacity, but instead are symptomatic of the inability of the United States’ energy infrastructure to meet the needs of consumers. If politicians continue to forsake the best interests of the nation in favor of environmentalist opposition, the United States economy will be crippled by skyrocketing energy prices, soaring inflation, higher real interest rates, and continued weakness of the dollar. Failure to embark on an aggressive and realistic plan towards energy independence will perpetuate the extraordinary transfer of wealth to oil producing nations, threatening the future of the U.S. economy. Congressional procrastination has eroded the standard of living of millions of hard working Americans and depressed economic growth. Further inaction will precipitate the end of U.S. economic supremacy.

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United States Congress: A Sanctuary for the Ignorant and Inept

A case study in organizational dysfunction, the United States Congress ignored early signs of trouble and trumpeted the strength of an economy built upon a precarious housing bubble. When signs of strain in the energy and oil markets emerged with the electricity crisis of 2000-2001 and the subsequent rapid ascent in oil prices, Congress cried “foul” but resisted proposals by the president to expand domestic drilling and nuclear energy production. Instead they idly watched oil rise from a low of $20 per barrel in 2001 to a recent high of $145, all the while decrying the “windfall profits” of oil companies and the exploitation of the consumer. Meanwhile, the Federal Reserve fueled the housing boom with excessively low interest rates and the corresponding surplus liquidity. Congress publicly celebrated the economic growth engendered by the mania of the mortgage and housing markets, but it currently attempts to deflect culpability now that the gravy train has been derailed. Accusatory fingers have been pointed at oil speculators, predatory mortgage lenders, and greedy bankers in an attempt to obscure congressional complicity in the excessive consumption, degraded lending standards, and lax monetary policy that beget the disastrous credit crisis gripping our economy.

Figure 1 – Oil Price History from 2001 to Present
7/15/08 - Oil Closed at $138.80 per barrel (Source: Bloomberg)

As oil prices climbed in lockstep with the rapid growth of China and India, Congress and the Federal Reserve extolled the virtues of low core inflation while headline inflation, an index that includes volatile food and energy prices, soared with the ascent of commodity prices. Higher commodity prices resulted in a corresponding rise in the trade deficit as the United States exchanges more than $700 billion for imported oil every year. Like a frightened deer staring into oncoming headlights, Congress and the Federal Reserve refused to respond to a steady decline in the dollar and the debasement of consumer spending power. Alas, the opportunity to prevent, or even abate, a credit market implosion and rampant inflation is a distant memory.

Figure 2 – Headline vs. Core Inflation and Spread
Green implies Headline Inflation > Core Inflation (Source: Bloomberg)

In an effort to justify their government salary, congressmen and women speak out with righteous indignation as they propose bailouts of financial institutions and individuals that are paying the price for their embrace of excessive consumption and fanciful lending terms. Whether it is a housing bailout bill supporting the banks that precipitated the credit crisis or multiple economic stimulus packages designed to subsidize consumers that borrowed excessively to finance insatiable consumerism, Congress never fails to embrace a solution that socializes the excesses of the few and engenders the political support of the beneficiaries. In an attempt to obfuscate their culpability, Congress inevitably embarks on a campaign of disinformation and persecution by calling for investigations, sanctions, and regulations to portray an appearance of action despite years of complicity.

Legislation that emerges from the throws of crisis and public outrage is often substantially flawed, contributing more to the problem than the solution. Restricting speculation in commodities will drastically reduce liquidity and constrain the price discovery function of free markets. The adverse impact on domestic commodities trading would drive well functioning capital markets to overseas financial hubs, further diminishing the appeal of the U.S. financial industry and exacerbating layoffs in an industry reeling from the credit crisis. The newly unemployed, however, should take solace in their receipt of another economic stimulus check that would do little to relieve their financial need. Additional stimulus packages, in combination with the $300 billion “housing” bailout bill and the original $150 billion stimulus plan, will grossly inflate the federal budget deficit contributing to a national debt that is spiraling out of control. In order to diminish the impact on the deficit, the Democrats would likely propose offsetting future handouts with “windfall” profit taxes on oil companies, further discouraging energy exploration and increasing our dependence on foreign oil. With congressional intervention, it seems the cure is worse than the disease!

