Are Bonds (Fixed Income) at a Tipping Point?

The heuristic is: Don’t fight the Fed.

On November 3, 2010 Federal Reserve Chairman Ben Bernanke made it official that the Fed would increase the money supply by $600 billion and buy Treasuries in an attempt to (his objectives):

1, Lower interest rates to help with home purchases, business loans, etc.
2. Lower the dollar to help exports by making U.S. exports cheaper
3. Increase commodity and equity prices giving a nudge to inflation

To date:
1. The ten year Treasury has moved up to 3.53 percent vs. 2.62 on November 3, (principal amount is down)
2. The dollar has been trending higher rather than lower
3. Commodity and stock prices are up (S&P500 up about 4%, gold is about the same price)

Not exactly what Chairman Bernanke had in mind, but it is early in this spending cycle. The data is certainly conflicting and with bonds selling off, we have to ask the question, Why?

1. Is it because people are beginning to fear coming inflation,
2. Is it because new money is driving up GDP and there is a growth scare (out of bonds and into stocks)
3. Is it end-of-year profit taking (bond prices peaked in October)?

I suspect we will see some clarification soon. What do you think?

Do We Really, Really Want To Pay Off Our Debts?

November 30, 2010


Last year America spent $3.5 trillion, collected $ 2.3 in taxes, giving us a deficit of $1.1 trillion for the year. We are currently projected to have another $1.2 trillion dollar budget deficit in 2011 and for many years to come.

Our current “public” debt (amount the Treasury owes through note and bond sales) is $13.7 trillion (with a vote to raise this amount coming in the next few months.)

To pay off our debts, we would have to balance the budget (cut spending to the amount we receive in taxes) which would require cutting the current budget by $1.2 trillion or 31%; plus, $1 billion more to begin to make payments on the debt of $1 billion per year.

At a repayment rate of $1 billion per year (and maintain a balanced budget), we could pay off $1 trillion of the debt in only 1,000 years and the entire debt in only 14,000 years. (with a budget surplus of $1 billion per year)

I know this is simple math and doesn’t take into account the drop in GDP that would result from a drop in government spending or any reductions in taxes, or new wars or?

If we chose to pay off the debts by raising taxes, we would have to move all tax rates up by 48% if we adhered to budget projections. For example, the lowest tax rate, 10%, (income up to $16,750) would go to 58% and the top tax rate, 35% (income over $373,650) would have to move up to 83%. Assuming everyone paid, that would cover the deficit.

Here are three other possible choices we have:

1.Default (government reduces value of dollar significantly)
2.Inflate our way out of our debt (keep printing dollars, like we are doing now) until we can pay back the debt in near worthless dollars
3.Grow our way out of this problem by rapid GDP growth (but we would have to go back to a capitalist economy to get entrepreneurs, technology and productivity going again.)

Which choice do you think we will end up taking? Which choice are you preparing for?

Expect The Federal Reserve To Downgrade the Economy

November 22, 2010

On Tuesday, the Federal Reserve releases the minutes of last Federal Open Market Committee Meeting. We know they decided to begin QEII (Quantitative Easing, part two also called printing money.) Therefore, we can assume they felt the economy was either not improving enough or sliding backward. Consequently, we should expect the minutes to show that:

1.The economy will not grow at the 3.5 to 4% rate used in previous discussions
2.The unemployment rate (one of their mandates) will not improve as quickly as they thought
3.Price stability (there other mandate) or inflation will remain low for longer than they thought at the last meeting (because QEII is a lot of new money.)

Also, Bernanke recently talked about the need for more government stimulus. That’s got to give you confidence---confidence that our monetary managers intend to inflate our way out of our debts.

A Potential Problem Few Are Talking About

November 11. 2010

Are you prepared for this kind of scenario?

According to a research report by Meredith Whitney1, the government, media and investors are all but ignoring the financial crisis currently being faced by the States. State deficits amounted to $200 billion in 2009 and another $200 billion in deficits are expected in 2010. Plus, estimates are that pension funds could be $1 trillion under funded.

The Federal government is currently subsidizing States (through direct money transfers, etc.) to the tune of 22% of their budgets. At the same time, local governments have become dependent on State funding (which appears to be in trouble.) Also, many of the Federal subsidy programs will run out in June 2011.

Why no concern? Everyone expects the Federal government to bail them out. Times are changing. Here is Meredith Whitney’s view:

“I expect multiple municipal defaults to trigger indiscriminate selling, which will prompt a Federal response.”

This would have a very big impact on the market. By the way, Harrisburg, PA has just hired a law firm to examine the possibility of filing bankruptcy.


