Track The Turnaround

It's the Business Climate, Stupid

President Obama said in his State of the Union Address that he wants to bolster job growth. Well, there's no mystery about how to accomplish that.

Crack open the recently released 2010 Index of Economic Freedom, note the strong link between economic freedom and prosperity and read about the examples of Hong Kong, Singapore, Australia, New Zealand and Ireland, which were ranked as the world's most attractive places to do business. Note other examples such as Turkey, Montenegro, Poland, Croatia and Qatar -- nations credited with significantly reducing home-grown, man-made barriers to business investment and economic growth -- and how they've prospered.

Specifically, these countries get credit for giving their citizens more freedom to work, produce, consume and invest, "with that freedom more protected and less restricted by the government."

In the meantime, the U.S., which got dropped from the rankings of the world's freest countries, got dinged for:

1. Burdensome top tax rates, exceeding international averages
2. Excessive government spending -- spending that's directly and indirectly displacing private-sector activity and growth
3. The 2002 Sarbanes–Oxley Act, which significantly increased disclosure and accounting requirements for small firms and reduced IPO activity
4. Government interventions in financial markets and the automotive sector and speculation about more change (the wrong kind) in the future -- changes that have increased price distortions, reduced market efficiency and raised concerns about the security of private property and the integrity of business contracts.
5. Uncertainties created by changes to regulation and policy that have discouraged entrepreneurship and job creation.

"The U.S. government’s interventionist responses to the financial and economic crisis that began in 2008 have significantly undermined economic freedom and long-term prospects for economic growth," the report concludes.

Here's what should be done:

1. Prioritize (for once) what the federal government does and slash government spending accordingly (easily done, right?)
2. Simplify the tax code and reduce taxes in a broad-based, even handed fashion that leaves it to the market to most efficiently pick winners and losers.
3. Stop scaring the banking system. One reason so many banks are restricting credit and holding so much in reserves is their uncertainty about what will happen to the economy and financial industry regulation.
4. Stop scaring small businesses: Suspend the most burdensome and time consuming provisions of the Sarbanes-Oxley Act when it comes to small business.
5. Make the temporary 2001 and 2003 income tax cuts permanent. The prospect of an automatic tax increase out there does not help business decisionmakers on the margins.
6. Increase human capital. When it comes to job growth, it takes two to tango -- a job opening and somebody qualified to fill it. Too many Americans are unqualified to fill 21st century jobs. Encourage (or rather, stop discouraging) states and cities that are trying to make the public K-12 system perform better, like the private sector, and compete for its clients (students, in theory). Read: more charter schools, more school choice. This costs nothing, on net, except some well spent political capital. The potential gain to the economy would be enormous. According to McKinsey and Company, the ongoing dysfunction of our public K-12 system costs our economy $2.3 trillion a year in lost human potential, and that's likely an underestimate. Granted, that's more of a long-term benefit, but necessary if we're to restore this economy's vitality in the long-run.
7. Reduce uncertainty. Stop scaring the markets with frequent, ever-changing policy prescriptions and announcements. Give businesses a more stable playing field. They need to be more confident about taking risky long-term decisions to expand their operations.

For each of these prescriptions, the president will find plenty of support from Republicans and moderate Democrats who understand how an economy works and, more importantly (for them), how much their political careers and legacies depend on getting it right.

While I've been skeptical about this "recovery" and its direction, recent events, including the President's change of focus, make me more optimistic about the U.S. economy's long-term prospects. What makes me most optimistic is that America's politicians and policymakers are losing their margin for policy error and folly.

We're facing sky-high deficits and debt, a refreshed and lengthening track record of bad policy and its consequences, a rising pile of economic casualties from those bad decisions and a growing litany of U.S. multinationals reporting intentions to scale down operations here and expand them abroad.

The financial crisis is just the latest in a 20-year string of bubbles whose implosions have exposed a long-running rot or hollowing out of the U.S. economy -- a development that preceded the crisis itself.

Generating economic growth the old fashioned way -- by earning it and improving the business climate -- is becoming one of the few options left as financial markets grow nervous about public sector debt in the U.S. and worldwide.

