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The emperor has no clothes... What's the problem?... Goodbye yellow brick road... Return to the gold standard?..

Feb. 16, 2009

February 13, 2009

Dear Reader,

It would be unfair to pounce all over Team Obama this early in their administration. After all, while the Democrats bear a lot of responsibility for the knee-deep toxic mess now covering the floor of the engine room, the bulk of the responsibility has to rest on the shrugging shoulders of Obama’s immediate predecessor and those that came before him.

Early though it may be, however, it’s not too early to come right out and say what needs to be said: when it comes to the steps being taken to address the current crisis, the emperor has no clothes.

Both President Obama and Timothy Geithner, the latest recipient of the Goldman Sachs Chair for Managing the Treasury, are on record as saying that the Japanese experiment in quantitative easing didn’t work. They say much the same about FDR’s New Deal. In both instances, they correctly point out that massive doses of government stimulus had no lasting effect.

If the history lesson stopped there, we could all nod our heads in agreement and go about our business.

Alas, the lips of Mssrs. Obama and Geithner keep moving… telling us with great confidence that the reason the fiscal exertions of Japan and FDR failed was only because in each case government didn’t act quick enough, or with enough monetary vigor.

Having thus explained the shortcomings in prior adventures in stimuli, the administration promises that “this time it will be different” and wholeheartedly commits itself to acting decisively, quickly, and with stunning amounts of cash. By doing so, we are told, they will shock the economy back to life.

But this argument simply doesn’t hold water -- there is zero historical precedent for the notion that applying blunt-force government stimulus will somehow mechanically “shock” an economy back into productivity. A couple of bullet points:

When FDR came into power in 1933, unemployment in the U.S. had reached a high of about 25%. Despite tripling federal spending on the much heralded New Deal, the best unemployment number achieved was 14%, in 1937. By 1939, however, unemployment was back up to 19%. Now, there is some nuance in those numbers, because the calculations include some number of people on the payrolls of the New Deal’s many make-work programs. Yet, given the fact those make-work jobs would have come to a quick end if the government had stopped its New Deal spending, the poor results of the FDR stimulus hold up. The experiment was ended by World War II, when the excess work force donned uniforms and were sent overseas, many never to return.
In the Japanese crash, the government spent hundreds of billions supporting banks and businesses, buying U.S. Treasuries in an attempt to keep the yen cheap and so their manufacturing sector at work. As the economic morass dragged on, the government cut interest rates to zero, then eventually accelerated spending in a five-year experiment in “quantitative easing,” which involved funding all manner of public works projects and other targeted infusions of government spending into the economy.

Using the equity market as a proxy for the broader economy, the Nikkei fell from around 38,000 at the height of the bubble in the late 1980s, down to around 7,000. During the five-year period of quantitative easing, 2001 to 2006, the Nikkei rebounded by about 100%, moving back to the 14,000 neighborhood. Importantly, however, the minute the Japanese government stopped the spending, the stock market came tumbling back down to around 7,500, which is where it remains today. Note that at no point did it get anywhere near the bubble high of over 38,000.

In sum, there is hard evidence that there is no permanent benefit to be gained from throwing a lot of money at an economy, though there is one clear negative: a steep ratcheting up in government debt. Of course, because the government doesn’t actually make anything, what we’re really talking about is a steep ratcheting up of your debt… and that of your children… and their children.

So, what’s going on? Don’t you think all the Obama’s horses and all the Obama’s men know this?

Maybe they do.

In earlier editions of this missive, I have commented that President Obama may be the best politician in U.S. history. How else to explain how a virtually unknown black man could, in just a few short years, become president. And do so despite a foreign father and two given names eerily reminiscent of two of the most vilified individuals in the current American ethos? Impossible, most would have said, if asked a few years ago. But here he is… undeniable proof of his political skills.

Not to be cynical, but what if, on surveying the landscape, Obama and his inner circle reviewed the facts and came to the following conclusions about the possible paths they could take in regard to the dismal economy:

Path One

Path Two

I sincerely believe that just this sort of calculation has been made, and not for practical economic reasons – but almost entirely political ones. Supporting that contention, roughly 60% of the spending in the latest stimulus bill is slated for 2011, the year before the next presidential election is held. Coincidence? You decide.

Then there is the $2 billion earmarked for ACORN in that same stimulus bill. While I tend to dismiss the allegations about ACORN’s purported voter fraud as desperate measures on the part of the McCain campaign, what we do know about ACORN is that their primary mission is voter registration, and that they are very friendly to President Obama.

It’s all a big win-win… as in “yes we can” win-win the next presidential election.

