A good doctor will not simply make a diagnosis based on measurements. The symptoms and complaints expressed by the patient are at least as important in making a determination as the data provided by diagnostic tools. When the data says one thing and the symptoms continuously say another, it makes sense to question the reliability of the instruments. This would be particularly true if the instruments are furnished by a party with a stake in a favorable diagnosis, say an insurance company on the hook for treatment costs. The same holds true for the U.S. economy. Although our government-supplied data suggests we are experiencing low inflation and modest economic growth, the economy shows symptoms of low growth, rising prices, and diminishing purchasing power.
In my latest commentary I discussed how the Big Mac Index (The Economist Magazine's 30 year data set on Big Mac prices) provided strong anecdotal evidence that inflation in the United States is higher than official figures. More information has come in since then that tells me the same thing: that Americans are downsizing their lives as their incomes fail to keep pace with rising prices. These symptoms are at odds with the widespread belief in an accelerating recovery that has resulted in braggadocio in Washington and euphoria on Wall Street.
Earlier this week Tyson Foods, one of the nation's largest providers of packaged meat products, announced that although their top line sales revenue increased by almost 2% (roughly in line with U.S. GDP growth), operating margins collapsed by almost 50%, leading to a 43% decline in profit. Consumer shifts away from relatively higher priced/higher margin beef and pork products to lower cost/lower margin chicken products were to blame. Tyson also noted that cost conscious consumers shifted away from higher margin packaged chicken products to fresh meat cuts, thereby sacrificing convenience for cost.
According to government statisticians, the Tyson announcement would reveal modest growth and low inflation. After all, revenue at the company grew and spending on their products had increased modestly. But rising prices were obscured by consumers purchasing lower quality products. Not only are consumers avoiding the beef and pork that they otherwise may have preferred, but they are opting out of the convenience of prepared foods. This behavior is symptomatic of diminished consumer purchasing power. This is known as getting poorer.
The trend corresponds with the steady increase in the share of income that Americans devote to food and energy. According to the Bureau of Economic Analysis data, in 2002 Americans spent about 17.8% of income on food and energy. In the first quarter of 2013 the share had risen by a factor of 20% to 21.3% of income. Increased share of spending on necessities like food and energy is consistent with falling living standards. In the poorest countries almost all of income is devoted to such things.
This week we also learned the seemingly positive news that the March trade deficit narrowed to $38.8 billion. But the reduction didn't come from increased exports (which actually declined), but by the sharpest drop in imports since February 2009. Oil imports declined to a seventeen-year low, in part due to rising domestic production, but also due to a record low in 13 years in gasoline consumption. While some may argue that is a function of greater energy efficiency, I believe it's more likely that usage is down because of high prices and high unemployment. Even more significant is that our trade deficit with China in March dropped by a whopping 23.6%, hitting a three-year low. On a year over year basis, the decline in our deficit with China was 90% attributable to the decline in imports.
In contrast to the declining import figures, the government reported that personal spending rose by .2% in March. If we are buying less stuff from abroad, where are Americans spending the extra money? If the prices are stable, and imports are way down, consumer spending should also be down and savings should be up. But the savings rate in March held steady at a meager 2.7%. The sad truth is that Americans are buying fewer Chinese products because they are spending more money on food, rent, utilities, healthcare, insurance, and other necessities that can't be imported. Again, this is consistent with a falling standard of living, as inflation forces consumers to forgo the things they want in order to buy the things that they need.
It was also announced this week that the big three airlines (United, Delta, and American) will be raising their "change fees" for booked tickets by 33%, from $150 to $200. However, it's unlikely that such a hike will make much of an impact on CPI. According to the CPI, airline fares in the United States increased only .3% from 2011 to 2012. This mild increase came at a time when airlines were rolling out more new fees than most air travelers could have possibly imagined.
But even if the government fully factored in the increase in fees, they would likely ignore the change in behavior that the increase would elicit. With the cost of changing a ticket so dramatically higher than it has been in the past, it is likely that far fewer Americans would be willing to change their travel plans once their tickets have been purchased. So even while the spending increase may be relatively small, the lost convenience is not factored into the equation. A ticket with low price (or no price) change option is a much better product than a ticket with high penalties.
CPI reports that from 2007 to 2012 air travel increased on average 4% per year. But that's only half the story. A new study released by MIT reports that during those five years, U.S. airlines cut the number of domestic flights by 14%,with the cuts falling most heavily on mid-sized regional airports. By 2012, the industry also closed more than 20 smaller airports, began using a higher percentage of larger airplanes, and reported record crowding on remaining flights. In other words, air travel not only became more expensive but less convenient and more crowded.
How much loss in value does this inconvenience and lack of flexibility create? It's hard to say, but we all have experienced it with varying degrees of frustration. But what is sure is that the government isn't interested in such trivialities.
The combination of these symptoms suggests that the extent to which people are being impoverished by accelerating inflation is not reflected in official government measurements. This explains why unemployment remains high even as GDP appears to rise. It is my belief that the unprecedented expansion of the money supply under the current Fed leadership is pushing up prices for stocks, bonds, real estate, and consumer goods. Market indices neatly capture the price increases for all of these categories except for the latter, which has been concealed by an overly adjusted CPI.
If consumer inflation data were reported more accurately, it would be revealed that much of the apparent growth is an illusion. The patient is getting sicker, but the doctors are too distracted to notice.
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
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Now that President Obama has been re-elected, the media is finally free to focus on something besides the clueless undecided voters in Ohio, Florida, and Colorado. The brightest and shiniest object that has attracted its attention is the "fiscal cliff" that we are expected to drive over at the end of the year unless Congress and the President can agree to turn the wheel or apply the brakes.
