Outside the Box

On Swamp Draining in Texas, Florida … and DC

September 13, 2017

For this week’s Outside the Box we have a two-parter of short essays. They are unrelated but equally important. First, in “Time to Drain the Fed Swamp,” Brian Wesbury and colleagues at First Trust make the case that it was the private sector, not the federal government or the Fed, that saved the economy after the Panic of 2008. The Fed has outgrown its britches, they argue, and it’s time to fill the Board of Governors chair and vice-chair positions with people who will hold the Fed to account for its mistakes. They conclude with this trenchant line:

We need a government that is willing to support the private sector and stop acting as if the “swamp” itself creates wealth. 

Then, in “Don’t Buy Into ‘The Broken Window Fallacy,’” good friend Doug Kass shares Frederic Bastiat’s parable of a broken window to demonstrate why destruction à la Harvey and Irma – is not a net positive for the economy in the longer term. I keep reading nonsense economics by people who say this is going to boost the economy; and in the seriously weird way that we measure GDP, maybe it will, however slightly; but it is a definite drain on the wealth of the country.

If you had a new car and then totaled it, even if it was insured it is unlikely that your insurance would give you enough to pay the car off. That’s just the perversity of insurance. So if you want another car, you’re going to have to pony up some money. And the insurance company loses money, by the way. There are no winners in this massive loss of vehicles to hurricanes, except that the car makers get to sell another few hundred thousand cars. But against the backdrop of the entire economy? It’s a losing proposition.

Further, it’s looking like close to 50,000 houses may have been totally destroyed, and many of those owners didn’t bother signing up for flood insurance, since they were above the 100-year flood plain. But since this was more like a 1000-year flood (by traditional standards, at least), the bulk of the homes destroyed were outside the areas where insurance is required.

Having gone to Rice University (68-72) I truly get that Houston is built on a swamp and after heavy rains doesn’t drain very well. But there were always the “good areas” like the Memorial neighborhood, not too far from Rice, which didn’t have many problems. Now I am hearing from friends about homes in that area that had eight feet of water in them. Everything totally destroyed.

Can Houston actually claim those damaged homes have a value for tax purposes? How much is this going to reduce the revenue of an already cash-strapped city, not to mention the outlying areas? And understand, some of Houston’s pension funds are in seriously deep kimchee.

If you’re retired and your home was destroyed and you get some insurance money, do you rebuild in Houston or do you decide that Austin or Dallas looks more attractive? Seriously, a number of those homes are not going to be rebuilt, and those properties will not help to swell the tax rolls for quite some time. These disasters in Texas and Florida will just exacerbate the pressure I’m going to be talking about in this weekend’s letter.

I am cruising along at 35,000 feet, flying from Boston back to Dallas. I’ve been in some of the most intense meetings of my entire life; but it all turned out well, and I think I will soon be able to announce a major new way to serve you, faithful readers. I am seriously pumped up.

And since my computer is telling me that my battery is low, I think I will go ahead and hit the send button. You have a great week!

Your always thinking about how to make your lives better analyst,

John Mauldin, Editor
Outside the Box

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Time to Drain the Fed Swamp

By Brian S. Wesbury, Robert Stein, and Strider Elass

Originally published here

The Panic of 2008 was damaging in more ways than people think. Yes, there were dramatic losses for investors and homeowners, but these markets have recovered. What hasn’t gone back to normal is the size and scope of Washington DC, especially the Federal Reserve. It’s time for that to change.

D.C. institutions got away with blaming the crisis on the private sector, and used this narrative to grow their influence, budgets, and size. They also created the narrative that government saved the US economy, but that is highly questionable.

Without going too much in depth, one thing no one talks about is that Fannie Mae and Freddie Mac, at the direction of HUD, were forced to buy subprime loans in order to meet politically-driven, social policy objectives. In 2007, they owned 76% of all subprime paper (See Peter Wallison: Hidden in Plain Sight).

At the same time, the real reason the crisis spread so rapidly and expanded so greatly was not derivatives, but mark-to-market accounting.

It wasn’t government that saved the economy. Quantitative Easing was started in September 2008. TARP was passed on October 3, 2008. Yet, for the next five months markets continued to implode, the economy plummeted and private money did not flow to private banks.

On March 9, 2009, with the announcement that insanely rigid mark-to-market accounting rules would be changed, the markets stopped falling, the economy turned toward growth and private investors started investing in banks. All this happened immediately when the accounting rule was changed. No longer could these crazy rules wipe out bank capital by marking down asset values despite little to no change in cash flows. Changing this rule was the key to recovery, not QE, TARP or “stress tests.”

The Fed, and supporters of government intervention, ignore all these facts. They never address them. Why? First, institutions protect themselves even if it’s at the expense of the truth. Second, human nature doesn’t like to admit mistakes. Third, Washington DC always uses crises to grow. Admitting that their policies haven’t worked would lead to a smaller government with less power.