Mario Gabelli of GAMCO Investors puts it well:

To create the next Google, the next YouTube, the next great startup, you have to give entrepreneurs the clarity and conviction that they can make money.

Listen carefully, and you'll find -- reading between the lines -- that this is being acknowledged more widely by the political class in both parties, including President Obama. The only question is, how long will it be before this option -- inconvenient and painful for many politicians -- becomes the only viable one left to them.

Where's the Growth? Not in Top-Line Sales

Bloomberg released some revealing stats yesterday showing little growth in top-line revenue growth over the past year outside financials and tech.

According to Bloomberg, year-over-year sales growth among companies within the S&P 500 has averaged 15.7%, but exclude financials and that number collapses to 2.2%. Take out Apple (AAPL) (even leaving in the rest of the tech) and that number shrivels to 0.5%.

Those last two numbers are below the 12-month rate of inflation (according to the consumer price index). That means the corporate sector represented by the S&P has actually shrunk. Given that small businesses have clearly fared even worse, the entire U.S. economy has clearly shrunk in real terms over the past year.

Recovery hype, inventory corrections, great drama over the coming Apple tablet and somersaults at CNBC notwithstanding, there's no growth in the U.S. economy outside government-supported finance and tech (read: Apple).

Earnings growth within the S&P over the past year has been driven primarily by cost cutting, growth outside the U.S. and DC's gigantic subsidies of the financial sector.

The bottom line is that there hasn't been much of a top line over the past year.

Not About Bernanke: The Growing Vote of No Confidence in the Fed

Make no mistake: Ben Bernanke will be confirmed by the Senate and stay on as Federal Reserve chairman, but that's not the point.

Don't make the other mistake either: Ben Bernake is disposable even if he isn't confirmed. There are other equally qualified candidates from Vice-Chairman Donald Kohn to Princeton Economics professor Alan Blinder (and that's just the East Coast), but that's not the point either.

The Bernanke-nomination uncertainty really isn't about Bernanke. It's about the Federal Reserve and the America's growing vote of no confidence in its central bank. A market reaction to a failed renomination would be more of a reaction to the Fed's diminished authority than the loss of Bernanke.

The high level of uncertainty over Bernanke's nomination shows a lot of confidence in the Fed's ability to deliver economic stability has evaporated, thanks to the crisis it helped unleash, starting with actions undertaken by Bernanke's predecessor. And because of this, its ability to make independent, unpopular decisions in the future -- decisions it'll have to make to keep inflation under control -- has been badly compromised. The Fed could be permanently tainted by the role it played in today's mess.

If Bernanke wins a projected "yes" vote from 62 senators (the National Journal's whip count as of Tuesday early afternoon was 44 votes in support), it'll mark a new low in confidence in the central bank.

Sources: Wall Street Journal, National Journal

Previous votes were overwhelming (and a lot more forthcoming) in their support of Fed chairman -- in several cases so overwhelming the confirmation was left to a voice vote without an official tally. Not so for Bernanke, as clearly illustrated by volatility in the Bernanke-confirmation futures on Intrade.

Much of Bernanke renomination drama has been glibly dismissed by commentators as political posturing and kabuki theater -- just politicians playing to the anger and anxiety of the American electorate.

Well, the fact that the public is that angry and anxious (enough for politicians of both parties to notice), that an unusual amount of this anger is being directed toward the Fed (note the rapid rise of long-time libertarian Fed critic Rep. Ron Paul), and that many politicians (including Senator John McCain) feel it necessary to play with dynamite underlines the new reality: Call it the Fed's very own "New Normal."

"Whether he's rejected or not, it shows there's a lot of displeasure," Senator Richard Shelby told Bloomberg. "There's a credibility problem here. The Fed set fire to a house and ran in with a firetruck. As a regulator, they were nonexistent [in preventing the bubble]."