Fresh from his victory, the President took time today to let the nation know how he proposes to avoid the cliff: to raise taxes on those Americans who make more than $250,000 per year. He made clear than no one making less than that will be asked to pay any more. The two percent of taxpayers that the President is targeting earn 24.1% of all income and pay 43.6% (as of 2008) of all personal federal income taxes. Sounds like a fair share to me. But the four or five percent tax increases on those earners that are being proposed would only yield around $30 to $40 billion per year in added revenue, a drop in the federal bucket. Even if they were to double the amount that they pay our deficit would only be cut by about one third (even if those increases did not trigger an economic slowdown).
So what exactly is this looming menace, and why is it so dangerous? Stripped of its rhetorically charged language the fiscal cliff is simply a legal trigger that will trim the deficit in 2013 by automatically implementing spending cuts and tax increases. In other words, the government will spend less, and more of what it does spend will be paid for with taxes rather than debt. Isn't this exactly what both parties, and the public, more or less want? The fiscal cliff means that the federal budget deficit will be immediately cut in half, shrinking to approximately $641 billion in 2013 from the approximately $1.1 trillion in 2012. What is so terrible about that? I would argue that there is a greater danger in avoiding the cliff than driving over it.
If you recall, the cliff was created by a deal last year when Congress couldn't find ways to trim the deficit in exchange for raising the debt ceiling. When they failed to reach an agreement, Congress knew they had to raise the debt ceiling anyway. The resulting Budget Control Act of 2011, signed in August of that year, offered the pretense that they were dealing with our long-term fiscal crisis and not simply raising the debt ceiling with no strings attached. This was done not only to appease some House Republicans, who had threatened to vote against a debt ceiling increase, but to satisfy the bond rating agencies that had threatened a down-grade if Congress failed to act.
Now the focus turns to how Congress will dismantle the structure it created just 16 months ago. There can be little doubt that they will as economists are assuring politicians that driving over the fiscal cliff will immediately bring on a recession. The expiration of the Bush era tax cuts for all taxpayers will cost Americans an estimated $423 billion in 2013 alone. Hundreds of billions of across the board spending cuts, including the military, have been delineated. No politician would allow that to happen.
It is amazing that members of Congress can keep a straight face as they claim to want to address our long-term deficit problem while simultaneously working to avoid any substantive action. No doubt an agreement will be reached that will replace the looming fiscal cliff with another one farther down the road (which they can easily dismantle before we actually reach the precipice). Will the rating agencies buy this bill of goods a second time? If we lack the political courage to go over this fiscal cliff, why should anyone think we will be able to stomach going over the next one? Especially since each time we delay going over the cliff, we simply increase its future size, making it that much harder to actually go over it.
Many currently believe last year's S&P downgrade resulted from the same congressional dysfunction that resulted in the fiscal cliff agreement. The truth is that the downgrade would probably have been much greater, and more rating agencies would have likely joined S&P in taking action, had it not been for the fiscal cliff agreement. If further downgrades fail to be issued when the lame duck Congress inevitably comes up with another can kicking deal, then the agencies themselves could lose any remaining credibility. In my opinion, the only explanation for inaction by the rating agencies would be for fear of regulatory retaliation by a vindictive U.S government.
I do not think it is a coincidence that while the banks are suffering a regulatory backlash as a result of their perceived culpability for the mortgage crisis, the credit rating agencies have been relatively untouched. But the credit agencies played a key role in catalyzing the mortgage crisis by giving questionable ratings to the mortgage backed securities. My guess is the government simply does not want to open up that can of worms as similar mistakes are being made with respect to the agencies' ratings of government debt.
The truth is that regardless of what you call it, going over the fiscal cliff is not the problem, it is part of the solution. Our leaders should construct a cliff that is actually large enough to restore fiscal balance before a real disaster occurs. That disaster will take the form of a dollar and/or sovereign debt crisis that will make this fiscal cliff look like an ant hill.
If no one seems to care that the Titanic is filling with water, why not drill another hole in it? That seems to be the M.O. of the Bernanke Federal Reserve. After the announcement of QE3 (also dubbed "QE Infinity") created yet another round of media chatter about a recovery, the Fed's Open Market Committee has decided to push infinity a little bit further. The latest move involves the rolling over of long-term Treasuries purchased as part of Operation Twist, thereby more than doubling QE3 to a monthly influx of $85 billion in phony money starting in December. I call it "QE3 Plus" - now with more inflation!
Inflation By Any Other Name
In case you've lost track of all the different ways the Fed has connived to distort the economy, here's a refresher on Operation Twist: the Fed sells Treasury notes with maturity dates of three years or less, and uses the cash to buy long-term Treasury bonds. This "twisting" of its portfolio is supposed to bring down long-term interest rates to make the US economy appear stronger and inflation appear lower than is actually the case.
The Fed claims operation twist is inflation-neutral as the size of its balance sheet remains constant. However, the process continues to send false signals to market participants, who can now borrow more cheaply to fund long-term projects for which there is no legitimate support. I said it last year when Operation Twist was announced, and I'll continue to say it: low interests rates are part of the problem, not the solution.
Interventions Are Never Neutral
Just as the Fed used its interest-rate-fixing power to make dot-coms and then housing appear to be viable long-term investments, they are now using QE3 Plus to conceal the fiscal cliff facing the US government in the near future.