1 Meredith Whitney Advisory Services,

Federal Reserve Says We Should Only Focus On The Benefits

November 3, 2010

The Federal Reserve today announced that it will create $600 billion to buy bonds over the next eight months ($75 billion of purchases per month.) Also, that we not worry about the extraneous things and focus instead on the benefits. These bond purchases will:

1, Lower interest rates to help with home purchases, business loans, etc.

2. Lower the dollar to help exports by making U.S. exports cheaper

3. Increase commodity and equity prices giving a nudge to inflation

I could give a list of reasons why this will not work, but I want to focus on two other major problems.

One, the Fed has blinders on. It is focused only on the “positives” and not the “negatives.” For example, lower interest rates could be a buying incentive if consumers wanted to spend. Evidently, a rate of 2.65% for ten years is too high. The Fed also needs to look at the people who are hurt by this policy. Savers, at these low rates, are being punished. We need savings so we can invest in growth.

Two, the Fed is only focused on short-term results. They may get some of the results they want; but long-term, the debasing of the dollar will reduce buying power and cause inflation.

The policy has been decided and will now be implemented. We have to determine how it will affect our business plans and our portfolios.

Which Is More Important, Tuesday’s Election or Wednesday’s Fed Meeting?

November 1, 2010

Tuesday, Americans will decide whether we should continue spending at the current, yearly rate of $2.2 trillion of tax money plus another $1.5 trillion of borrowed money or whether we should reduce spending and shrink government. Research polls indicate the latter.

Wednesday, the Federal Reserve will meet to decide how much money they will print in an effort to keep interest rates artificially low, “re-inflate” the housing market and incentivize consumer spending. The trillions spent to date have not worked. There is no reason to believe this round of money printing will work either. However, many support it because they believe the “government” must do something.

The more important of the two days is Tuesday. Runaway fiscal policy is the more dangerous policy. The economy needs time, not more spending, to deleverage and get to equilibrium.

The markets at this point, may have priced in much of the election results (unless there is a surprise) and at least some of the expected $1 trillion in new money to be printed. Then, there will have to be a reassessment. Prepare and adjust your portfolios as required.

It’s Time To Look At America’s Two Economies

Today, when you open the business section of your newspaper or watch financial news on television, it is obvious that we have moved from an entrepreneurial economy toward a very centrally planned economy. Fiscal and monetary policies have become almost an obsession. Politicians and pundits have convinced most people that the government can and should solve any problems we have. And as you know, politics drives fiscal and monetary policy. Therefore, it is important that each of us have a longer-term understanding and outlook of the economy; and it must be as non-partisan as humanly possible.

Following is my view. This view may differ from yours because my assumption is that the economy and markets do not work, except on a very long-term basis, the way most people think they should.

First, we need to put the real economy (not just the political economy we read about every day) into context so we can distinguish the actual economy from the artificial, centrally planned economy. This makes it possible to see the two economies. Once you understand both, you will be in a position to develop a short-term plan for your business and your investments; and a longer-term plan for when these two economies collide.

Most people think that when the economy (GDP) grows, corporate profits grow which causes stock prices to increase. This is true if you are thinking very long-term. But what really causes the economy to grow is when the government increases the money supply (prints money.)

GDP growth, by definition, is only possible if you increase the money supply. If the money supply did not increase, you would have a fixed number of dollars in the economy. Therefore, increased spending in one area of the economy would cause a decline in another area with net, aggregate growth of zero.

If the definition of economic growth was more wealth, rather than more money, the economy could certainly grow if GDP stays at zero. Think about how technology has increased our wealth over the years at the same time that prices were are being consistently reduced.

However, the problem with increasing the money supply is:

1.It decreases the value of the dollar, reducing buying power, which then causes inflation.
2.It causes malinvestments (investments go into marginally productive ventures that cannot sustain themselves once interest rates rise or when credit or money is withdrawn from the financial system.) It can/does cause bubbles.
3.It reduces the ability of productive companies to obtain the capital they need) long-term) crowding out real productive ventures.

Current fiscal and monetary policy

The Federal Reserve Bank, using a government (Keynesian) periscope, has decided that we are not de-leveraging (bringing prices back to equilibrium); we are instead close to falling into deflation. This Keynesian definition means a chronic slowing of consumer spending or demand. It is not the original or traditional definition of deflation which is a contraction of the money supply.) Therefore, the Fed is expected to soon (maybe in November) begin the second round of quantitative easing (printing money.)

