The problem with economics

The piece below by Peter Boettke summarizes what I think about current economics. The Keynesian model or paradigm is wrong and always has been. Two primary reasons it was adopted were 1) the crisis of the 1930s was misunderstood but demanded “action” of some kind and 2) it gave the politicians a license to steal power and money from the citizens. If economics were a physical science where data could refute false hypotheses, it is doubtful that the paradigm would still exist today. Because it isn’t, reason number two became paramount. Most economists initially objected to  the theory, gradually agreeing with it over time. After all, it also provided lucrative rewards for them in terms of higher paying jobs in government and eventually a route to tenure after it dominated university economics departments.
The books referenced below in the fifth paragraph are excellent reads for anyone interested in the flaws and inconsistencies in the so-called General Theory. “The Critics of Keynesian Economics” book is especially insightful because it is a collection of great economists (authors include Jacob Viner, Frank Knight, Garet Garrett, Jacques Rueff, Benjamin Anderson, Frederick Hayek, Ludwig von Mises, and others) contemporaneously passing judgment on the then “New Economics.” Most of the essays were written in the 1930s or early 1940s and accurately saw the inconsistencies in

The government guaranteed all their debt

• Oh yes — this is surely a sign that the credit crunch is behind us. Regulators closed seven more regional banks last Friday, bringing the tally for the year to 106. There have been more bank failures this year than in the past 15 years combined, and the only reason why the big boys never followed suit was because the government guaranteed all their debt and then allowed them to hide their losses by switching to mark-to-model accounting from mark-to-market. Believe us when we tell you that even the most renowned experts could not tell you what is really sitting on the balance sheets of these large U.S. banks — but there is limited downside risk because Uncle Sam has deemed them all to be ‘too big to fail’. Those who were investors in American United Bank, well, we are sorry to have to tell you that you were involved in an institution that was small enough to close down.
• We realize that this did not make it anywhere in the weekend press (outside of a microscopic piece in the IBD) but the ECRI leading economic indicator actually fell (by 0.2 of a point) for the second week in a row (and the smoothed annualized growth rate declined 1.6% —- now what is that all about?).

Foreign resource stocks might do especially well

Peter Schiff adamantly recommends getting out of the dollar. His presentation, if correct, will be devastating for this country and wipe out the wealth of the middle class. All of what he says is correct, although his timing may be off. Furthermore, there is the possibility that our government might change course, although I, like Schiff, feel that unlikely. His recommendation to own “real stuff” is correct. If the stock market goes up, I doubt whether it will keep pace with inflation. The best performing stock market in the world in recent years has been Zimbabwe, but it did not keep pace with their inflation.
So, what to do? If as some believe that the dollar will decline by 50% from here over the next 10 years, then having your funds outside the dollar (in other currencies) would presumably produce a 7% average return per year. Investing in foreign stocks would provide that 7% plus the returns (or losses) obtained in foreign stock markets. Precious metals, as money substitutes, should do well. So should natural resources and other hard assets like land. Foreign resource stocks might do especially well.
None of this is meant to be investment advice. If what Schiff (and I) fear comes true, some of the above might be reasonable investments/hedges. On the other hand, all of the above comments would be 180 degrees wrong if we were to end up in deflation instead of inflation.
Schiff was very emotional, practically begging people to get out of the dollar. I suspect the economy and markets over the next year or two will justify his emotion. Whether his scenario results or not, is the more difficult issue.

Makes meaningful economic recovery impossible

It is about Citibank and is outrageous. Apparently it is going on with other credit card issuers as well.
This is the sort of thing that, in my opinion, makes meaningful economic recovery impossible. 

Here’s what it says:
To continue to provide our customers with access to credit, we have had to adjust our pricing.
….
These changes include an increase in the variable APR for purchases to 29.99% and will take effect November 30, 2009.
(It then goes on to say that if you pay on time you can get 10% of your interest charges back, which lowers the effective rate by about 3%.)
I have multiple copies of this letter, all on the same theme – 30% interest rates, vastly higher than they were.
The obvious message in this letter is simple: Those who are responsible and can pay their bills will be subsidizing those who cannot – that is, you, the responsible cardholder, will pay the deadbeat’s bill!
Citibank has 92 million cards in circulation and is #4 in market share in terms of purchase volume, with 11.05% of the total.
Overall, consumers hold an average of 5.4 revolving (credit) cards.  Half of all undergraduates in college have 4 or more cards.
Average card debt per household, including households that have no cards at all, is $8,329.  For households with one or more cards, it is $10,679, both figures at the end of 2008.
Of the 73% of families with credit cards, 60.3% carried a balance.  This means that for those with balances, the average balance is nearly $18,000.
If the previous interest rate on those cards was around 20% and is now 29%, the average family with a balance (about 44% of all households) was paying $3,600 in interest charges previously, but now will be paying $5,220, and increase of $1,620 a year or $135.00 a month.
There are approximately 116 million households in the US.  As a consequence the decrease in disposable personal income attributable to this sort of interest rate change is approximately $113 billion, or a bit under 1% of GDP.
And that’s only the direct cost of the interest.  What cannot be measured is the impact on consumer spending that comes from changes in consumer behavior – that is, this is only the interest component of the change in rate.
If this interest rate change prompts people to pay down just 25% of their credit card debt over two year’s time the impact on GDP simply from paying down the debt as opposed to holding it level will raise the impact to approximately 1.9% of GDP, or about $270 billion annually in foregone consumer spending.
Good luck with your “recovery” thesis folks.

Unaccountable political formulation

Commentary by Chris Whalen:

“I submit that our spendthrift government, the Federal Reserve System and the TBTF banks together now comprise the paramount political tendency in America today. This tripartite “Alliance of Convenience,” let’s not call it a conspiracy, fits beautifully into the corporatist mold that seems to be America in the 21st Century – but only viewed by the elites in cities like New York and Washington. Many Americans of all political descriptions oppose this corrupt and unaccountable political formulation. I hope and expect that these differences will become even more pronounced as the election approaches next November.

The difference that separates the United States from the rest of the world is the difference which has always divided us, namely our at least theoretical devotion to individual liberty and free markets. Until we break the Alliance of Convenience between the Congress, the Fed and the large, TBTF banks and force our public officials to embrace core American values regarding transparency, insolvency and accountability, we will not in my view find a way out of the crisis. In may ways, the differences that separate the popular view and the views of our political elite have been turned on their heads compared with a century ago, but this does not mean that the debate and resulting political competition for ideas will be any less intense.”

It is terrible economics but wonderful politics

Interventionism is economic intervention by the government into the free market. It typically involves subsidies or penalties to particular groups. Interventions never improve the economy. Indeed, many interventions lead to additional interventions to attempt to correct the harm done by the first action. Interventions may improve the lot of a targeted group, but does so at the expense of society. While a particular group may be said to benefit, the total economy is always made worse off.

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Others like Bastiat expressed a similar views about a hundred years before. Based on Bastiat, this wrong-headed Keynesian thinking has become known as “The Broken Window Fallacy.”
Why do governments continue to do something that doesn’t work? Because it works for politicians in terms of “vote-buying.” The beneficiaries know that they have received a gift. The harm done to the other individuals cannot be traced back to the “beneficial” program. Hence, the harm cannot be blamed on anyone. It is terrible economics but wonderful politics.
Barry Ritholtz discusses the intervention of providing Credit for First-time Homebuyers. (Similar and equally disturbing analyses were produced regarding the Cash for Clunkers program.)

$15,000 Home Buyers Credit Costs $292,000/home

I have long argued that home prices are elevated, and until they normalize, the economy will be stuck in the doldrums. I even wrote a chapter of Bailout Nation, titled “The Virtue of Foreclosure.” I make a basic economic argument that the excess credit of the 2001-07 era is unwinding, and foreclosures are part of that process.
The simple premise is that the abdication of lending standards by both bank and nonbank lenders created an enormous credit bubble. Easy money drove home prices to unsustainable and unaffordable levels. People bought homes far more expensive than they could reasonably afford. Many assumed they would be able to refinance, paying for the excess costs by cashing out the price appreciation everyone knew was sure to follow.
Of course, we know what happened next. Prices rose unsustainably, credit tightened up, and the supply of greater fools abated. So much for the real estate perpetual motion machine.
What we were left with was an oversupply of new homes, and 4-8 million people in homes they couldn’t really afford. When measure by traditional metrics like median price to median income, costs of ownership relative to renting, or Homes as a % of GDP, houses were extremely expensive.
Running 300,000 monthly foreclosures — on pace to do 3 million foreclosures this year — the prior boom process is now unwinding. Excess prices are normalizing — but they still remain somewhat elevated compared to historical ratios. Perverse though it may be, the mass Foreclosures are helping to drive prices back to normalized historic levels.
Although this process is a necessary evil, Politicians of all stripes hate it. Between the NAR and NAHB, they have ready lobby fighting market forces. The lobbyists shamelessly ignore the role their members played in blowing up the bubble, and how they encouraged irresponsible and in many cases illegal behavior. The NAR and the NAHB have yet to offer up their mea culpas for their contributions to the mess, but their roles were substantial.
All of the home mortgage modification programs and foreclosure abatements are attempts by politicos to “ease the pain.” These programs have proven themselves to be ineffective in preventing defaulting mortgages from going into foreclosure. More than 50% of all mods slip into foreclosure again, and in some instances, we see 70-80% delinquency rates.
But the real question is “Why are we trying?” Except for those instances where there has been fraud or predatory lending, we really should not intervene. The foreclosure process is restoring prices to where they should be. (Note I suggested a voluntary program last year that helped banks forestall writedowns, and allowed viable homeowners to keep their houses, but also lowered prices).
Now comes the latest attempt by politicians to intervene in the housing market: Expanding the about to expire, $8,000, first time home buyers tax credit to a $15,000 credit for everyone.  This is counter productive. (Won’t that just make prices more expensive?) The lobbyists want to goose the housing market by any means possible — even if it is an expensive and unhealthy method.
A recent Brookings Institute analysis  demonstrates persuasively that the $8,000 subsidy actually costs $43,000 per extra house sold; worse yet, the new $15k tax credit will ultimately cost $292,000 per home.
How does that math work? :