As the Fed extends the average maturity of its portfolio, it is locking in the inflation created in the wake of the '08 credit crisis. Back then, we were promised that the Fed would unwind this new cash infusion when the time was right. Longer maturities lower the quality and liquidity of the Fed's balance sheet, making the promised "soft landing" that much harder to achieve.
The Fed cannot keep printing indefinitely without consumer prices going wild. In many ways, this has already begun. Take a look at the gas pump or the cost of a hamburger. If the Fed ever hopes to control these prices, the day will inevitably come when the Fed needs to sell its portfolio of long-term bonds. While short-term paper can be easily sold or even allowed to mature even in tough economic conditions, long-term bonds will have to be sold at a steep discount, which will have devastating effects across the yield curve.
It won't be an even trade of slightly lower interest rates now for slightly higher rates in the future. Meanwhile, in the intervening time, the government and private sectors will have made a bunch of additional wasteful spending. When are Bernanke & Co. going to decide is the right time to prove that the United States is fundamentally insolvent? Clearly this plan lays down an even stronger incentive to continue suppressing interest rates until a mega-crisis forces their hands.
Also, when interest rates rise - the increase made even sharper by the Fed's selling - the Fed will incur huge losses on its portfolio, which, thanks to a new federal law, will become a direct obligation of the US Treasury, i.e. you, the taxpayer!
Of course, the Fed refuses to accept this reality. Even though a painful correction is necessary, nobody in power wants it to happen while they're in the driver's seat. So Bernanke will stick with his well-rehearsed lines: the money will flow until there is "substantial improvement" in unemployment.
Does Bernanke Even Believe It?
Even Bernanke must have a hunch that there isn't going to be any "substantial improvement" in the near term. I suggested before QE3 was announced that a new round of stimulus might be Bernanke's way of securing his job, but recent speculation is that he may step down when his current term as Fed Chairman expires. Perhaps he is cleverer than I thought. He'll be leaving a brick on the accelerator of an economy careening towards a fiscal cliff, and bailing before it goes over the edge. Whoever takes his place will have to pick up the pieces and accept the blame for the crisis that Bernanke and his predecessor inflamed.
Don't Gamble Your Savings on Politics
For investors looking to find a safe haven for their money, QE3 Plus is a strong signal that the price of gold and silver are a long way from their peaks. Gold hit an eleven-month high at the beginning of October after the announcement of QE3, but the response to the Fed's latest meeting was lackluster. When the Fed officially announces its commitment to QE3 Plus in December, I wouldn't be surprised to see a much bigger rally. For that matter, many are keeping an eye on the election outcome before making a move on precious metals.
However, seasoned readers of my commentary know that short-term trends are not a good reason to invest in physical precious metals. QE3 Plus can only boost the confidence of anyone intent on the long-term protection of wealth through hard assets. No matter who takes office in January, Helicopter Ben Bernanke will continue on the path of dollar devaluation until there is a flight of confidence from the dollar.
25 years ago, on another Monday in late October, the financial world seemed to disintegrate in a heartbeat. Though the 205 point drop in the Dow last Friday (the technical anniversary of the '87 Crash) was somewhat reminiscent of its 108-point drop on Friday, October 16, 1987, the real action in '87 was on the Monday that followed. And while this Monday is not nearly as black, it is important that we use the opportunity to recall the circumstances that nearly sent the stock market into cardiac arrest.
While there were technical reasons that allowed the snowball to gather so much mass, it was major economic problems that started it rolling. Those issues remain to this day, but have grown much, much larger. But while they terrified the market 25 years ago, they don't rate a second look today. Whether investors have gotten wise, or merely oblivious, is the question we should be asking.
Though most simply remember the 1987 Crash as one panicked selling day, Black Monday was just the largest drop in a string of bad days. On the Wednesday before, the Dow sold off 95 points (then a record) and dropped another 58 points on the Thursday. On Friday the selling got worse, with the Dow setting another record with a 108 point drop. After thinking about it over the weekend, investors decided to preserve what remained of their gains by selling on Monday. Unfortunately, everyone got the same idea at the same time.
It is true that the Crash was in some ways a technical phenomenon. As of August of 1987,stocks had surged 75% from January 1986, and 40% from January 1987. After such an upswing, it was inevitable that investors were on edge. Rather than taking profits, many on Wall Street instead hedged their positions using the new, and largely untested, trading programs that were designed to put a floor under losses if the markets turned south. But when the selling came in waves, the machines went into overdrive. Selling begat selling and an automated rout ensued. When the dust settled, the Dow was down 22% in a single day.
If that was all there was to the story, we would be left with a neat cautionary tale about the folly of placing too much faith in machines. But that is a distracting sideshow. In truth, the market was spooked by concerns over international trade and government debt, which then became known as the "twin deficits." After widening earlier in the 80's, investors had hoped that these gaps would come under control. But as Ronald Reagan's second term wore on, those hopes faded.
From 1982 to 1986, the U.S. trade deficit had expanded 475%from $24 billion to $138 billion. Most economists blamed the trend on the dollar gains in the early 1980's, which had apparently made U.S. products uncompetitive. As it was assumed that a weakened dollar would solve the problem, in 1985 the leading western democracies and Japan announced the Plaza Accords to systematically push down the dollar against the Japanese yen and the Deutsche mark. By 1987, the plan had "succeeded" devaluing the dollar 51% against the yen. But by the second half of that year it became apparent that the Plaza Accord had failed in its real mission to cut down on the U.S. trade deficit. Despite the plunging dollar, the deficit expanded that year by another 10% to $152 billion.