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American Banks: A House of Cards

Reputation and trust are the cornerstones of financial stability. Once public confidence is eroded, an institution loses the ability to fund illiquid long term assets as credit availability evaporates. In order to magnify the relatively small spreads earned between borrowed funds and earning assets, banks utilize a high degree of leverage, often operating at an 8 percent capital cushion and 12 times leverage. As short term funding becomes prohibitively expensive or vanishes altogether, the financial institution quickly becomes insolvent as in the cases of Bear Stearns and IndyMac. Commonly referred to as a “run on the bank”, this phenomenon can quickly become a contagion as growing uncertainty causes depositors and creditors to become concerned about return of capital as opposed to return on capital. The continuing erosion of credit quality in the mortgage market leads to growing unease among lenders and depositors in America’s financial institutions. The slightest hint of weakness, such as comments by New York Senator Charles Schumer about the prospects at IndyMac, quickly brings down the house of cards.

The U.S. financial system is trapped in a seemingly endless cycle of crises that elicit the typical policy response – a government bailout. Bank executives, politicians, and government officials generally try to support the financial system through public speeches and policy statements, but responses become limited once distrust and fear permeate throughout the public consciousness. As a crisis of confidence takes hold, the U.S. Treasury and Federal Reserve must respond by orchestrating bailouts and providing financial support such as the Term Auction Facility for banks and brokers and an expansion of credit lines and equity financing for government sponsored enterprises Freddie Mac and Fannie Mae. These bailouts encourage a misallocation of capital that perpetuates the mortgage crisis and ultimately effects substantially higher losses.

The notion of “too big to fail” has become popularized among investors that view the largest commercial and investment banks as certain candidates for a government bailout in the event of insolvency. A sense of security, reassured by previous Fed actions, permeates the investment decisions of institutional and individual investors alike. These investors allocate excessive capital to weak financial institutions, postponing or potentially averting another bailout. Given the perception of a government guarantee, investors accept lower risk premiums and devour new debt issues as though they will provide a risk free premium to treasuries. Until the government restores market discipline through effectively managed dissolution of failed institutions, it risks enabling new asset bubbles by replacing overvalued mortgage securities assets with mispriced bank debt.

The Treasury and Federal Reserve must regain control of the financial system and restore discipline in an orderly manner. Replacing the housing bubble with new excesses fails to address the issues and postpones necessary market corrections. In order to restore discipline, the government must resist the easy solution of taxpayer funded bailouts and instead facilitate the sale or dissolution of the failed institution. The coordinated sale of Bear Stearns, while painful for equity investors, generally bailed out creditors while transferring almost $30 billion of credit risk to the Federal Reserve. The regulatory environment for the investment banks and government sponsored enterprises must be reformed so the Federal Reserve can take receivership of failed institutions and orchestrate an acceptable disposition, much as the FDIC is now coordinating with IndyMac bank. The creditors of the failed institutions, as opposed to uninvolved taxpayers, should absorb any residual losses resulting from insufficient capital. Until market discipline is restored, asset bubbles will continue to pervade our economy and innocent taxpayers will subsidize the excesses of the wealthy and privileged.

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Will Fannie and Freddie Cause More Credit Market Turmoil?

With the credit market recovery predicated on the precarious balance derived from Federal Reserve liquidity injections, capital infusions by sovereign wealth funds and investment managers, and bailouts of major financial institutions, one must wonder if this period of stability has legs. Prior fits of turbulence in late summer 2007 and March 2008 led to dramatic market seizures that froze access to capital, eroded confidence in counterparties, and led to the demise of two dominant financial institutions. The current credit market predicament is the result of years of overabundant liquidity and exorbitant hubris among Wall Street bankers that led to an inexplicable decoupling of risk and return. Begrudgingly, market participants are revaluing deflated assets as the extent of credit impairment in the financial system continues to be exposed.

The erosion of capital at both large and small financial institutions has resulted in unprecedented campaigns to recapitalize through both equity and debt issues. Thus far, liquidity has continued to be available, especially for those institutions deemed “to big to fail”. A failure of any of the largest financial firms, it is suggested, would erode public confidence and permeate through the financial system such that regulators would be compelled to step in and prevent the inevitable collapse. Once the Federal Reserve stepped in to coordinate a bailout of Bear Stearns, precedence was established giving credence to the theory of “too big to fail” and providing a false sense of security that decouples risk from return. Investors of all stripes have devoured new debt and equity issues of large banks and financial firms under a false sense of security. Ultimately, investors will once again realize that no firm is immune from failure and there is much more risk in the system than originally perceived.

