WOCIC

A funny thing happened on the way to the office today; I helped save the EU banks. You did, too. As well as Canada, England, Japan and the Swiss (if needed).

In the event that you happened to sleep through the entire morning, here’s the lowdown on what happened (or is it DL? It’s tough to get older): At 8 o’clock this morning EST, the announcement came out that our own Federal Reserve, in conjunction with the Bank of Canada, Bank of England, Bank of Japan and the Swiss National Bank agreed to lower what’s essentially the borrowing costs of obtaining dollars to help backstop those European banks that are struggling. To see how the equity markets have rallied off of this news, you’d think the Fed was giving the money away, but in reality all they did was cut the borrowing rate from 100 basis points (1%) to 50 basis points (.5%). The perception is that those Euro banks now have the backing of another source of funding, since the European Central Bank (ECB) cannot print money, due to its charter language. All this was apparently enough to send U.S. equity prices off the launching pad, with both the Dow and S&P up approximately 3.5% on the news at midday. But I’m getting a bit ahead of myself; as you might expect, this action raises a boatload of questions and demands analysis. So let’s take a closer look, since unintended consequences usually get pushed aside when there’s money to be made (did I say that out loud?).

First off, let’s address why this action happened in the first place. Major European banks are awash in sovereign debt (government debt), as well as a host of bad loans generated during the boom years of the global economy. There’s an old saying that things can continue to merrily hum along as normal, until they don’t. It happens in family budgets, municipalities and governments. As long as the income stream flows consistently, all can be paid for and all is right with the world. But when there’s a slip and a stumble (job loss, lower taxes, ie: recession), things can go sour quickly, which is, of course what has happened over the past few years. Therefore, banks hold bad loans, governments (Greece, Portugal, now Italy) have difficulty paying on the promises they’ve made to the general public and they have trouble financing their debt. Since it’s the banks that hold much of this bad debt, they are the ones on the hook if/when these loans and bonds go south, meaning they have to write off the debt as losses. They know this; which is why initially they start to constrict their lending (to keep more cash on hand), as well as to borrow more in the “interbank” market, which is where they can borrow global currencies.

If they continue to feel uncomfortable with the economy in general AND they feel the odds are increasing that the debt on their books may be uncollectable, they will not only further constrict consumer lending, but also lending to each other begins to slow. Basically, they begin to hoard cash as their own backstop against deteriorating loans. Another problem is that lending on the interbank market becomes more expensive. Recently the interlending rate between European banks reached a three year high, which meant the cost of borrowing money on the open market was becoming very expensive. At this point the EU has to assess its options; does it “print” euros to increase the flow of money to prevent a liquidity freeze (think TARP), does it let some of the banks fail or do they reach out to the international community for help?

Obviously, we now know the answer and this is where it gets interesting. Remember in “Hope As An Option”, I stated that the ECB does NOT have the capability to “print” euros, since the EU (European Union) charter forbids it. Why? Remember again that Germany (and France) had considerable influence on the drafting of the charter and what the ECB currently decides. Germany remembers all too well the disastrous effects of hyperinflation during the Weimar Republic after WWI (attached below is a PBS link detailing hyperinflation during the Weimar Republic) and is none too thrilled with reliving those years in which their currency (the mark) was virtually worthless. http://www.pbs.org/wgbh/commandingheights/shared/minitext/ess_germanhyperinflation.html

This is why AT PRESENT the ECB does not print to fund its member banks with euros; in order to do so, it would require Germany’s approval to alter the EU charter to allow it. This is very unlikely UNLESS there is a game-changing moment in which printing is the lesser pain versus allowing some EU countries to fail, which is always led by the banks failing first. That is why today’s action of lowering the borrowing cost (and increasing availability) of dollars is being hailed as a solution; no perceived future euro hyperinflation and the banks receive needed capital. As long as it works, euro printing will not be an option.

As an aside, let’s clarify what “printing” means in this context. When the U.S. “prints” dollars through quantitative easing, Ben Bernanke isn’t actually directing the GPO (Goverment Printing Office) to print more paper money. Rather, he’s instructing the Federal Reserve to buy debt from the Treasury and open market (banks) and adding to the Fed’s balance sheet. It’s really an accounting maneuver which transfers dollars from one entity to another. Since the dollars go only one way, it’s as if the goverment is adding or “printing” dollars to pay for that purchased debt. However, if the Fed buys debt, but at the same time sells debt they already own, it’s revenue neutral, meaning nothing is net added or “printed”. This is what “Operation Twist” is about. Regardless, the eventual effects of the added or “printed” money will be felt in time, as if it actually was paper money being exchanged.

What is bothersome however, is the rapidity and suddenness of the global central banks’ agreement this morning. One has to wonder just how close to freezing the credit lines of the European banks actually were and if there was any time left to debate the merits of euro printing (not to mention the coordination of voting to alter the EU charter to do so!). It’s quite apparent the equity markets were completely taken by surprise, since the U.S. equity futures were only moderately higher prior to the announcement. This truly was a European “bazooka” approach, although as in most quickly implemented plans, there will be unintended consequences.

One of those consequences (unintended or not) is currently on display as I write; that of the U.S. equity markets rising stratospherically. With U.S. dollars in place to act as a backstop to EU banks, both the Dow and S&P 500 are up approximately 3.5%. The reason is fairly transparent; if the risk of European banks failing has lowered dramatically, then two things may very well occur: most importantly, the risk of a European recession has been lowered significantly due to increased liquidity; secondly, the confidence of knowing that the banks will continue to be there to lend, thereby continuing consumption and finally, the perception that asset prices will inevitably rise as that consumption resumes. There are however, unintended consequences involved that are as of yet, not being discussed.

Since it’s the dollar that’s being borrowed and put into circulation, that in and of itself is inflationary, if not immediately, then in due time. For example, if the Fed (or the interbank) is holding dollars, but now is lending them to EU banks, that money will initially find its way into bank vaults as a backstop and/or to be used as credit lines. Additionally, if the cost of borrowing dollars has fallen, borrowing demand for those dollars will probably increase, thereby potentially increasing the Fed’s balance sheet. The question is, will the Fed deem it necessary to do so? Eventually, however, those dollars will find their way into commerce as a result of loans from banks to individuals/corporations, which in turn will spend that money in the economy. Since as a general rule, the more of anything reduces its value, the more dollars in the global economy that are present, the less its value will eventually be. If the value of the dollar falls, then it stands to reason that it takes more of them purchase the same goods and services than it did before, thereby making it feel as if prices have risen. The argument can be made that the U.S. has potential inflation problems of its own making due to TARP and QE2, but the addition of extended, easy credit on a global basis may exacerbate the problem by flooding additional dollars into the global economy, thereby fueling dramatic increases in inflation. Granted, it won’t happen immediately, but it will happen if left unchecked. Normally, when price inflation is caused when too many dollars chasing too few goods brought upon by a strong economy, the solution is to increase interest rates to cool demand. However, when price inflation is caused by a devalued currency in an economy in which jobs are not being created, that same strategy can be catastrophic. Easy credit to the eurozone may not be the appropriate solution.

There can be other problems on the horizon due to too many dollars in circulation. If the dollar is being used to backstop EU banks and if the EU finds this course of action preferable to printing euros, the opposite of the dollar falling in value would be for the euro to maintain or perhaps increase, its current strength. This has implications for trade. Since the eurozone is dependent on exports (especially the southern zone), a strong euro will keep European goods expensive relative to the dollar. This means that if the dollar falls and the euro stabilizes or increases in value, the same European goods being exported to the U.S. will be more expensive. This had two negative effects: first, the very same European countries that need to export to rebuild their economies will be charging more for their goods and may experience an additional slowdown because of it. Additionally, with austerity measures being voted on in the EU, government spending in conjunction with slower sales could prove to be a “double whammy” for Europe.

Secondly, U.S. importers would feel the pinch, as their sales would lag, which in turn may slow down that sector of the U.S. economy. This, in conjunction with decreased government spending cuts and mediocre jobs creation, could further be a drag on the economy and very well might be the catalyst for another recession. The bright side would be that U.S. exports would in turn be cheaper, thereby potentially increasing sales overseas, should those markets’ demand pick up. In this scenario, a combination of higher priced imports and cheaper exports could result in a new “buy American” campaign, in which Americans purchase more domestically made products. The downside, however, is that in that type of environment, protectionist measures (tariffs) usually are the result, followed by retaliation. Wars have started because of such measures, but that is for another post.

As if all that’s happened today isn’t enough, last week the US “Super Committee” failed to agree on $1.2 trillion of budget cuts over ten years. Just another example of “punting” the problem down the road. Why make the hard decisions and risk election fodder when you can wait until after the election? While their outcome itself isn’t too surprising, it will be surprising to see just what the “mandatory” cuts that will be in put in place will be.

One thing is certain; we’re all in this together. Thank you for reading!

DB

Much has happened globally since my last post, with most of the news still centering on Europe. The usual back-and-forth of Greek loans vs austerity cuts (and subsequent rioting) has been recently accompanied by a much larger player in the arena, Italy. This isn’t really much of a surprise, since the growth slowdown that’s slammed Europe is making its way through the EU (European Union) members one-at-a-time, with crisis’ hitting the southern periphery due to the excessive debt they hold. What is new however, is the way the Europeans are addressing these crises; they have formally created a new entity to deal with the debt of struggling nations. But before we get into that, the fictional example below may be of help to clarify what is being contemplated.

