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8/24/2010 1:15:01 PM - The Economic Future Will Be More Volatile

I just saw the following quotation and thought that, given the current situation today, it was particularly poignant/relevant/apt:

You cannot help the poor by destroying the rich.
You cannot strengthen the weak by weakening the strong.
You cannot bring about prosperity by discouraging thrift.
You cannot lift the wage earner up by pulling the wage payer down.
You cannot further the brotherhood of man by inciting class hatred.
You cannot build character and courage by taking away men's initiative and independence.
You cannot help men permanently by doing for them what they could and should do for themselves.

- Abraham Lincoln, February 12, 1809 April 15, 1865

The way out of the depressed economic situation today is not by raising taxes. Tax revenues skyrocketed over the last decade, yet government spending rose even faster - well beyond the rate of inflation. Why is it that while private payrolls have been decimated over the last few years, government headcount has stayed steady or even risen? Does it make sense to have a smaller pool of workers supporting an even larger government? Why aren't governments held to the same standards of financial responsibility as are private corporations and citizens? Many companies would like to expand into new areas of business. Many people would like to purchase a new car. If the financials don't warrant it, though, the corporations and average citizens constrain their spending to meet the current financial situation. Only government ignores such natural limitations...to its, and our, detriment.

Personally, I don't think that governments should run deficits...in good times or bad. If the private sector has to cut back in lean times, then governments should as well. Many economists and equity analysts will throw out nonsense along the lines of deficits not mattering - that it's the annual deficit relative to GDP (the Gross Domestic Product, the sum total of all of the goods and services produced by a country) that really matters and that as long as it's just 2-3 percent (of GDP) or so that future growth in the economy will keep the deficit at an acceptably low level in terms of total government debt to GDP. This line of thinking is similar to borrowing money at a low interest rate, investing it, earning a better return, and keeping the difference. That sounds great but...what if you aren't able to obtain a percentage return superior to your cost of capital? What if the economy grows more slowly than expected, is stagnant, or even contracts? In the end, assuming that deficits are ok as long as they're "only" a few percent of GDP each year is just speculation and I'd prefer that the government not engage in financial guesswork where its finances are concerned.

There's no easy way out of the current situation. I think that if the government were to downsize itself as appropriate given its current income - by shaving roughly a trillion dollars a year from its spending - that it would make the current economic situation considerably worse in the short term. Unemployment would rise even farther. Consumer spending would remain depressed. Corporate investment would shrivel. In time, though, things would heal. You'd no longer have to worry, for example, about what's going to happen when interest rates skyrocket at some point in the future (due to all of the money printing that the US Treasury - as well as other central banks - have been doing) and the government finds itself completely unable to afford the interest on its existing debt and even the most basic of its spending obligations (such as Social Security, Medicare, Medicaid, and the military.) With such worries hanging over the future, I wouldn't consider investing for the long term for even a second. The cumulative effect of millions of investors like me behaving in this manner is to keep economic growth - what little there is, at the moment - to a minimum. At some point given the current trajectory of things, the financial system - worldwide, as they're all connected on a macroscopic level - is going to collapse if something dramatic is not done. Unfortunately, the only "vision" offered by politicians is to increase taxes...so that they can raise spending even more...at which point they'll say that the only way out is to raise taxes...ad infinitum.

If the government got its spending under control I'd become far more optimistic about the future. I'd be willing to make longer term financial bets because I wouldn't have such a strong feeling that the finanical system is eventually going to implode.

I often use an analogy that I came up with when talking about the worldwide economy. The system can be viewed as a series of horizontal weights, with each weight connected to its left and right neighbor via a spring. Each weight represents a particular aspect of the economic landscape - tax rates, government debt, consumer debt, consumer confidence, financial leverage, interest rates, productivity, retail inventory levels, etc.. Whereas in reality each of these issues affects many if not most or all of the others to some degree, for simplicity you can view each as having a direct impact only on its immediately neighboring weight, with its effect on other weights farther down the line diluted by the distance between them. The point is that when a weight moves, its overall impact is negated because an equal and opposite force - to quote Newton - is imparted into the system to counteract it. For example, if tax rates were to rise dramatically, investment would tend to decline precipitously because there would be less incentive to for an investor to take the risk due to the decreased potential for reward. The overall economic system can be viewed, then, as a series of oscillating weights. Whereas individual weights may periodically become unstable, their overall impact on the system is muted and eventually reversed by the other weights. The system breaks down entirely, though, if one of the weights swings with such force that it breaks the spring connecting it to its neighbors. I believe that's what awaits the world at some point in the future. US, European, Japanese, and other leading economies cannot continue down their current path without destabilizing the entire system. The interest rate that Greece had to pay on its national debt, for example, skyrocketed from about 4.5% to 15% in a matter of months. If the interest rate that the US government has to pay on its debt reach even half of those levels it would be catastrophic. The results of such a calamity wouldn't just affect the US. The US would undergo hyperinflation and the effects would ripple out to the rest of the world like waves from a tsumami. Fear and panic would reign.