The government, seeking to prevent future failures, has attempted to pass legislation to bailout the mortgage lenders, transfer risk to the Federal Housing Administration, and facilitate jumbo lending through Fannie Mae and Freddie Mac. By encouraging the refinancing of mortgages through the FHA, Congress will effectively transfer future housing losses to taxpayers while enabling financial institutions to offload their highest risk loans. Given that previous attempts to stimulate the mortgage market by expanding the lending limits of Fannie and Freddie have failed and the securitization market has collapsed, the only source of incremental mortgage liquidity is through government guaranteed FHA loans. Soon, however, the limited liquidity provided by Freddie and Fannie in the conforming loan market may dry up as well. Mounting credit losses confront incredibly low capital levels, raising the risk of default and dictating a Herculean campaign to raise at least $75 billion in capital. Major commercial and investment banks, however, have raised more than $100 billion over the past year jeopardizing the GSEs’ ability to amass the requisite amount of new capital.

A further contraction in mortgage market liquidity could push the credit and housing market to the brink of collapse. Just as an abundance of easy money drove the housing bubble to inexplicable heights, a lack of liquidity has restricted access to credit and reduced turnover in the housing market. Without additional capital, Fannie and Freddie will be forced to constrain their balance sheet, limiting their ability to issue new mortgage loans. This will lead to a dramatic increase in mortgage credit losses, a slowdown in economic growth and employment, and further write-downs which raise the probability of bank failures. With the Federal Reserve’s policy responses limited by the bailout of Bear Stearns and its Term Auction Facility (TAF) commitments, the government, and ultimately the taxpayer, will be forced to bailout the financial system in order to avert disaster. The ability of Fannie Mae and Freddie Mac to raise capital over the next few months may determine the future of the credit and housing markets and dictate the severity of the economic downturn.

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NAFTA and Protectionism in the U.S.

Now that the Democratic Presidential nominee is all but official, the rhetoric about revising successful free trade agreements has dissipated, but the underlying protectionist movement continues. Recent actions by Congress blocking free trade agreements favoring U.S. companies, most notably the Columbian Trade Promotion Agreement, has destroyed years of precedence and hamstrung U.S. trade negotiators. Despite frequent consultation with members of Congress and years of negotiation, Democrat Nancy Pelosi, the House Speaker, effectively killed the Columbian agreement by blocking a vote within the 90-day limit. Columbia already enjoys preferential access to U.S. markets as a result of the Andean Trade Preference Act. The U.S. – Columbia TPA would convey substantial benefits to U.S. industry, but election year politics and rhetoric unearths a growing protectionist bias that threatens to derail the global economy and further disadvantage American companies.

Protectionists, viewing globalization as a threat to American workers, seek to block all trade pacts under the guise of human rights, working conditions, or environmental policies. The most vocal of all protectionists are the large unions that wish to maintain their profitable control over a shrinking organized workforce. Unions exploit their base by extorting dues from hard working Americans, utilizing the majority of these funds for political purposes rather than labor negotiations. Legislative attempts to enable workers to request a refund of dues not used for collective bargaining have been met with fierce resistance. Unions prefer to leech off the productive labor of their members and lobby for protections that often are aligned with political ideology rather than the interests of their constituents. The protectionist movement reasserted its voice once the Democrats regained control of Congress, severely threatening global economic growth and opportunities for developing nations.

As one of the global economic superpowers, the United States has significant negotiating power ensuring that trade agreements are beneficial to society as a whole. The North American Free Trade Agreement (NAFTA) has strengthened ties between the U.S., Canada, and Mexico. Signed into law in 1994 by President Clinton, NAFTA eliminates virtually all duties on goods traded between the three counties. The efficient U.S. agricultural and equipment industries have boomed as a result of open access to new markets. Alternatively, Mexico has benefited from a rising wage base due to an influx of basic assembly jobs in the automotive and appliance industries. U.S. manufacturers are more competitive globally due to the basic assembly work performed by their Mexican subsidiaries while many Mexican workers have obtained relatively high paying local jobs. As trade increases the standard of living in Mexico, the strains on U.S. infrastructure due to illegal immigration are abated. Conversely, the integration of Canadian and U.S. economies has provided access to Canadian natural resources that are integral to the energy and raw material intensive U.S. economy.

Why, then, would there be such opposition to a mutually beneficial trade pact by well educated politicians such as Barack Obama and Hillary Clinton? The comparative advantage of nations dictates that some industries will benefit more than others leading to displacement of workers in less efficient industries while creating higher paying jobs in others. In Mexico, NAFTA has led to more jobs in assembly and manufacturing while the domestic agriculture industry has suffered due to a relative inefficiency compared to U.S. agribusiness. Alternatively, the U.S. has seen a decline in basic manufacturing jobs but a dramatic increase in high value research, technology, and service industry jobs. Labor unions, fighting to protect their gravy train of dues, lobby intensively and wield extraordinary political influence. The authenticity of the anti-trade rhetoric extolled by Barack Obama while campaigning in Ohio, a state suffering from a decline in manufacturing jobs, has been called into question. Some Democrats, however, acquiesce to the demands of the unions and embrace the protectionist movement knowing that a windfall of campaign contributions and political support will ensue. They choose to forsake the good of the nation and deliver protections to the minority. Currently labor unions represent only 7.8% of the private sector workforce, but their lobbying power far exceeds their size as a result of their ability to extort dues from the American workforce.