At around that time, the U.S. government budget deficits also became a major concern. Everyone remembers Ronald Reagan as a small government champion, but many conveniently forget that he presided over a significant expansion in government spending. Federal deficits rose 199% from 1980 ($74 billion) to 1986 ($221 billion). Although the deficit came down to $150 billion in 1987, many were frustrated that it remained stubbornly high by historic standards.
As early as August of 1987, concern over the twin deficits, which together accounted for 6.4% of the nation's $4.76 trillion GDP became critical. Given the prior run up in stocks, this was enough to convince many investors to head towards the exits. Before Black Monday (October 19), the Dow had already declined 18% from its August peak.
When we look back at those events from the current perspective, it almost seems comical. Government deficits now approach $1.5 trillion annually and annual trade deficits exceed $500 billion. Today's twin deficits now add up to more than 13% of current GDP (twice the level of 1987). But today's investors are largely untroubled. Oftentimes news of a falling dollar and wider deficits will spark a stock rally, and the issues barely rate a mention in a presidential debate.
Are investors today simply more sophisticated than they were then? Have they lost an irrational fear of deficits? To the contrary, I believe that we have arrived at a point where money printing and government stimulus has replaced manufacturing and private sector productivity as the foundation of our economy (see my lead commentary in the October 2012 edition of the Euro Pacific Global Investor Newsletter for more on this). As a result, most investors are now blind to the dangers of deficits. But that does not mean that they don't exist.
When America's creditors wake up, particularly those foreign governments now shouldering the lion's share of the burden, concerns over our twin deficits will return with a vengeance. As the problems now loom larger than ever, so too will the economic and market implications when the issues come to a head. Interest rates will surge and the dollar will fall. But the U.S. economy is not nearly as well equipped as in 1987 to withstand the stresses. Given the relative size of our imbalances, the manner in which they are being financed, and the diminished state of our manufacturing sector, higher interest rates and a weaker dollar will exact a much greater toll.
Despite this, I do not believe that the stock market is as vulnerable to another Black Monday. With the Federal Reserve so committed to its current course of quantitative easing, it seems to me unlikely that they will allow such a steep one-day drop. Also, with bond yields so low, domestic investors are currently presented with fewer attractive options. If anything, the next Black Monday is more likely to occur in the currency and/or bond markets, with safe haven flows moving into gold not treasuries.
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
Journalists, politicians and economists all seem to agree that the biggest economic issue currently worrying voters is unemployment. It follows then that most believe that the deciding factor in the presidential race will be the ability of each candidate to convince the public that his policies will create jobs. It seems that everyone got this memo...except the voters.
According to the results of a Fox News poll released last week (a random telephone sample of more than 1,200 registered voters), 41% identified "inflation" as "the biggest economic problem they faced." This is nearly double the 24% that named "unemployment" as their chief concern. For further comparison, 19% identified "taxes" and 7% "the housing market" as their primary concern. A full 44% of women, who often do more of the household shopping and would therefore be more sensitive to prices changes, identified rising prices as their primary concern.
While these statistics do not surprise me, they should shock the hell out of the establishment. According to the Federal Reserve, inflation is not a concern at all. Time after time, in front of Congress and the press, Fed Chairman Ben Bernanke has said that inflation is contained and that it is below the Fed's "mandated" rate of inflation (whatever that may be.) The Bureau of Labor Statistics is saying the same thing. The measures they use to monitor inflation, such as the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE), show annual inflation well below 2%. In fact, the GDP price deflator used by the Commerce Department to calculate the second quarter's 1.3% annual growth rate assumed annual inflation was running at just 1.6%.
In fact, Bernanke thinks inflation is so low that he is actually worried about deflation, which he believes is a more dangerous issue. As a result, he is recommending policies that look to raise the inflation rate, not just to combat the phantom menace of deflation but to boost the housing market and reduce unemployment. He mistakenly believes these problems are the ones that concern Americans the most.
If inflation really is as subdued as the government claims, how is it that so many people are concerned? It's not as if the media or political candidates are fanning the fears of rising prices. In fact, given the media's preoccupation with the housing market, the fact that nearly seven times as many Americans worry more about rising food prices than falling home prices shows just how large the inflation problem must be. Yet most economic observers continue to swallow the government's inflation propaganda hook, line and sinker. In fact, although the Fox poll came out last week, I did not read or hear a single story on this topic, even from Fox news itself, which appears to not have noticed the significance of its own data.
For years my critics have always attempted to discredit my inflation fears by pointing to government statistics showing low rates. However, I have long maintained that such statistics under-report inflation, and the results of this poll seem to confirm my suspicion. There are only two possible ways to explain the disconnect. Either the government is correct and consumers are worried about a non-existent problem, or the consumers' concerns are real and the government's statistics are not. From my perspective, it seems that it is far more likely that consumers are in the right. If so, we are in a lot of trouble.
If annual inflation is actually higher than 3%, which would certainly be the case if consumers are so worried about it, then we are already in recession. Had government used a 3% inflation deflator (rather than the 1.6% that they actually used) to calculate 2nd quarter GDP, then growth would have been reported at negative .1% rather than the positive 1.3%. I believe that if the government used more accurate inflation data over the past several years, it is possible that we would have seen no statistical recovery from the recession that began in the fourth quarter of 2007. This would help explain why the "recovery" has failed to create jobs or lift personal incomes.