Let’s say our fictional individual has accumulated an inordinate amount of debt during the boom times of 2003-2007 and now that it’s become unmanageable due to a variety of factors, he’s decided he needs to do one of two things to restore sanity back into his life: either refinance it at historic low interest rates or default on it (bankruptcy). The fastest solution (although with negative consequences) would be default. Doing so would give him a fresh start rather quickly, allow creditors to write off the losses (and know what those losses actually were) and be a sobering lesson that living outside of one’s means only leads to pain. The negative consequences (to him) would be that credit would be unobtainable for a lengthy period of time and his ego might be seriously bruised. The positive aspects would be that the debt might be completely gone (liquidation) or at the least would be paid back on a manageable basis, probably discounted from the original amount. All in all, though, the bottom line would mean that he’d have his fresh start, but recovery would be difficult (he’d have to live within his means, as limited as they might be) and there would be few, if any support resources to help him.

HOWEVER, what if, as an alternative to default, he walked into his local bank and told the banker that he’d like a loan to pay off all of his debt (preferably at zero to 3% interest)? Of course, the first question the banker would ask is what collateral our individual had. The next question would be what his income stream looked like and what the total debts are. Let’s say our individual answered with “well, the only real collateral I have is my house, which is worth about half as much as what I owe and I’m only working part time at present. And oh, by the way, I’m hoping that my creditors will take only half as much as what I owe, especially since I have a few credit cards that I owe on and also that pesky home equity line of credit that never seems to go down. That will help me out a lot. I’m also hoping that I can pay back the loan you’re going to give me with an IOU, since my future income will be much higher than it is right now. Things should get better, right? I mean, they always have…why should now be any different?”

Sounds rather ridiculous, doesn’t it? But before I go further, let me just say that I fully understand that this situation is not fictional at all to many Americans and Europeans. Desperation exists out there for too many people and some relief, any relief, is preferable to the stress of wondering what tomorrow, let alone next year, looks like. And the irony is, that for as many individuals and families that are struggling to work through their own deleveraging process (paying off or defaulting on debt), most of the countries they live in are trying to do the same thing, looking at the same solutions to do so. Ok, I’ll get off my soapbox now.

So why the illustration of our fictional, heavily indebted individual? As you may have figured out, this is basically what is underway in Europe right now. Loans are being given to financially troubled nations with payback dependent on the future ability of those nations to pay. Of course, it’s a bit of an oversimplification, so first some background on the two primary European financial “players”, the ECB (European Central Bank) and the EFSF (European Financial Stability Facility).

The ECB was an entity created in 1998 by the member nations of the European communuity to monitor monitary policy of the euro. Since the EU is comprised of 13 different countries which use the euro for their currency, there needed to be a central bank to manage the common currency (euro). Each country’s contribution was based on a combination of their population and GDP (gross domestic product or what it produces annually), with the starting amount having been approx $5 billion euros. This cash is spread among the ECB’s central banks (member banks), with each bank being a “shareholder”. These “shares” cannot be used as collateral for loans, meaning that each country cannot take out a loan against the amount of shares it has (leverage), thereby attempting to solve its own financial crisis by its own manipulation of the euro (the more euros in the market equals lower value, therefore for a country such as Greece, a lower euro would mean more exports, since the price of the euro would fall in relation to the value of the dollar, thereby making its exports cheaper. The unintended consequence however, would be that the same would hold true for the stronger countries of the EU, such as Germany), making them more competive as well. Further, the ECB’s primary objective is to keep inflation in check (the prices of goods and services). It does this by manipulating the interest rates it charges the member banks, much like our own Federal Reserve does. It does NOT have the ability to “print” or create money as our Federal Reserve does.

What the ECB can and has done (under criticism from some member states) is to buy the debt (bonds) of some of the troubled countries in the EU. This is very similar to what our own Fed has done, in buying treasuries to keep interest rates artificially low. However, while the Federal Reserve is buying US debt, which is arguably from a stable economy with a stable government (therefore with low volatility), the ECB is buying debt from economies which are unstable at best, highly volatile at the worst. What this means is that the ECB is buying debt that may or may not pay full value at maturity and in fact, may not be able to make the interest payments during the life of the bond. If it cannot do either, a real risk is created where the value of the euro may be in jeopardy, since those bonds might not get redeemed for what was paid for them. Indeed, they might not get redeemed at all. Such a scenario would cause a severe loss to the ECB, since those assets would now, at best, become worth only a fraction of their initial value or become worthless entirely.  And it isn’t just the ECB’s member banks that are at risk; any pension fund, foreign government or corporation which bought those bonds are also at risk.  This type of risk is what’s referred to as “sovereign debt risk”, because the debt of the troubled country finds its way outside of the host country into other entities, thereby infecting other countries’ institutions, as well as running the risk of not paying back those who bought it (default). Another problem of  bond buying is that the ECB’s pockets are only so deep; since they cannot “print” money, their ability to relieve the troubled nations of their debt is limited.

While the ECB was confident it could manage the Greek situation (it’s too easy to say “Greek tragedy”) by granting loans in return for the Greeks drastically cutting expenses and living within their means, it became clear that as other member nations started experiencing their own debt difficulties, another entity would be needed to stem the tide of all-out contagion. As mentioned above, we now have Italy coming right behind Greece with its own debt fiasco. Italy is not Greece, in that it is the third largest economy in Europe and contributes much to the global economy. Therefore, the creation of the EFSF is either insightful (to help fund countries in need) or another example of the region “kicking the can down the road” (since the fundamental problems, notably debt and spending, have not been dealt with).

The EFSF is an entity that was created on May 9, 2010 to help financially troubled EU countries. The basic idea is that, unlike the ECB, it creates bonds, which it sells and utilizes the proceeds to give loans to those countries undergoing financial difficulties, either by capitalizing banks (deposits) or by buying government bonds. The actual EFSF bonds are backed by guarantees by the euro nations (13 of them) in proportion to their share of capital in the ECB. This is called the “ah-ha” moment. Two things should stand out clearly here: first, the bonds that are being created are going to be backed by those very same nations that they’re supposed to be helping. What this means is that the ability of those countries to pay back their loans is completely contingent on their ability to grow their economies at a rate that’s substantially higher than the norm, which will be difficult considering the austerity measures that will undoubtedly be forced upon them in return for those loans. Additionally, the growth rates of most of those countries will be dependent upon exports, since most economic growth from southern Europe is export driven. This means two things: US appetite for European goods must increase dramatically (along with Japan, China and other emerging markets) and the euro must lose value for the price of those goods to be competitive with, you guessed it, China and other emerging markets.

The second “ah- ha” factor is that, since Germany is the 900 pound gorilla in the EU room (they have contributed most of the ECB capital), they hold quite a bit of the responsibility and arguably, “say” in what the criteria will be for helping these nations out. This is why European news events ALWAYS revolve around what Germany (and to a lesser extent France) either decide or don’t decide on. Whatever the eventual outcome is for those nations that need a loan will be, Germany (and France) will be directly affected by it. If those countries needing loans do in fact eventually recover, the overall strength of the euro (and the area) will eventually strengthen as well, since it will attract investment; if they don’t recover, the euro will weaken, thereby weakening the overall area via a flight to stronger currencies.

To sum it up, financially strapped nations are guaranteeing bonds sold to help those same  nations out, to be paid back by higher than normal growth while under austerity agreements (lower taxes, see “The Irony of Austerity”), utilizing a currency that’s trading above the dollar. And since eventually there will be more nations taking advantage of this “program”, the question which arises is, “who’s going to buy all of these EFSF bonds”? And did I mention that these bonds are all rated AAA? Another question is “can everyone simultaneously grow their economies while paying their way out of debt”? Not likely. The only solution I can think of is that we all need to do our global duty and buy that Ferrari and some Greek olives! But save some cash; you’ll need to buy something Irish and Spanish as well. Hope as a strategy, indeed! At this point your head may be spinning, as common sense seems to have moved on to a distant planet. But, as they say, “wait, there’s more”. We haven’t discussed the size of the EFSF program.

The initial size of the program was 440 billion euro (its lending capacity), but can be increased by 60 billion euro using the EU budget as collateral (they’d better get growing!). ADDITIONALLY, there is another 250 billion euro that can be tapped into the IMF (International Monetary Fund), for a total of 750 billion euro lending capacity. Once again, two points to be made here:

First, the IMF consists of 187 members (nations) from around the world (including the United States). This brings a whole new dynamic into the picture. If the full lending capacity of the EFSF is utilized, not only will European capital (money) be at risk, but other nations’ capital will be as well, since they contribute to the IMF. This raises the political argument of whether US dollars should be used to help save the European continent at a time when we’re having to deal with our own budgetary/debt woes. Further, it’s fair to ask if we should be partially funding our competitors versus our own domestic companies/institutions. Once again, just how many customers are out there and how can all the global nations grow out of the same problem at the same time?

