A few brief comments on America’s fiscal choices
- The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect). That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
- Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
- Since state and local governments are constrained by falling tax revenue and the inability to print money, only the Federal Government can run large deficits.
- Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
- Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
- As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
- Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
- From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.
–The recession is over but the depression has just begun, October 2009
I don’t see the need to change any of these bullet points because the logic of that post is still operative. We are now at bullet points number 4-7 in this time series. Look at the budgetary debate in Washington as proof of point 4. Look at QE and the liquidity provided by the ECB and the BoJ and the increase in commodity prices as proof of point 5. Look at the imminent increase in rates in Europe as proof of point 6. Look at the unrest in the Middle East as proof of point 7.
Note that the commodities complex is still moving higher. Gold is trading near a record high of $1459. Silver is trading at a 31-year high near $40 an ounce. Brent crude is above $122 a barrel while WTI is above $108.
For readers like Ralph who object to the use of the phrase "print as much money", I must add that quantitative easing is an asset swap. Looking at the Federal Reserve as part of the U.S. government’s consolidated balance sheet, the Fed is creating electronic credits that it swaps for interest bearing bonds. No net financial assets are added to the system. In reality, money is created when government spends since there is no corresponding financial asset that it buys in doing so.
In my view, the ongoing fiscal debate in the U.S. will lead to a contractionary outcome – at least in the short-to-medium term. Longer term issues regarding malinvestment are less clear. With household balance sheets highly leveraged and the financial sector still fragile, the potential for economic and market tail risk is large.
As an aside, I should also note that the situation in the Ivory Coast is spinning out of control. If one listens to BBC World Service radio, one can hear much of the news is on this and the situation in Libya. According to the BBC, there is a food and water crisis developing as we speak as refugees enter neighbouring countries. Yet, no one is talking about a no-fly zone or humanitarian intervention. The reason should be clear: there is no oil in the Ivory Coast.