The Fed's zero percent interest rate policy is predicated on the assumption that there is currently no inflation. If this is not accurate, then they are making a major policy mistake. The Fed is easing when it should be tightening. If inflation is such a major concern now, imagine how much bigger the problem will become once the Fed achieves its goal of pushing the rate higher. More importantly, how much tighter will future monetary policy have to be to put the inflation genie back in her bottle? If inflation becomes so virulent before the Fed realizes its mistake, then it may be forced to raise interest rates significantly. U.S. national debt is projected to reach $20 trillion within a few years. As a result, a 10% interest rate (which would be needed to combat 1970's style inflation) will require the U.S. government to pay about $2 trillion per year in interest on the national debt. This will absolutely upend all economic projections.
Since 10% interest rates will likely crush the economy, not to mention the banks and the real estate market, tax revenues will plunge and non-interest government expenditures will go through the roof. Assuming we try to borrow the difference, annual budget deficits could go much, much higher from the already ridiculously high levels that they have reached during President Obama's term. Annual deficits of $2 trillion, $3 trillion, or even $4 trillion, would result in a sovereign debt crisis that would force the Federal Government to either default on its obligations or inflate them away. Given the tendency for politicians to prefer the latter, voters who think rising prices are a problem now should just wait until they see what is waiting down the road!
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
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For much of the past few generations, the debate over balancing the federal budget has been a central feature of every presidential campaign. But over time, the goalposts have moved. As the amount of red ink has grown steadily larger, the suggested time frames to restore balance have gotten increasingly longer, while the suggested cuts in government spending have gotten increasingly shallower. In recent years, talk of balancing the budget gave way to vague promises such as "cutting the deficit in half in five years." In the current campaign, however, it appears as if the goalposts have been moved so far that they are no longer in the field of play. I would argue that they are completely out of the stadium.
It says a great deal about where we are that the symbolic budget plan proposed last year by Congressman Paul Ryan, the newly minted vice presidential nominee, has created such outrage among democrats and caution among republicans. The Obama campaign warns that the Ryan budget is a recipe for national disaster that will pad the coffers of the wealthy while damning the majority of Americans to perpetual poverty. The plan is apparently so radical that even the Romney campaign, while embracing the messenger, is distancing itself from the message (it appears that Romney wants to bathe himself in the aura of fresh thinking without actually offering any fresh thoughts). In interview after interview, both Romney and Ryan refuse to discuss the details of Ryan's budget while slamming Obama for his callous "cuts" in Medicare spending.
(It is extremely disheartening that the top point of contention in the campaign this week is each candidate's assertion that their presidency could be the most trusted not to cut Medicare. Mindful of vulnerabilities among swing state retirees, Republicans have also taken Social Security cuts off the table as well. What hope do we have of reigning in government spending when even supposedly conservative Republicans refuse to consider cuts in the largest and fastest growing federal programs?)
So what was the Ryan Budget's radical departure from the status quo that has caused such uproar? If enacted today, the Ryan budget would so drastically upend the fiscal picture that the U.S. federal budget would come into balance in just... wait for it.... 27 years! This is because the Ryan budget doesn't actually cut anything. At no point in Ryan's decades long budget timeline does he ever suggest that the government spend less than it had the year before. He doesn't touch a penny in current Social Security or Medicare outlays, nor in the bloated defense budget. His apocalypse inducing departure comes from trying to limit the rate of increase in federal spending to "just" 3.1% annually. This is below the 4.3% rate of increase that is currently baked into the budget, and farther below what we would likely see if Obama's priorities were adopted.
Because there are no actual cuts in his budget, Ryan hopes that fiscal balance can be restored by 2040 only because he assumes that we achieve returns to the annual economic growth that are equal to levels averaged for much of the last century. In other words, he sees slow growth of the last four years as the aberration, not the new normal. As with all other government projections, this is on the extreme optimistic end of the spectrum. In truth, there is nothing on the horizon that should make anyone think these growth figures will be achieved. America's crushing debt, burdensome regulations, political paralysis, and nagging demographic problems bode poorly for the return to trend line growth anytime soon. More likely, based on the speed towhich republicans will shrink from popular backlash, is that the "cuts" that Ryan proposes will be abandoned as soon as they prove to be politically unpopular.
In fact, among his other overly-optimistic assumptions are that the unemployment rate falls to 4% by 2015 and an unprecedented 2.8% by 2021, another real estate boom begins almost immediately, and there is an average inflation and ten-year treasury rate for the next ten years of 2.04 and 4.15 respectively. These are assumptions that would make even the most rabid economic cheerleaders sit on their pompoms. Despite these pollyannish economic growth and record low unemployment projections, Ryan still assumes interest rates will remain near historic lows and that none of the cheap money showered onto the economy will ever find its way into the CPI. In other words, it's the economic equivalent of winning the lottery twice in a row while failing to account for the higher taxes that accompany such good fortune.
Like all other government forecasters, Ryan never considers how rising interest costs on the many trillions of dollars of outstanding government debt holdthe potential to completely upend budget projections. For more on this, see my recent commentary "The Real Fiscal Cliff."
More likely, the continued accumulation of unsustainable levels of debt under the Ryan plan will eventually cause our creditors to lose confidence in our ability to repay. It will cause interest to spike, the economy to tank, unemployment to soar, spending to rise, revenues to decline, and the budget deficit to spiral out of control. Rising interest rates hold the potential to spark a sovereign debt and currency crisis that willrender the entire plan irrelevant anyway.
While I appreciate that Ryan has the courage to take a position at the vanguard of his party in the campaign for fiscal responsibility, the modesty of his plan is just the latest reminder of how utterly divorced from reality Washington politicians remain. Like all of his brethren, Ryan is pinning his budget battling plans on the pain free "grow your way out of it plan." But as long the government consumes so much of the nation's productivity, the conditions to create that growth will never occur. Hope is not a strategy.