“[The] refundable tax credit, which was part of the February stimulus bill, gives $8,000 to first-time homebuyers (but is phased out at higher incomes). It is scheduled to expire on December 1, 2009, although the sponsor of the initial proposal, Senator Johnny Isakson, now wants to extend the credit for another year, and expand it to $15,000. This extension would be a mistake.
Approximately 1.9 million buyers are expected to receive the credit, but more than 85 percent of these would have bought a home without the credit. This suggests a price tax of about $15 billion – which is twice what Congress intended – for approximately 350,000 additional home sales. At $43,000 per new home sale, this is a very expensive subsidy . . .
An extension and expansion of the tax credit will cost far more than the $15 billion of the current credit, likely in excess of an additional $30 billion. And the cost per new house sale will likely be much higher going forward, as a greater proportion of the sales will be for those who would have bought anyway, without the credit. (emphasis added)

In a latter posting, Gayer does the math on the new tax credit: A one-year, $15,000 tax credit  apply to all home buyers, would cost the Treasury ~$73.9 billion. Gayer estimates that beyond the people who would have purchased homes anyway, the increase in house sales would be about 253,000. Each extra home sales costs the Treasury $292,000 ($73.9 billion divided by 253,000.)
Randall Forsyth points out a lower (but still absurd) figures calculated by the NAHB:

The National Association of Home Builders, not exactly a disinterested bunch, figures the subsidy would boost house sales considerably more, by 700,000 homes. That implies each of those additional sales would cost American taxpayers only $133,000 — still “a very expensive and poorly targeted subsidy,” writes Gayer.

Its one thing to argue as to whether the government should be so brazenly intervening into the housing market, and I can understand reasonable people disagreeing. But the subsidy — whether its $133,000 or $292,000 — is absurd.

Now practically doomed to foreclosure

When it come to home ownership, condo prices are the last to rise and the first to go down. Given the glut of condos and unfinished condos in the bubble areas, the following article should not be surprising.
Please consider Experts: Plummeting prices have rendered condos nearly worthless by the Arizona Republic.

New federal loan-guarantee rules imposed to fend off future government losses from plummeting condominium prices have rendered condos utterly worthless, Valley real-estate experts said.The Federal Housing Administration rules, which took effect Oct. 1, prohibit any new FHA-backed loans on condo units in projects that include more than 25 percent commercial space.

In addition, no single investor – including the developer – may own more than 10 percent of the units in a particular project. That particular restriction alone creates a catch-22 from which condo builders most likely cannot escape, said mortgage originator Jill Hoogendyk of Wallick & Volk in Glendale. Another rule that has sellers and brokers scratching their heads prohibits FHA loans in condo developments that aren’t “primarily residential,” which could be taken to mean the FHA won’t guarantee loans in future mixed-use projects.
“I’m predicting that what we’ll see is whole condominium complexes sitting empty,” Hoogendyk said.
The new rules are a reaction to substantial losses on federally insured condominium mortgages in the past year, government officials have said compared with about 4,900 units sold during the same period.
Bowers said there are Phoenix-area condominium projects in which only a handful of buyers purchased individual units. The only viable use for such projects would be renting the unsold units as apartments, which many condo building owners already have been doing.
However, most have continued trying to sell units, hoping to eventually sell out as the real-estate market recovers. Because of the new rules, local and national experts seem to agree that owner-occupants in half-empty condo buildings are now practically doomed to foreclosure.
What applies to Arizona also applies to Florida, California, Las Vegas, and anywhere else there is a glut of condos.

On top of the above rules, it is going to be difficult to buy into buildings with less than 70% occupancy. Cash buyers can close of course, but I would not recommend it.

When this false rally collapses

10/09/09 Stockholm, Sweden – The biggest story generally going unreported in the mainstream media is that many financial institutions are simply failing to pay back your hard-earned tax dollars.
According to USA Today, “The U.S. taxpayers’ investments in smaller banks are increasingly at risk… 34 financial institutions did not pay their quarterly dividends in August to the Treasury on funds obtained under the Troubled Asset Relief Fund (TARP). The number almost doubled from 19 in May when payments were last made,” a clear sign the trend is worsening.
Among the non-payers are obvious weak giants like AIG and CIT, but the list goes on and includes many other players. It’s an especially disappointing trend given that we’re in a period of “recovery.” When this false rally collapses the number of institutions that are unable to meet TARP obligations are bound to skyrocket. Taxpayers beware.

Greater amounts of the securities it prints

Bernanke‘s backdoor tricks to support the growing deficits via stealth Quantitative Easing can no longer be hidden. Things must be really getting desperate over there. They usually wait 3 or 4 days before doing what they deny they are doing. This latest example took all of 30 minutes! Is funding getting so desperate that they couldn’t have waited a day or two?
From Zero Hedge the following quote and story:
“We hope that as Bloomberg and other MSM conduits disseminate this and other relevant stories, that more and more people become familiar with the behind the scenes machinations that the Fed is doing, all in its single-minded pursuit of gobbling ever greater amounts of the securities it prints, all with the hidden agenda of destroying any residual value the US currency may have as any confidence that the dollar may be worth anything is promptly refuted by the most recent wave of dollar bills printed by the Chairman.”