The trend towards protectionism has dire consequences for the U.S. economy. It was protectionism, such as the Smoot-Hawley Tariff act of 1930, which drove the U.S. economy into the devastation of the Great Depression. More than 1000 economists opposed this legislation, but President Herbert Hoover acquiesced under political pressure leading to devastating consequences. The mere prospect of greater tariffs and barriers to trade likely precipitated the stock market crash of 1929. The U.S. will quickly be left behind in a global economy that bows not to the whims of self-interested politicians, but instead reacts to the demands of market forces. Growing protectionism threatens more than just the union jobs it seeks to defend, but also undermines the economic growth and competitiveness of American industry. Given the current fragility of the global economy combined with anemic growth domestically, the U.S. can ill afford a resurgence of protectionism and the devastating consequences that are sure to ensue.

Independence Day

On this Fourth of July, the anniversary of our great nation, let us remember the brave men and women that have made selfless sacrifices in defense of liberty and freedom. Our fathers and theirs have toiled at the crucible, dreaming of a better life for their families paid for through sweat and blood. They left this earth a better place for their children and the generations to come. As we celebrate our independence and liberty, let us not forget the challenges that face us today and strive to conquer these obstacles for the betterment of mankind. Global energy shortages, a housing crisis, rising inflation, excessive consumer spending and debt, terrorism, and an anemic economy threaten the viability of our way of life. Celebrate this memorial of our independence by approaching these threats with steadfast resolve and innovative solutions as collectively we will persevere.

Happy 4th of July. Be safe and dream big.

The Future of American Automobile Manufacturers

Skyrocketing oil prices combined with a slowing economy has put the brakes on an automobile industry that was already reeling from supplier bankruptcies, labor unrest, and shifting global preferences. U.S. automobile sales fell to an annualized rate of 13.6 million vehicles, the lowest volume since 1993, with declines of 28 percent at Ford and 16 percent at GM. The rapidly accelerating sales declines at American automobile manufacturers are symptomatic of a product mix that no longer meets the needs or preferences of the American consumer. Despite many warning signs and vocal encouragement by prominent members of Congress, the Big Three ignored market signals and charged forward with an emphasis on large cars and trucks. The long design and development times for new automobiles seriously impugn notions that bankruptcy can be avoided at GM or Ford.

The current state of the U.S. automobile industry can be attributed to many factors. An entrenched history of unionization led to regular power struggles over pay and benefits leaving the Big Three constrained by high labor costs and barriers to restructuring. The UAW lost more than half a million jobs during the oil crisis of the 1970s and early 1980s leading to contract negotiations in 1984. A notorious consequence of these talks was the creation of the “jobs bank” that guaranteed downsized or idled UAW members full pay and benefits resulting in more than 12,000 workers drawing approximately $400 million per year. The Big Three, therefore, were unable to react to market forces through restructuring efforts without assuming significant dead weight costs. Additional labor costs were incurred as a result of rich retirement and benefits packages for a growing pool of retirees, thereby placing U.S. manufacturers at a cost disadvantage compared to Asian competitors.

In order to cope with a higher cost structure, the Big Three chased fat margins on large cars and trucks that, in retrospect, are a symbol of the excess and blatant disregard for energy consumption that defines our addiction to foreign oil. As the shift in consumer preferences became more obvious, Detroit stubbornly persisted with its dependence on big gas guzzling vehicles, opting to shun trends towards improved fuel economy and hybrid vehicles. They pursued solutions that required minimal redesign or innovation, choosing instead to embrace oil substitutes such as ethanol in the development of “Flex Fuel” vehicles. The inflationary impact of ethanol on food prices and commodity prices, while painfully obvious now, was not considered when President Bush and Congress subsidized significant domestic investments in corn based ethanol. General Motors and Ford both knew that Flex Fuel vehicles with no improvements in fuel economy would fail to address our insatiable demand for oil. Meanwhile, Toyota and Honda developed innovative hybrid solutions that secured an engineering and manufacturing advantage not easily overcome by the bureaucratic leadership in Detroit.