Therefore, to increase consumer demand, the Fed plans to hold interest rates artificially low and pump money into the banking system to incentivise the consumer. This, plus continuous stimulus programs and overspending tax collections have not worked to date. Some of the reasons are:

1.Banks have over $1 trillion in excess reserves but are not lending (for several reasons) so credit expansion is not occurring which is necessary to hype demand
2.We have had over $900 billion in stimulus programs plus $2.7 trillion in “additional” government spending over the past two years. GDP has risen by about $800 billion over the same two-year period.
3.A lot of this money has found its way into emerging countries in the form of investments. Two emerging countries have started to tax foreign investment funds in order to slow down their growth.

Conclusion

Government (fiscal and monetary) policy cannot continue down this same path much longer without it causing horrendous inflation. Our debt and committed future obligations already exceed 100% of current, tax collections for many decades into the future.

Plus, we still have many significant economic problems before the economy can really begin to grow including the financial system, housing, over-levered consumers, unemployment, states and municipalities in serious deficits and asking the federal government to bail them out (estimates are around $300 billion now) and many more.

Therefore, unless there is a clear change in government policy (by both political parties,) it appears that additional stimulus, low interest rates and excessive printing of money will continue. Since money supply is the initial driver of our economy, the GDP number may stay positive and above water. But, this printing and spending money plus low interest rates will require investors to make significant changes in all asset classes.

Does The Economy Drive The Stock Market?

What drives the capital markets? Is it the economy or something else? The short answer of course is the economy, but only over the long term. There is much more to it than a simple, if A then B.

I recently read an excellent article by Kel Kelly (writer and former trader)who ties the business cycle into the relationship between the economy and the markets. I thought I would share my interpretation of some of his thoughts with you. This will take several articles but I think you will get a better understanding of the relationship between the market and the economy.

If you listen to the pundits and the media, you get the impression that capital markets are driven by things like:

1. Psychology or crowd behavior or “animal spirits”,consumer sentiment or
2. Technological analysis or patterns of behavior (charts), instant correlations or
3. Data points like corporate earnings or expected earnings, revenues or
4. Marginal economic data points like consumer spending, interest rates, GDP growth, increasing or decreasing labor costs, etc.

In the real world, the most common view is that the economy drives the markets. As the economy (GDP) grows, corporate revenues and profits grow. This growth increases profits and the value of the company, which is then reflected in the stock price. The reverse is also true; if the growth rate of the economy declines, profits are reduced and stock prices fall.

While this view is basically correct, over the long term; you could have a difficult time predicting where the market is headed in the short-term. I looked at the quarterly, rate of change in the economy and the S&P500 over the past ten years. The correlation for the two is 0.40. Not that strong a relationship.

Yet, most economists and pundits today use at-the-margin data points (for example, a monthly turn in the data, a two or three month trend, etc.) to predict the future direction of the economy. This is a backward looking view of the economy not a forward-looking view. Plus, they are always waiting for the next data point rather than making a definitive decision. By the way, you have to stay tuned for tomorrow’s new, backward-looking data.

Can you remember the last time one of these projections was correct? Just to add a little humor into this, how about the National Bureau of Economic Research’s ruling a few weeks ago, after 18 months of rigorous analysis, that the current recession ended in March of 2009.

Real force driving the stock market

Over the next few articles, I hope to show that the real force driving the market, over the longer term, is changes in the quantity of money and the volume of spending in the economy. This precedes the rise in GDP (economy.) In other words, capital markets rise when the money supply is inflated and stocks fall when the money supply contracts (note: they can fall for other reasons as well.)

What are banks going to do with their 1+ trillion dollars in excess reserves?

If you follow the money, you know that banks (after bailouts, Fed purchases of toxic assets, guarantees, etc.) now have over $1 trillion in excess reserves per the Federal Reserve. Banks normally lend this money out and with over $1 trillion of reserves; they could create over $80 trillion in new credit. But is this a reality in today’s environment?

The housing problem is still not solved and will require banks to write off billions more in “bank assets.” They could loan this money to businesses, but few of them really want to take on additional loans with the economy in such bad shape. They could lend to consumers but they can’t afford more debt and their FICO scores have dropped making them less “qualified.” Anyway, consumers have decided to become more frugal.

If banks were to pump out trillions of dollars in new credit that went directly into the economy (to companies producing goods and services and consumers buying goods and services), it would certainly cause GDP to spike up and maybe we would be off to another bubble. But, adding that much credit into the economy would significantly reduce the value of the dollar and thereby cause serious inflation.

Yet, this is what a lot of people think will happen. The government continues to spend money hoping to fill the demand gap in the economy. The Federal Reserve keeps “printing money” for the government to spend; and at the same time, keeps interest rates low to encourage spending and to help prop up the housing market. Once everything becomes perfect again, the government can cut spending and the Federal Reserve can contract the money supply eliminating the threat of inflation. Bingo! Utopia.