The second point is that in terms of the size of the EFSF, numbers being tossed around to save Italy are approaching 300 billion euro. If most of that money will be used for just one country, what about others that may (will) need it? What about Spain? Portugal? Ireland? Italy’s problems are on the front burner at present, but others are sure to follow. Just this week Italy’s 10yr bond yield surpassed 7%. This is what happens when the bond market suddenly sells bonds at heavily discounted prices due to a lack of confidence in a government (remember, there’s an opposite relationship between price and yield of bonds). At present, it’s a bit below that, but only because Italian Premier Silvio Berlusconi has agreed to step down; no formal solutions to Italy’s debt problems have been reached. No nation can continue to pay its mid term debt when servicing that debt increases to 7%.

As I said earlier, common sense, like Elvis, has “left the building”.  Surely, some nations will be saved, but some must default. Italy for one, as the region’s number three economy, is being categorized as too big to fail. A massive default by them would plunge Europe into at the very least, a severe recession. Probably more like a depression. Italy has a chance of growing its way out of its problems, but I’m not completely convinced. The political will to force austerity via spending cuts while attempting to stimulate industry might not be there. And, as stated earlier, there are other countries in the same situation. Others, like Greece, remind me of the old saying “throwing good money after bad”. Their outcome is eventual, if only because their export economy is too small to pay back all the loans they have (or might) receive.

Two things are certain: first, not all of Europe’s nations can accomplish the same goal at the same time. It’d be like all the teams in either NFL conference all going undefeated in the same year. The decisions to be made will not be easy and the problems are coming fast. Secondly, like all problems, these will get worked out. Maybe not in the way most want, but they will. And as they do, however long it takes, new opportunities will unveil themselves and money will be made. Most importantly, lessons will be learned.

Thank you for reading.

DB

So the debt ceiling was finally passed by Congress with all the passion of a divorcing couple sizing each other up as their mortal enemy. Each party boldly declared victory while blasting the other party as the major impediment to what could have been an earlier solution. Yet, for all of their grandstanding, what did it really get us?

Well, for one it raised the ceiling by a total of $2.4 trillion, $400 billion of it effective immediately. An additional $500 million can be requested by President Obama as soon as  the next few months, but can be rejected by a two-thirds override by Congress, which would be veto-proof. Finally, the balance of $1.2-1.5 trillion could be doled out at a later date if a special 12 panel committee (six nominated by Republicans, six by Democrats) deems it necessary AFTER they find a matching amount of spending cuts. Hmmm…I’ll bet there will be at least 12 districts that won’t feel much pain from THOSE cuts. However (at least there’s a “however”), if the Fab 12 simply cannot agree on which cuts to make (or if they’re rejected by Congress), then automatic $1.2 trillion of “across the board” spending cuts will take place.

And as usual, there is a big Washington caveat to all of this; the special commitee will not be meeting until later and they must have a final vote on the cuts by December 23rd. In the meantime, apparently vacations and palm pressing (while filling up the 2012 re-election coffers) are in order, more so than getting our fiscal house straightened out. Talk about kicking the problem down the road. Again.

And the payoff for all this intense Congressional wrangling? A whopping $900 billion of savings over the next ten years. Sarcasm aside, when you’re running a deficit of $14 trillion (more on that later), $900 billion over a ten year period is not going to get the job done. Unless the CBO (Congressional Budget Office) is looking at an economy expanding at a rate of 4-5% annually (so tax receipts come in as a perpetual tidal wave), Uncle Sam is still going to be in direct competition with you and me for those dollars. One guess who usually wins that tug of war. So while I’m pleased that the ceiling WAS raised (as distasteful as it was) to avoid our creditors’ crisis of confidence, I’m none too thrilled that the hard decisions of what exactly gets cut are yet again deferred, as well as left lacking in real substantive reductions.

Anyhow, with the debt ceiling being “settled”, a poem from my childhood came to mind immediately; one that’s been ringing in my ears ever since. It’s entitled “Mighty Casey At Bat” by Ernest Lawrence Thayer and it’s one which I’ve recalled on more than one occasion when I’ve come across overconfidence (of course, never relating to your author, ahem…). The taste of humility is never sweet at the time, but like any hard lesson, it’s one that bears fruit over time. You can click the link here to read the poem. Note the date it was published. Some things really are timeless.  http://ops.tamu.edu/x075bb/poems/casey.html

The Irony of Austerity

Wikepedia gives the definition of austerity as “sternness or severity of manner or attitude”. In economic terms, “the policy of deficit cutting, lower spending and the reduction in the amount of benefits and public services provided”.  These definitions point clearly to Greece and what will amount to its near and long term future. Plainly speaking, it’s my opinion that Greece is headed toward an all-out depression, regardless of what the media says or what Greece itself wants to believe. Years upon years of living beyond its means, giving out generous social benefits which generations came to believe was their birthright, all the while failing miserably at collecting taxes on their citizenry have led to massive deficits and continued refinancing of their debt. And when it came time to join the EU (European Union) and adopt the euro as their currency, Greece was more than happy to tie their debts to a currency that was stronger than their drachma (their native currency). After all, the euro is primarily tied to the two largest economies in Europe: Germany and France. It didn’t take long for the Greeks to realize that if they weren’t able to solve their problems on their own, they would now have deeper pockets upon which to rely to solve them. Greece’s problems would become Germany and France’s problems. Greece saw an economic savior of sorts, while Germany and France would basically inherit the equivalent of a dysfunctional family who lacked the discipline to make the hard choices at the time when they mattered.

Why is it Germany and France’s problem? While the Greek economy is tiny compared to other European economies, their debt was bought by those other economies (across Europe, not just Germany and France) and became a virus of sorts in European banks and other investments. When that debt started to lose significant value due to the inability of Greece to make good on its debt payments, those institutions were facing sizable losses. All of which meant that the free flow of credit in Europe could freeze if enough losses and fear were realized (as in, runs on banks). Since Germany and France are the two largest economies in Europe, as losses mount and economies unravel, they would inevitably begin to feel their economies slow down; slow at first, then all at once. It’s in their interest to string along Greece until a true solution is found that doesn’t have as much of a potential impact on them as an all-out default. What that is, if it even exists, remains to be seen.

Which brings us to the present. Greece has now received two “stays of execution” regarding its debt with the ECB (European Central Bank). Not only has the ECB given out additional loans to keep the Greek economy afloat, but it also “restructured” the duration of the original debt, which means that the major players (Germany and France) have had to agree to extend the duration of that debt to allow Greece time to get its economy in economic order. And just what is that “economic order”? This is where austerity comes in. Part of what Greece agreed to was the implementation of severe governmental spending cuts. Those cuts included much of the entitlements the Greek populace became dependent on, namely governmental pensions, early retirement income payments and other public services which were taken for granted. Remember, generations of Greeks viewed these benefits as their right and when they learned that they were being cut dramatically, rioting broke out in the streets.

So what is the economic irony in the austerity measures? Well, since the Greek government is such a big part of their economy (when they make pension payments to their citizens for example and that money is spent in their economy), a serious reduction in those payments means that the amount of cash spent in the economy will be severely cut as well. If there’s that much less money in circulation in the economy, it’s only a matter of time before businesses start failing, which leads to higher unemployment. Two things happen here: one, tax receipts will be lower initially, since there’s less money in circulation and two, as businesses start to fail an additional shortfall of tax revenue now exists. The end result is that for a government (which is depending on a consistent tax revenue amount to be generated) to make its agreed upon restructured debt payments as promised, its cutbacks in benefits have actually made it more difficult for it to do so. So the irony is that the very cuts the EU wants to see so that Greece does not overspend (they only spend approximately what they bring in) will inevitably lead to slower growth, further layoffs and finally, lower tax receipts to pay off its obligations. Greece finds itself in a very sticky situation; it must either cut its spending and thrust itself into a painful, very slow growth path or it can do what many believe is its eventual outcome: default and a return to its own currency. Doing so might give it the fresh start it needs, but the economic fallout in Europe (as well as the precedent it would be setting to other countries) would be nothing short of volatile.

Austerity American style, anyone?

First, the good news: we’re all Americans. Regardless of how we feel about our elected officials and the general state of the economy, I feel that there is truly no better place to build (or rebuild) a rewarding life, limited only by our imagination and perserverance. We’re free (in too many ways to mention here), with many brave men and women having given their lives so that we can have the opportunities available to fulfill our dreams now. Let’s never forget that. We owe them at least that much.

Now the not-so-good news: our government has a leadership void and the American people are beginning to realize it. This doesn’t manifest itself in an obvious manner, much like when there’s an argument and each side is loud and argumentative about their position. Rather, it’s more of a retrenchment, where consumers put their hand on their wallet (or purse) and decide it’s probably better to “wait and see” than buy now. As I said in ” The Road Narrows”, when there is no leadership, there’s very little confidence. If individuals, companies and municipalities don’t know what the economic landscape (jobs and taxes) is going to look like within the next few years, they have little incentive to put their hard earned cash in big dollar purchases (durable goods, capital spending).