The past week provided clear lessons not just in how central bankers have a limited ability to positively influence the economy but also how they are limited in their capacity to deliver the shortsighted policy actions that investors currently crave. The developments should provide new reasons for investors and economy watchers to abandon their faith in central bankers as super heroes capable of saving the economy.
The employment report released on Friday confirmed that the U.S. economy is stagnating at best and actively deteriorating at worst. While the numbers of jobs created in July was actually better than many economists expected, it was still far below the levels that would indicate a growing economy. But more important than the official unemployment rate (which ticked up to 8.3%) or the number of jobs created, is the number of people who have left the workforce out of frustration or despair. This number continues to head higher. The labor force participation rate, which is the percentage of healthy working age Americans who actually have jobs, is at one of the lowest points since women first started working en masse in the 1970's. It's also instructive to add back into the unemployment rate those who want full time jobs but who have had to settle for part time work. This figure, reported under the "U6" category, currently stands at 15.0%. This is just a 12% decline from the 17.1% high seen December 2009. In contrast the "official" (U3) unemployment figure has declined 17% from its peak.
In explaining these bad results, most economists simply look at the stimulating effects of monetary and fiscal policy, not at the problems that those measures create. As a result, it is assumed that not enough stimulation, in the form of quantitative easing or federal deficit spending has been applied to the economy. The next logical assumption is that if the measures of the past few years had not been applied, we would have seen much weaker results over that time. In other words, no matter how bad things are now, defenders of the status quo will always describe how bad things "could have been" if the Fed hadn't stepped in. This counterfactual argument gets increasingly threadbare as the years wear on.
Rather than admit that its policies have failed, the Fed statement last week gave all indications that it will continue with its current inflationary policy to the bitter end. These are the same errors that inflated the stock and real estate bubbles and ultimately resulted in the 2008 financial crisis and our continuing economic malaise. Without any fresh ideas, Fed press releases have become a Groundhog Day repetition of the same pronouncements and diagnoses. Oddly, many market watchers are frustrated that the Fed has not telegraphed that more stimulus is forthcoming. While it should be obvious that our current "recovery" is dependent on monetary support, it should be equally plain that the Fed can't actually admit that fragility without spooking markets. To be clear, QE III is coming, but the markets should not expect Bernanke to supply a precise timetable.
Without question, if the Fed had not stimulated the economy with zero percent interest rates, two rounds of quantitative easing and operation twist, the initial economic contraction would have been sharper. But such short-term pain would have been constructive. By not taking away the cheap-money punch bowl, the Fed has delayed the pain and prolonged the party. But to what end? So far all we have received is a tepid phony recovery that has sown the seeds of its own destruction.
In contrast, real economic restructuring would have resulted if the Fed had withdrawn its monetary props. This would have paved the way for a robust, sustainable recovery. Instead, the Fed helped numb the pain with unprecedented (and apparently permanent) liquidity injections. Its actions merely exacerbate the underlying imbalances that lie at the root of our structural problems, and thus act as a barrier to a real recovery. So long as the Fed fails to learn from its prior mistakes, the phony recovery it has concocted will continue to fade until we find ourselves in an even deeper recession than the one we experienced in 2008.
Those who believe that artificially low interest rates are needed now, fail to see the price that will be paid down the road. By keeping rates too low, the Fed continues to lead an overly indebted economy deeper into the financial abyss. However, its ability to maintain rates at such low levels is not without limits. Just as real estate prices could not stay high forever, interest rates cannot stay low forever. When rates finally rise, the extent of the economic damage will finally be revealed.
The sad fact is that no matter how impotent and dishonest Fed officials become, their elected rivals on Capitol Hill (who control the fiscal side of the equation) have become even less significant. The complete lack of any political conviction to take steps to confront our fiscal imbalances means that Ben Bernanke and his cohorts are seen as the only cavalry capable of riding to the rescue. But no matter how often they blow their bugles, our economy will continue to deteriorate until we stop waiting for a savior and instead fight the battle for prosperity ourselves.
Many people became convinced that data releases earlier this year indicated that "recovery" in the U.S. was imminent. But as I have been saying for months, this evidence would ultimately be shown to be as reliable as sightings of Bigfoot. Lots of people claim to say they have seen it, some even produce plaster footprints, but in the end all we have is a guy in an ape suit. The economic recovery, that has been discussed so loudly and often in recent months, will be shown to be similarly mythical.
A torrent of recent economic data now reveals weakness, and investors are beginning to take notice. Today's release of the May jobs report showed a paltry 69,000 jobs created during the month, far below consensus estimates. Not only did the current month disappoint, but the June numbers were also revised down by 49,000. This release follows yesterday's downward revisions of first quarter GDP growth from 2.2% to 1.9%. Also lost in the headlines was that the savings rate dropped to 3.4% in April, the lowest rate since December 2007. This shows that Americans may need to deplete their already meager savings just to keep their heads above water as the U.S. economy sinks back into recession.
The bad news sent stocks swooning. The latest sell off brings the S&P 500 down close to 10% from its levels in early April. On the other hand, bonds have reached record highs as investors seek safety in treasuries. However, I believe that treasuries will turn out to be the Facebook of safe havens. Before Facebook went public everyone wanted a piece of the action. But once the allure wore off, and people realized they owned shares of an overhyped company with unreliable earnings and a sky high valuation, the shares quickly lost a good deal of their appeal. Despite the best efforts of the media to declare the end of gold's appeal, the metal continues to shine. Today's reportalso sent gold up nearly 4 per cent. Gold is now down just 3 per cent from May 1, a period that has been horrific for other asset classes.