Since we know this is a fairy tale, how about another alternative for all those “excess reserves” the bank has. What if this “excess” money in the banking system simply gets re-circulated. Banks could put all that money back into the financial system rather than back into the economy (the goods and service producing segments.) For example, they could buy assets like stocks, bonds, gold, real estate, etc. (GDP wouldn’t go up much.) They could buy these assets around the world (reducing the inflation potential here) and they could finance real things like factories, but overseas (Oh, darn, they couldn’t bring the profits home because of taxes.)

Is it possible? I don’t know. I am not a conspiracy theorist but we have to keep our critical thinking skills sharp and keep looking for possible alternative futures.

Bernanke Said What?

Since the housing market peaked and the financial crisis began, the government has spent:
$3.6 trillion (net after some repayments) on various stimulus programs,
$16.3 trillion in government guarantees to various financial institutions; plus
$7.2 trillion in federal government spending (the budget) trying to hold up the economy.

That’s a lot of money for a $14 trillion dollar economy. Yet the net result so far is an economy barely growing at 1.6 %, unemployment at 9.5% (or 17% depending on how you count unemployment,) a very troubled housing problem (inventories last month were at 12.5 months supply) and a financial system that can’t afford to lend (for fear of future defaults and/or the risk-free money they are getting because of Fed policy.) And this is only a few of our problems.

Now, last Thursday at the Jackson Hole Conference (isn’t that more expensive than Las Vegas,) we were told by Federal Reserve Chairman Bernanke that he has changed his mind and the economy may be showing down even more than he thought. Also, that the economy can not even handle the Fed keeping the interest and early payoff money the Fed is receiving from the bonds it purchased. That he is going to spend that money as fast has he receives it rather than shrink the Fed’s balance sheet. What a confidence builder. Plus, and this a big one, that the Fed is ready to print more money, in addition to what they have already done, to keep the economy going.

We have been debating how the Fed is gong to reduce its balance sheet. Now we learn that even the simplest reduction seems impossible. So get ready for Quantitative Easing, round 2.

As you know, critical thinkers have to look at all sides of the argument. Here is a summary of their analysis and proposals.

The Keynesians, economists like Paul Krugmanand and James Galbraith, want the government to significantly spend more money because we didn’t spend enough to begin with. They say the economy is not recovering at all. Federal Reserve policy has been “grossly inadequate”. The Fed should increase its balance sheet from $2 trillion to $4 or $6 trillion (would this cause a printing company bubble?) Most economists are Keynesians and they are putting a lot of pressure on Congress and the Federal Reserve to stimulate more and print more money. They, as always, are concerned only about the short-term.

The Keynesian-lite or Supply-side economists like Brian Wesbury or Larry Kudlow want additional tax cuts and more incentives for businesses to expand and hire employees. They say the economy is recovering, but very slowly. I am not sure they still believe in the V shaped recovery. They also claim that uncertainty, especially in tax policy, healthcare policy and undefined new financial regulations are some of the reasons the economy is not growing faster. They also believe tax cuts and incentives will result in more production which will keep inflation low. But, since a tax cut without an offsetting spending reduction is a stimulus, it would mean more borrowing, more quantitative easing. They too are only concerned about the short-term.


The Capitalists like Peter Schiff, Mark Faber and other Austrian economists want the government to get out of the way and let the economy heal itself. Sooner or later, we have to get to price equilibrium (in housing, wages, interest rates, etc.) They say the government has already spent far too much money. They believe that the free market, if left alone, will self-correct. That is how we get to the bottom. That is a recovery, getting rid of the excesses. All this government intervention is doing is delaying the recovery and laying a base for the next boom or bubble. The mal-investments caused by artificially low interest rates and the excessive expansion of money not only delays recovery but cause the next boom. For example, what is going to happen to wind power when the stimulus goes away? Or what’s going to happen to bond prices when inflation (caused by inflating the money supply) begins to rise rapidly?

We all see the economy through different lenses, but I am sure you will agree that most Americans think spending and then printing the money are out of control. Short-term and long-term. We may not be able to go from over indulgence to austerity in one step, but we sure need a plan and we sure need to get started.

Get Ready For the Next Big Stimulus Program

The government has been trying to hold housing prices up for two years without much success. Many “experts” agree that we will see another drop in housing prices due to high prices, lack of demand, unemployment, wages, etc. It has also been estimated that an additional 10% drop in prices is possible (which would get us to about the 50 year trend line) which would put a significant number of additional residential mortgages under water (negative equity). Being underwater is one of the major (if not main) reasons people walk away from their mortgage commitment. Plus, the economy is not helping and may be turning down again.