Ultimately, it is this bureaucracy that impeded the innovation and restructuring that was necessary to save America’s automobile manufacturers. General Motors marketed vehicles under 12 different brands, with management at each competing for resources and ultimately survival. Over the years, the distinction between the brands became blurred and the infighting distracted from the ultimate goal of designing and manufacturing innovative automobiles. Redundant brands, such as Oldsmobile, lingered on life support for years despite a poorly positioned brand and growing customer apathy. While economies of scale promote design and manufacturing efficiencies, the disparate and competing demands on management hindered GM and Ford’s ability to rapidly respond to shifting customer preferences allowing foreign competitors to slowly erode their market share.

The eventual fate of GM and Ford is uncertain. Cerberus Capital Management, one of the largest U.S. private equity firms, acquired Chrysler in 2007 and a majority stake in GMAC in 2006. With the market capitalization of GM and Ford recently falling to $5.6 million and $9.8 million respectively, industry consolidation is not unfathomable, but the large pension and health care obligations combined with a stubborn unionized workforce erects a potentially insurmountable barrier to acquisition. Bankruptcy, on the other hand, is politically unacceptable due to the large, well paid labor force that the automotive manufacturing industry supports. More than a quarter million people work for U.S. automobile manufacturers with another 750,000 employed at domestic suppliers and parts manufacturers. Further job losses in this industry would devastate the U.S. economy and lead to an economic depression across the Midwest, raising the probability of government intervention. A bailout of GM or Ford would perpetuate the market distorting notion of “too big to fail” companies (e.g. Bear Stearns) and create a false sense of security among individuals and corporations alike that a government safety net will absolve them of financial responsibility. Alas, years of mismanagement and blind disregard for market signals has left GM and Ford grasping at straws in a desperate attempt to resurrect what is left of their former glory.

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European Inflation has Dire Implications for U.S. Recovery

Despite comparatively high interest rates, European inflation is rising rapidly under the pressure of higher oil and commodity prices. June inflation in the Eurozone rose to 4% from 3.7% in May creating a conundrum for the European Central Bank (ECB). Inflation hawks will call on the ECB, which is constrained by its single mandate to control inflation, to increase interest rates in order to stave off inflationary pressures, despite significant unemployment among younger workers and anemic economic growth. Increasing Eurozone interest rates will result in further depreciation of the U.S. dollar versus the Euro by effecting higher import costs for U.S. consumers and fewer exports from Europe. The combination of higher interest rates, a stronger Euro, and a more challenging export market erodes economic growth in the Eurozone while concurrently resulting in further weakness in the U.S. dollar, rising import costs, and greater inflation in the United States. The integration of the global economy enables the diffusion of U.S. economic weakness and global inflation in commodities around the world.

Eurozone inflation (orange) spikes to 4%, approaching U.S. inflation of 4.25% (red), after years of stability at 2-2.5% annual inflation. (Source: Bloomberg)

Inflationary pressures are running rampant in the U.S. and Eurozone economies. What started with commodity driven inflation has dispersed throughout the economy affecting upstream products such as chemicals, food, and manufactured goods. Wage pressures are already increasing as Bloomberg reports that ground workers at Lufthansa are demanding a 9.8% increase in pay to cope with increasing costs and the erosion of their standard of living. Europe, with greater board level representation afforded to employee groups, will likely experience more rapid wage inflation than the U.S. due to the substantially higher bargaining power European employees wield. Ultimately, the inflationary forces in both the Eurozone and the U.S. will entail arduous decisions and portend dire economic consequences if inflation escapes the control of the central banks. The combination of sluggish economic growth, rising inflationary expectations, and mounting unemployment threaten to confound a difficult economic environment that has, thus far, been immune to monetary and fiscal stimulus.

The probability of an ECB rate hike is open to debate, but the recent discourse by policy makers suggest that it is increasingly likely as inflation ticks ever higher. With the U.S. Federal Reserve walking the tightrope of uncontrollable inflation and economic recession, the potential for continuing weakness in the dollar and higher import costs leaves policymakers in a precarious position. The traditional response of lowering interest rates to support economic growth has limited the options available to the Fed. Further monetary stimulus is constrained by the currently low rates and an already weak dollar, but interest rate increases would jeopardize the economy already teetering on the brink of recession. It is increasingly likely that the ECB will raise rates ultimately increasing the pressure on the Fed to follow suit. Absent a corresponding action by the Fed, further weakness in the dollar and increasing inflationary pressures in the United States can be anticipated. With the Presidential election just months away, expect the Fed to resist dramatic action in the interim resulting in serious economic challenges for the next administration. Be prepared for a wild ride!

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