With America's unemployment rate likely to stay in double-digits for some time, a bigger permanent American underclass in the making, economic growth poky and government-inflated at best, no clear signs over the horizon of any significant commitment to improve America's growth the old fashioned way (earn it by improving the business climate), D.C. more widely derided than it's been in decades, and an historically debt-heavy government that will be under ever more pressure to inflate its financial problems away, the Federal Reserve is and will be under the gun in a way it hasn't been since Paul Volcker headed the Fed through the energy crisis of the late 70's and early 80's.

Actually -- the risk is greater today. Paul Volcker had the absolute backing of then-President Ronald Reagan to do what it took to keep inflation under control (including jacking up interest rates into the double digits). The U.S. was in a better financial position back then (a debt-to-GDP ratio of 30% versus today's nearly 100%). Volcker had bigger pro-votes in the Senate than Bernanke appears likely to get. President Obama's current support notwithstanding, Bernanke can't count on that support tomorrow when political push comes to shove. President Obama no longer enjoys Reagan-sized popularity, and the President's party -- predisposed to putting short-term growth ahead of inflation control and long-term stability during the best of times -- can be expected to put more pressure on the Fed to be more loose than it would otherwise be, especially as the 2010 and 2012 elections approach.

A key measure of the Fed's credibility gap going forward -- one investors are already starting to trade on -- will be the spread between U.S. Treasuries and U.S. inflation protected Treasuries and the spread between yields on U.S. Treasuries and similarly dated German bunds, Germany being the gold standard of nationally-backed, inflation-controlling credibility. Trade that gap -- short long-dated Treasuries, go long on German bunds (follow PIMCO's lead on this one) and Inflation protected Treasuries, as well as commodity indexes and ETFs.

But not all in -- at least, not just yet. Wait for more confirmation that inflation is perking up -- especially through real time, market indexes of commodity prices. Leave room to add to those holdings as we get closer to the point the Federal Reserve will have to raise rates, but finds itself less able to, as inflation expectations and inflation itself reassert themselves. That time will be sooner rather than later, especially if growth remains lackluster and unemployment high.

Because of its underperformance (to put it mildly), the Federal Reserve, along with much of the rest of the federal government, has lost credibility and future freedom of action -- whether or not Bernanke gets his second term. The Fed's commitment to inflation fighting is already in serious doubt, no matter what happens to Bernanke.

Plan accordingly. Invest accordingly.

U.S. Much Less Competitive: Bad for 'Recovery'

Any investor still wondering whether this "recovery" has legs, what's holding the U.S. economy back or where to find some of the best prospects abroad going forward will find a great resource in today's release of the annual Index of Economic Freedom, put together by the Heritage Foundation and Wall Street Journal.

It's bad news for the U.S., which dropped to eighth from sixth place, leaving Canada, rather than the U.S., North America's best business climate. In a shocker, for the first time the U.S. is no longer ranked among the world's most "economically free" countries.



There was deterioration in 10 subcategories ranging from financial freedom to property rights thanks to greater regulation, more protectionist trade policies, massive stimulus spending and bailouts of corporations deemed "too big to fail," dragging the U.S. index score to 78 from 80.7 on a 0-to-100 scale.

The report's editor says:

"Policies have resulted in job losses, discouraged entrepreneurship, and saddled America with unprecedented government deficits... These trends are important because study after study shows a strong correlation between economic freedom and prosperity."

Unable to count anymore on a rising tide of inflating credit to artificially lift all boats, the U. S. economy will need to generate economic growth the old fashioned way -- earn it -- as more of the world's growth is enjoyed by countries with good or improving policy and business climates.

Hong Kong, Singapore, Australia, New Zealand and Ireland are now ranked as the world's most attractive places to do business, according to the Index ratings. Turkey, Montenegro, Poland, Croatia and Qatar show some of the most rapid improvement in their attractiveness. That's where more of your focus on growth needs to be.

The U.S. meanwhile joins the U.K., Iceland, Bulgaria and Yemen, among countries suffering the steepest erosion in economic freedom over the past year.

Peter Boockvar of Miller Tabak put it best, when he recently told Bloomberg News that the recovery story "is all about the business climate."

"We need to make it more attractive to do business here [in the U.S.]," he said. "It's the only way we're going to be able to get real, solid economic growth over the next five years."