Foreign investors from Treasuries

Timothy Geithner, the current Treasury secretary, has tolerated the greenback’s 12 percent slide from its peak this year in March as measured by the Federal Reserve’s trade- weighted Real Major Currencies Dollar Index. While he said as recently as Oct. 3 that “it is very important to the United States that we continue to have a strong dollar,” the last time the U.S. intervened in markets to support its currency was 1995.
The weaker dollar may boost America’s exports as the economy recovers from the deepest recession since the 1930s. The risk is that it may also drive away America’s largest creditors just as the Treasury relies more than ever on foreign investors to buy the bonds financing Barack Obama’s stimulus spending. The dollar’s share of global currency reserves fell in the second quarter to 62.8 percent, the lowest level in at least a decade, the International Monetary Fund in Washington said on Sept. 30.
“Since the dollar has been weak and weakening for years, Geithner was using a code phrase, a carry-over from the Bush administration,” said David Malpass, president of research firm Encima Global in New York. “It means that the U.S. approves of a constantly weakening dollar but doesn’t want a disruptive collapse,” said Malpass, the former chief economist at Bear Stearns Cos. and deputy assistant Treasury secretary from 1986 to 1989.
Poorer Americans
The dollar’s 15 percent decline against the euro and 11 percent depreciation versus the yen since early March are increasing concern among world leaders. At the same time, Americans are getting poorer.
Per capita net wealth tumbled to $172,749 in August from a peak of $212,599 in September 2007, government figures show. A United Nations Human Development Report released Oct. 5 showed America’s quality of life dropped to No. 13 in a 2007 global ranking from No. 5 in 2000.
European Central Bank President Jean-Claude Trichet said today in Venice that a strong dollar is “important,” repeating remarks made in Brussels on Sept. 28. Toyoo Gyohten, an adviser to Japan’s new finance minister, said the same day there is “no better alternative to the dollar.” Bank Rossii First Deputy Chairman Alexei Ulyukayev said Sept. 29 that Russia will keep buying Treasuries because there’s no realistic alternative.
The dollar fell as much as 0.7 percent against the euro today, before trading at $1.4736 as of 2.35 p.m. in London, from $1.4691 yesterday.
‘Special Burdens’
“We recognize that the dollar’s important role in the system conveys special burdens and responsibilities on us and we are going to do everything necessary to make sure we sustain confidence,” Geithner told reporters after attending a meeting of counterparts and central bankers from the Group of Seven in Istanbul on Oct. 3.
The comments came after policy makers from China to Russia called for an alternative to the world’s main currency in foreign-exchange reserves.
“Major reserve-currency issuing countries should take into account and balance the implications of their monetary policies for both their own economies and the world economy with a view to upholding stability of international financial markets,” China President Hu Jintao told the Group of 20 leaders in Pittsburgh on Sept. 25, according to an English translation of his prepared remarks.
Bentsen, Rubin, Summers
When Ronald Reagan was elected president in 1980 his platform called for a “strong NATO,” “strong leadership,” “a strong peace,” and a strong currency. “A sound monetary policy will be restored — one designed to instill confidence in the American dollar abroad, as well as bring down the rate of inflation at home,” according to a 1980 brochure from Reagan’s campaign.
The preference for a strong dollar was brought back under Lloyd Bentsen, Bill Clinton’s Treasury secretary, in 1994 and the phrase was used regularly by his successors, Robert Rubin, a former Goldman, Sachs & Co. co-chairman, and Lawrence Summers, who is now the director of Obama’s National Economic Council.
Intercontinental Exchange Inc.’s Dollar Index, which tracks the currency’s performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, gained an average of 4.93 percent a year between 1996 and 1999 when Clinton was in office.
Rubin Mantra
“By not varying the statement, an issue never arose about whether a comment involved a subtle change or not in the policy toward the dollar,” former Fed Chairman Alan Greenspan told his colleagues on the Federal Open Market Committee in 2001, according to a transcript of the meeting. “It was boring, it was dull, it was repetitive, it was nonintellectual, and it worked like a charm.”
Rubin, a former senior counselor at New York-based Citigroup Inc., wasn’t immediately available to comment. A spokesman for Summers referred questions to the Treasury.
During the presidency of George W. Bush, the Dollar Index declined 20 percent.
The government has used the phrase for so long that “I don’t think it has much meaning left for the markets,” said Vassili Serebriakov, a currency strategist at Wells Fargo Bank in New York. “Once you have this policy in place I don’t think there’s any possible choice but for the Treasury to stick to what it’s been saying all this time.”
More Expensive
The decline means it’s becoming relatively more expensive to live in the U.S. The difference in per-capita income with Canada has shrunk 87 percent since October 2008.
A McDonald’s Corp. Big Mac sandwich cost $3.57 in the U.S. in 2009, unchanged from 2008, according to The Economist magazine’s Big Mac Index. That compares with a 13 percent decline in the euro region to $4.62 from $5.34, and a 19 percent drop in the U.K. to $3.69.
One benefit to a depreciating dollar is that it helped shrink America’s trade deficit to $32 billion in July from the record $67.6 billion in August 2006, data compiled by the Commerce Department show.
Exports rose 5.7 percent to $127.6 billion in July from the low this year of $120.6 billion in April, the most recent data show, led by sales of capital goods including cars, civilian aircraft and computers, as well as stronger demand for industrial supplies and consumer goods.
Theory ‘Problem’
“The Washington theory is that dollar weakness will benefit the U.S. by inflating our way out of debt and causing more exports,” Encima’s Malpass said in a Sept. 25 note to clients. “The problem with this theory is that it assumes capital stays put while the dollar devalues.”
While the dollar dropped in global currency reserves, holdings of euros rose to a record, the IMF report shows. The U.S. currency’s portion declined to 62.8 percent from 65 percent in the first quarter. The euro’s share rose to a record 27.5 percent from 25.9 percent while the pound and yen gained.
The share of reserves in dollars declined even after the Fed and the government lent, spent or guaranteed $11.6 trillion to shore up the economy and the financial system. The Fed has increased the size of its balance sheet to $2.144 trillion from $906 billion in September 2008.
Treasury officials rely on foreign investors to buy the record amount of debt needed to finance the more than $1 trillion budget deficit. The gap will grow to $1.6 trillion in fiscal 2010 before narrowing to $1.4 trillion the following year, according to the Congressional Budget Office.
Treasury Sales
The U.S. sold $1.517 trillion of notes and bonds this year, compared with $585 billion at the same point in 2008. London- based Barclays Plc forecast total 2009 issuance at $2.1 trillion, and $2.5 trillion in 2010.
Dollar bears say net purchases of long-term U.S. securities by foreign investors fell below the trade deficit by $46 billion in the first half of the year, one of the only three occasions since 1994 there was a shortfall, according to Treasury Department data.
China has slowed purchases, increasing its holdings 10 percent to $800.5 billion through July after a 52 percent rise in 2008 and 20 percent in 2007, according to the Treasury Department. Foreign ownership overall has risen 11.4 percent to $3.43 trillion, after gaining 31 percent in 2008.
Chinese Premier Wen Jiabao said in March that the Asian nation was “worried” about the safety of its investment in U.S. debt, as a weakening dollar eroded the value of its record $2.1 trillion of foreign-exchange reserves.
Dollar Index
The Dollar Index, which was as low as 75.896 today, is still above the lows in March 2008, when it fell to a record 70.698. The decline isn’t as steep as in the late 1980s, when it tumbled 48 percent to 85.33 in January 1988 from 164.72 in March 1985.
There’s no sign slower purchases of U.S. debt are leading to higher borrowing costs. The yield on the benchmark 10-year Treasury, which helps determine everything from mortgage rates to auto loan payments, has averaged 3.17 percent this year, compared with 5.6 percent since 1989.
“The dollar will fall against the euro into the year end as investors reallocate funds in search of higher yields,” said Hans-Guenter Redeker, the London-based global head of currency strategy at BNP Paribas SA, the most accurate forecaster of 2007. “This is only capital export though, not capital flight. There is no evidence whatsoever that the weak dollar will lead to capital flight.”
No Inflation
There is no inflation in the U.S. that would deter foreign investors from Treasuries. Consumer prices fell 1.5 percent in August from a year earlier, and have dropped for six straight months, the Labor Department in Washington said Aug. 16.
“Inflation is still declining in the U.S. so it’s wrong to say that the dollar is losing its purchasing power,” Redeker said. “The U.S. is a domestically driven economy. It has huge output gaps and these are going to keep inflation subdued for at least two years.”
G-7 finance chiefs stopped short of singling out the dollar for criticism in a statement after talks on Oct. 3, saying that “excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability.” That’s the same language they used in April, when the Dollar Index rose to 86.871.
“It’s hardly a decisive statement by the officials but at the same time it shows that they prefer the dollar steadies in the current range and they could learn to live with it,” said David Cohen, director of Asian economic forecasting at Action Economics in Singapore. “I’m sure Geithner wouldn’t mind the dollar becoming a little more competitive but he doesn’t want to threaten the dollar’s status as the reserve currency, so by definition he has to play a delicate balancing act.”

Banking system with fresh capital

An excerpt from a very interesting post by Gregor MacDonald that deals with the Inflation-Deflation scenario happening simultaneously. It includes the notion of an inflationary depression.

Our society’s hierarchy rests in part upon the following assumption: that the intellectual capacity of the chairman of the Federal Reserve, with his PhD and his white papers, is superior to that of a mortgage broker from Orange County, California. I think we need an adjustment to this type of assumption. Because the spread I see opening up everywhere in the US economy is what I call the Prestige-Performance gap, whereby the assertions of our elite no longer comport with observable reality. If the chairman of the Federal Reserve will not allow that the greatest credit bubble ever has now burst, or that it ever existed, then this partially explains why he would think stuffing the banking system with fresh capital would revive the economy.
Asset reflation therefore, in equities and especially in gold, should be seen not as exuberance but merely as part of the same chaos in pricing unleashed by The Federal Reserve, starting earlier this decade. As so clearly outlined in the recent data on employment, credit demand, consumer spending, and our (in)ability to save there is little to no prospect for a sustained economic recovery for one simple reason: Americans are now trapped by their debt.
For those who recognize a rising stock market as evidence of disarray, what we should anticipate now is the recognition phase where the wider public finally comes to understand the nature of our inflationary depression. My marker has been 100 dollar oil and 15% unemployment in California. That should finally get the message across. But other combinations will do: 1300 dollar gold, 1300 on the SPX, and more problems with Commercial Real Estate will also suffice. Like the prestige-performance gap, the divergence between the economy and asset prices apparently has to become even more grotesque before people will understand.

The fact that a free-market economy is resilient

As discussed rather simply in Econ 301 – Clunker Economics macroeconomics rests on a false premise. Despite its fundamental flaw, it is a wonderful political tool in two ways. First, it provides the intellectual cover for politicians to do what they want to do — spend more money. Second, it provides political cover in the sense that it can be claimed that “we have taken massive ‘corrective’ actions to cure the problem(s).” The fact that a free-market economy is resilient and self-healing enables the scheme to appear to be valid. In that sense, it is almost a perfect scam. Like witch doctors who claim to heal their patients when the mere passage of time is responsible for the cure or the rooster who thinks his crowing brings the sun up, the government takes credit for something that occurred quite naturally. (They never think that the problem might have been caused by their prior actions.) Unfortunately sometimes the well-intentioned witch doctor kills an otherwise healthy patient. We may be at just such a moment in history regarding the current economic crisis.

