How Obamacare Could Harm Economic Growth, Part I

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We are in the midst of one of the most difficult investment environments of the past 60 years. It may not seem like it, given how the market has charged upwards over the past few months, but enormous macroeconomic issues still linger in the background.

In one regard, I am a classical value investor. I seek out companies with strong fundamentals that are trading at discounts to their intrinsic values. This has proven to be an extremely effective long-term wealth creation strategy, but I’m also very cognizant that there are assumptions underlying value investment. When one of those assumptions gets undermined, what once looked like “value” can suddenly become very expensive.

There are numerous political currents that could undermine value in the next few years, including the ongoing troubles in the eurozone, Japan’s attempts to weaken its currency, and China’s fixed asset bubble. However, the one being most ignored by mainstream investors right now is the Patient Protection and Affordable Care Act, more commonly known as “Obamacare.”

The Affordable Care Act could have a destructive impact on employment, price levels, consumer spending, and overall economic growth in the United States in the upcoming years. At the very least, it will probably result in a relative decline in the growth rate for GDP, and at worst, could even push the US economy into outright recession in 2014.

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Spending Cuts and Economic Growth

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In the past 100 years, total US government spending has only fallen more than 1% in six years:  1920, 1921, 1922, 1946, 1947, and 1948.   From 1920 – 1922, spending was cut by almost 60%.  From 1946 – 1948, it was cut 53%.

Two of the US’s biggest economic growth cycles of the 20th Century came in the 1920’s and the 1950’s, right after these major spending cuts.  It’s not a coincidence.   Large government spending takes resources away from private sector investment.  Private sector investment is by far the largest driver behind sustainable job growth.

The sequester is a small pittance.  Not only would it be beneficial, but we need to go much, much further.  Military spending needs to be cut down to no more than 3.5% of GDP.  We spend almost 6 times as much as China, the next biggest military spender.  There’s no need for our military budget to be this high.

Even more importantly, Medicare and Medicaid need to be reformed significantly, and Social Security should to shifted over to a 401(k)-style system.  If we took these actions, we’d began to see economic growth again.

Not only would these reforms create more growth, they’d also allow us to keep more beneficial Federal programs.  As Democrats and Republicans have fought tooth and nail to keep the status quo on the entitlements, it’s forced them to cut things like national parks. Essentially, we’re gutting every useful program we have in order to save unsustainable military and entitlement spending.

Excessive spending does not merely stifle sustainable growth; it also leads to inflation.  Inflation is a stealth tax on the middle class.  The easiest way to lower the cost of living and create jobs is to lower government spending.  It might cause a year or two of minor pain, but we will be vastly better off in the long-run.

CFPB’s Tighter Underwriting Standards Will Not Prevent the Next Bubble

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“A house is not an investment.”  

It’s a common lament that I hear from some economists and finance professionals.  Yet, if anything, it’s a sentiment that is wrong-headed in every way.   A home is absolutely an investment, and one that often has greater risks and rewards than your average stock or corporate bond.  America’s great mistake was not treating housing as an investment, but rather pretending that it could be anything other than one.

This flawed mindset has caused us to make many terrible public policy choices over the past eight decades, with the move by the Consumer Financial Protection Bureau (“CFPB”) to tighten mortgage underwriting standards being the most recent example.  These new standards by the CFPB have the potential to adversely impact our economy, exacerbate wealth disparities, and increase the risks of a future bubble.

Before we dive into the CFPB’s latest prescription for our banking woes, it’s first necessary to understand risk in the housing market.   In a simple example, let’s say we buy a $100,000 home with a 5% down payment.  For simplicity’s sake, let’s say this is an interest-only loan for the next three years and we sell the home at the end of that period.

If the price of the home were to increase 20% over that three years, we would make a profit of 400% on our equity position.  That’s more impressive than the returns for nearly every three year run in the entire history of the US stock market!  On the flip side, if the price of the home were to fall 20%, we’d lose 400% and be left with a negative $15,000 equity position, putting us significantly “underwater.”