This is beginning to show up in the numbers: revisions to our gross domestic product have gone all the way back to the fourth quarter of 2010 and not in the right direction. For the 4th quarter of 2010, the economy only grew 2.3% (initially, it was 3.1%); 1st Qtr 2011: 0.4% vs 1.9% initially; 2nd Qtr 2011 1.3% vs initial forecast of 1.8%. Wrong direction indeed. Further, consumer confidence is at its lowest level since 1980 and shows no sign of rebounding to the upside soon. What we’re beginning to see is that more Americans are once again implementing their own brand of self imposed austerity; spend less and save more (or pay down debt). And when consumers pull back, tax receipts inevitably contract. This is where a different kind of auterity settles in; one not mandated by creditors, but rather one that evolves due to lack of confidence and uncertainty. Since the government coffers shrink due to less spending, two things happen: first, federal spending declines, meaning entitlements and transfer payments (unemployment comp, food stamps, etc…) might be cut, along with payments to states. Secondly, state budgets must adjust to lower tax inflows, meaning all non essential items in the budget get cut (and perhaps some essentials, like lower education spending, which would have catastrophic long term competitive results). Either way, it has the same outcome in principle as what Greece is experiencing; whereas Greece’s economy was government fueled, the U.S. economy is 70% fueled by consumer spending. Reductions in the type of spending that an economy is used to will result in contraction and, if not remedied, recession or possibly depression.

So what’s a government to do? It’s been debated by many that an all-out reduction in spending to only match that which is brought in (tax receipts) should be implemented so as not to add to the deficit. In this scenario, any additional spending would have to be met with cuts in current spending. The thought behind this logic is that it would deficit neutral, meaning that no additional debt would be taken on. This has merit, except that the initial shock of cuts to those receiving benefits currently would undoubtedly add to the unemployment rolls (it’s doubtful that eliminating all “pork” would balance income vs spending without affecting benefits payments). Doing so would decelerate spending intially, thereby actually adding to the deficit, by virtue of less tax receipts due to reduced spending. It may also add to the misery index of those who suddenly find themselves without income or a job.

Others (Keynesians) believe yet another round of stimulus (QE3) is the path that needs to be taken; this time squarely directed at infrastructure spending (roads, bridges, etc…), which may give a direct injection to the economy, as well as badly needed improvements. While I’m not advocating such a program, there is a significant difference between that type of stimulus and QE1 and QE2; QE1 was primarily directed at restoring liquidity to avoid credit freeze, with the unpleasant side effect of benefitting many who were responsible for the collapse in the first place; Qe2 was used to purchase treasuries and other debt to keep mid to long end interest rates down (to stimulate home sales, etc…). While it’s debatable if either was the success they were meant to be, (QE1 kept credit flowing, but actually increased risk by shrinking the number of major financial institutions;  QE2 didn’t have the stimulative effect that was intended, ie: at least 3% GDP and also fueled the rise in equity and commodities prices; see “The Problem With Bubbles”), what isn’t debatable is that many now have no appetite for any additional government spending.

QE1 and QE2 also didn’t have a direct effect on the velocity of money (the frequency  which money changes hands), only on the availability of credit and cost of borrowing, kept low to incentivize spending. In a capital improvements “stimulus”, states and municipalities could receive a certain amount dedicated for infrastructure. The state then can increase that amount by floating bonds if they desire, the interest of which can be paid by ”user fees” or increased tax receipts brought in by the increased spending.  In a work for hire setting, when one is hired, he is paid fair market value for work performed. From his paycheck he purchases essentials (and perhaps non essentials as well). From that same paycheck he also pays taxes, which reimburses the government for part of the stimulus. Additionally, the merchants he buys from also pay taxes on the goods and services sold. Local and state taxes also increase, as the more money changes hands, the more tax is paid. The velocity has therefore increased not only from our employee, but also with regards to tax receipts and those he purchases from indirectly. One last additional “perk”; now that our individual is working, he’s undoubtedly feeling more confident about his own financial future and will probably work to rebuild his credit by paying off his debt (deleveraging). This “stimulus” is not without its own faults, but is better than handing a check to someone for doing nothing. Just saying…

Compare this scenario against what has taken place over the past few years, namely increased transfer payments (unemployment benefits, food stamps etc…). These payments, which primarily have fixed value, are given without any corresponding value in return. The velocity, therefore, is static at best and the payback to the government is limited (by the way, 40 million Americans are now on some form of “welfare”; this is way too sad and must be corrected!) Entrepreneurship and competition is non existent in this setting and the value of work (to both the individual and country) is devalued; in the former example, both are encouraged.

So what’s the answer to the current economic malaise we’re in? What’s NOT the answer is what Washington has been doing, namely attempting to paper over the problem without generating any real value. Somewhere in the answer lies a mix of spending cuts, redirected spending of existing resources to generate value and incentives for entrepreneurs to start businesses. And that requires leadership, which sadly, is AWOL at the moment. It won’t be easy, there will be pain, but it will be defined by the work ethic that made our country great in the first place. And we are great; it’s just occasionally a crisis needs to come along for us to rediscover what made us great in the first place. If we hold true to our work ethic, “American Austerity” will be one of manageable choice, not of mandate. God Bless.

In Long Road To Recovery, I stated that we are in a plodding economy, characterized by slow growth, mediocre jobs creation and waning consumer confidence. After a robust 4% annualized GDP number for the fourth quarter of 2010 (largely due to pent up consumer demand), the advance first quarter GDP number for 2011 came in at 1.8%. That number has been finalized to an underwhelming 1.9% annualized GDP. Pretty abysmal, to say the least. Not that the second quarter should be much better; consumer spending is still constrained, jobs growth is still anemic and Congress has done nothing more than posture for the cameras, rather than tending to the work of the American people.

And what is that work, exactly? First and foremost, this American would like to see our elected officials get serious about the debt limit, which currently stands at $14.3 trillion. That’s an interesting number, considering it’s our current public debt, as shown on the US Debt Clock. You can take a look at it by clicking on the link below, but make sure all sharp objects are out of reach. You may also want to make sure you’re on the ground floor. Have a seat as well. http://www.usdebtclock.org/index.html

This continuously updating chart is a wealth of information, as you can tell. But what is most concerning is the total debt subject to the debt limit (upper left, in red) and our total gross domestic product (about a third of the way down in the middle, in green). To refresh, gross domestic product (GDP) is basically the sum of all goods and services produced in the U.S. If you’re startled that our total debt is just about equal to what we produce, then you’re getting the picture. Now consider that INTEREST must be paid on that debt, as that’s the debt that people, governments and institutions buy and expect to get paid for the privilege of buying it.

So why all the concern about us reaching the $14.3 trillion mark? That’s right, us; YOU own it; so do I. Each of us owes approx $46,400 of the debt. If we all got our checkbooks out right now, we could each write a check and wipe it away. Happy days are here again. What’s that? You don’t have $46,400 to give to Uncle Sam? No worries, neither does he; at least not cumulatively. So Congress sets an arbitrary “ceiling” (kind of like a line of credit), presently $14.3 trillion, presuming that we’d never actually reach it. But add up one TARP, a QE2, various consumer incentive programs and a couple of wars, ON TOP of the debt that was already in place and we find ourselves pushing against that ceiling, since we spend more than what we take in. And like a line of credit, once it’s met, any spending over what the government takes in stops. No additional amounts over what it takes in goes out. And since it has more obligations than income, it will have to choose what creditors to pay and what not to pay. Kind of like a household might have to decide whether to buy food, pay the car payment or make the mortgage payment. So, if such a scenario occurred, what would our creditors think? Rather, what would they demand? Probably higher interest rates, since we would no longer be thought of as risk-free (think Greece, Spain, Italy). They’d probably reject any interest rates offered by Washington at debt auctions and wait until it was “sweetened” to compensate them for the additional risk of wondering if they’d get the next interest payment. What effect would that have on you and me? Since Washington would now be forced to pay higher amounts as interest (they’d use more of the cash in the current money supply), they would now be in competition with the private sector; therefore, interest rates would move up. Remember a basic law of economics: when the same amount of supply is met with rising demand, the price goes up. In this case, government needs more from the same amount of supply, therefore, the cost of money is what rises. Mortgage rates, car loans, credit cards, business loans, all types of lines of credit would all get much more expensive. Which means that already restrained consumer spending would shrink that much more, which could mean more layoffs, which would mean higher unemployment. Not a pretty picture at all. Add to that major budget cuts (austerity) that would force the government to live within its means and spend considerably less. And although that sounds attractive, those types of cuts would probably mean Social Security, Medicare and other social programs. If this sounds like those who are least fortunate feel most of the pain, you’d be right.

Unless of course, that ceiling (credit line) can be raised higher. But unlike us mere mortals, who are probably out of luck when we reach the end of our credit rope, Congress can magically vote to raise their credit limit, so the spending fun doesn’t end. And since we’re so close the limit at present, urgency is starting to set in. The hard date to get it raised is August 2, which is the date Treasury Secretary Timothy Geithner, calculated as the date the ceiling is met. The problem is, as I mentioned earlier, the limit is being held hostage to political maneuvering and grandstanding. Fear tactics are being used by liberals, where a lack of raising the limit will mean anarchy close to what’s being displayed in Greece. Fiscal conservatives are demanding any raise be met with spending cuts to offset any raise in the ceiling, which means in a contracting economy, the odds of falling back into recession increase. While both sides have some good points, the truth (or solution), falls somewhere in the middle.