Oil prices continue to slide as traders brace for a fall-off in global demand that will come from the return of a global recession. What these traders fail to understand is that the recession will likely be resisted by central banks around the world with massive money printing. Such action will be much more likely to push oil prices back up to levels higher than those seen before the recent downturn. Yes recession means consumers will use a lot less oil, but inflation created by the central banks means that they will likely pay a lot more to purchase it.
In recent months as turmoil bubbled across the debt markets of Europe, the United States had beckoned as a safe haven. But in truth, the problems are as bad, if not worse, on this side of the Atlantic. Ironically, America has not had to deal with its day of reckoning because lesser problems surfaced first in Europe. But when Europe comes to some modest resolution of its problems, or when bond investors realize they have jumped from the frying pan into the fire, there will be no hiding from the unresolved problems here.
As the intoxicating effects of Fed stimulus wear off, the hangover is setting in. To delay the pain, I believe that there can be little doubt that the Fed will unleash its next round of stimulus, in the form of QE3. My guess is the Fed has always known more QE was needed but it has been waiting for the most politically palatable time to announce it. That "stunner" can't be far off with the data so bad and the elections so near.
Eventually more people will figure out just how precarious America's fiscal position truly remains. That's when interest rates will finally rise in the U.S. There is no way to justify record low interest rates in this country given our atrocious fiscal position. I believe interest rates here should approach levels comparable to the more indebted European countries. Once it becomes obvious just how many dollars the Fed is prepared to print to stave off recession, people running into treasuries today will likely suffer buyer's remorse. When they rethink their assumptions, as buyers of the Facebook IPO clearly have, the Fed will then become not just the buyer of last resort, but the buyer of only resort. Then the Real Crash may finally be upon us.
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Paul Krugman sounded the war cry this Sunday on Fareed Zakaria's program Global Public Square. After all, he asserted, only spending equivalent to another World War could lead us back to prosperity. That, and a healthy dose of inflation.
Krugman argued that inflation would address our debt problem by reducing our bill in current dollar terms and that the Second World War was a giant stimulus plan that actually worked. Thankfully, he added the refrain, "Hopefully we don't need a world war to get there," but I sensed a tinge of regret in his voice. After all, the Keynesian economist's favorite pastime is seeing people waste their lives digging holes in the ground or sacrifice their lives in war. Both acts create economic growth according to the topsy-turvy logic of men like Krugman.
The truth is that wars are a miserable misallocation of capital and usually leave financial ruin in their wake. The US did not boom in the '50s because we fought World War II, but because we resoundingly won. It was the byproduct of having an unscathed manufacturing base, solid infrastructure, an intact military, most of the world's gold, and the only reserve currency.
The logical implication of Krugman's arguments remains that working in productive employment is not at all necessary. If this is true, why not have people just save gas and stay home? The government could simply borrow and/or print money and send it to foreign countries that are dumb enough to produce goods and services for US consumption. Christina Romer, former Chair to Obama's Council of Economic Advisors, also sided with Krugman in a commentary posted in Sunday's New York Times finance section. In it, she pontificated on the lessons to be learned from the Great Depression, saying: "It would be a mistake to respond by reducing the deficit more sharply in the near-term. That would almost surely condemn us to a repeat of the 1937 downturn." This misdirection demonstrates her lack of understanding of what causes economic depressions in the first place.
The cause of the Great Depression in the 1930s and the Great Recession beginning in December 2007 were one and the same - an over-leveraged economy. Easy money provided by the banking system eventually brings debt in the economy to an unsustainable level. At that point, the only real and viable solution is for the public and private sectors to undergo a protracted period of deleveraging. The ensuing depression is, in actuality, the healing process at work, and is marked by the selling of assets and the paying down of debt. Unfortunately, our politicians today are focused on fighting the natural healing process of deleveraging by promoting the accumulation of even more debt.
During this latest economic contraction, the Federal Reserve has taken interest rates to near 0% for the past 2 ¾ years, and it has just promised to keep them there for an additional 2 years! Meanwhile, the Obama administration is leveraging up the public sector to record levels in an effort to re-leverage the private sector. The government's philosophy is tantamount to sticking a frostbitten man in the freezer so he won't have to suffer the pain associated with the thawing of his extremities.
During the Great Depression, real GDP plummeted 32%. The Great Recession, through which we are still struggling, began in December 2007, according to the National Bureau of Economic Research. But, in contrast to the 1930s, GDP during this recession shrank only 3.6% from the fourth quarter of 2007 through its low point in the second quarter of 2009.
The contraction in GDP during the Great Depression was the direct result of consumers paying down debt and selling off assets. Household debt as a percentage of GDP reached nearly 100% in 1929. To put that number in perspective, household debt did not go back above 50% of GDP until 1985. And it was not until the first quarter of 2009 that household debt once again approached the 1929 level.
Between the start of the Great Depression and the end of World War II, household debt fell from 100% to just above 20% of GDP. Getting there was a painful process, but such de-leveraging was the only real cure for an economy swimming in debt. Thanks to government efforts to carry on our debt-fueled consumption binge, during today's Great Recession, household debt has barely contracted at all - it has only been reduced to 90% of GDP as of Q1 '11.
To make matters even worse, during this current crisis our government's response has been to dramatically increase its own borrowing. At the start of the Great Depression, gross national debt was 16% of GDP. It peaked just below 44% when the Depression ended. While the national debt did increase significantly during that period, it was still relatively benign compared to other Western governments. The US entered this current Great Recession with gross national debt equal to 65% of GDP. It has since exploded to 98% of GDP!