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The Problem with Financial Reforms Since the Crisis

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On a grand level, the problem with Dodd-Frank and the Obama Administration’s attempts to reform the financial system is that they are trying to turn mortgage lending into a no-risk activity, when real estate investing is inherently risky.  We can not re-legislate the laws of economics to change this reality.

The real problem was never weak lending standards to begin with.  It was “free money” created by the Federal government, which ran loose monetary policies under Alan Greenspan from 1997 to 2004.  This was compounded by reckless fiscal policies under the Bush Administration (which have been replaced by the even more reckless fiscal policies of the Obama Administration.)  When you combine these developments with massive Federal subsidies and government backstops in the mortgage lending market, you create a market that provides a “free lunch” to commercial lenders, so long as they can find a way to make more loans.

We have not corrected any of these underlying problems.  Instead, we’ve decided that the symptoms of this flawed system (weak underwriting standards) were actually the true problem, because it’s easier to blame the banks, rather than for the politicians in Washington to blame themselves.

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The Absurdity of the US Mortgage Market

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As I’ve looked into buying a home recently, I’ve come to discover that the US mortgage market seems to be completely detached from reality. Due to the Federal government regulations and a prevalence of standardized products, lending standards have become extremely mindless, with a heavy focus on wage income and gross debt. This is “mindless” because these two attributes are not necessarily the most important ones in accessing the ability to repay, or the overall risk of a loan.

A Better Way to Access Risk / Reward

If I were a lender and we were in a free market mortgage system, I’d analyze a real estate purchase in the exact same way I’d analyze any other business. Real estate is an investment, and it should be examined based on the potential profitability; the income-producing alternatives; the character, creditworthiness,and resources of the borrower; as well as the ability to repay.

The first thing I’d look at the potential income produced by the property. Could the borrower theoretically rent out the property at a significant higher rate than the mortgage payments? If so, the property itself may be lower-risk. If the situation is reversed and the mortgage payments were twice that of the potential rental value, I’d consider that high risk. It’s irrelevant whether the borrower wishes to actually rent out the property or not, because rental is merely an alternative action that helps access the true level of risk. If the borrower has a very good alternative action, they are very unlikely to default, since they would give up profit to do so. Even if they do, the bank is unlikely to lose as much money, since the property value likely increased in order to eliminate the arbitrage opportunity in the market.

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14 Charts on Money Supply, Deficits, and Housing Prices

Milton Friedman once declared that “inflation is always and everywhere a monetary phenomenon, in the sense that it can only be produced by a more rapid increase in the quantity of money than in output.”

Friedman might not have been 100% correct on this, but he was damn close. For instance, San Francisco real estate price inflation can be more easily explained by artificial scarcity resulting from development restrictions than money supply growth. Yet, most instances of nation-wide price increases can be explained by high money supply growth, typically resulting from excess spending by the Federal government, and/or via loose monetary policies from the Federal Reserve Bank.

For this reason, I’ve been watching money supply growth and housing prices closely over the past few months. My view is that stagflation is a real possibility in the upcoming years; perhaps somewhat similar to what we saw in the 1970’s. Such an episode would favor certain investment classes, with real estate, commercial banks, and insurers being most likely to benefit in my view.

It’s extremely difficult to predict rates of inflation or future housing prices with any degree of accuracy, and it normally suffices merely to be correct about the general direction of things. That’s my primary goal.

Unfortunately, it’s complicated by the tug of war that is currently happening in Washington. Even with the fiscal cliff deal, we now have another potential debt ceiling battle. Let’s also not forget another major economic event that will take place over the next year: the implementation of Obamacare. While the past data may point one way, it would be easy for another political event to shift things in another direction.

That said, here’s the data I’ve been looking at.

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The Fiscal Cliff and the Dangers of Centralized Power

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Trying to figure out what to make of the horrendous “fiscal cliff” deal.   A few news outlets are reporting that for every $41 in tax increases, there was $1 in spending cuts.  The bulk of those tax increases hit the middle class directly.  The Federal government just got a bit fatter, while most of the rest of us just got a bit poorer.