The Fed has become massive. Its balance sheet is nearly 25% of GDP. Never before has it been this large. And yet, the economy has grown relatively slowly. Back in the 1980s and 1990s, with a much smaller Fed balance sheet, the economy grew far more rapidly.

So how do you drain the Fed? By not appointing anyone that is already waiting in D.C.’s revolving door of career elites. We need someone willing to challenge Fed and D.C. orthodoxy. If we had our pick to fill the chair and vice chair positions (with Stanley Fischer announcing his departure) we would be focused on the likes of John Taylor, Peter Wallison, or Bill Isaac.

They would bring new blood to the Fed and hold it to account for its mistakes. It’s time for the Fed to own up and stop defending the nonsensical story that government, and not entrepreneurs, saved the US economy. Ben Bernanke and Janet Yellen have never fracked a well or written an App. We need a government that is willing to support the private sector and stop acting as if the “swamp” itself creates wealth. 

Don’t Buy Into “The Broken Window Fallacy”

By Doug Kass
September 12, 2017

The broken window fallacy was first expressed by the great French economist, Frederic Bastiat. Bastiat used the parable of a broken window to point out why destruction doesn’t benefit the economy.

In Bastiat’s tale, a man’s son breaks a pane of glass, meaning the man will have to pay to replace it. The onlookers consider the situation and decide that the boy has actually done the community a service because his father will have to pay the glazier (window repair man) to replace the broken pane. The glazier will then presumably spend the extra money on something else, jump-starting the local economy….

The onlookers come to believe that breaking windows stimulates the economy, but Bastiat points out that further analysis exposes the fallacy. By breaking the window, the man’s son has reduced his father’s disposable income, meaning his father will not be able purchase new shoes or some other luxury good. Thus, the broken window might help the glazier, but at the same time, it robs other industries and reduces the amount being spent on other goods. Moreover, replacing something that has already been purchased is a maintenance cost, rather than a purchase of truly new goods, and maintenance doesn’t stimulate production. In short, Bastiat suggests that destruction - and its costs - don’t pay in an economic sense. 

The broken window fallacy is often used to discredit the idea that going to war stimulates a country’s economy. As with the broken window, war causes resources and capital to be funneled out of industries that produce goods to industries that destroy things, leading to even more costs. According to this line of reasoning, the rebuilding that occurs after war is primarily maintenance costs, meaning that countries would be much better off not fighting at all. 

The broken window fallacy also demonstrates the faulty conclusions of the onlookers; by only taking into consideration the man with the broken window and the glazier who must replace it, the crowd forgets about the missing third party (such as the shoe maker). In this sense, the fallacy comes from making a decision by looking only at the parties directly involved in the short term, rather than looking at all parties (directly and indirectly) involved in the short and long term.

Investopedia, “The Broken Window Fallacy” 

Yesterday many – including Jim “El Capitan” Cramer – emphasized that the dual hurricanes in Florida and Texas were net economic positives as they would stem the peaking already apparent in autos and housing.

As Jim wrote:

It’s simple. When you get flooding like we had in Texas, you are going to have perhaps hundreds of thousands of people shopping for new cars, all at once. If you get storms that destroy houses with wind and rain, as is the case in Florida, you get checks to fix them up almost instantly.

Jim Cramer, “Hurricanes Will Break the Decline of the Auto and Housing Industries

While it is clear that the need to replace destroyed autos will reduce car inventories temporarily and assist in the sale of homes, the benefit – as described above in The Broken Window Fallacy – is not likely to be long-lasting or stem the peaks in car production and housing sales. Those who are looking at a net benefit are restricting their observations to only the parties directly involved in the short term, rather than looking at all the parties directly and indirectly involved in the short and long term:

* A rebuild of what you already had in Florida and Texas is restorative and does not increase an economy’s productivity or capacity.

* By contrast, the infrastructure build discussed by the administration is incremental; it increases productivity and makes the American economy better and stronger. As many of you know (see “The Orange Swan Returns With a Vengeance“), my view is that Trump’s infrastructure bill as well as tax reform and other legislation are unlikely to be passed on a timely and non-diluted basis. It may be argued now that the Florida and Texas rebuilds may be another excuse for non-passage. 

* The rebuilds from Hurricanes Harvey and Irma will increase the deficit due to the direct expenses and loss of tax revenues created by a business slowdown over the next two quarters from the storm’s damage. That deficit has now eclipsed $20 trillion.

* The rebuilds also may extend the already-stretched affordability issue facing housing, as it will increase building material prices and inflation, serving to increase the prices of homes.

* There is not an infinite supply of labor. The construction workers who will be moving to Houston and Tampa to rebuild are being taken away from other markets.

* Finally, in the local areas involved in the path of the worst destruction there is often a net loss as people leave and don’t come back. New Orleans’ population is about 80% today of what it was before Katrina. This is at best a zero sum, but in reality probably is a net loss because many people are uninsured and can’t afford to rebuild or buy again. In addition, there is a human toll on health, etc.