In any event, the way the current mess will actually get cleaned up is through the adoption of measures that support, or at least don’t hinder, entrepreneurs running or starting businesses and expanding into new markets. What we have instead is yet another experiment in more government.

The emperor has no clothes.

And there’s one more thing, which most of you already know. The potential wrench in Obama’s well-laid plan is that thanks to its strong export sector, Japan ran a trade surplus throughout its crisis period. By contrast, the U.S. entered the crisis as the world’s largest debtor nation, with historically high trade deficits and a record number of U.S. dollars in the hands of foreign holders. We are talking trillions of dollars, a scale unseen at any prior point in the history of the world.

To the extent that these foreign holders are willing to play ball with Obama, they may not use their dollars in a way that goes against U.S. interests. But, as our own Bud Conrad will explain momentarily, foreign buyers are already slowing their buying of U.S. government paper and are mostly staying away from anything other than the shortest-duration paper when they do buy.

One of these days, however, for reasons all their own, and unknowable at this time, they may decide not to roll over their dollar investments, or to actively dump them… leading quickly to a catastrophic collapse in the dollar (and Obama’s reelection hopes). While it’s a bit dramatic, subscriber and new correspondent Nitin from Nepal sent along a video clip from an old movie many of you may remember. Well worth a view…

http://www.youtube.com/watch?v=iQ-IPb8AOZE&feature=subscription

As an aside, Doug Casey, on viewing that clip, commented that he thought the real life situation the U.S. now finds itself in is even more dire than portrayed in the movie clip. Gee, I hope not.

But there is good news in all of this: if you can anticipate what’s coming, you can get positioned to profit. To that end, we apply the following exercise in Aristotelian logic:

If Obama is an excellent politician, he will almost certainly do whatever it takes to get reelected.

If the best way to get reelected is to keep the economy from collapsing before the next election, and he thinks he can achieve that by applying massive stimulus -- ignoring long-term consequences, because they are not relevant to reelection -- then he will apply that stimulus. (To the extent that this stimulus can be used to improve those reelection prospects, either in timing or patronage, all the better.)

The only way that the stimulus can be paid for is through taxation, borrowing, or simply creating the money out of thin air. As taxation is politically risky, borrowing at current low interest rates becomes difficult, and borrowing at higher interest rates threatens the economy before the elections, creating the money out of thin air becomes the only viable option.

The spending required to try and keep the bubble afloat is massive and therefore must be supported by an expansion in the money supply.

The greater the monetary expansion, the greater the ultimate price inflation.

Recognizing this, individuals and institutions will become increasingly interested in inflation hedges, starting with gold, which is why gold has been so strong and will get stronger still.

Buy gold.

Do you see a flaw in my logic? If so, drop me a note at david@caseyresearch.com.

Meanwhile, Bud Conrad just weighed in on the topic of the stimulus. Here are his comments…

What’s the Problem?

By Bud Conrad, February 2009

Early in 2006, we were talking of the housing bubble and in 2007 discussed the specifics of subprime bankruptcies, seeing the slowing of mortgage equity withdrawal as leading to a severe slowdown. Now everybody sees the mortgage toxic waste that has weakened banks, and unemployment numbers are making headlines.

Politicians say we need to fix these problems:

1. We need to get housing prices up by bailing out Fannie and Freddie and giving guarantees.

2. We need to get banks to lend by giving them bailouts.

3. We need to get more jobs by government spending.

It all sounds sensible, but in my view, these “solutions” miss the real problem. The three items above are the symptoms of collapse; they are not the source of the problem. The source is the imbalance from too much debt. The chart below shows the debt growing much more than GDP.

Debt brings forward future spending by letting consumers have now what they won’t be able to pay for a few years. When debt becomes too extended and borrowers can’t pay back the loans or even the ongoing interest, then the debt bubble bursts and we get the problems above.

But I say that the problem was the overextension of debt, not the collapse. The current period is extremely painful, much like a drug addict in detox – but detox is not the problem, it was the drugs. Similarly, all the fixes above are giving the markets the equivalent of another fix: more debt. It won’t work very well as these fixes add debt rather than manage it down.

The point of view is important. The problems occurred in the 2003–2006 debt bubble. Today it’s time for the solution, but our leaders are trying to apply fixes that are really just extending the problem.

Ed. Note

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Goodbye, Yellow Brick Road

One of the most obvious but generally unremarked-upon aspects of the current financial crisis has to do with expectations.