So with politician’s approval ratings extremely low and pressure from their economic advisors (Keynesian economists in both parties) to put more stimulus into the economy, it might happen soon. Evidently, the trillions spent so far haven’t been enough (for example, “The Third Depression” Paul Krugman in the NYTimes) to turn the economy around yet. Now add to this, the clamor (after financial reform?) to do something about Freddie Mack and Fannie Mea (FNF).

It would be a lot faster to “do something about housing” then turnaround the economy in the next three months. Some are now thinking that the government will begin a massive, new, program of mortgage modifications where FNF will offer low, permanent interest rates on reduced mortgage amounts. This may happen before the election. The money was allocated a year ago when FNF were given unlimited funding authority (at least up to $1 trillion) even though they had not used the $200 billion already allocated at that time. After all, they are owned by the government where spending has no limits. Also, the government does not have to go to Congress for this as it has already been “approved.”

If you are a Keynesian, this kind of spending and short-term fix makes sense. Spending is what you must do in a recession. If you are a capitalist, you understand that this will only add to our problems short- and long-term; prolong the recession; and increase inflation further.

If Bernanke continues to punish savers, should you change your strategy?

If Fed Chairman Bernanke continues to punish savers by holding (“for an extended period”) interest rates at extremely low levels, should you increase your risk and buy higher yielding bonds and preferred stocks? His actions seem to indicate that is what he wants you to do.

Before doing this simply by increasing risk (lower rated bonds) or extending maturities (going from short-term to long-term bonds), you should consider approaching the income portion of your portfolio with a strategy hedge funds use to reduce some of this risk. Think about both principal risk (return of principal) and market risk (volatility of your principal.)

You know that selecting strong companies or government bonds (with taxing authority) that have the financial ability to pay the principal (at maturity) plus every interest/dividend payment should reduce your principal risk.

But there are ways you can also reduce your market risk. Start by asking, “What could cause my principal value to decline during my holding period?” One big reason is inflation or an increase in interest rates.

Therefore, to hedge or minimize market risk (principal volatility), you would want to purchase a security that moves in the opposite direction of the security you purchased for income. When one security goes up in value, the other goes down. This should leave your principal “flat” while you collect the higher interest rate.

Stocks too, may require a different strategy

A protracted slow growth period for the economy will have its effect on stocks as well. It may be very difficult to increase revenues, maintain margins and earnings, etc.; so you may want to consider stocks that are not dependent on the economy for growth.

Look at companies that have a product or service whose success depends on the growth and acceptance of their product rather than on the success (general growth) of the economy. It helps if they are not limited to the U.S. economy only, but are able to sell worldwide. Also, in this environment, it might help if they do not need to raise money for the next few years.

If: the economy continues to slow down and the government does not pass new stimulus programs, will the U.S. head into a deflationary spiral?

Recent economic data and Chairman Bernanke’s recent statement suggest the economy is slowing down. The “’09 stimulus package” has peaked and its effects will be gone by the end of the year. The G20 agreement reached over the weekend says governments “agree” to cut their deficits by 50% within two years. The U.S. would have to cut almost $800 billion of the $1.5 trillion deficit in 2010 alone. Good luck with that. Here are some reactions:

Keynesian (Demand-Side) economists are up in arms. Paul Krugman in an article in the New York Times today has an article titled, “The Third Depression.” He states that we are worried about inflation when the real problem is deflation; and the failure to stimulate (re-inflate) the economy will result in a long, Japanese style deflationary environment. He has suggested another $one trillion in stimulus.

The Keynesian-lite (Supply-Side) economists are still convinced the economy is turning around (although they have become less passionate in the past week) and that inflation is the potential risk. They do want taxes reduced to create jobs (but without cutting spending, you simply have a different type of stimulus program.)

The Capitalist economists see de-leveraging or deflation which is normal after our world-wide, gigantic credit bubble fighting inflation (low interest rates and the massive printing of money.) If this deflation-inflation struggle continues, it will take a long time to get to price equilibrium (e.g., bottom on home prices) and the amount of money created by that time will cause huge inflation. Therefore, the sooner the government gets out of the way, the sooner the recovery can begin.

Since we have a mixed economy rather than a capitalist economy, I do not expect the government to get out of the way. And since we have Keynesian government and Federal Reserve, I expect more stimulus rather than austerity.