From my grandstand view, the ceiling needs to be raised. We simply cannot afford to have  our debt buyers (creditors) begin to believe the United States of America cannot pay its bills. The economic fallout would carry beyond our borders to other countries, as uncertainty begins to unwind economic confidence. While many believe this is the prescription needed to cure our debt ills, I believe the economic pain would be overwhelming. When one cannot or does not pay his bills, one falls into an economic spiral that takes much longer than he may realize to get back to where he once was. Again, not a pretty picture.

But if the ceiling is raised, what then? Should it mean that Congress can continue to rubber stamp spending increases to fund an already bloated budget? My answer: H-E-double-toothpicks-NO!! Since spending without accountability got us into this mess (along with the previously mentioned investment bank greed I outlined in other posts), spending caps should be implemented immediately to at least slow the bleeding of dollars. Logic would then dictate that additional revenues need to be addressed as well, to offset whatever bleeding still exists. And while I agree that there are some in society who have benefited tremendously from the tax breaks of the past ten years (think millionaires and billionaires), making them pay more now (and they should) will only be a drop in the fiscal bucket. Further, increasing taxes at a time where we’re straddling the post between fragile recovery and recession will only push us over the post to the recession side.

What’s needed are incentives to encourage entrepreneurs to take risks, start businesses and/or expand existing businesses. What’s also needed is leadership by our elected officials to get this done. Most businesses have no idea what to expect over the next year, let alone the next five or ten, which is how most businesses plan. Ditto for individuals. Will the tax cuts be extended or not, will an energy policy ever be put in place and will corporate taxes be lowered or not? Is it any wonder businesses are leery of hiring when none of these questions have been answered? Many are utilizing temp agencies to fill their positions when they’d gladly hire workers full time. But when you don’t know what your expenses are going to be one year to the next, prudence dictates you keep your expenses as low as possible; therefore, no new hires, who carry the added expense of benefits. For individuals, not knowing if your household expenses will increase next year means holding off on that new car or vacation. Households are also concerned about their employment; jobless claims have not been moving down lately, which means jobs are still being lost. If households are not confident in their employment situation, again, the odds of them making big ticket purchases stagnates.

Congress needs to show leadership in these areas. By committing to concrete plans so as to allow businesses and households to plan over a moderate time frame, as well as to design incentives to encourage business start-ups, over time additional revenues will be generated to not only stop the bleeding completely, but also pay down our $14 trillion of debt. We don’t have to needlessly allow our AAA rating to be cut along with an austerity-type budget in order to get our fiscal house in order; we DO need to get serious about spending cuts and generating real revenues from growth. Real wealth is borne from limited debt in conjunction with consistent revenues from growth. Enough of the drama and grandstanding that Washington so clearly loves.

That’s going to do it for now; it’s late and while I was going to comment on Greece, that will have to wait. At least until tomorrow. You however, can comment below on this post if you wish. Don’t worry, I have a tough skin.

One last thing; a while ago I came across these two videos on You Tube; Keynes vs Hayek. Although I haven’t really touched on it, the amount of stimulus (TARP, QE2) is straight out of the economic textbook of John Maynard Keynes, a 20th century economist who believed that government should stimulate the economy when the private sector is unable or unwilling. Truly Ben Bernanke’s hero. Friedrich Hayek was a 19th century economist who believed strongly in free market capitalism without government intervention. It’s a bit of comic relief that I think you’ll enjoy. Take care and God Bless. And remember, not one second of congressional dramatic posturing is surprising to Our Savior.

David J. Babecki

Keynes vs Hayek, Round 1 http://www.youtube.com/watch?v=d0nERTFo-Sk

Keynes vs Hayek, Round 2 http://www.youtube.com/watch?v=GTQnarzmTOc

“You can always count on the Americans to do the right thing, after they’ve tried everything else”.

Winston Churchill

Churchill’s blunt comment is basically a summary of the frustration I believe most of us (or maybe it’s just me) are feeling after the financial crisis of 2007-2008. Like him, we know that our government is capable of making correct decisions, but seemingly lacks the motivation to do so until its back is firmly planted against the wall (or is staring out over the abyss). This motivation is usually usurped by short term profit fueled by self serving greed which only benefits the few, but is sold to the masses as “necessary” in times of crisis. One can argue that this mentality has always been the core of our capitalistic society, however, in order for that society to be healthy, it first must be balanced by genuine concern for the populace. When one sector of the economy is propped up at the expense of future generations (ie; TARP, QE2), the underlying logic is dysfunctional at best.

But I digress; like Churchill, I firmly hold onto the conviction that in due time we will realize the only option left is to take on our problems directly. When it’s apparent that no amount of smoke and mirrors will hide the reality of decaying debt buried beneath the surface of what looks like a flower garden, we will finally make the hard choices to correct the sins of the recent past. It won’t be easy, it won’t be pretty and it will be uncomfortable. The easy choices to correct are all in the rearview mirror. But we need only look across the Atlantic (Greece, Portugal, Spain and Ireland) to see what the results of constant neglect to our fiscal policy would bring. Further, the bond market will let its voice be heard should no (or not enough) progress be made on the cutting of our debt. We can’t let it get to that point. And now, onto The Long Road To Recovery.

Much economic data has been released over the past few weeks, some of it encouraging, but most of it showing that the economy is operating at stall speed. Most of us inherently know this, as the businesses we work with (or ourselves, independently) are working ever harder (and longer) for customers. But before I get into that data, a clear definition of GDP is needed, since it is such an important (if not the most important) element of our economy; so here goes.

Basically, GDP (Gross Domestic Product) is defined as:

Consumer Spending (or consumption) + Investments + Government Spending + Exports minus Imports (net exports).

This formula is measured both on an annual basis and on a quarterly basis. It is critical to measuring the health of our economy, since it measures how much we spend as a nation (remember the US economy at present is approx 70% driven by our spending), how much we invest, how much Washington is spending on infrastructure and incentives for business and if we’re selling more to other countries than what we buy from other countries. If GDP is clipping along at a rate of say, 4-5% annually, we know the economy is healthy and jobs are being created (mostly in the private sector), since the higher the annual GDP number, the more spending (and earnings) are being generated. In the past, when annual GDP rose too high, the Federal Reserve has raised interest rates to “cool off” the economy and  slow it down a bit. Without this type of intervention, prices will climb very quickly, as more consumers (most of whom are gainfully employed at this point and feeling confident about their finances) “bid up” or chase the goods they want to buy (which is exactly what happened during the housing bubble; rates were not raised quickly or often enough, leading to too many consumers/investors using “cheap money” to both “bid up” and buy more houses).

On the other hand, if GDP is only around 1-3% annually, we know the economy is weak, since there isn’t as much spending (earnings) or investment occurring. Therefore, private sector jobs are not being created very quickly and government will more than likely attempt to revitalize the economy in some way, usually with lower interest rates. However, because of the severity of the financial crisis (which brought on the most recent recession), lower interest rates were not enough; historic intervention on the order of the Federal Reserve buying US treasuries (and other debt) were needed not only to keep interest rates at historic lows, but to keep banks and other companies solvent (in business) as well.

With the understanding of GDP now hovering in the background, let’s move on to the recent data and see how it applies. First off, remember that GDP for the fourth quarter of 2010 (Q410) shot up to approx 5% annualized, as consumers returned to the malls and decided that their self imposed spending moratorium was over (at least temporarily). This number was a big surprise to economists and signaled to some that the recovery had started. Indeed, talk of raising interest rates (from 0-.25%) started to make headlines as well, since such a recovery start meant that further quarters of growth would be even more heated. It was my feeling then that that type of number was but a temporary blip, since jobs still were not being created at anything near the rate needed to sustain that type of spending.

At the end of April, the first quarter 2011 (Q111) advance GDP number was released and with it, a heavy dose of reality. The economy had grown by only 1.8% annualized (US Dept of Labor), as consumers retrenched in a big way and resumed paying down their debt (it has since been confirmed at 1.8% as of Thursday, 5/26/11). No doubt increased gasoline prices contributed to the pullback in spending, as more households had less to spend on luxuries and were forced to spend more to commute. Job expectations among the unemployed remained weak as well, with only 5.2% stating that jobs were “plentiful” (The Conference Board).

This general feeling of malaise and higher fuel prices translated into May’s numbers, which showed the continuing sluggishness of the economy through both manufacturing and non-manufacturing. The ISM Non-Manufacturing survey, which measures new orders, employment and deliveries, showed the lowest number in over a year (52.8). The Empire State Manufacturing Index (which measures New York manufacturers’ conditions) showed a lower number as well, but did show that companies do plan on spending more in the future after being encouraged by their quarterly profits (let’s face it, when prices are down and you’re flush with cash, it’s a good time to invest for the future). The Philly Fed Index (The Federal Reserve Bank of Philadelphia) also showed general business conditions softening, as new orders, shipments and prices paid all fell; inventories are building back up. This was also confirmed in the Durable Goods report, which was released Wednesday, 5/25/11. This report shows the sales of goods that are supposed to last at least three or more years (such as refrigerators and other appliances, cars, aircraft and computers). The numbers for April (most recent available) show that those orders declined by -3.8% after posting a +4.4% gain for March.

