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The Fiscal Cliff Is Here
So, this is it. It should be soon that we finish the season of waiting. We will have a deal in Washington in the next few days, or we won’t. Most clients we talk to are interested in looking through the fiscal cliff.
In our view, this is because if the fiscal cliff can be managed, the U.S. economy is poised to grow. China is likely bottoming. Oil prices are down. Europe looks more stable (for now). Central banks are accommodative & there’s a U.S. pent-up demand story developing. There’s just one more (big) step - or set of steps - that needs to be taken in Washington.
True, the U.S. LEI fell -0.2% m/m in November, but it was pulled down by the surge in jobless claims (which has already reversed as the hurricane effects have ebbed). Claims have trended around 360,000, which is roughly where they were trending before the hurricane impact.
The U.S. housing data also remain solid (existing sales +5.9% m/m in November, new sales +4.4%, and home prices up in October). Housing starts fell -3.0% m/m in November, but the NAHB index continued to rise to a new cyclical high in December. Pending home sales increased +1.7% m/m in November.
The Philadelphia Fed index surged in December from -10.7 to +8.1 with a broad-based improvement in the components (which helps offset the weak NY Fed mfg index at -8.1). The Chicago PMI improved in December, with a sharp jump in new orders to 54.0 (though employment weakened). The Milwaukee PMI also surged. Real GDP in 3Q was revised up to a 3.1% q/q annual rate (5.9% nominal).
It is likely that any announced “deal” this week will not be good enough to solve the fiscal cliff alone. But that’s not the point. What’s key is whether – if there’s the political will to get a deal – additional deal(s) will follow. Can we break the Super-committee curse?
Like everyone, we are staying tuned.
Regulation Is Always Incomplete
Most of the consequences of regulation are unintentional in nature, and sometimes, they even spur the need for new regulations to offset the consequences of the first round of regulations. This is nothing new to anyone who’s watched the evolution of the government’s regulation of the financial markets over the past 100 years. The financial markets always seem to evolve faster than the government’s ability to foresee change, and the initial round of regulation tends to create bigger problems, decades or more into the future, that no one ever envisioned. It seems as if regulations create new arbitrage opportunities, new laws of economics, and consequently, new structures that could only exist under ideal regulatory circumstances, thus requiring more regulations to deal with them.
By now, it seems abundantly clear that the Volker Rule, Dodd-Frank, and the Basel Accords before them (as well as the U.S. tax code) are all examples of regulatory systems that could be remembered most for their ability to spontaneously create demand for more regulations. This concept of an “incomplete system”, where new laws always seem to unlock an endless demand for even newer laws is not new. Under reasonable conditions, most, if not all logical systems, are incomplete, or so go the famed “mathematical incompleteness theorems” proven by the early 20th century mathematician Kurt Godel. Among other things, in their abstract form, the theorems imply that any system that is based on logical axioms (i.e. truths that can never be proven) is, and always will be, incomplete. Put another way, there will always be new axioms, which flow directly from the original axioms, that must also be assumed as true or else chaos ensues. There will also be other new concepts, which now CAN be proven to be true as a consequence of these new axioms, and they’re not always intuitively obvious. Thus, the logical system that you’ve constructed from seemingly obvious axioms (regulations) is incomplete in the sense that there will always be new axioms that must be assumed (passed into law), as well as newly provable truths (arbitrage opportunities) which follow.
This theorem holds for all logical systems that fit a certain criteria, whether they be languages, social cultures and norms, properties of the natural numbers, or even regulatory regimes in economic systems (though mathematical purists may argue that the criteria is more narrow than I’ve described). In languages, we see something similar to this when we note that written English always follows spoken English, which itself tends to follow observations of social behavior and nature. In essence, words are axioms, and the system of words and rules known as English is, and always will be, incomplete. Thus, we need to constantly add new words from time to time. In economic systems, such as our financial markets, our axioms are a collection of rules of etiquette, “laws” of economics, and the deepest of all, government regulations. Each of these types of economic axioms has consequences for the evolution of our economic systems. Another term for these axioms is “institutions” and, as it’s often stated in developmental economics, “institutions matter”. In fact, institutions matter because they may have far greater impact on a civilization’s long-term development than access to natural resources, climate, or any other natural barriers to growth. Operationally speaking, the reasons why institutions (economic and social axioms) matter, is because our choices of economic axioms determine which axioms will later have to be assumed to keep the logical system from collapsing and which economic arbitrage opportunities will be tolerated as exploitable, and this sequence determines the foundation of our economic (and social) culture. Sometimes the cultural axioms are so absurd that they require a doubling down of cultural dogma, which can stifle the economic and cultural creativity of a society. History has had no shortage of these types of civilizations, and they tend to be short-lived and usually militaristic in nature. Other times, our economic axioms may not be fatal to the economy, but they still create perverse effects, which we often call the “law of unintended consequences”. In short, the law of unintended consequences is just a reformulation of Godel’s incompleteness theorem, as it illustrates how economic regulations tend to instantly imply the need for new regulations, usually by creating arbitrage opportunities that never previously existed, and no one ever anticipated. The evolution of these arbitrage opportunities is the primary catalyst for the never ending growth in regulatory and tax codes (for example, in the presence of taxes, debt is now usually cheaper to issue than equity, which spurs debate on interest expense deduction caps).
Unfortunately for our economic systems, policy makers seem to have great tolerance for axioms that create perverse consequences, or so it would seem. Government regulations tend to be imposed based on ideological forces, rather than the limits of our logical capacity. As a result, we’re more inclined to assume, and tolerate false axioms in economics than in other fields (i.e., the assumption that markets have failed to enforce a vital code, so government needs to impose a law to correct the wrong is a common one). When confronted with false axioms, governments, more often than not, chose to double down on regulations to negate the unintended consequences. This frequently results in the need to “expand the scope of regulations”, because each new crisis grows in magnitude. Whether this doubling down effect is a consequence of ego, greed, or an inability to grasp the notion that the consequences of our actions are too numerous to fully anticipate, regulatory systems tend to increase in scope over time more rapidly than other logical systems (Euclid’s postulates haven’t changed since we studied them in high school, but the tax code sure has). And changes usually come in a way that stifles creativity, slows innovation, and, inevitably, goes against the best interests of those that government was initially trying to protect. Perhaps this is inevitable in all logical systems, and our mathematical systems will also one day face the same consequences (the axiom of choice has long been a target for just such criticisms).
In many ways, economists and policy makers are luckier than mathematicians since economic systems show the ill effects of invalid axioms fairly quickly (highly developed black market trade in illicit goods is one frequent example). The question is, will policy makers ignore the signs when the financial and economic regulations bearing their names are shown to be invalid or inconsistent with previously held axioms, or will they double down to regulate away the unintended consequences. These are questions to ponder now as we head into Thanksgiving, with the uncertainty surrounding the election now resolved, and, hopefully, the uncertainty about Washington’s future direction also soon to be resolved.
Fixed Income Strategist