I don't think that such a calamity is coming today, next week, or next month. Ironically, as long as there's so much fear in the financial marketplace, the system is probably "safe" (meaning that rather than an outright collapse, your primary risk is more that the financial markets gradually deteriorate in their inflation-adjusted value.) The reason is that widespread fear causes investors to park their money in government debt despite the ridiculously low yields being offered. The US government, for example, can currently borrow money for 2 years at less than half a percent and for 10 years at about 2.5%. (If the guys in the US Treasury were smart they'd be locking in these ridiculously low rates for much longer periods of time - 30 years at a minimum, although they could probably find buyers for quite a few 50 and 100-year Treasurys in the current climate. They'd pay a bit higher percentage on the debt - which is why they don't do it - but dramatically lessen the damage that will eventually result when the US has to refinance its short-term, low interest debt with new, far more expensive debt. It's kind of like ARMs for the housing market - except the consequences of not being able to refinance at low rates will be catastrophic to the country and to much of the rest of the world. The problem will evoke memories of the recent financial crisis where top tier companies like AT&T, IBM, and GE were running into cash flow problems because they had tons of short-term debt coming due and the market wasn't receptive to extending additional credit for anything other than astronomical rates.) The government's borrowing and the resultant spending is artificially propping up the debt and equity markets at the moment, but also sewing the seeds of an even larger problem that will eventually take center stage. When the economy and equity markets eventually stabilize and beign to look more sustainably positive, I think that will signal the beginning of the end - the end of economic stability and growth being the norm. The problem, you see, is that as investors begin to re-allocate their capital into equities, the US government will have to pay higher and higher interest rates in order to attract enough buyers to the Treasury auctions. As interest rates climb higher, the market will gradually take notice of the fact...and of its dire implications. At some point, the system will transition from an orderly increase in interest rates to a state of panic. That's essentially what happened to Greece recently. It went from having to pay about 4.5% for its government debt to over 15% in a matter of months as concerns about its fiscal situation grew. With the US dollar still the reserve currency of the world and the US economic situation still considerably better than Greece (but deteriorating rapidly), you might not see interest rates hit similar levels. Interest rates in even the high single digits, though, would be catastrophic. Interest payments on US government debt would skyrocket as a percentage of the annual federal income. It will likely, at that point, be far too late to implement any measures that won't be extraordinarily painful in order to, eventually, remedy the situation. The US government - and others that will find themselves in similar situations, perhaps even sooner - will have to dramatically curtail its government spending (which will be a huge drag on the economy and jobs, and spur a considerable decline in consumer confidence) or...print money regardless of the interest rates being offered, which will only serve to further fuel the fires of inflation. Either way, the outlook won't be pretty.

I think that the forces imparted to the worldwide economic system by the massive inflation eventually coming to the US (and probably several other large and advanced economies) will cause the weights, in the aforementioned analogy, to snap their springs. Whereas relative stability was once the norm because of the interconnected nature of the system (with a rise in one "weight" being diluted due to the offsetting nature of others), I think that the future period of which I speak will be filled with instability - asset bubbles and crashes, financial panics, and many other such things.

Many people currently consider deflation a larger threat than inflation. I don't believe that for a moment. Deflationists see too many goods and services, too low an employment level, high consumer debt levels (although they've recently improved a bit, they're still far, far higher than they were when the US emerged from the last major recession three decades ago) constrained consumer spending, declining housing prices, and an increase in the consumer (which is about 70% of the US economy) savings rate. That's all true. Many people liken the the US' current situation to Japan but I don't think that's particularly accurate. Japan experienced a protracted period of deflation but a significant part of the reason was that the Japanese population is shrinking (which makes deflation easier) whereas the US population continues to grow. Japanese corporations and banks hold the vast majority of Japanese government debt (which insulates their government from the interest-rate demands of foreign investors), whereas in the US more than half of its Treasury debt is held by foreign countries like China and Japan (which makes the interest rates that it must pay more subject to the whims of foreign investors.)