So long as people hold onto the expectation that recovery could be brought about by fiscal measures, no national consensus can be built to proceed with the painful disposition of nonperforming assets. It is necessary to learn by firsthand experience that fiscal measures are only makeshift. In this context, the enormous fiscal deficit that will be built up in the US in the coming months may be the political cost for consensus building, which would be a replay of what Japan went through in the 1990s. [emphasis added]

The above quote is from Keiichiro Kobayashi, Senior Fellow at the Research Institute of Economy, Trade and Industry. The quote appeared in Will Ignoring Past Mistakes Result in a 20-Year Bear Market? by an unnamed author in Seeking Alpha. It is a nice summary of why present policies cannot work and why we will likely end up with a Japan-like lost decade or two.

Big bank bailouts are necessary

“Too Big to Fail” is cited as the reason why big bank bailouts are necessary. When George Shultz was Treasury Secretary and encountered this defense, he allegedly replied: “Then make them smaller.” In what appears to be an increasingly State-complicit media, not much is heard regarding opposite beliefs. A range of different views are presented by George Washington.

To many, the Washington-Wall Street connection is seen as a convenient partnership that works well for them but not necessarily for the rest of the country. From this viewpoint, one understands why the biggest rocks are not overturned. They hide the biggest lizards, rodents and other critters.

Damaging the housing and economic recovery

The on-going deficits forecast for the US cannot be financed out of domestic savings.  The shortfall must be covered via  foreign funding or the Federal Reserve monetizing the debt. The Fed has announced that its purchase of Treasuries will stop at $300 billion. That limit was reached last week. If one believes the Fed, they are done (monetizing), and the safety net under Treasury auctions has been removed. Without this backstop, there is risk of a failed Treasury auction, an event that could prove cataclysmic to financial markets in this country and around the world. As discussed by Graham Summers:

A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!
In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter. It also shows us that foreign holders (China, Japan, etc.) are reducing their purchases of US debt at an incredible rate.

The Treasury is scheduled to sell $78 billion in debt obligations this coming week. This number is large historically, but not large in light of recent and forecasted government spending/taxation. Deficits, including off-balance sheet items, will be about $ 2 Trillion this fiscal year. Additionally, about $2 Trillion of existing debt must be re-financed each year. Debt auctions must average about $80 billion per week, week after week after week ad nauseum or ad failed auction.
The dependence of the US on foreign governments to finance our deficit is the Achilles heel of both the dollar and the Treasury bond markets. Will it be possible for the Fed to stop buying Treasuries? Unlikely. If they stop and failed auctions occur, interest rates rise, damaging the housing and economic recovery. If the Fed continues to monetize (buy Treasuries), the dollar will continue to decline, perhaps precipitously. The Fed (and the US government) is nestled uncomfortably between the classic “rock and a hard place.” Chris Martenson’s take on this subject is summarized below:

The US government continues to have impressive borrowing needs, but the Federal Reserve has claimed to be done with its program of buying US government debt.
At the same time, the truly spectacular inflows of foreign dollars into US Treasury paper cannot logically continue forever, especially given the collapse in export markets.  There is even some mystery as to how they could have been as large as they’ve been.
Taken together, it would be logical to suspect that US Treasury paper and new debt issuances would come under some pressure, which we would detect as falling bond/note prices and rising yields.
However, that’s not at all what we are currently seeing, as indicated by the 10-year note yielding a paltry 3.2% and recent auctions have had more than three buyers biding for each bond.  The question before us is, can we see anything that might cause this to change?
I would submit that the US lacks sufficient domestic savings and productive capacity to finance its fiscal deficits internally so I propose that there are only two paths forward.  Either foreigners continue to finance the US deficits, or the Fed will resort to even more printing to cover the shortfall.
Where will the foreigners get the money?  Alternatively, how will they react if the Fed simply prints up the difference?

The dollar/bond market is unsustainable for the long-term, but may last for a while longer. It is highly unlikely that foreign Treasury demand will meet US deficit needs. It is even more unlikely that the Fed will allow the government to start bouncing checks.  Hence, the Fed will continue monetizing the debt, either openly or surreptiously. Eventually the unsustainable equilibrium represented by today’s dollar and interest rate structure will adjust to reality. Watch these markets closely because the next phase of the crisis will emanate from one or both.

Unfolding economic and political events

Those who have been following this blog know that the US dollar is vulnerable. It may be the most important factor in determining an investment strategy over the next couple of years. This conclusion is based upon the mathematical impossibility of servicing government debt and obligations. Either the government must drastically curtail the welfare state (social security, medicare, etc.) or abandon the dollar. Politically, it is considered impossible to do the former. Hence, the most likely outcome is either a continuing or precipitous drop in the value of the US dollar.

Sprott Asset Management has just issued a report entitled “Safe Haven No More” that is a MUST READ. It discusses why they believe the dollar must go down. It is entirely consistent with my reasoning. In the report, they nicely lay out their thought process, including a detailed look at Federal obligations. This is very valuable information because it is important that investors understand the magnitude of the problem the US government has created.  Whether or not you agree with the conclusions, it provides a perspective to judge unfolding economic and political events.
Their calculation of debt excludes virtually all stimulus that has not been reflected in the deficit already. Hence, it understates this problem to the extent of guarantees and funds committed but not yet spent. I agree with virtually everything in the report. However, I do not believe that the expected strategy can save the welfare state. If/when the dollar collapses, the welfare state does not suddenly become sustainable. It is the root cause of where we are and must ultimately be dealt with. The  government has  promised over $100 trillion (present value) dollars in social programs. The total wealth of the country is only around $50 trillion. If they confiscated every dollar of wealth from every citizen, firm, charity, etc. they would still be 50% short of being able to honor their promises. Such social promises are absurd and totally unfundable. They cannot be remedied by trashing the dollar. Hence, trashing the dollar may buy some time but cannot save an overly bloated welfare state. Either these committments will have to be cut drastically or they will be funded via a Zimbabwe-style inflation.

The 19th century under a gold standard

What if the price of Gold is manipulated? First, some background.

Gold has virtually no industrial demand. Its value derives almost solely from its use as a currency or currency substitute. For over 5,000 or so years it has been the ultimate money because its supply is relatively fixed. It is beyond the ability of politicians to manipulate the supply. In a world of fiat money, where supply is controlled by the government or Central Banks, there is an inevitable political tendency to increase supply (an increase in the money supply is the proper definition of inflation).  To contrast the two standards, during the 19th century under a gold standard, the US had virtually no inflation. The value of the dollar as measured in purchasing power remained constant. Since the creation of the Federal Reserve in 1913, inflation has been a way of life. The purchasing power of the dollar since 1913 has declined by 93%.
As “the canary in the coal mine,” free market gold prices are a reasonable measure of the amount of true inflation in the economy. (Measures such as the CPI are inadequate proxies for inflation, and have consistently been manipulated to under report price increases as detailed by John Williams among others.) As such, gold is the ultimate nemesis for fiat currency regimes. For the past several years, gold bugs have maintained that Central Banks have suppressed the price of gold in order to hide the real deterioration in the purchasing power of fiat currencies. The Gold Anti-Trust Action Committee (GATA) has been on a crusade to expose the price suppression of gold and has produced various evidence of such manipulation. Now, new evidence of gold price suppression has been uncovered that is unequivocal. It is in the form of a memo from Chairman of the Fed, Arthur Burns, to President Gerald Ford written June 3, 1975. (Recall that the dollar was redeemable in gold up until August 15, 1971.) Thus, the suppression of gold prices appears to have been going on almost from the time the world went to fiat currency.
One of the damning quotes from the memo follows:

I have a secret understanding in writing with the Bundesbank that Germany will not buy gold, either from the market or from another government, at a price above the official price.

What are the implications of such a finding? First, we once again find the government lying to its people. There are innumerable instances where Fed Chairmen have denied manipulation or suppression attempts of the price of gold in any way. Is gold the only market manipulation that occurs? Does anyone believe that the same manipulation does not go on in other markets? After all, President Reagan formed the “Plunge Protection” team after the 1987 market crash for the purpose of “stabilizing” markets. Perhaps a better question might be: “What markets have not been manipulated?” Additionally, is there anything that government tells us that we can believe? Is this currently going on in the Treasury market? Could some of these or similar questions be the reason why the Fed is so adamant against an audit by Congress?
The second implication involves investment considerations. Does this mean, even at a price of $1,000, that gold is grossly undervalued? If so, what should its price be if this manipulation were not ocurring? Further, what might be a realistic outlook for inflation? What implications might this have for all fiat currencies? We know there is great concern regarding the dollar as the international currency. Replacing it with some world currency has been bandied about. Does such talk reflect more than weaknesses associated with the dollar?
These questions are all valid. But valid questions do not necessarily have valid answers. The fact that they can be raised and not seem outrageous should make one cautious. There is enough risk and challenge to investing when markets are honest.

