PERFORMANCE ANNOUNCEMENT

As Of: September 26, 2005

HURRICANES

Govt Spendng = Long Term Problems.

    How Congress and the Federal Reserve react to hurricanes Katrina and Rita will affect the economy both in the short run, and also for many years to come. While it is still unclear what choices will ultimately be made, the policy decisions that are currently being addressed will determine the national growth rate, inflation rate, unemployment rate, and interest rate. These macroeconomic factors will in turn influence the decisions that individuals make regarding their purchase or sale of real estate, their borrowing and debt load, their consumption, and their savings and investment.

    In the classical theory of macroeconomics, a simple measure of the demand for the economy's output comes from consumption, investment, and government purchases. The general equilibrium model postulates that the gross domestic product (GDP) is determined by a balance between the supply for goods and services and the demand for goods and services. As just mentioned, in a closed domestic economy, the demand = output and can be expressed as:

    GDP = Consumption + Investment + Government Spending

The economy is growing when GDP is growing. Growth should produce the desirable result of lower unemployment and a higher standard of living. In the US economy, more than two thirds of the growth in GDP has traditionally come from the consumer. Now, not only because of the devastation that has been wrought by hurricanes, but also because of the politics surrounding these events, the government has pledged to spend hundreds of billions of dollars in relief and reconstruction. This is on top of the hundreds of billions of dollars being spent on the wars in Iraq and Afghanistan. And additionally on top of billions of dollars being spent on new national health initiatives. In the above equation, an increase in government spending means an increase in GDP. While this would seem to be a pleasing and desirable result, the larger question is where will the money come from for this government spending? If the government has excess savings, the government can dis-invest and use government savings to increase spending. However, the United States is already a debtor nation. Therefore, only two choices remain. The government can raise taxes; or the government can borrow additional funds in order to increase spending.

    If taxes are raised, the consumer will have less money to spend. Combined with higher energy prices and the high level of debt already embraced by the consumer, a tax increase could be enough to throw the economy into recession. Making President Bush's previous tax cuts permanent and/or addressing any additional tax changes to stimulate the economy is now a very sticky problem for Congress.

    If the government borrows for additional spending, the direct result is that interest rates will go up. In simple terms, if national savings = GDP - C - G, then when G (government spending) goes up, national savings must go down for a given level of GDP and consumption. Since savings is a function of interest rates, interest rates must go up when the government crowds out borrowing. The Federal Reserve can hold interest rates below appropriate market levels, but this will effectively monetize the debt and create inflation.

    The bottom line is that these natural disasters have caught the United States at a difficult time when the country is not economically prepared to take on the additional expense that these hurricanes have generated. The individual investor will have to take his cue from future events depending on the balance between the stimulation that additional spending will bring versus all the negative results that will emanate from paying the bill for this spending, an obligation that may be with us for decades to come.