In the Japanese crisis mentioned above, the Japanese economy, driven by debt, had soared to unsustainable levels (at its peak, the Japanese stock market represented 40% of the value of the world’s equities markets). But then the debt bubble popped and after falling steeply, Japan, Inc. has pretty much flatlined.

In the case of the U.S., the government makes statements to the effect that they will implement new plans that will, in time, return the economy to its recent golden years. Thus we hear all sorts of comments about the need to get banks to lend again and businesses and consumers to borrow and spend again. C’mon, we are all cheered on, let’s put our worries aside and spend, spend, spend!

Encouraged, perhaps, by the sparkling new administration (well, not quite so sparkling, now that it has been dipped in the acid bath of reality…), many Americans hold on to the fantasy that, with just the push of a button or the pull of a lever or two down at the Treasury, the government will soon have us once again optimistically skipping down the yellow brick road.

To which I say, miserly though it may sound, “Get over it, those days are gone forever.”
That is not at all to say that all I see for the future is dark clouds, though that may be the case for the next couple of years.

It is rather to say that the days of stupid credit and the round-the-clock orgy of consumer excess are done. Kaput. Finished. And that the implosion of the excesses created on all levels has dropped the U.S. economy into a deep, smoking crater from which it may take generations to recover.

Consider the U.S. financial sector, which had grown to the point where the revenues it generated represented a huge swath of U.S. GDP – something like 20% at the peak, if memory serves me right. Well, that sector, or what’s left of it, has been hugely discredited. If it does ever return to its former significance, it won’t be in our lifetimes.

And manufacturing? Similar to Japan, which has seen its manufacturing sector shipped out to Taiwan, South Korea, and China, among others – helping to keep it in the doldrums – the U.S. has shipped its manufacturing sector offshore and it’s not coming back (especially with the new, union-friendly administration in power).

In fact, at this point, the only growth industry in the U.S. is government, but they don’t actually produce anything. In time, the fiction that the U.S. government should play the big kahuna in the economy will be discredited, after which U.S. entrepreneurs will accentuate their many positives and the economy will stabilize… but at a level that is much reduced from the recent glory days.

In the meantime, and for as far as the mind’s eye can see, the citizenry will need to downsize their expectations and take measures to live more simply, focusing on enjoying what they have and buying only what they need.

But that’s not all that bad. In the words of Marcus Aurelius, “Remember this – very little is needed to make a happy life.”

Return to a Gold Standard?

If the current crisis morphs – as we expect it to – into a serious monetary crisis, we would expect an increasing number of people to conclude that a fiat money system is a sure loser over time, given that politicians of all stripe and inclination just can’t keep their paws off the money supply.

As the monetary crisis rages, some will also remember that linking the currency to something tangible and relatively hard to come by is about the only sure way of keeping a government from debasing the money supply for political ends. Gold works better than most things for that purpose, if for no other reason than that people in every corner and almost all cultures of the globe (not sure about the Eskimos) have faith in it as money.

It was, therefore, encouraging to read a well-argued editorial in favor of the gold standard by one Judy Shelton in the February 11 edition of the Wall Street Journal. While the entire article is worth reading and passing on to your less-informed friends, here’s a quick excerpt.

Who knows, maybe something good will come out of this crisis after all. You can read the entire article by clicking here .

Hey, look what just popped into my inbox… another snippet from the tireless Mr. Conrad.

The Falling Trade Deficit, Less Foreign Investment Leads to Higher Treasury Rates

By Bud Conrad

The U.S. trade deficit is falling, meaning that we are not importing as much. That comes from our slowing economy and from the lower oil price. Surprisingly, on an annualized basis, the trade deficit has dropped from $750 billion to about $500 billion.

The other side of that equation, as you can see from the chart here, is that foreigners have less trade surplus from which to generate dollars to reinvest in the U.S.

It gets complicated as the investment measures include the purchases of Treasuries, agencies, stocks and corporate bonds, as well as the sale of foreign stocks and bonds by U.S. holders. The net of all these is plotted and smoothed by using a 3-month average. As you can see, the total of investment in the U.S. moves with the trade deficit. The last data to November show both dropping.

The problem, of course, is that the U.S. has relied on foreigners to buy virtually all the newly issued Treasuries (federal government debt) for the last 10 years. With the trade surplus now falling, so is the amount of dollars available to purchase more Treasuries… and just at the time when the U.S. government needs to push more paper than ever before. The budget deficit for 2009 is likely to be over $2 trillion, a major step up from last year’s record $455 billion, opening up a big gap between what the U.S. government needs to finance and the potential investor to provide that financing. This leads to the conclusion that the Fed will have to monetize the debt and that banks will buy Treasuries rather than loan their TARP and bailouts. All of which indicates pressure on Treasury interest to rise from current low levels.