There were some bright spots however, in that non-farm jobs rose by 244,000 in April (Bureau of Labor Statistics). Remember that approx 150,000-175,000 jobs must be created monthly just to absorb new workers into the economy and to keep the current unemployment rate where it is. Another positive was that of jobless claims, which fell to 414,000 for the week ending 5/14/11 (but did move up to 424,000 as of 5/21/11); not getting significantly better, but not getting significantly worse, either (hardly time to pop the champagne, though).

So what does this all mean in a big picture setting? Basically, after the consumer went on a bit of a binge last November and December, he/she has sobered up and decided that it’s time to become more restrictive in their spending. The combination of flat wage growth, higher gasoline and food prices and continued debt paydown has led to business surveys moving lower in both the first and second quarters. To reiterate, we currently have an economy that is plodding along, showing no real signs of GDP growth, due to a lack of spending tied to a lack of jobs growth and/or confidence in the current employment environment. Once again, we wait for Washington to take the lead in giving substance to the creation of a recovery plan.

I now want to comment on the notion of a government conspiracy to drive down the value of the dollar to worthless levels, so a new “global” or “new dollar” currency can be issued. Personally, I’m not in that camp yet. Far too much would have to happen (or actually, not happen) for me to move into that direction. First, regarding a global currency, look at all the problems that are present with the euro, due to the differences in size of the various European economies. Can you imagine how much more those problems would be amplified if there truly were ONE global (or just a US/European) currency adopted? Simply due to economies of scale, the larger economies would be asked to “prop up” the smaller, weaker economies, thereby losing much wealth. The smaller economies would get a “free ride” on the backs of the larger economies, much like Greece has done since the euro was adopted. It hasn’t worked out too well for them (or Germany, the larger economy, for that matter). It’s being asked (and will continue to be asked) to finance much of the Greek/Portuguese/Spanish (and maybe Irish) bailout, to much grumbling of its citizens. We haven’t seen the end result yet, but it COULD result in Greece leaving the euro, with perhaps some countries going back to their own currencies. So much for one currency for the eurozone.

Regarding a “new dollar” currency, that scenario would play out a bit differently, but still bring wealth destruction. The new currency would probably be a “reverse split”, much like a reverse stock split, in that say, 100 old dollars would be exchanged for 1 new dollar. This would undoubtedly occur after the current dollar had been driven into the ground, much along the lines of the German mark after World War I and Zimbabwe of recent past. The total value of the new vs exchanged currencies would still equal the same, but there would be fewer dollars. This would probably be so that the new dollar could once again be tied to a tangible asset (gold?) and be given a “reset” over the current dollar.

Here’s the problem however, as I see it: by allowing the current dollar to destruct to a level in which the above scenario would occur, the wealth destruction that would take place would be enormous. Most of the American population would lose most, if not all of their wealth. Municipalities, the financial sector, businesses, etc., would ALL lose an extreme amount of their wealth and along with it, a global breakdown of unprecedented scale. The few that would benefit (the top 1%, probably invested in commodities) would be under constant verbal (if not physical) attack from the other 99% of citizens. Further, the credit rating of the U.S. would be ruined, relegating it to third world status. In such a world, obtaining credit to function on a global scale would be difficult, if not impossible, since financing costs would be outrageous. To me, this scenario doesn’t make much sense.

What does make sense to me is a grass roots groundswell of support demanding our elected officials start taking the current debt/spending crisis seriously (much like Paul Ryan R-WI, is attempting to do) and stop playing to whatever will get them re-elected come 2012. There are some congressmen/women who truly do understand the magnitude of our debt/spending problem and are taking political chances at sounding the alarm (hey, they have kids, too). These people need to be supported and encouraged by our votes and emails. They also understand that this problem will not go away within a few years. It took a DECADE for us to get to where we are (see “The Problem with Bubbles…”) and will probably take just as long to get out, IF the right decisions are made. And those decisions will be felt. There should be Medicare and Social Security reform (read: lower benefits and probably means tested, as well), but only for those who are not yet retired. There should be serious budget cuts, both federally and locally, meaning welfare-type benefits will get cut (this is where we, the church step up). Unemployment will probably stay near or at double digits for the foreseeable future. Any new spending should be offset by AT LEAST the same amount in budget cuts. There might be a national sales tax (“value-added tax”) to offset lower income taxes. The wealthy (coin toss on that definition) will probably pay more in taxes, since they’ve reaped most of the benefits over the past decade. There should also be additional incentives for savers, so as not to be penalized for keeping savings accounts. Finally, since it’s my belief that one of the most patriotic acts any of us can perform is to start a business, there should be incentives to do so, perhaps an expansion of the Small Business Administration to administer low interest loans.

In summary, a combination of spending cuts in conjunction with additional revenue generation while adopting pro-growth strategies is far more preferable than forcing wealth destruction so the “dollar reset button” can be hit, thereby decreasing the value of our debt. It may seem like an attractive alternative, but the social unrest and global disarray would be more than anyone would want to experience.

And let’s not forget one indisputable fact: the U.S. is the largest economy in the world and has 300+ million citizens. Like a heavyweight fighter, we can take many hard shots and still be standing. A bit bloodied perhaps, but still standing and ready to recover between rounds for eventual victory. I’ll take that over the alternative anyday. God Bless.

David Babecki

“When I get to the bottom
I go back to the top of the slide
Where I stop and turn
and I go for a ride
Till I get to the bottom and I see you again”

Helter Skelter/The Beatles

Maybe The Beatles didn’t have an economic implication with these lyrics when they wrote “Helter Skelter”, but it nonetheless fits,  especially when we consider the effects of TARP and QE2. These two government programs, designed to reinflate the economy by allowing the Federal Reserve to buy bad assets off the books of the banks and to become a customer of treasuries, has given life to equities and commodities all in the same breath. The purchasing of those two asset classes has pushed down the dollar, thereby making riskier assets more attractive. We call this the “risk trade” and it’s what can happen when Uncle Sam props up one sector of the economy at the expense of another. More on that later. But first, I hope you’ll indulge me in setting the stage for what has led to not one, but two asset bubbles over the past decade. I realize many of you have heard me speak about what got us here, but a refresher might be welcome. I’ll also be brief.

We have to go all the way back to 2001, when Alan Greenspan, then Chairman of the Federal Reserve, lowered interest rates all the down to 1% (from 5.5%) by 2003 to help pull the U.S. out of a prior recession. This was due to the aftereffects of bubble #1, the tech bubble, where companies’ stock prices traded at price earnings multiples significantly higher than what could have been justified at the time. In that bubble, primarily played out in the Nasdaq stock exchange (where most technology companies traded), the advance of internet companies attracted investors first by a trickle, where the Nasdaq traded at approximately 1,000. As investors realized the new industry that was being created was one of historic significance, more money flowed into these stocks, sending share prices higher. It wasn’t long before share prices reached irrational levels and, beginning in 1999, the frenzy started. With the Nasdaq at around 2,200, it took only one and a half years before it reached its zenith, topping out at approximately 5,000. Irrational exuberance, fueled by the sentiment that “this time it’s different”, meant that normally rational investors through caution in the wind, as no one wanted to be left of the ever faster bandwagon.

But it wasn’t long before exuberance was dealt a blow of reality, as the economy began to falter and with it, the selling of those same bulletproof stocks that seemed invincible. Enter Alan Greenspan, who, with the economy in free fall (and after 9-11), felt that interest rate cuts were the answer to stimulate the economy once again. These interest rate cuts (from 5.5% in January 2001 to 1% in June 2003) were the fuel that helped to ignite the housing bubble (the top of the slide), which served as the catalyst for the worst financial collapse since the Great Depression. From 2003 to 2007, extremely low interest rates incentivized at first individuals, then developers and investors and finally financial institutions to take risks which, up to that point, were considered off limits by ethical standards. We’ve all heard the stories of average Americans taking out multiple contracts on properties with the intent to “flip” them and make a profit. Developers were getting dizzy attempting to keep up with the demand, while Wall Street urged banks to make even more loans to satisfy the demand for yield generated by the packaging of mortgage loans into collateralized debt obligations (CDO’s). And while there were a few voices attempting to inject sanity into the madness, they were quickly silenced as profits reigned over concern.

Additionally, consumers joined in on the act, not by flipping properties, but rather by using their homes as ATM’s. By taking advantage of their rising equity, homeowners found that they could take large home equity loans and/or lines of credit to purchase everything from cars to vacations to new furniture.