However, many taxpayers are upset with all the spending. I had expected another large stimulus package this year, but one large stimulus package does not seem viable in this climate. Then, I expected to see the large stimulus package broken down into smaller pieces (a $50 billion package for unemployment benefits, a $50 billion package to help the states, an $8 billion package to hold up home prices, etc.). But last week, the Senate was unable to get closure on the unemployment package and therefore could not vote on it.. This might signal that additional stimulus through fiscal policy, may be difficult to do.

However, I think the answer to question posed is no. The government is to frightened of deflation to let it happen. Therefore, the Fed and Chairman Bernanke may be called upon to stimulate the economy through monetary policy (keep interest rates low and print, print, print money.)

Chairman Bernanke Effectively Downgrades the Economy

Media coverage of the Federal Open Market Committee (FOMC) meeting on Wednesday basically stated that little had changed from the April 28th meeting: interest rates remain at basically zero percent and will remain so for some time, the economy was in recovery, etc. However, there were some serious changes made to Mr. Bernanke’s statement that implied things were deteriorating rather getting better.

Most media coverage focused on what did not change in Bernanke’s statement: they left rates at zero, for an extended period, subdued inflation trends and expectations, continued low rate of plant utilization, unemployment continues to be a concern, etc.

But, here are some significant changes in attitude and content that, I think, effectively downgrades the growth rate for the U.S. economy. For example:

1.Attitude. Less talk about short-term tightening and the timing and plans to do so,

2.Economy. In the previous statement (April), Bernanke stated, “Economic activity has continued to strengthen.” In this June statement, he stated, “The economy continues to recover.” (this is far different from continues to strengthen and I think a downgrade on growth rates)

3.Employment. In April, “Labor markets beginning to improve.” In June, “Jobs are being created, gradually.” (Again, I think a less robust outlook.)

4.Financial System. In April, “Financial market conditions remain supportive of economic growth.” In June, “Financial conditions have become less supportive of economic growth...”

5.Housing. In April, “Housing starts have edged up but remain at d depressed level.” In June, he left out “have edged up” and simply said, “: Housing remains at a depressed level.”

I think this is significant because Bernanke and the Federal Reserve Bank have been trying, very hard, to present the economy as beginning to improve. After all, as good Keynesians, they have already spent a ton of our money and they need those “animal spirits” (I guess that means our greed) to make the handoff from government spending to private spending (or their theory doesn’t work.) Is this a signal that we will get even more government spending?

Should we be worried about future deflation or inflation?

There is a lot of worry these days about weather we are in deflation, slipping into deflation or about to enter into an inflationary environment. It obviously makes a big difference in future planning and how investments are allocated. As you can imagine, there are very different views among the different economic philosophies.

Before I get philosophic differences however, I need to provide a simple definition of inflation and deflation. Very simply, inflation means an increase or inflation of the money supply (more money units) and deflation means a contraction in the money supply. In the case of inflation, an increase in money units means that each unit is worth less or one’s purchasing power is diminished. Therefore prices increase. Inflation, the way the word is used today means an increase in prices. Therefore, the cause of inflation is usually misdiagnosed. I’ll talk more about this in other posts. So lets look at the different viewpoints.

Keynesian/Demand-Side View
The big government economists (Keynesians and demand-side economists) are worried that the money spent to date (the stimulus and fiscal and monetary policy) is not enough to fill the spending gap left when consumers and businesses reduced spending.

Influential economists like Paul Krugman, have said all along that the stimulus packages have not been large enough to fill the gap in spending and that now we need a much bigger stimulus package in the neighborhood of $1 trillion more dollars if we are going to turn this economy around. If we do not get that kind of spending, we will slip into a deflationary death spiral that is very difficult to get out of. Therefore, we could end up like Japan in the 1990’s with 10 years or more of almost no growth.

Their definition of deflation is falling prices (due to lack of demand) and they see falling prices everywhere (housing prices, food prices, car prices, etc.) He doesn’t see falling computer prices over the years as detrimental or deflation however. He also does not mention how we are going to repay the loans.

Keynesian/Supply-Side ViewThe opposite position is taken by the less government economists (Keynesians and supply-side economists) who see a marginal improvement in GDP growth, which they have extrapolated into a V shaped recovery. They are worried about the coming inflation because of artificially low interest rates and high debt levels.

They see inflation (a rising consumer price index or CPI) everywhere. They think that unless the Fed raises interest rates very soon and begins to take money out of the system, we will get severe inflation within the next year to eighteen months. Interest rates should be raised to one percent higher then the nominal growth rate of GDP (growth rate before inflation.) So if the economy is growing at 3-4% as they expect, interest rates should be at 4-5% not zero.

