What's Going On?

Many observers have commented on the strange constellation of facts pitting the record breaking stock market (S&P 500 at its highest today, DJIA closing in on 15000) against the gnawingly high unemployment rate (8% but closer to 13% if you count those that just gave up looking for a job), and the record use of food stamps in the U.S.  What's going on?

U.S. transnational companies are sitting on over $1 Trillion in cash, much of it in off-shore operations. They can't move it back into this country because they will be hit with a 35% tax bill (to feed the great sucking sound that is Washington). Paying such a bill when they don't have to would violate the companies' fiduciary to their (mostly, U.S.) shareholders.

If it were possible to repatriate this money, it would have gone into building factories, supporting infrastructure, training and educating workers, philanthropy, and the pockets of investors and pensioners.  Instead, the money is kept prisoner overseas because this Administration and the Congress is more concerned about the optics of fairness than they are about what really creates economic wealth and social welfare - free choice and free markets.

If the corporate tax rate was zero, the acceleration in wealth creation accompanied by the advancement of the middle class would be unprecedented.

Sequestration is Good for Economic Renewal

This may sound a little cold but sequestration is not a bad thing if it focuses attention on the problem of government growth and over-reach. Given that the economy has not grown very much over the last decade, the acceleration in government size effectively crowds out private enterprise. For example, the very idea of government 'supporting' entrepreneurship makes no sense. In the classic definition, entrepreneurship is opportunity identification and risk taking. Government 'support' distorts the supply and demand relationship and thus obscures those opportunities that represent real demand for goods and services. This, in turn, distorts the risk/return calculus, so that bad ideas are kept alive while good ideas are starved for capital. Sequestration is a good thing if the net effect is to pry the sclerotic hands of government off from private initiative, innovation, and economic renewal.

China's Economy

China's economy is a derivation of the demand driven economies in Europe and the U.S. As these economies have experienced declines, pressure on China to maintain a high growth rate has increased. At the same time, it has been worried about the steep growth in real property prices and a general trend toward inflation, direct results of the 2 decade export boom.  These price increases have landed squarely at the middle and lower classes, creating an explosive political situation. The Economist reports that for the first time, China is not acting as aggressively to pump prime its  economy, prefering instead to exploit the global slowdown as a way to cool expectations.  Additionally, it has moved quietly to reduce its exposure to global currency risk by increasing the share of reserves in renmingbi, effectively using its large trade surplus as a hedge.  In a year of messy political transitions, this is a pretty saavy two-step.

ECB Prints Money

Yesterday, the European Central Bank announced that it will purchase all 1 to 3 year bonds issued by troubled EU governments in order to recapitalize those economies.  In exchange, issuing governments commit to a path of public austerity. Given the heavy reliance on government handouts in Europe, this is probably not enforceable (at least without a lot of violence in the streets).  To save the Euro, the ECB and Brussels have no choice but to do this.  While this step averts the risk of default, it could be extremely inflationary.  The immediate impact would be to inflate the cost of exports for such counties like Germany and Finland that count on their strong export oriented economies to stave of recession.  A second impact would be to deflate the value of household savings in high saver countries like Germany. This deal of a lifetime may be the deal with the devil.

Dollarization of Greece?

We now know that the Euro is based on a flawed design. The region has no centralized fiscal policy with vastly different political philosophies and social institutions, and no way to credibly sanction wayward countries. Therefore, there is no reason why the types of upheavals we now see will end. The lack of fiscal discipline is core to the problems of the Euro. 

In the late 1990s, Ecuador was facing a similar situation.  The country dollarized the economy, removing fiscal and monetary discretion from the politicians.  After a short period of intense economic hardship, the country has been on a steady path of growth. Even with the recent loss of fiscal discipline, as seen by the actions of the current U.S. administration, the size of the U.S. economy provides the stability that individual small countries cannot do for themselves. Greece and the other at-risk EU economies should consider dollarization.  It's radical, somewhat old fashioned but it can work.