Tax increases will not change that reality

We are told that massive tax increases will be needed to cover the large projected deficits. History, however, shows that this strategy will not work. Regardless of the tax rate or the tax structure, tax revenues remain relatively constant as a percentage of GDP. Whether the “Laffer curve” or disincentives are responsible is moot. The fact is that since the mid 1940s there has been a ceiling on tax revenues related to GDP. The ceiling is unaffected by low or high top marginal tax rates that have ranged from 28 to 90%.  Government is too large and needs to be cut back. The common man understands this; pompous politicians do not or will not. We now have a government that has become the biggest bubble of all. Like all other bubbles, it too will burst. The deficits are unsustainable. Tax increases will not change that reality.

Federal Income Tax Rates and Total Revenues

The Treasury plan

Too Big to Ignore

Volcker says Treasury’s reform will lead to future bailouts. He’s right.

President Obama’s economic advisers are struggling to sell their financial reform plan to . . . an Obama economic adviser. Paul Volcker, the Democrat and former Federal Reserve chairman who worked with President Reagan to slay inflation in the 1980s, now leads President Obama’s Economic Recovery Advisory Board. He warned in Congressional testimony Thursday that the pending Treasury plan could lead to more taxpayer bailouts by designating even nonbanks as “systemically important.”
“The clear implication of such designation whether officially acknowledged or not will be that such institutions . . . will be sheltered by access to a federal safety net in time of crisis; they will be broadly understood to be ‘too big to fail,’” Mr. Volcker told Congress.
Rather than creating broad bailout expectations destined to be expensively fulfilled, the former Fed chairman wants Washington to draw a tighter circle around commercial banks with insured deposits. Those inside the circle get heavy oversight and are eligible for assistance during a crisis. Assumptions that various other firms also enjoy the federal safety net “should be discouraged,” said Mr. Volcker.
We don’t agree with all of Mr. Volcker’s prescriptions—nor he with ours—but on too big to fail he’s exactly right. As he also told Congress, regulators are unlikely to correctly guess which firms will pose systemic risk, and the implicit protection by taxpayers could put firms not deemed important by Washington at a market disadvantage. He also pointed out that, while Team Obama pushes its plan to address firms that are “systemically important,” Treasury still hasn’t said what exactly that means.
Mr. Volcker’s comments won’t endear him to Administration officials due to receive more power under the Treasury plan, but taxpayers should be cheering his counsel.

Our fiscal irresponsibility

Despite all the hoopla regarding an economic recovery, there can be no recovery until the economy sheds the excess debt.  The consumer is tapped out and is adjusting his balance sheet to reduce leverage. That is good, despite what the government wants (another credit bubble).

The so-called stimulus programs can mask economic performance for a limited time only. They may produce increased GDP reports in the third and fourth quarters, not unusual in the middle of recessions. The media and Bernanke have already proclaimed that recovery is underway. Supporters will only become louder if positive GDP stats show up soon. Do not fall for this hype.
The statistics will be hailed as confirmation of a recovery. However, they are merely statistics produced by government that have more to do with GDP methodology and reporting bias than real growth or real recovery. They cannot go on forever, and they do not produce real growth or balanced economic activity. David Rosenberg, in his daily eletter, exposes the effects of stopping such programs:

POST-CLUNKER ECONOMY LOOKING CLUNKY
Edmunds.com just reported that U.S. motor vehicle sales so far in September are running at an 8.8 million annual rate — a 28-year low and a 38% plunge from the incentive-induced 14.1 million tally in August. If this is what autos do, imagine what housing does once the $8,000 first-time homebuyer tax credit expires (if it does) at the end of November (not to mention what the Fed does in terms of extending its mortgage purchase program beyond the December expiry too — it has had a hand in financing 80% of all new mortgage issuance. But look at the good news — at least we will be able to see what the economy can do without the walker.

What is coming will not be pretty! If the government renews these programs or implements new ones targeted at other sectors of the economy, it may be able to produce a short-term effect. However, this “benefit” is only created by pulling demand forward. That is, it pumps up current results at the expense of future results as Rosenberg discussed above. Even if one were to (erroneously) argue that these programs did some good, we are fast approaching the limits of what can be done. Each involves government subsidies of one sort or another. As such, each involves widening the deficit and increasing Federal debt, whether it be via tax rebates or increased spending. There is a limit to Federal debt. We have already passed the tipping point of being able to service government debt and promised social benefits. Our creditors know this better than we do and periodically scold us for our fiscal irresponsibility. We have become the Blanche du Bois of the world economy, dependent upon the kindness of strangers. At some point, when it best fits their interests and not ours, these strangers will cut us off.

Government and corruption

Has a grownup finally shown up?

Paul Volcker dropped a bombshell on Friday. The importance of his pronouncement is less economic than political. It appears to indicate a serious rift between him and the Administration.  A post by Larry Doyle provides some details and analysis of the economics. Here is an extract from Doyle’s piece:

Mr. Volcker takes on the White House and Congress with his proposal. We know Volcker is no favorite of Larry Summers. Knowing the explosiveness of his proposal, Volcker is not bashful in addressing the discomfort his proposal would create for the Washington insiders who are in Wall Street’s pocket. The WSJ sheds further light on this point:

Mr. Volcker said he would appear before Congress next week to discuss his views in more detail. A Treasury Department spokesman declined to comment.
Asked after his speech if his comments represent a break with the White House’s proposal, he replied: “Nothing I said today should be a surprise” to the administration.

In the future, this announcement may viewed as the beginning of the end of Obama’s presidency. While other factors will certainly play roles, the importance of this event is easily overlooked. The event’s importance derives as much from the messenger as it does the implications of the message. It is the first shot fired from a highly qualified and credible figure, who also happens to be on the Obama team. First some background on the messenger, and then an explanation as to why Friday might be so important.
Paul Volcker and Warren Buffet were early supporters of Obama. They appeared often during the campaign and were widely represented as his economic advisers. After the election Volcker was appointed to a titular position as Chairman of a new economic committee with no power, seemingly no purpose and little reason to meet. Whether Volcker and Buffet still support Obama is unknown, but both men seem removed from the president. Buffet’s move was probably by choice, while Volker seems to have been exiled.
Paul Volcker is not one to take lightly. He combines brains, gravitas, integrity and courage. He is an icon of Central Banking. He literally walked softly and carried a big stick in the late 1970′s. As Chairman of the Federal Reserve he faced the worst inflation in our country’s history (save possibly the Civil and Revolutionary Wars). Economic experts believed it would take a decade or more to tame inflation. He stopped it overnight, despite the political uproar over the unavoidable recession. Recent administration economic policies are so foreign to Volker’s economic thinking and methods as likely to be abhorrent to him. He knows the oligarchy that is Washington and Wall Street and clearly disapproves. While Volcker’s standing in history is established, to be associated (in an entirely passive role) with the economic debacle that is being imposed on this country cannot set well. As a proud and capable man, the manner in which he was used as a political prop and figurehead is likely to be even more disturbing.
Does Volcker’s apparent break represent a tipping point for the Obama administration? It might in the sense that it was a the-emperor-has-no-clothes moment.  On Friday, he confronted the administration, directly challenging their philosphy regarding the regulation of the banking industry. Less appreciated was the indirect challenge to the philosophy of government which goes to the heart of Obama’s declining popularity. Implicit in Volcker’s talk were questions regarding the proper role of government and corruption, the primary motivating forces behind recent protests. The perceived corrupt partnership between Washington and Wall Street is believed by most on Main Street. Volcker seems to provide support this perception. His great reputation and the fact that he is/was an Obama guy only adds to the potential political ramifications.
Will other business and/or political figures follow Volcker’s lead and speak out?  While Volcker cannot be hurt at this stage, it will take extreme courage for the next critic. The fear and reality of government retribution is an enormous deterrent, yet Volcker has provided some “cover.”  As the damage of the Administration’s policies become more apparent, it is likely that others will follow. Not only on banking regulation but in other areas as well. Once this criticism starts, a snowball effect is likely, and another failed presidency will occur sooner rather than later.

Inflation is the only reason

While it is still too early to determine whether inflation or deflation awaits in the near-term, Peter Schiff writes of Gold as the “canary in the coal mine:”

Like a battering ram in a medieval siege, gold keeps hammering away at the gate. For the third time in less than twelve months, the yellow metal is once again crashing into the $1,000 per ounce level. As of press time, it looks like gold will close above that level today and will set a new record in the process. Even if the breach is fleeting, who can doubt that it will mount another assault soon? In the meantime, there is no shortage of market analysts who are not buying gold while questioning the motives of those who are. Although they offer a variety of strained reasons, they nearly all agree that it has nothing to do with inflation, which is nearly universally considered dead and buried. As a self-confessed gold bug, I can assure all that inflation is the only reason I buy gold. And recently, I’m buying a lot.