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Miscellany

Lloyds takes a dive on unexpected derivatives loss. Just when some people thought it was safe to get back in the water, the UK’s Lloyds Bank unexpectedly announced a 10-billion-pound derivatives loss. The bank’s stock took a sharp 40% haircut, and the prospect for yet another UK bank nationalization looms again. Story here.

Fridge police. Since we’re on the topic of the UK, here’s another confirmation that the nanny state is alive. Here’s the story.

Nationalized health care slipped in with the stimulus bill? Well, at least one observer thinks it is, and makes a pretty good case for that contention. Read it here.

Bring back the flogging post! There was an item this week that made me growl menacingly. It was about two judges in Pennsylvania who pled guilty to accepting millions of dollars from a private youth detention center in exchange for giving teenagers long sentences on almost any pretext. For example, one 17-year-old was sentenced to 3 months detention for “being in the company of another minor caught shoplifting.” I hope you don’t think I’m overreacting when I say that this sort of judicial misconduct should be dealt with in a manner commensurate with the crime, starting by sentencing the judges – and the operators of the facility – to the combined total of the excess sentences meted out. But only after giving them a good old-fashioned flogging. I’m sure they wouldn’t have a hard time raising volunteers to take turns as the whip hand. The story is here.

We’re all in it. Regular UK correspondent Sadia sent along a link to another great article by Ambrose Evans Pritchard from the Telegraph. It’s on the global nature of the unfolding mess and worth a read.

Bring ‘em back alive! Did you read how Microsoft has offered a $250,000 bounty for the creator of the Conficker computer virus? Sure, they could have filed a legal complaint, then waited… and waited… and waited for the feds to try to track down the perp, or not. Instead, they just cut to the chase and put up a bounty. I can almost picture the creator of the virus, his pear-shaped body slumped in his well-worn chair, empty bags of potato chips cluttering the basement floor, as he tries to remember all the people he bragged to about his new virus.

Phyle update. For those new to this service, or to Casey Research, a number of groups – which we call “phyles” in tribute to the voluntary associations of like-minded individuals described in Neil Stephenson’s excellent Sci-fi novel The Diamond Age, have popped up here and there and everywhere. Periodically, these groups of Casey subscribers get together to share notes on the economy, investments, and anything else they find of interest. We don’t organize the phyles or even officially sanction them… but we are most flattered and encouraged that they exist. Periodically, as I do below, we post the list so you can see if there is one in your neighborhood. If you want to participate in one of the groups, just drop us an email at phyles@caseyresearch.com and we’ll make the necessary introduction to the local coordinator.

Ohio (Cincinnati, Columbus, Dayton, Indianapolis)
Silicon Valley/Palo Alto, CA (Bud Conrad pops in on these meetings on occasion)
Sacramento, CA
Los Angeles, CA
Orange Country, CA
New River Valley, VA
Bend, OR
Denver, CO – looking for a new coordinator
Princeton, NJ
DC/Baltimore
Birmingham, AL
Scottsdale, AZ
Ann Arbor, MI
Tampa, FL
Seattle, WA
Paris
Toronto
Auckland, NZ

Also…

Lincoln from Kingston, NY wrote in this week looking to start up a group in that area.
And the Dallas, TX phyle is looking for a co-coordinator or new coordinator.

And that, dear readers, is it for this week. As I sign off, a quick glance at the screen tells me that the U.S. stock market is mostly flat, gold is holding up pretty strong at $940, probably because the stimulus passed, and oil is up 10% to about $37.00.

Of course, now that the stimulus has failed to impress Mr. Market, the government is announcing that it is working on a number of other plans, including trying to ratchet down mortgage rates. But here’s an idea. What if Obama just said, “Okay, there’s your stimulus. We’re done. That’s it. Get used to it, and don’t forget to make it a great day!”

Sure, things might get a little sloppy, frantic in fact, but only for awhile. Because it is only when businessmen and investors are able to focus on things as they are, rather than as they might be… following the next piece of government legislation… that they will be able to begin the process of adapting and adjusting their plans to survive and, in time, prosper.

Put another way, in and of itself, the uncertainty inherent in a government approach that promises endless fiddling until they “get it right” will keep money on the sidelines and stupidly investing in government Treasuries for almost no yield… and keep it out of the working capital of corporations – the only vehicle through which sustainable wealth can be created.

Food for thought… but with that I must run.

Until next week, thank you for reading and for being a subscriber to a Casey Research service.

David Galland
Managing Director
Casey Research, LLC.