The Markets

We either are in one of the greatest bull markets of all time, fueled by eight years of more monetary cow bell, or our markets as in 2000 and 2007 likely are ignoring numerous uncertainties, extended valuations and other headwinds – as I say, rationalizing the irrational.

As an example, the markets rose modestly last Friday, anticipating a huge storm – and subsequent replenishment and rebuild – that could have resulted in more than $150 billion of damages.

Yesterday the markets ramped up by more than 25 S&P handles on light volume after never really going down because the hurricane’s wrath and impact was far less than initially anticipated.

To many it was a Goldilocks just-right outcome, as some thought the damage of the natural disasters was still enough to restrain the Fed’s tightening yet enough to halt the peaking of the automobile and housing industries. The former, autos, was suffering from too much inventory relative to sales, the need to expand incentives (a threat to auto industry profitability), lower used-car prices and a deterioration in subprime auto paper delinquencies. The later, housing, was threatened by stretched affordability and stagnating incomes.

To some, this contradiction is natural, but it is not natural to me.

Bottom Line

The hurricanes experienced over the last two weeks will result in a restoration and not in an incrementally improved and more productive U.S. economy.

Think “The Broken Window Fallacy.” Destruction does not benefit an economy.

I remain bearish on both stocks and bonds.

Position: Long SDS large, SQQQ large, QID, TBT; short SPY, QQQ

Douglas A. Kass
Seabreeze Partners Management Inc.
411 Seabreeze Avenue
Palm Beach, Florida 33480

Telephone: (561) 714-7484
Web Site: http://www.seabreezepartners.net
Email: ekass73388@aol.com
Twitter: @DougKass

 

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Comments

Rolf H Parta

Sep. 15, 8:42 p.m.

If, as some still contend, Bastiat is wrong on this, then war is urgently to be desired and the more destructive, the better.

You can’t tell me with anything like a straight face that the economy of any European country involved in the most recent edition of the great war was better off in 1946 than it was in 1939.  Such a lie would be the proof of Bastiat’s contention.

The negative side effects to unknown third parties will always outweigh the production to replace effect.

jack goldman

Sep. 13, 7:49 p.m.

I grow weary of commenting on the obvious. Stocks were 995 US Treasury silver dollars in 1966 and are 995 US Treasury silver dollars in 2016. We have had fifty years of NO REAL GROWTH, only fake growth, in fake counterfeit US Debt notes at the Federal Reserve. We have an economy that is a fraud, based on counterfeit currency. The dollar has collapsed 95% in buying power from 1966 to 2016. The US Treasury silver dollar buys the same in 2016 as it did in 1966. Dollar debasement loses 6% a year to counterfeiting. Debt is growing at 12% a year, out of control, from $300 billion in 1966 to $20 Trillion in 2017. We are selling our unborn children and newly arrived immigrants into debt slavery. I will protect myself by buying land, real estate, and gold bullion. It’s a fake financial fraud promoted by the Federal Reserve a fake counterfeiting cartel owned by European banks. Good luck to us all John Mauldin. Good luck.

Alan Shaver

Sep. 13, 6:50 p.m.

What no one has yet acknowledged is the impact on all the credit unions and local banks which lent money secured by liens on all those businesses, automobiles and houses that have been destroyed and are not covered by insurance.  There will be a “ripple effect” as some of those financial institutions become insolvent when their borrowers prove unable to pay and the collateral is worthless.  As a board member of a federally chartered credit union I have a great concern for this “ripple effect”.  Getting back to “normal” is going to take a lot more time and effort than most of the pundits believes.

abbjrmd@gmail.com

Sep. 13, 3:24 p.m.

Quick comment—-many investors and certainly MANY residential areas have not recovered their valuations since the financial crisis. The residential recovery is largely dependent on whether one resides in a large urban area or on a popular seacoast.
Many homeowners remain very much underwater at this point.

mike_bradley@mentor.com

Sep. 13, 2:41 p.m.

Two issues I have with the window fallacy:

1) it could be that an unemployed person is now employed.  True the shoemaker does not get an additional pair of shoes, but it could be the window maker was previously unemployed, collecting food-stamps, etc. and is now productive.

2) Not everyone cares about the shoemaker.  Not trying to be harsh, but smaller business which leave the economy in Houston are essentially replaced by car manufacturing, and construction workers temporarily working in Houston, and taking their money back home.  Thus, the economy of Houston is worse, but the economy of others is better.

Just like NAFTA and the like benefited the general consumer, it hurt the factory worker in the US.  So, the benefit/harm is based on your viewpoint and place in the economy. 

If Jim Cramer says its a net win for auto makers and construction, he may be correct, in that most of the US will ignore the effects on the local economies, and instead focus on the larger segments that will benefit.

So, I say Bastiat wins the battle on the window theory, but likely loses the war, as it falls on many deaf ears.