The idea that the Federal government redistributes wealth from the rich to the poor is the most brazenly stupid idea of our time.  All empirical evidence in the world suggests that a larger, more centralized government results in more corruption, more cronyism, a weaker middle class, weaker economic growth, and wider disparities in wealth.   The Constitution was written to deter centralized power for this very reason.

A bigger Federal government means that power is taken away from middle class consumers and put into the hands of a small cadre of Federal politicians and their big-money backers. It means that entrepreneurs and small business owners have less capital to expand their businesses, and hire more people.  Meanwhile, halfway across the globe, more innocent people will have their communities destroyed by more drone strikes and military invasions.

It’s really time we start to realize that the Federal government can not play Robin Hood.  The Federal government redistributes money from the small business owner and middle income consumer and gives it to the ultra-wealthy monopolist, while throwing a few scraps out arbitrarily to least productive members of society, under the guise of “helping the poor.”  That’s why the disparity between the rich and the poor is at an all-time high.  Higher taxes only exacerbate the issue.

What we really need is a movement to decentralize power again — to take power out of the hands of the Federal government and shift it back to private individuals, as well as state and local governments. The more decentralized power becomes, the more likely that all of us can meet our own needs.  The US Federal government is not in the business of helping out the middle class.

M2 Money Supply and the Danger of Rising Inflation

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I get a sense that the investment world has begun to discount the possibility of a significant increase in inflation over the next 1-3 years.  I think it’s a pretty big mistake.  The housing market appears to have bottomed out and with that, loan demand should start increasing.  With a down housing market no longer dragging loan demand to the floor, what’s left to hold back inflation?

The US Federal government continues to create a massive amount of new money each year with large budget deficits.  These act as a fiscal stimulus that has been roughly around 8% – 10% of GDP over the past few years.  That’s a lot of new money!

Federal Reserve policies are loose.  That wasn’t really much of a problem with a weak housing market dragging down loan demand, but now that housing is rebounding, I’d worry a bit  more about this.  The Feds totally ignored the last bubble, which started around 1998 and was exacerbated greatly by Fed policies in 2001 and 2002.  What actually worries me more isn’t the “loose Fed policies” so much as the dedication to keep those policies loose until certain (perhaps unreasonable) conditions are met, such as 6.5% unemployment.

So based on all of this, I’ve become more concerned about rising inflation.  I’ve been watching a few key indicators over the past several months.   M2 money supply is among them.   I feel like our high M2 money supply growth rate is being virtually ignored by the investment community right now, which is a mistake.

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Cory Booker’s Pointless Food Stamp Experiment

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Newark Mayor Corey Booker has embarked upon a publicity stunt of sorts.  He has dedicated himself to living an entire week on the equivalent of $33 worth of food stamps.  His goal would appear to be to expose how difficult it is to actually survive on nothing other than food stamps.  Yet, this entire exercise seems to be a case of “missing the point.”

The food stamp program was never designed to provide a 100% subsidy for the food needs of Americans.  It’s a supplemental income program; it’s not meant to be a substitute for permanent employment.  Yet, Booker’s experiment seems to assume just that.

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Why Do Revolutions Fail?

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The apparent failure of the Egyptian Revolution makes me wonder how feasible it is to transform a dictatorship into a government that provides more freedom for its citizens in a short period of time.  Most revolutions in authoritarian nations have merely resulted in a new type of authoritarianism.  Why is this so?

There have only been a handful of “successful revolutions”, with the American Revolution normally being near the top of the list.  But why did the American Revolution succeed, where others failed?

The answer is actually simpler than one might think.  The American Revolution succeeded because most of the protections and freedoms that Americans demanded, were already won and/or expected in the English system of governance.  Moreover, the realities of the American frontier tended to naturally create more freedom from centralized governmental power.  As a result, by 1776, American colonists already had considerably greater freedom than their English counterparts.

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