In the end, if deflation in the US were to occur, I think that it would be minimal, extremely temporary, and only in selected areas (such as housing and possibly labor costs, and not in many commodities such as gold, oil, copper, and wheat.) I think that inflation will, inevitably, be coming in spades. It may take a year, or two, or even three, but it will arrive and its effects will be significant. There's no guarantee that you'll have a lot of visibility into when exactly an inflation spiral will begin, either. Greece was able to borrow at rates very close to Germany despite its finances being in far worse shape for years until suddenly the spigot closed and its rates skyrocketed. Given that the US dollar is - as of now - still the reserve currency of the world, I think that the US will face a prolonged period of gradually rising inflation (and interest rates) before, at some point, the possibility of a short and painful spike becomes likely.

The US government constantly points to its CPI index as a sign that inflation, at the moment, is practically non-existent. That's true, but I - and many economists - think that it's a flawed measure of inflation. For one thing, there's too much subjectiveness to it - it specifically excludes food and energy prices because of their volatility, even though food and energy costs are a significant portion of a typical consumer's expenditures. The index looks into the past as opposed to the future (and is thus a poor gauge as to whether or not inflation is approaching) because it takes time for increasing input prices (such as copper, palladium, wheat, milk, etc.) to work their way to the consumer (as the manufacturers gradually try to increase their prices to the consumer in order to compensate.) Lastly, the CPI index arbitrarily adjusts for things such as computers - if a computer in 2011 costs the same as one in 2011, the CPI index would typically treat that as deflationary because, they argue, you're getting more for the same amount of money. That might be true, but it doesn't change the fact that you don't usually have the option of leaving off any additional features that you find "unnecessary" and thus it's not truly deflationary in terms of the actual cost, which is, in the end, the most important aspect of "deflation".

I think that if you adjust for inflation, the returns from being invested in equities over the next decade or two will be pretty poor unless you're very nimble and buy when prices are depressed and sell when they bounce. If you simply buy and hold for a long period of time, I don't think that you'll be compensated anywhere near adequately for the risks that you are enduring.

I've been saying for the last couple of years that I think that commodities would be a good 10-20 year bet to make, although I'd only focus on things like copper, platinum, and other materials that are actually utilized in the economy. The problem with gold is that studies have shown that it's not nearly as great an inflation hedge as many people believe it to be, and since it's not used much at all in industrial production it tends to rise most significantly only when people are fearful. Even in an inflationary environment, gold may suffer if people simply become accustomed to the situation - if the overall level of fear subsides. That said...I suspect that gold will continue to move slowly higher - perhaps 10% or so a year - over the next few years as it continues to become a viable currency in its own right - a monetary equivalent that Central Banks across the world can't devalue as easily as they can their own currencies.

While I'm certainly not a "day trader", the bets that I do make are typically all very limited in terms of their duration. Hence, even though I think that you'd probably earn a decent long-term inflation-adjusted return by holding commodities, I don't actually hold any of them at the moment (although I do on occasion have my financial interests aligned with their prices.) A typical bet for me lasts about a month. I only trade for the very short term because I think that the two major market crashes of the last decade won't be the last and, if anything, all of the increased direct and indirect sovereign leverage now inherent in the system is going to increase volatility in the future. If you purchase and hold commodities and wait years for an eventual payoff, you'll almost assuredly have to endure some stomach-churning volatility in the interim. I think that over the next 10-20 years that the time-honored "buy and hold" strategy will prove to be just as large a failure - when your returns are adjusted for inflation - as it has been for the past decade. I think that if you're going to successfully play in the equities market that you'll have to be quick and nimble, often moving into and out of various positions in order to make a decent profit.

I think that over the next several decades economies and equity markets worldwide will be considerably more volatile than they have been in the past due to the massive financial leverage now ingrained within the US, European, and Japanese governments. I think that you'll have more asset bubbles and busts. I think that, adjusted for inflation, the returns you'll get from holding stocks will be mediocre at best (if not outright negative.) Finally, as I've been saying for the last couple of years...unemployment is likely going to remain far higher than it has been in the past in the US. An 8% unemployment rate is probably going to be the new baseline - the bottom of the range for the foreseeable future (as opposed to the 5-6% average of the past couple of decades.) That, of course, implies that you're using the actual government unemployment figures (which excludes part-time workers that can't find full-time work and others that have left the job market because they've given up all hope of finding a job.) If you include those people, the base unemployment rate in the US over the next decade will probably be considerably higher than 8%.

- TZ

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