US federal debt did rise dramatically during World War II, topping out at 120% of GDP in 1946. But consumer debt plunged concurrently. So, while Washington was adding debt to fight and win a global war, households were taking the necessary steps to ensure their balance sheets were well prepared for the aftermath of the battle.
Today, for the first time in our history, gross national debt and household debt are both at least 90% of GDP.
Mr. Krugman and his allies believe that we can grow our way out of this recession like we have in the past few. Unfortunately, we're dealing with a completely different animal. In every past recession, the government, under the guidance of Keynesians, decided to put off deleveraging in return for artificial growth. Well, that tab has come due.
Since these economists keep trying to spend like it's World War III, we are moving inexorably closer to causing Great Depression II. If policymakers and mainstream economists fail to understand that the progenitor of a depression is debt, they will also be unable to provide a genuine solution. Instead, by pushing public debt past the point of our creditors' willingness to lend, they may ensure that this next Great Depression will be accompanied by runaway inflation. If history is any guide, this is a truly lethal combination.
The reliance upon the U.S. dollar as the world's reserve currency and "safe haven" asset has created a perverse, but deeply entrenched, mindset among global investors. In fact, many believe the major financial players have no alternatives to owning U.S. debt and dollars. They argue that the market for U.S. dollars and Treasuries is the only financial pool large enough to handle the massive liquidity that sloshes around the globe on a daily basis. This idea makes a mass exodus from U.S. debt holdings seem impossible. This provides a nice explanation why the U.S. Treasury bonds can rally even while the government openly flirts with default and ratings agencies issue downgrades. But just because an illogical event occurs habitually does not mean it is logical or tenable.
The sophomoric reasoning behind the dollar "exceptionalism" argument is like assuming a stock can never fall unless a significant portion of shareholders decide to sell. In reality, a buyers strike is all that is needed to puncture a market. If the U.S. experienced just one disastrous Treasury auction, prices could nose-dive and yields could skyrocket across the board on all U.S. debt.
But the problem doesn't just lie with the United States. Investors around the world are finally beginning to understand that central bank's thirst for creating inflation, in order to keep their banks and governments solvent, will never be quenched.
This week, the Swiss government took action to weaken the surging franc by lowering interest rates and printing currency. The franc was pushed down briefly, but then snapped back. It's hard to keep a good currency down. Similarly, the Bank of Japan announced that it won't stand for Yen appreciation much longer and would likely soon intervene to buy dollars and weaken the Yen.
Meanwhile, problems at the overly indebted countries just get worse. Italian and Spanish debt yields are now following the upward spiral of Greek bonds (and hitting multi year highs). Italian ten-year notes have surged from just above 3% in late 2010 to well over 6% today. For a country whose debt to GDP ratio is currently over 120%, a doubling of interest rate expenses spells disaster.
Enter Jean Claude Trichet who will certainly use his printing press to buy much of the weakening Italian debt that is now festering on the balance sheets of the biggest European banks. But the size of the bailouts needed to deal with Italian and Spanish debts will be several orders of magnitude greater than those needed for Ireland or Greece. Anticipating a massive increase in the Euro money supply, investors are flocking to gold to protect themselves from currency debasement.
Adding fuel to the gold fire is the recent debt deal reached in Washington. The disgusting agreement virtually assures that over the next decade the U.S. will add an additional $8 trillion in public debt, an increase of nearly 80% in ten years! The back-end-loaded deal will cause the amount of deficit reduction to be just $21 billion in 2012 and $42 billion in 2013.
But even this modest debt reduction depends on rosy assumptions from Washington that are always wrong. For example, the Obama administration predicts GDP growth will average well over 3% for the coming decade. But the annualized GDP growth in the first half of 2011 was just 0.9%. That means the actual deficit and debt figures will be far greater than the projections. Given the immediate increase in borrowing needs, and the obvious slowing of the tepid "recovery," there can be little doubt that the next round of quantitative easing will be launched sooner rather than later.
The incompetency of U.S. credit rating agencies has long been suspected. But their actions in the wake of the debt ceiling agreement now confirm them as liars. After threatening to downgrade U.S. credit if Washington failed to cut $4 trillion in spending, neither Moody's, Fitch nor S&P had the courage to carry through, despite the fact that the total cuts would amount to only half their requirements. But a credit rating downgrade on Treasuries did come-from China. The Dagong Global Credit Rating agency cut the credit rating on U.S. sovereign debt to A from A+, 5 notches below AAA. And since the Chinese are the biggest foreign buyer of Treasuries, their opinion counts.
This week, more evidence of U.S. stagflation emerged. The ISM manufacturing and non-manufacturing reports showed a slowdown in new orders and employment and the ADP report showed that the U.S. lost 7,000 goods-producing jobs in July. Other data releases showed that layoffs surged 60% last month to a 16-month high. Meanwhile, YOY consumer prices are up 3.6% and M2 money supply is up 7.5% YOY and rising at a 14.6% annual rate in the last quarter. As the problem with stagflation becomes worse, international investors will avoid the U.S. dollar and U.S. debt at an ever increasing rate.
With soaring debt-to-GDP ratios in Japan, Western Europe and America, the desirability of owning precious metals will grow as investors realize the fiat currency system's days are numbered. Those holding U.S. dollars and U.S. debt will feel the biggest brunt of the change. But it is always darkest before the dawn. As a result of the carnage the re-establishment of gold as the world's reserve currency is, hopefully, only a few years away.
Nothing discussed on the show is an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy. All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns if measured in U.S. Dollars. Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. Investments may increase or decrease in value and you may lose money. International investing may not be suitable for all investors.