Their definition of inflation is a rising CPI index (which is the symptom of inflation, not the cause.) The CPI index as you know is a basket of goods and services the government uses to measure price changes.

Capitalist ViewThe almost no government economists (Capitalists, Austrians, Objectivists) have a much different definition of deflation and inflation. They see deflation and inflation as it was originally defined: expansion or contraction of the money supply. Their view is that the government has been and continues to pump money into the economy (print money), which will be inflationary. However, consumers are currently over-leveraged (too much credit vs. disposable income) and must reduce spending and increase savings in order to b ring their financial lives into balance. This slowdown in spending looks like deflation (prices are being reduced by almost every store advertising.)

Therefore we are currently in a period of de-leveraging, not deflation and until the consumer starts spending again (by using or reducing his savings or expanding his credit) we will not enter an inflationary phase. But based on the money that has been added and expected to be added to the economy, we could be in for serious inflation.

Conclusion

Therefore, your current position should be focused on a de-levering economy, which will take considerable time and considerable pain. However, if the government pumps too much money into the economy (a debatable number) or credit becomes too easy again, too soon, it will be time to reposition yourself for inflation.

Consumers Are Beginning to Spend, But Where Is the Money Coming From?

Retail sales were up 1.6% in March and 10% year-over-year. These are not new highs but, the short-term trend offers some hope at least. However, faced with many and much talked about headwinds, the question really is: Where is the money coming from and is it sustainable?

This is very difficult to answer, on a fundamental basis, because the government is so involved in the economy that it’s hard to tell what is real and what is stimulus. None the less, following are the current positions of the three major branches of economic thought.

Keynesians (Demand-Side Economists)

Consumers are spending, and are being helped by government stimulus programs (the $800 billion dollar stimulus program plus cash for clunkers, mortgage modification, home purchase incentives, extended unemployment benefits, etc.) However, consumers are not spending enough and credit is too restricted for the economy to grow again without government help. The problem now is that stimulus money peaks in June 2010 and then trails off. Therefore, we need to keep interest rates low and we need additional stimulus spending to keep consumers and the economy “growing.”

Here is quote from the Cleveland Federal Reserve that I think sums up the Fed’s position,

“What does all of this bode for a recovery of consumption, the primary driver of the U.S. economy? The data shown here point to a long road ahead for a sustainable recovery. Consumers are paying down loans or defaulting, and those looking for new consumer loans are likely to find that banks are still pulling back on lending, though individuals who can secure a loan face historically low interest rates. Given the hangover of outstanding debt and recent memories of shrinking asset values, consumers may not be motivated to ramp up their expenditures. Rather, consumption will likely recover slowly as households save more and await the return of an improved labor market and the sustainable source of funding—disposable income—that it typically provides for consumption.”

Keynesian Light (Supply-Side Economists)

Consumers are spending more and that spending is becoming broad based. According to Brian Wesbury, Chief Economist at First Trust in Chicago,

“Economic data clearly traces out a V shaped recovery.”

He acknowledges that many headwinds do exist, but not right now --not until some time in the future. His reasons for increased consumer spending include: 1, the pace of debt reduction is slowing (if you pay off less, you have more of your income to spend) and 2, incomes are growing and recovering (a three month trend of incomes show a slight increase.) This is a very short-term view, but Keynesians are focused on the short-term.

Capitalists/Austrian Economists

Capitalists agree that on a short-term basis, consumer spending is increasing, at the margins, but for mostly the wrong reasons. Capitalists look at consumer spending differently. First, the short-term, aggregated numbers do not tell the real story. For example, gasoline prices have gone up about $1.00 over the past year increasing spending in this category. That will/could amount to a lot of consumers spending; but it certainly hasn’t helped the consumer or the economy.

Capitalists contend that it’s not government or consumer spending that is the problem, it’s the lack of investments. Investments and productivity are what generate job creation. That should be our concerned. Savings (ours or foreigners) are needed in order to have investment. Also, the consumer is still deeply in debt and needs time to reduce debt levels (and hopefully save) before meaningful spending can be sustained.

But, where are consumers getting the money?

Here are some other ideas:

1.One source is “strategic defaults.” These are people who are underwater on the value of their homes and can afford to pay their mortgages, but are chose to let their homes go into default and eventually foreclosure. There are currently about 6 million people in the process of foreclosure. These strategic defaults may be adding about $200 billion to annual household cash flows. (Per economist David Rosenberg.) Some of these people have not even been contacted by the bank in over a year.

2.Tax refunds which might be lower than previous years but do fuel consumer spending.

3.Savings rate has dropped from a recent high of 4.6% to 3.1%. That alone would explain a lot of spending.