Global Warming research grants

Below is an article suggesting that the Federal Reserve has corrupted the economics profession. While I don’t disagree, I think the academic profession has been even more damaging. There are two primary forces that have caused the profession to lose their independence. First is the grant process where money flows to research that is acceptable to the grant provider — the Federal government. Thus research is skewed to produce support for an expanding government role in the economy. (It is similar to the Global Warming research grants.) Second, the government (or the Fed) provide status, prestige and higher living standards to academics who are fortunate enough to land “plum” jobs. Anyone looking for such a position will not be critical of Keynesian economics, the theory that enables politicians to spend and gain power. As President Eisenhower so aptly warned in his farewell address:

“The prospect of domination of the nation’s scholars by Federal employment, project allocations, and the power of money is ever present – and is gravely to be regarded.”

The unemployment rate

“Indeed, let’s compare the economic background last October compared to today:
•
The unemployment rate was 6.6% then, today it is 9.4%
•
The level of employment (nonfarm payrolls) was 136.35 million; today it is nearly 4.0% smaller at 131.5 million
•
The level of nominal GDP was $14.347 trillion; today it is $14.143 trillion
•
The level of real GDP was $13.149 trillion; today it is $12.892 trillion
•
The 4-quarter trailing operating EPS was $49.50; today it is $39.90.
•
The 4-quarter trailing reported EPS was $14.90; today it is $7.90.
•
The dividend yield was 2.9%; today it is 2.3%
•
The P/E ratio (operating earnings) was 19.6x; today it is 25.2x
•
The “real” yield (5-year TIP), which is a bond proxy for “real” growth expectations was 3.0% back in October; today it is 1.7%
•
Industrial production was 106.2 (index); today it is 10% smaller, at 96.0
•
Industry wide capacity utilization rates were 75.4% then; they are 68.5% today
•
Manufacturing inventory-to-shipments ratio was 1.33 back then; now it is at 1.42
•
Housing starts were 763k (annualized) units; today even with the recovery they are 581k (24% smaller)
•
Commercial construction was $729 billion then, it is $712 billion today
•
Oil prices were $71/bbl then, about where they are today
•
The “real” yield on the Baa corporate yield was 5.2%; today it is 8.6%
•
Bank credit was $9.5 trillion back in October; it is $9.2 trillion today
•
The federal deficit was running at a $550 billion 12-month run-rate; today it is $1.3 trillion
•
Corporate spreads were 450bps back then; they are 300bps today (this, along with ISM, home sales and consumer confidence polls, are better, and that’s about it).
At least we can say with some certainty that the 50%+ rally is divorced if not separated from the economic realities we listed above.”

Business deals were often done with handshakes

This started out to be an article in the investing series, but began to wander into other areas. While I am overdue for the investment article and hope to have it out soon,  I thought I would publish these ramblings.

There will be a major article out mid-week on QE2. It will be the basis of my current thinking on where the economy is going. Investors should not miss this.
I have been an investor for decades. When I started, investing was simpler in the sense that there were fewer choices for individual investors. Stocks, bonds and real estate were the primary ones. Brokers had to be involved and outrageous fees were charged compared to today. Now trading costs are almost zero, information is instantly accessible and it is possible to trade almost any market at any time of day from anywhere.
Government played a smaller role in the economy and in markets. The Keynesian notion that government was necessary to offset slumps and equilibrate the economy had not yet taken hold. Once it did, politicians exaggerated its claims and abused the tool. Spending, under the guise of economic necessity, became a preferred vote-buying vehicle. Earmarks quickly became a staple of political behavior.
Honesty and integrity used to characterize relationships between people. Business deals were often done with handshakes, without hundreds of pages of legal documents. “His word is his bond” was assumed until proven otherwise.
People believed in what was “right” rather than what was “legal.” Today the ethical “right” has been replaced with “is it legal?” To paraphrase what passes for today’s morality: “I don’t care what’s right; can I get away with it legally?”

Justice Brandeis

Ethical behavior is rarer now, perhaps for the reason cited by Judge Brandeis:

In a government of laws, the existence of the government will be imperiled if it fails to observe the law scrupulously. … If government becomes a lawbreaker it breeds contempt for law: it invites every man to become a law unto himself. It invites anarchy.

On the other hand, perhaps none of this is new. Edmund Burke, reflecting on the French Revolution, expressed similar concerns over societal deterioration:

The age of chivalry is gone. That of sophisters, economists and calculators has succeeded.

Perhaps it is just a natural cycle of civilization where moral decay precedes and then accelerates the decline of a nation.
Our economy used to be driven by manufacturing and productivity. Growth could be expected to be about 3% per year, except in years when recessions hit. Recoveries were generally quick, characterized by rapid growth that offset prior bad quarters and returned the economy to its 3% trendline.
Our economy is now diminished. We no longer manufacture much, at least on a percentage basis as compared to the past. Instead, we have driven GDP via massive consumption. Consumption is not a bad thing, but to sustain it requires the creation of value or wealth. That comes from production and productivity growth. We have recently engaged in massive consumption without either.
When you are not producing, the only way that to increase consumption is via the draw-down of savings/investment or debt-based purchasing. Both have occurred and both have been the main drivers of our economy for the past three decades. Both are unsustainable over the long-run.
The capital base (real savings and investment) of an economy is the most important determinant of wages. Economies that have tools for their citizens are more productive than those that don’t. Hence they have higher wages. Our people earn more than most of the world not because we are “chosen.” We earn more because we have more capital in the form of machinery and equipment. A bulldozer operator moves more dirt in an hour than a primitive-based economy using hundreds of workers with crude implements can do in a day. The bulldozer operator as a result earns much more than he would without the equipment.
If physical capital is not growing faster than the population, real wages must come down. In our consumption economy, capital has been used up and not replaced. As a result, the average real weekly wage today is lower than it was in 1964.  Nominal wages are higher, but the dollar buys less as a result of inflation.
The other driver for consumption has been debt. For at least the past twenty years, people lived beyond their incomes. Consumption soared, but production did not. Many of us borrowed our way to a better life. The financial industry was abetted and encouraged by the government to create easy credit.
For a while, this behavior appeared rational. After all, credit was cheap and our monetary wealth exploded primarily due to a run-up in the stock market and housing prices. When the dot-com bubble burst in 2000, Alan Greenspan dropped interest rates too low and held them there for too long. This created the housing bubble which was also assisted by a loosening of credit standards for those buying homes.
Existing homeowners felt rich as the value of their homes soared. Many used these increased values as a source of better living by refinancing to higher loan levels and taking cash out of their homes. Reality set in when housing values began to collapse and return to traditional norms, leaving many homeowners “under water.”
There are plenty of villains in the saga of the last few decades. There is no need to affix blame other than to say that when government intervenes it distorts prices. Prices are information. They are “language” in the sense that they tell us how to behave – conserve here, expend more there, invest more or less over here, etc. Distorted prices cause a distorted allocation of resources. By distorted allocation, I refer to one that cannot be sustained once the interventions end.
It is useful to offer a few comments on “greed.” Many individuals were “flipping homes” and were wiped out. They have been accused of being “greedy.” Greed is always something that someone else engages in. When we engage in similar behavior, we think of it as self-interest, trying to improve the quality of life for our families. I don’t know how to define greed and neither does anyone else. As Gordon Gecko stated: “Greed is good.” I interpret greed that way so long as it stays with the law and ethical norms. Then, it is no different than ambition or motivation.
The story of the last couple of decades was distorted prices that misled consumers and investors. Government intervention distorted housing prices. For several years, home prices rose rapidly in some markets. Stock prices were languishing. Many believed that the best investment they could make was in second homes, expanding their existing homes or flipping homes. Rising home values signaled to people that they were “rich.” Based on signals from the marketplace, there was no need to continue to save for retirement because their homes would provide that. People unfortunately borrowed against what they believed to be real wealth.
None of this behavior was irrational unless you were a knowledgeable economist who understood what was happening. And even economists missed what was happening. Most of the world was behaving rationally by taking actions that we now know were wrong. They trusted our information system known as prices. They did not know that government intervention had produced false and misleading prices, driving housing values beyond what could be sustained.
The tragedy of housing and other asset bubbles is that people trusted their government and trusted the price system that government was distorting.  They had no way of knowing the the government had ruined this information transmission mechanism. It was not “greed” that created the economic mess but government intervention.
In hindsight it is easy to see that housing was a massive bubble. Yet the average Joe is not a sophisticated investor. He has innumerable interests, probably none as important as improving the quality of life for his family. Economists like Ben Bernanke missed the bubble. Why would we expect a plumber, accountant or even a business executive to spot it?
Unfortunately government intervention is still distorting prices. Investing success will come to those able to spot these distortions and properly estimate how long they might continue.