It didn’t take long before the 2000-2001 recession was far behind in the rear view mirror and the economy was roaring along at 6% nominal GDP between the first quarter of 2005 and the second quarter of 2006 (gross domestic product, the sum of all goods and services; not adjusted for inflation. www.data360.org).  Money was being made, jobs were in abundance and the national unemployment rate for 2007 was just 4.6% (www.infoplease.com). There was only one problem; it was all being done with debt, not true growth generated from production. While it’s true that debt is an essential part of our economy (as well as constructive, as long as it’s being used to create), as in all of life, too much of one thing can be intoxicating and eventually, destructive. While debt used for consumption will drive jobs growth in the near term, too much will enslave the consumer by making him believe the upside is never ending and he’ll always have enough income to pay for the excess. That’s the problem with bubbles; reality usually is hidden behind a curtain while ever more engage in the “too good to be true” feeling of the moment. Reality then comes crashing down hard as the excesses give way to a sobering revelation: there really is a price for everything.

By mid 2007, the upside came to a screeching halt, as subprime borrowers began to falter on their obligations. The rest, as they say, is history, as Lehman Bros and Bear Stearns led the way into the worst financial meltdown since the Great Depression. Bubble #2 had burst. And along with it, 8 million jobs had vanished; construction jobs, financial jobs, retail jobs, auto sales jobs, manufacturing jobs. No sector was spared. All at a time when many Americans had “levered up” (or borrowed) up to the maximum their credit rating would allow. It was no surprise then, that foreclosures and bankruptcies soared to historic levels, both on a personal and business level.

It was clear that Washington had to act. Unemployment had skyrocketed to officially over 10% (although those “underemployed” or who had simply given up were not counted. If they had, the rate would have climbed significantly higher). Credit had frozen, as banks refused to lend not only to individuals or businesses, but to other financial institutions, since they didn’t know how many toxic assets (CDO’s) were on the books of those other institutions. Therefore, there was no comfort level as to the ability to repay. This forced Washington to respond in the only way they truly could to keep the flow of credit (aka business) moving; they guaranteed deposits at banks, brokered deals between financial institutions to buy out those that were about to fail and passed legislation to purchase up to $750 billion of toxic assets from those financial institutions. Effectively, the government had given these institutions cash in return for their toxic assets and/or taken stakes in those companies, thereby wiping out their bad assets. The printing of dollars to pay for toxic assets while rewarding these companies for their irresponsible business practices was unprecedented.

But it didn’t end there; with unemployment in double digits and the economy in shambles, Ben Bernanke (Chairman of the Federal Reserve) lowered interest rates all the way down to .25% (that’s one-quarter of one percent). His rationale for doing so was to restart (known as reflating) the economy by making loans attractive. While only banks could actually get the 0-.25% rate the Fed was offering (known as the Federal Funds rate), all loan rates, from mortgages to car loans, were cut to entice consumers to borrow to get the economy rolling again.

The historic government sponsored bailout to financial institutions (and non-financial as well, aka GM and Chrysler), in conjunction with the lowering of interest rates to approx zero, had another impact as well. With fixed rate investments (bonds, especially treasuries) now offering historic low yields, two consequences from that action would occur, thereby creating another bubble; commodities would soar in value and the “risk trade” would increase.

The “risk trade” is basically defined as when investors, who would normally limit the amount of risk of their investment portfolio, decide to take on more, for one of two reasons. The first reason is that, historically, investment grade bonds (rated BBB or higher, as well as money market accounts) paid anywhere from 2-5.5% interest (known as “yield”), without much risk. When the Fed lowered interest rates to 0-.25%, fixed income investments correspondingly yielded much lower as well. In the real world, this may look as follows: a retiree, who is used to getting 5.5% on his treasury bond without risk, might now only get about half of that. If his budget is based on the higher yield, he needs to either make up for the lost income or decrease his spending. And with food, energy and medical expenses continually rising, limiting his spending might not be an option. So where does he get the extra yield/income? Either from lower rated fixed income (known as “junk bonds”, lower rated bonds that carry additional default risk) or by investing in the equity markets, where dividend paying stocks and funds may not only make up the difference, but also give him appreciation as well. The downside to him “reaching for yield” is that he’s increased his risk substantially, since stocks and funds can and do move up or down in price on a daily basis versus a bond, which pays a stated rate of interest until maturity. At maturity, our retiree gets his principal investment back without risk of loss of principal.

The second reason an investor would increase his risk is to maximize return. This investor, who typically would allocate a percentage of his portfolio to fixed income for income and stability (a part of ”asset allocation”), may find that since the income is so low, the price aspect of the investment may be compromised as well (the fixed income investment may fall in value, due to other investors looking for growth and/or yield; therefore, they sell their fixed income). He may feel that it makes more sense to sell his fixed income investments and buy dividend yielding stocks and/or funds. Further, since interest rates are at historic lows, he may “leverage” or borrow money at cheap rates and invest it in dividend paying stocks and/or funds that yield significantly more than the fixed income investments. Effectively, he would then accomplish his goal of more income, while simultaneously increasing the value of his portfolio, due to other investors adopting the same strategy, thereby raising share values of stocks. Since it fell to a  low of 676 in March 2009, the S&P 500 has doubled to 1,355 (as of April 27, 2011), all while unemployment rates have continued to struggle near double digits, GDP is still anemic and no significant jobs have been created. This is in direct contrast to past recoveries where, as the stock markets recover, GDP averages approx 5% annually and jobs are created at a rapid pace, which lowers unemployment and stimulates consumer consumption.

The other consequence is what we’re all currently witnessing; that of a runup in commodities prices. To keep it simple, we’ll limit it to the two that are most in the news: gold and silver.

Simply put, precious metals rise in value due to one important reason; as a hedge (or “bet”) against world currencies. If investors worldwide believe that a currency or currencies may lose their value sometime in the near future, either due to a lack of confidence in currencies or because of inflation, they may start purchasing precious metals as a way to invest in something tangible that has actual value. The dollar is the world’s reserve currency at present and has been since President Nixon took the US off the gold standard in 1971. Since that time, the full faith and credit of the US government has replaced the gold standard and the dollar has been the currency that the the world recognizes as the standard of the world. Since 1971, countries the world over have had the same type of confidence in the dollar as they had in gold. And since that time, the US government has, by and large, managed its currency responsibly (if not selfishly at times), so that that confidence did not waiver.

What happens then, when the US lowers interest rates to practically zero and also enters the fixed income market as a customer of its own debt? We’ve seen from above that the equity markets react favorably, since the hunt for yield forces investors to take on more risk, more than they might want. It also brings about a greed mentality, as the attraction of leverage entices investors to take on more risk than they may otherwise usually take when interest rates are higher.

But what about the dollar and its status of reserve currency of the world? Will other countries continue to view it as the “safe haven” as the US continues to print more and buy more of its own debt? The precious metals markets (and other commodities markets) are telling us that the US may be embarking on a strategy that ultimately changes the way the rest of the world views us. Confidence and inflation could ultimately undermine the dollar and push metals higher.

Consider: the US prints billions of dollars to buy the bad assets off of the books of the banks. Two years later it announces QE2 (Quantitative easing #2), a $600 billion Federal Reserve program that buys debt from the US Treasury, much the same way as Japan, Europe or China does; basically, it’s another customer. The result of such an expansion of its “balance sheet” (or increase of its debt load), is that interest rates are held down, since price and yield of bonds move in opposite directions. So if the US is buying bonds, the price of the bonds is pushed up (or maintained), but the yield is held down. Additionally, because the yield is low, those other countries looking for yield will only look to US debt as a safe haven, but not as an investment that pays well. Consequently, the dollar’s value may begin to lose value. All of this is fine as long as the buyers of US debt believe that the interest payments on the debt they’ve bought can be paid on time. But what if they don’t? What if one day they take a look at all the debt the US has generated ($14 trillion worth) and begin to wonder if they’ll continue to make payments? What if they begin to believe that the “safe haven” is not so safe? What could they do now as an insurance policy to “back up” their investments in the event that the US cannot make good on its obligations? After all, if the debt they hold is only as good as the credit of the issuer, what else could they purchase that historically doesn’t have as much volatility? And what if the dollar loses value because of that lack of confidence, to what extent can they offset that decline?

Enter gold and silver, which is still accepted as the universal standard of payment when currencies of the world begin to falter. Countries the world over have begun to invest in  the metals as a way to “hedge” against currencies (especially the dollar), should the US not find a way to manage its debt in a responsible manner. Individual investors as well, have started to look at precious metals as a way to hedge their portfolios in the event that the dollar begins to tumble due to a lack of confidence. The price of an ounce of gold has risen from approximately $870/ounce five years ago to over $1,500/ounce today. As the US continues to procrastinate in its efforts to lower its debt, confidence continues to waiver, meaning precious metals prices continue to flourish as a hedge.

Which begs the question what, if anything, would happen long term to the dollar in the event confidence begins to waiver? We’ve already talked about the purchasing of precious metals short term, but after that? Buyers of US debt would undoubtedly respond to a lack of progress on the management of the US debt (read lack of action by Congress) by demanding higher interest on that debt. Whereas currently, buyers are content to continue buying debt at or around prices that are still favorable to the US, if the time comes when they decide that no progress is being made or worse yet, refuses to be made due to the hardship it would entail, the bids they may offer could be lower than the US would like to accept. If that happens (remember that price and yield move in opposite directions), the US would have to offer higher yields just to sell that debt. The effects of that would be two fold.

