Dan’s Blog

The Fed's Misplaced Priority

Dan Calandro - Wednesday, April 29, 2015

While the markets have oscillated since my last blog their status remains unchanged. All stock markets, American or otherwise, remain near all-time highs. Here are a few Wall Street Journal headlines that can be tied to recent stock market volatility.

  • GDP Growth Estimates Tumble, Again (3.25.2015)
  • U.S. Stocks Down After Weak Economic Data (4.2.2015)
  • Fed’s Rate Decision Hangs on Dollar, Growth Concerns (4.22.2015)
  • European Stocks Tumble as Greece Crisis Roils Markets (4.17.2015)

Economic growth has been weak, uneven, and unreliable since the economy was leveraged out of recession in 2009. That’s because government stimulus programs and ballooning national debt are not ingredients to long-term growth and vitality. Instead, they are unsustainable band-aids that do little more than make things look better than they actually are.

Despite the fragile economic base stock valuations are 24% higher than they were at the peak of the housing-boom, when GDP growth was three times stronger than it is today. The word overinflated is an understatement in today’s stock markets. And how did that condition come to pass? 

Bad monetary policy.

Remember when the Federal Reserve engaged in its low interest rate policy in the wake of the ‘o8 crash? Back then easy money policies were implemented to return the American economy to growth from recession, and to lower the unemployment rate to pre-recession levels. But isn’t that where we are?—The economy has averaged 2%+ growth for more than 5 years and the unemployment rate has averaged 6.5% for more than two years – it’s currently at 5.5%.

Why hasn’t the Fed increased rates? 

Well, according to the WSJ article noted above, "the strong U.S. dollar and unsteady global economy" are the primary concerns for the Fed’s interest rate decision.

So let me get this right, America has to wait for the economies in Europe and Asia to correct before U.S. monetary policy can be normalized.—Really???

Let’s correct the record to begin the discussion. The U.S. dollar isn’t getting stronger; the Euro and Yen are getting weaker, as both the European Central Bank and the Bank of Japan are in the midst of quantitative easing programs. The dollar appears stronger because the U.S. has concluded its devaluing effort via QE. Again, the only reason the dollar appears to be getting stronger is because other major currencies are getting weaker. Dollar strength is via smoke and mirror. 

And while it is true that higher interest rates will "strengthen" the dollar to some degree, and that that event will most probably hurt U.S. exports, those aren’t the Fed’s true concerns.—Instead, they’re worried about the "global economy." There is a reason for this.

Just as the former Soviet Union proved communism a bankrupt ideology, Europe is on its way to do doing the same for socialism – and Greece is the face of it.  That’s why news regarding the financial condition of Greece "roils" the markets.

Consider that the highest individual tax rate in Greece is 45% – which kicks in at just $100,000. On top of that individuals pay a social security tax of 16% and a Value-Added Tax (VAT) of up to 23%.  (A VAT is like a sales tax and excise tax rolled into one.) That is to say high earners can pay up to 84% of their earned income to their central government. Local taxes and fees would be on top of that high central rate. 

Greek Corporations are a bit luckier. They pay an income tax of 26% and a social security tax of 28% – totaling 54% to the central government – plus various other fees, licenses, and local taxes.

Because of the high tax rates Greek unemployment is a repressive 26%, and the economy has been in recession since 2009. And despite the high tax rates 20% of all Greeks live below the poverty line and the government still can’t afford them. Their national debt is 175% of Gross Domestic Product and they can’t borrow any more money.

As Margaret Thatcher once said, "The problem with socialism is that eventually you run out of other people’s money."

The central problem with socialism is that it doesn’t incentivize high output and performance. The tax structure encourages minimal effort and greater dependence on government. How could it not? When people pay an 84 % tax rate they have no incentive to earn at high levels and every bit of incentive to demand more from their government – regardless of their income level.

That’s what inspired the most recent Greek election results. 

Radical left-wing socialist Alexis Tsipras was recently sworn in as the new prime minister of Greece. Tsipras ran as the "anti-austerity" candidate, promising to eliminate EU mandated budget cuts if elected. That’s code word for higher taxes and more government spending.

High tax rates do not make a State solvent. In fact, the opposite is true.  As the population drawing off of the welfare system increases and high earners decrease a budget deficit has no choice but to ensue. Socialist governors like those in Greece then raise taxes higher, borrow more money from other nations, and make greater promises to unhappy constituents who are paying too much and getting too little. But sooner or later the spigot runs dry.

And that’s where Greece is today.

The EU is the chief financier of Greek budget deficits, and they imposed the budget-cut demands in exchange for increased funding. Lenders have that legitimate right. So it should be no surprise that a stand-off quickly followed Tsipras taking office: Greece won’t cut government entitlement spending – and because of that, the EU won’t lend them any more money. And why should they? Greece doesn’t have the money to payback what it already owes. 

Even so, there is little doubt that Greece would have benefited from the ECB’s quantitative easing effort if they played ball and moved towards fiscal responsibility – the policy of affording oneself. But no, Greece isn’t interested in that. They believe they are entitled to more – and that other nations should pay. 

Greece is proving Margaret Thatcher correct – but the proof doesn’t end there. Several countries over there are in major trouble, Portugal, Cypress, Ireland, and Italy, to name a few.

So if the United States has to wait for Greece and the rest of socialist Europe to get healthy before interest rates are intentionally increased then monetary policy may never be normalized here. And that’s the real shame; America desperately needs higher interest rates to incentivize lenders to lend – especially to small businesses. That, along with the boost in purchasing power a stronger dollar provides American consumers, would greatly help strengthen the domestic economy.

But no, the Fed’s priorities are elsewhere -- and their logic is misplaced.

As the "risk-free" rate the U.S. drives world interest rates. Higher rates in America will cause Greek interest rates to move much higher. That will make it harder for Greece to borrow additional funds (a good thing) and most certainly expedite their exit from the Euro. And Greece wouldn’t be the only one -- just the first one. So yes, higher U.S. interest rates would be good for us and bad for them.

Sadly, Europe and their failed socialist cause matters more to our Federal Reserve than the prosperity of American free-market capitalism.

And we let them get away with it. 

 ShieldThe road to financial independence.™


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