Economic apocalypse rather than recovery

Count us among the optimists who think this is good news, a sign that markets are concluding that the economy is improving as major policy obstacles recede and the risk of deflation vanishes, if it ever existed.

This graph shows the dramatic rise which commenced in early October.
Ben Bernanke stated the objective of QE2 was to lower interest rates (or at least to maintain them at low levels). Clearly that has not happened. Whether Bernanke was wrong again or possibly masking some other reason for QE2 is not relevant to judging the Journal’s optimism. It likely is relevant in judging Bernanke and his capacity to do his job properly.
Interest rates are clearly rising. Most people, including Bernanke, would consider that bad news for the economy because higher rates generally dampen business investment and hiring. Ultimately they translate into lower stock prices because of the discounting process assumed to value future cash flows. They certainly are bad news for the government deficit as new debt and rollover debt will be financed at higher rates than projected, increasing the deficits.
Is the WSJ rationalizing this news in an effort to produce a “green-shoot?” Are they being pollyannish in order to bolster confidence in markets and the economy? Or, is there validity in their claim?
All prices, including bonds, are ultimately determined by the interaction of supply and demand. The WSJ believes the demand for Treasuries has decreased as a result of investor increased confidence in the economy. Investors who fled to Treasuries as a safe haven are now believed to be leaving Treasuries and returning to riskier assets. That process reduces the demand for Treasuries, causing their prices to drop and interest rates to rise. That is the basis of the WSJ’s claim.
While they have focused on one reason for interest rates to rise, there are other reasons. None of the others allow for optimism. Demand for Treasuries would drop if people believed Treasuries no longer were a safe investment. Interest rates are also affected by supply changes. We know the supply of Treasuries is increasing, with no apparent end in sight according to government budgets. Either of these two reasons are at least as plausible to me as the one cited by the Journal. Yet both are antithetical to the expectation for an improving economy.

The Fisher Equation

Irving Fisher

The difficulty with economics is that it is complex and multi-variabled with many decision makers. Irving Fisher, a famous American monetary economist, used a conceptual model to deal with interest rates. Fisher decomposed the nominal rate of interest into several parts:

R(n) = R(rf) + R(u) + R(p),

where:

• R(n) is the nominal interest rate (the interest rate we see and are quoted)
• R(rf) is the risk-free interest rate (what the interest rate would be for a security with no default risk)
• R(u) is the uncertainty premium to compensate for default risk
• R(p) is the purchasing power risk (the risk that your dollars will be worth less in purchasing power, due to inflation, when they are paid back)

In words, the nominal interest rate is made up of the risk-free rate plus the risk premium for default plus the premium for anticipated inflation. The nominal interest rate is the only one that we actually know. It is the rate quoted (or calculated) when we purchase a home, buy a car or buy a bond. The others are not seen or truly known. They are conceptual constructs.
There is literally a Fisher equation for each and every debt instrument, although only one is needed for pedagogical purposes.
From the WSJ article, it is unclear which of the variables they believe to be responsible for the rise. I suspect R(rf) or R(p) or both. They would not consider a rise in R(u) a positive as will be dealt with below.

The Keynesian Influence

An increase in either R(rf) or R(p) would raise interest rates. To assume that a change in R(p) is a positive development requires a Keynesian mindset. Only Keynesians believe that increased inflation can be a good thing. The belief derives from their mistaken notion that aggregate demand is the primary driver of inflation. Keynesians believe there can be no inflation with an “output gap,” their description of inadequate aggregate demand. If inflation is expected to increase it must be due to aggregate demand rising and the output gap closing.  This belief continues to be held despite the stagflation of the 1970s when inflation and inadequate aggregate demand co-existed despite Keynesianism’s belief that could not occur.
The all-encompassing animal spirits can never be rejected as a Keynesian explanation. Presumably a shift in animal spirits could increase the risk-free rate of return. R(rf), while not considered constant, is generally considered stable, certainly more so than the other two components in the equation. R(rf) is presumed to be influenced primarily by individual time preferences and anticipated returns on capital, depending upon your economic religion. It is doubtful that R(rf) could have a big enough impact to account for the large move up in the 10-year rates.

The Fatal Factor

The term R(u) represents the risk of default. For Treasury securities, that risk has traditionally been assumed to be zero. That is, it has been assumed that the Federal government cannot default. This assumption is becoming more suspect as we see the problems in Europe, the balance sheet of the US government, the insolvency of various welfare programs and the coming bankruptcies of various states. Sovereign risk is so apparent that the ratings agencies have threatened downgrading the credit rating of the US government.

Moody’s warned Monday that it could move a step closer to cutting the U.S. AAA rating if President Obama’s tax and unemployment benefit package becomes law.  The plan agreed to by President Obama and Republican leaders last week could push up debt levels, increasing the likelihood of a negative outlook on the United States rating in the coming two years, the ratings agency said.

Neither rises in R(rf) or R(p) are likely to produce a meaningful beneficial effect on the economy. The component that could have the most dramatic impact on interest rates and a strictly negative effect on the economy is a perception that the US government could default. Is this what is driving rates higher? I don’t know, but neither does the WSJ.
Anyone who says he knows what is moving interest rates (or stock prices, for that matter) is speculating. In a free country everyone has a right to an opinion and speculation. The interpretation by the WSJ could be correct. Time will eventually provide a judgment.
Investors should weigh the impact of alternative interpretations to what the Journal has suggested. In my opinion, there is a greater chance of the rise in interest rates signaling negatives rather than positives for the economy. In the event that US bonds are seen to be risky rather than risk-free, there may be more likelihood for an economic apocalypse rather than recovery.

Rules and regulations

In this article the outlook for the economy is discussed. This outlook is my opinion and is probably worth no more than what it costs you.
For those easily depressed, read no further. There is little positive that follows regarding the economic future. For the adventuresome, however, volatile and potentially dangerous times present opportunities to make large amounts of money. Of course they also present opportunities to lose lots as well.
Unfortunately traditional investors are apt to be seriously harmed by following traditional investing rules. The tragedy is that most of us, whether it be due to risk aversion, age or other responsibilities, do not want to be “gunslinging” hedge fund type investors. We would prefer challenges more boring with a future more certain.
That kind of investing scenario, at least for the next decade and perhaps more, is not likely to be available. To be forewarned is to be forearmed. Wouldn’t your investment strategy this century be different from last?

Anticipated retirement amount has been reduced

… your $200,000 ten years ago has been halved in terms of purchasing power. However, in terms of planning purposes, your anticipated retirement amount has been reduced by 75%. Given these outcomes, who will be able to retire? And for those already retired, how many will “unretire?”

Confused and desperate over the economic debacle

In my next investing article, the continued weakness, if not the collapse of the dollar will be a crucial element. If you believe that is a likely outcome, then you should begin to think in terms of protecting yourself against it.

Hat Tip to the Freeman for the following post:

The Dollar Meltdown: Surviving the Impending Currency Crisis with Gold, Oil, and Other Unconventional Investments

by George C. Leef

Imagine an ice cube on an asphalt roadway in the mid-summer heat, quickly melting away to nothing. That’s a good way of thinking about what government policy has been doing to the value of our money. In The Dollar Meltdown, investment adviser and former radio talk-show host Charles Goyette explains why the dollar is melting away and offers sound advice for people who prefer that their wealth avoid the fate of that ice cube.
Goyette begins by noting that while the federal government has been going through money like a drunken sailor for decades, the last ten years have been simply devastating. In 2004 Congress had to raise the government’s debt ceiling to over $8 trillion. The increase in federal debt just in the first three years of the Bush II presidency was two and a half times greater than the total debt the government had accumulated from 1776 to 1980. Gold, which Goyette calls the canary in the coal mine, rose to $442 per ounce with that increase. Of course, the politicians could not restrain their appetite for spending and in 2006 Congress once again had to raise the debt ceiling (not much of a ceiling!) to $9 trillion. Gold had risen to $554 by then.

All the toxic paper still in the banks

Ian McAvity is an excellent analyst. In this interview he talks about the economy, the stock market and precious metals.

Anyone interested in these subjects should read this material from Goldseek.

Be Careful What You Wish for

The Gold Report caught up with Deliberations on World Markets Writer Ian McAvity between sessions at the 36th New Orleans Investment Conference, held October 27–30. In fact, Ian was among the experts featured on the conference agenda, graphically updating his big-picture expectations for stocks, gold and the dollar. He continues here in that vein in this Gold Report exclusive.

The Gold Report: Over time, Ian, you have accurately predicted the bull market in the ’80s, the housing bubble and the credit crisis. So the obvious question: what are your key predictions going forward?