First, interest rates in the US would rise, since the goverment would have to pay more interest on its debt to debt buyers. This would mean that interest rates in the private sector would also increase, since there would be competition between the public and private sectors. There would also undoubtedly be a downgrade in the debt rating of the US, currently AAA (by the way, over the past week the US debt rating has been put on “negative” watch by Standard and Poor’s, which ironically, fell asleep at the switch when it generously rated many CDOs as AAA during the runup in housing prices).

But the title of this post is “Bubbles” and that is where pain would be felt. Remember, equity prices have risen in no small part to the Fed keeping interest rates low (yes I know, corporate earnings have been positive; more on that on my next post). But in the event the US does not get its fiscal house in order (and that may require more pain than our campaigning elected officials may want to acknowledge), along with the combination of rising interest rates, plunging consumer confidence and rising commodity prices may very well send the US economy back toward recession and instigate another equity market selloff. In that scenario, more than just lower equity prices could be in store; a lack of confidence of that magnitude could mean that the dollar could begin to fall, starting a currency crisis.

How to deal with that though, is the subject for another post, as is the remedy for this problem that, so far, our elected officials are only at best, giving lip service to. Until then, enjoy the view from the top of the slide.

David Babecki

It’s been a while since my last post and I acknowledge quite a bit’s gone on in the world since then. Quite a bit’s gone on in our lives as well, as Kim and I welcomed our second grandson, Aiden Micah, born to our daughter and son-in-law. We had the pleasure of watching Aiden’s older brother for four days (Kim even longer) and reminds me of why the young have children (it’s humbling to realize I’m not 25 anymore). What I also realized is that as events unfold in the world, life continues to go on (as it should). It was a reminder to me of how crucial our younger generation is to the events we’re living in and how important they are and will be to solving the problems we’re just now entering. But more on that at a later date; it’s time to jump into “Denial”.

denial: refusal to admit the truth or reality (Merriam Webster dictionary)

Most of us have experienced denial at one or more times in our lives. Let’s face it, it’s a common fleshly fault that we bring about when we just don’t want to deal with a current situation or the one we see looming on the horizon (believe me, I’m including myself here). Usually, we’ll continue to embrace denial and ignore the problem until it’s staring directly at us and we’ve exhausted all other options, except…dealing directly with it. Reasons can be many (we can be pretty creative), but boil down to just not wanting to deal with the unpleasantness of the situation. After all, by acknowledging it, we admit we really don’t have all the answers and/or how we’ve dealt with it to this point hasn’t worked. What we don’t want to admit is failure, because we fear that can damage not only our own confidence, but the confidence those close to us have in us as well. What we often realize late in the game is that, if we’d only dealt with it head-on, the pain wouldn’t have been as great.

Governments work the same way, in that they must portray confidence in their actions to inspire us to take chances, start businesses and purchase big ticket items. Without that confidence, business can slow or even grind to a halt, which only further erodes an already difficult time. Most of the time, what all governments realize too late, is that if they were just transparent with the public in the first place, the public would have understood (although they may not have liked it!). For example, when the Greek government made promises to their citizens for full benefit early retirement (as well as other promises) while continuing to annually roll over high amounts of debt onto future years (you can do that when the risk is spread over one currency, the euro), would it not have been better if they’d admitted to their citizens that this path was unsustainable before they were forced into what will admittedly be severe public cuts (think depression)? So governments can (and will) embrace denial while kicking the can down the road, believing something will change, altering the unpleasantness of an oncoming train.

Our government is no different; I listened to the media report the unemployment rate last Friday and was surprised to learn that it had fallen to approx 8.8%. Not too long ago wasn’t it around 10%? (it was). So that had to be a good number and worthy of high fives all across Washington, right? To hear the media talking heads and U.S. Dept of Labor, the lower rate proves that the recovery is taking hold. Then there’s the consumer price index number (the cost of most everything you buy), which shows annualized inflation at approx 2.1% as of the end of February. Subtracting food and energy, that number was 1.1% (unemployment and CPI data from the Bureau of Labor Stats). For March (which doesn’t get released until mid April), I think we can all testify to higher food and energy costs, as it’s costing an ever increasing amount of the family budget just to fill the gas tank and put food on the table.  My point is this; a number of 2% annualized inflation looks pretty tame on the surface, but gasoline increased at an annualized rate of over 19%. It doesn’t take long before the American consumer starts making the hard decisions to limit other purchases, so he/she can pay for gas just to get back and forth to work. Remember, it was about two years ago that we were all feeling the pain of $4 per gallon gas and that proved to be the stalling point of the economy, to which it cried “uncle”.  And when that happens, business slows right at the time the economy is struggling to add more jobs. Which, if left unchecked, can mean sliding into another recession. In my view, Washington needs not to sing us lullabies regarding low inflation, but be proactive in putting in place an energy policy that takes advantage of what we already have in abundance (mainly, natural gas and yes, oil, during a transitory phase into new energy sources).

Let’s get back to that unemployment number. 8.8% looks good, considering over 200,000 jobs were created last month (remember, we need at least 150,000 jobs per month just to stay where we are, considering new entrants into the work force). However, digging deeper, questions abound. Government jobs are declining and at a rapid pace. These jobs are well-paying and have generous benefits attached. The holders of those jobs were able to consume at a steady level, as their benefits gave them confidence that, in the event they were faced with a crisis (medical or otherwise), it could be dealt with without fear of exhausting their savings. Jobs that have increased (and have taken the place of government jobs) have been from the private sector. It’s unclear what type of quality these jobs are made of, ie; do they have medical and retirement benefits attached and is the pay scale in line with that of the government jobs lost. Remember, most businesses cut back severely during the recession; they are not apt to offer generous wages and benefits just as the economy is showing a pulse. Further, there are those who have given up looking for work, categorized as those who have been unemployed for over two years (the “chronically unemployed”). Since they are not looking for work, they simply are not counted. So are we really down to 8.8% and if so, are those jobs being created of the quality needed to instill the confidence needed for an economic recovery? Time will tell.

Finally, there’s government debt. Most of you know by now that we have $13 trillion of debt to deal with as a nation. For me, that amount of money is not only staggering, but incomprehensible. Now for the kicker: Washington has to find a way to pay it down and it’s not going to happen with a mere few hundred million dollars in cuts here or a billion there. Real cuts have to be made and that means the third rail of politics, entitlements. So far, no politician has had the courage to admit to the public that social security, Medicare and Medicaid have got to be on the chopping block, along with those that they’re already talking about. And why would they? It’s political suicide. Look at Greece and England, where massive protests by thousands of citizens have intimidated government officials into stalling for time. Are we any different? If Washington took a sobering stance on what exactly is needed as far as spending cuts, would most Americans understand or would they start marching as well? I believe this is a risk most politicians don’t want to take. It’s much easier to believe the continued spending will eventually lead to a genuine economic recovery. After all, doesn’t life feel well, pretty normal? Interest rates are low, credit is flowing and most Americans have jobs. Washington is betting that the huge debt we now possess can be paid off by acting confident in their ability to manage that debt with low interest rates, which encourage the forementioned risk taking and spending. As Americans spend, business expands by hiring, which in turn translates into more confidence. As business recovers and more people are hired, more taxes are paid, which will enable the government to slowly pay down the trillions of dollars of debt. This is the gameplan they want to use, so as not to make the truly difficult choices unless or until they have to. And as far as the fourth quarter of 2010 went, they had the numbers to back it up.

During Q410, annualized GDP (gross domestic production, a measure of all goods and services produced in the U.S.) shot up to 5%, which is exactly what is needed for a true recovery. I said then that that number, although it looked good on the surface, could not be sustained. First, most Americans had gone through their own self-imposed “austerity program”, in which they cut spending dramatically. During the past two years, the national savings rate actually increased from our normal, anemic rate of around 1-2% to a more responsible 6%. Additionally, they paid down their debt from already high levels. However, during Q410, as the economy began to feel more “normal” (in conjunction with Christmas), Americans decided to release their pent up spending and did so rather well.

For the first quarter of 2011 however, that spending has tailed off noticeably, to the extent that most economists are now predicting Q111 (first quarter 2011) GDP to fall to between 1.5-2% annualized. Americans still have high levels of debt and continue to pay it off, rather than spend as they did in the fourth quarter of 2010. Factor in also the increased price of oil (gasoline) and further spending reductions by the populace may be in the cards. Finally, consumer confidence plunged just last month, as wages have shown no real growth over the past quarter and they income they do have is being spent more on energy and food than luxuries.

What will be Washington’s answer to a contracting GDP, if it in fact happens? Will it continue it’s assault on deflation and job losses by continuing QE2 (Quantitative Easing 2), in its attempt to continue to stimulate the economy at the expense of additional spending we cannot afford? After QE2 expires, if the economy is still not on solid footing, will it introduce QE3 as a no-expense effort to try to generate jobs? Or will it finally look deep into its own distorted mirror and realize their can has finally run out of road? If that indeed does happen, maybe it will finally learn that the art of denial is really just another term for self delusion. After all, facts don’t change; attitudes do.

Thank you for reading this edition of Between the Lines. I hope you’ll join me on my next post this coming week. And always remember, none of this is surprising to the Lord at all. God Bless and have a great week.

David Babecki