Thursday, February 2, 2012

We Are Hosed

Federal Reserve Chair Ben Bernanke spoke before House Budget Committee today regarding our fragile economic recovery and its relationship to the growing US debt situation. While he sees an improving economy, Bernanke is simultaneously worried about the growth of public debt and the role of the government in guiding the economic recovery.

What Bernanke is recommending is
a classic Keynesian approach to economically sluggish times. Unfortunately, there are signs that the Keynesian model could be wrong and even harmful. Fundamentally, in a high-debt environment Keynesian economics, the dominant economic theory at work in the world today, inevitably leads to one economic bubble after another.

Reading my iPad last night I came across a couple of current pieces on various economic issues. The best one is written by respected investment analyst Bill Gross. He does not mince words.

“A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.”

What is at stake here is something more profound than
keeping new jobless claims under 400,000. The Gross commentary points out that keeping interest-rates low can negatively affect the risk-taking that is usually necessary to pull out of a recession. This is due to the fact that low-rates often reflect a fear of the return of money rather than a return on money.

But, more importantly according to Gross, “When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected ‘clean dirty shirt’ sovereigns, then the dynamics may change. Money can become less liquid and frozen by ‘price’ in addition to the classic liquidity trap explained by ‘risk.’”

Thus, banks are not lending cash. Investors want to remain in cash. The reward is not worth the risk. At best, this leads to stagnation. But, it is also a Catch-22. The US will
refinance almost $3 trillion in public debt in 2012, about 20% of our ridiculously high total public debt. It is great that we can refinance the amounts at such low interest rates. However, what happens if rates were to rise? It would only increase the weight of the debt as it becomes refinanced.

Richard Russell has argued for the past year about “the effects of negative compounding.” It is a well known axiom of investing that the compounding of interest earned or profits taken, i.e. the re-investing of money made on investments, is the secret to exponential growth in personal wealth. You take everything you ever make off savings or investments and you put it right back in to your savings or investments and allow that new money to compound into more new money which gets re-invested and so on. That is how you turn $1,000 into $1,000,000 over a few decades.

Well, the reverse is also true on the debt side. If the debt grows and just gets refinanced, particularly at higher rates, then the amount of debt compounds and weighs more heavily on the economy over time. Where interest rates are concerned, it would seem we are damned if we do and damned if we don’t in terms of keeping rates low.

Of course, I realize that in a democracy such as ours it is impossible to burden the voters with metaphysical truths when so many of them are struggling just to make ends meet. I understand that the urgency of the moment seems to trump any meta-considerations. This is part of the problem we face. There is no genuine incentive for politicians to address the real problems because the only solution to those problems means pain for their constituents. This is borne out in a current article on
The Atlantic website.

“The ten year cost of the Bush tax cuts is $2.8 trillion, but only about a quarter of that is for the taxes on high earners; the rest is for tax breaks affecting those making less than $250,000 a year. Moreover, 'extend tax policies' also assumes that we fix the AMT to prevent it from hitting middle-income voters. That costs another $800 billion over 10 years--about the same as the 'tax cuts for the rich'.

“In other words, the lion's share of that money is going to the middle class, not the rich. To close the deficit, we're going to have to soak them.”

That article goes on to examine the consequences of cutting spending to balance things out. But the two primary drivers of current spending (outside of defense) are temporary programs for the unemployed and the weight of retiring baby boomers on the cost of entitlement benefits. Will any politician attempt to cut Social Security and Medicare to reduce the deficit? Not one that is likely to get re-elected.

The Atlantic continues:
“In other words, none of the possible changes is going to be popular… Deficits are a drag on future growth whether they are spent on supply-side tax cuts, or whizzy infrastructure. If you believe that one is a problem, you should also worry about the other.

“Of course, like most commentators on the deficit, I doubt the politicians who asked these questions were actually worried about the effect on their future. Rather, this was a proxy for the argument they wanted to make: for or against lower taxes, for or against higher spending.

“But the rest of us should care. Our deteriorating fiscal condition is going to have far-reaching and rather unpleasant effects. And our Congressmen are mostly focused on scoring ideological points.”

Everybody seems to be interested in
“decoupling” the US economy from the Euro Zone. Indeed, so far in 2012 we have seen modest economic growth in the US and some consider the immediate future bright. It is hard to argue against what has been realized so far this year. But, as I have said before, the debt is only getting bigger and the problem is only magnifying, slowly perhaps, like global warming; a gradual worsening that does not cause general alarm but ultimately has consequences for everyone.

Another respected analyst, John Mauldin, wrote at the end of 2011 that
“You Can’t Solve A Debt Problem With More Debt.” In that article he examined the various options out of the current situation. In a nutshell they are: savings, faster economic growth, and/or inflation. But, each of these alternatives is difficult or impossible to achieve in the current environment. That is why every central banker on Earth is pushing more debt. It is the most workable alternative.

Bernanke’s statement before congress today reflects all the internal contradictions of this truly ominous situation. We need to find a “sustainable debt trajectory” without “threatening the uncertain recovery.” Bernanke believes we can do both, but he was pretty short on specifics as to how to achieve this apparently delicate balance.

It is a tight-rope act, for sure. But, in the end, here’s what will probably happen: Politicians will do everything to avoid pain and get re-elected. The debt will continue to grow. Interest rates will remain low for the next few years and this will solidify stagnation. The weight of the debt will grow modestly until it reaches some sort of tipping point in the not-too-distant future. At the point of crisis, matters will be dealt with abruptly and, mostly likely, painfully.

Or some variation of these things. Uncertainty prevails any way you want to cut it. My guess is that this uncertainty will continue to be good for gold. There is even talk today of bringing back the gold standard. I don't expect that to happen. Long-time readers know gold is where I have most of my money. I could be wrong, of course. But, that is what “risk” is all about - you take your chances and place your bets.

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