Ian McAvity: Despite people thinking that with all of the bailouts and everything else in the last year somehow the crisis is over, I think basically that the crash of 2007 through 2009 was only the first half of a much larger problem. I don’t want to say the worst is yet to come, but the second half may not be any more pleasant. The housing, banking and financial industry situations have not changed at all. The accountants changed the reporting rules so you just don’t see all the toxic paper still in the banks, and they don’t have to report it.

This inflationary road was made long ago

Since 2007, we at Barnes Capital have been making predictions about what will happen in the New Year. Thinking about the future and what could happen is crucial for us in our role as a steward of people’s finances.  History has shown the importance of a diverse portfolio, particularly in times of great change. Although we are not negative about the future, worst-case scenarios are something we think about.
We positioned all of our portfolios for the continued debasement of fiat currencies (those currencies not backed by hard assets).  We did this mainly though investing in Gold and Silver bullion and some mining stocks.
The political headwinds of what many perceive – with merit –as a bankrupt economy propelled political and fiscal policy in 2010.  We believe that the Quantitative Easing II compromise struck by Obama in late November, means that the dominant themes that we’ve believed to be most likely, including high deficits, government bailouts, higher commodity prices and the debasement of currencies, will continue into and beyond 2011.
Economic activity is made up of government spending, corporate spending and consumer spending. Consumer and corporate spending have declined dramatically since 2007.  Government spending is trying to make up for the decline with increased spending of its own.  This government spending will be financed by the existing monetary system, which enables the debt to be issued by the Treasury department and purchased by the Federal Reserve.  This system is strongly supported by the creditor nations of the world, including China, Japan, and the European Core.  Ultimately, it is an inflationary path, and we are currently overspending governmental tax receipts by between one and two trillion dollars annually.
The choice and path down this inflationary road was made long ago.  And it’s not a terrible path; at its core, debt and currency erosion is populist in nature.  In the medium- and long-term, it harms creditors and help debtors.  That means that those most willing to spend (debtors) have greater means to do so, and those most able to have the purchasing power of their assets erode (creditors), pay the price for offering of excess credit — their own profligate ways (and the country’s).

2010 PREDICTIONS RECAP:

We got a lot of things really right in our 2010 predictions.
First, we predicted that Obamacare would become law, and that it would pale in comparison to the unemployment problem in 2010 and that did happen.
Real estate did have a tough year, as we predicted, but higher long-term mortgage rates didn’t materialize.  Gold did indeed mark its 10th straight year of upswings, as we predicted, but it was less volatile than we expected. It did indeed close the year strong at $1421, which is close to our $1450 prediction.  Municipal bonds performed better than we had predicted before weakening at the end of the year, and they delivered expected returns. Oil prices did indeed stay within our projected band of $65-$95.
Of our more unlikely predictions, the yield curve did become extraordinarily steep, but 30-year bonds failed to make it back to even 5%, let alone the 6% that we predicted.
The European sovereign debt crisis abated fears of a dollar meltdown, but nonetheless the dollar finished at a very low level of 79 on the U.S. $ index for the year.  A culture of thrift continued to exert itself, requiring another $600 billion in Quantitative Easing Part 2 in November as the jobless recovery continued and corporate profits continued to record the highest margins ever.
Amazon did do well, as we predicted, but Apple continued to be the beacon of fashion and success across all ages of consumers – and we predicted that that company might have problems within a culture of thrift.  That sure didn’t happen.
Democrats did lose the house as we anticipated, but Obama hasn’t got much veneer left, let alone Teflon. Finally, high uncertainty continues to reign, but risk assets, namely stocks, rallied through the last six months of the year to end at their highest levels.
The Federal Reserve continues to effectively print extra trillions of dollars each year to support the recovery. Stocks are more immune to this governmental Ponzi scheme of money printing; consequently, they are rising.
In many ways, 2010 was our Brian Downing year. Downing, a baseball player, was a career .275 hitter. On the 1979 division-winning California Angels squad, Downing hit .326  – and he never hit .300 again. We don’t expect to ever top our 2010 predictions in terms of accuracy. Nonetheless, here’s what we imagine for 2011:

2011 PREDICTIONS

1)     Municipal bonds are cheap, again.  We expect that they’ll decline in volatility and deliver solid after-tax returns for investors in the 25% tax bracket and higher. We are delighted to buy California General Obligation bonds, which deliver 4%-7% tax-free yields on coupon-bearing and zero coupon issues.  For a typical California investor in the 40% marginal tax rate, our 5% bonds are yielding an equity-like 8.33% return on an after tax basis.
2)     Gold.  Gold is real money. That’s not really anything new; we’re in the late innings of the ballgame on this one. But the biggest money in any bull market is made in the final, speculative 3rdpart of the cycle.  We may be approaching that third and final phase, which we imagine will last for 3-plus years.  Gold will climb again in 2011 and finish above $1600/oz.
The following is a list of the spot price of Gold on the last day of the year for 12 years.
1999 — $288
2000 — $271                     -6%
2001 — $278                      2%
2002 — $348                      25%
2003 — $415                      20%
2004 — $437                      5%
2005 — $516                      18%
2006 — $634                      23%
2007 — $833                      31%
2008 — $881                      6%
2009 — $1096                    24%
2010 –$1421                       30%
3)     Oil will break out to more than $100 a barrel, and this will reduce global growth as it did in 2008, stalling the economic recovery, again.
4)     Real estate will continue to bottom. Corporate real estate will fall between 5 to 10 percent and residential prices are likely to remain flat or go down as well, as low mortgage rates and higher dividend and capital gains rates support many current market prices in real estate.
5)    Stocks will actually perform decently and with less volatility than the last several years.  The current policies of Federal Reserve, however, are leading to trouble. It won’t happen this year, however. That Armageddon is destined for a Judgment Day in 2012 or perhaps during the ironic 2013 centennial of Ponzi banking system of the Federal Reserve.
Unlikely to Happen: but it wouldn’t surprise us if . . .
6)     Equities become the rage du jour, and stocks start to party like it’s 1999.  Why? Because perceived safe bonds pay paltry interest rates (10-year taxable treasury is 3.4%), whereas many blue-chips stocks are paying 3-4%, and stocks offer inflation protection, which bonds do not.  The Dow Jones delivers an 18% return to finish within shouting distance of 2007 levels.
7)     Some states seek the political cover of economic receivership due to budgetary impasse.  Without this cover, existing contracts cannot be renegotiated.  This roils the markets for a number of weeks, but like the European sovereign debt problem, it doesn’t de-rail the strong year for equities.
8)     The foreclosure problem hasn’t been solved.  Many homeowners continue to be unable to afford their homes.  Meanwhile, four out of five economics professors predict that Orange Countyhousing prices will rise 2-7% in 2011.  The fifth says it’s falling 9%.  Since housing declines tend to last a decade, and this one started in 2006, our money is with the minority forecaster.  A number of different issues could bring another 10% decline real estate in 2011.
9)     The Simpson Bowles plan manages to stay on life support throughout 2011.  This was the ambitious plan to reduce the national debt with real cuts in Medicare, Social Security, and other large entitlement programs.  This plan is currently DOA following the QE2 issuance and other Obama compromises, which affectively drove a stake through the heart of the Simpson Bowles austerity proposal.  America has no appetite for austerity.  Thrift perhaps, austerity – “Nein! Danke”
10)   Gold fever turns speculative.  Gold flirts with $2000/oz prices and gold stocks double with the Joe Public finally buying his pieces of gold.  Like any bull market, the most money is always made (and lost) during the speculative phase.  When the speculative phase in precious metals arrives, we expect it to last for multiple years, and as with the Internet, the dot-coms, and real estate, it will go on for far longer, higher and further than anybody believes possible.  QE 3 next autumn might kick off gold’s speculative phase.

IN CONCLUSION

The year 2011 shows signs of a cyclical rebound driven by government spending, government-subsidized low interest rates, large corporate balance sheets and an increase in risk appetites.  There’s a chance that the balanced money manager (me) could be underinvested in risky assets this year. After strong performances in 2009 and 2010, we enter 2010 underweighted in risk assets and we will not be surprised if we underperform market returns in 2011.
Today’s values in stocks and bonds are not overly compelling.  We see modest returns over the next five years in the mid-single digits.  Therefore, we will not increase our risk exposure substantially this year, in order to achieve a pyrrhic one-year victory.  Our clients’ primary needs are wealth preservation.  We believe that real wealth preservation in inflation-adjusted terms is going to be difficult to achieve this decade and our investment strategy is focused on safe returns, not optimal returns.  We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds and Gold and Silver allocations.
A cataclysmic meltdown seem unlikely this year, there is simply too much money being printed by the policies of Ben Bernanke with the Federal Reserve for things to fall apart.   Austerity, it isn’t. But, to employ an overused cliché, we’re just kicking the can down the road.  Let the next president preside over structural change; this one’s just muddling through as best he can.