4.Additional stimulus programs to come.

Short-term, it appears that consumers are spending more and adding to GDP (which certainly looks good ;) but long-term, we need to solve the problems that caused this recession in the first place and that will take time not money.

Comments always appreciated.

What is going on with the market?

As you know, I understand that stimulus money drives up the GDP numbers making it look like the economy is getting better, but I have been very concerned about 2010 because of many impending headwinds:

1. Mortgage delinquencies about to rise significantly. Note, we are now entering the 2005-07 period when the option-ARM’s made up the majority of mortgages (pay what you want to per month and we will add the unpaid balance of principal and interest due to your mortgage)
2. Banks will have to report, for the first time, off balance sheet assets in their first quarter reports,
3. Unemployment is high and probably getting worse (except for government census workers),
4. Mortgage resets have started to rise and with about 25% of homes underwater, there may be no way for most people to refinance,
5. Home inventories are high (over nine months supply at the current sales pace) plus significant shadow inventory (from banks and home owners) is waiting to come on the market when times improve,
6. Current taxes and fees are poised to increase significantly and new forms of taxes (like a national sales tax) may be required to fund our unsustainable spending,
7. State (and local) budgets are in trouble (estimates are from a $200 to $300 billion deficit) and Governors are asking for more help from the Federal Government (who has no money), and
8. Consumers still very over-leveraged.

That’s enough. I am not trying to get you depressed; I just wanted to make a point.

I am trying to understand why the market continues to rise and why traders are apparently throwing risk out the window again. Bears are down to a low 21%. Then I learned about Richard Russell’s latest newsletter. He publishes the DOW Theory Newsletter and is one of the most respected market analysts anywhere. Plus, almost “everyone” buys his newsletter including Goldman, hedge funds, the Bank of China, etc. In his latest newsletter, he explains that he expected the market to close below a critical number (10,750) last Friday which would have turned the market negative. However, during the final six minutes of trading, volume suddenly surged and lifted the DOW above the critical level of 10,750. This was very unusual and caused him to ask:

“Where did that very late buying come from? I have to think this was one of the most flagrant cases of manipulation that I have every seen. Was it the Fed; was it Goldman or Morgan Stanley buying futures on orders from the Fed?”

Note: he is not enamored with the Fed to begin with. But, it got me thinking.

Fiscal and monetary policy is being run by Keynesians (and has been since FDR.) Keynesians believe that in a crisis, you quickly lower rates, print money and then stimulate the economy to fill the drop or gap in spending. If you stimulate enough, the economy (GDP) will “climb” and soon consumers will believe the economy is coming back and will start growing again. The return of the consumer completes the circle and allows the government to hand off the economy, once again, to the private sector.

Now to complete this conspiracy theory, imagine the Fed and the Treasury sitting around wondering how they are going to get the economy going again when “the demand-side” or consumer is over leveraged and can’t buy or borrow money and the banks can’t lend because of impending asset losses and the capital asset requirements needed to remain solvent.

I am not a conspiracy theorist by nature, but I am having a difficult time understanding this market and continue to search for answers.

Are Our Economic Woes Behind Us Or Ahead Of Us?

The way the market has been performing (Dow hitting a high of 10,750 in September and now six months later, with volatility, it is almost flat at 10,550.) Does that mean our woes are behind us or still in front of us? Following are a Macro and Micro view of what is occurring and what might occur.

The Aggregated or Macro View of the Economy

There seems to be two overriding views of the economy. The first is that both demand-side and Supply-side economists (Keynesians) see the economy through the lens of an aggregated economic model or the GDP. When you look at the economy this way, you see the “big picture;” but you don’t see the depth or interrelationships among elements within the economy.

For example, you see the economy growing at 5.9% in the fourth quarter---exactly what, you as a Keynesian, expect. This gives you confidence that the government is doing the right things to fix the economy. First, monetary policy: lowering interest rates and expanding the money supply and than fiscal policy: providing stimulus to get the economy back to normal and subsequently growing.

Now, with the economy focused in Washington (where the money is) and the math looking better: 5.9% growth; you could see our woes as being behind us. Even though Q4 inventory adjustments contributed 3.4% of the 5.9% GDP growth and inventories actually fell $39 billion. That’s the way the GDP model works and you could say that since it fell at a slower pace, things are getting better.

I think the macro conclusion is that things are turning around and with some additional stimulus; the government can keep this economy growing.

The Capitalist or Micro View Of the Economy

The other view, the capitalist view, sees the economy as interactions between individuals (micro view) rather than as an aggregated model (macro view.) Therefore, they look at how the pieces of the economy work on a supply-demand basis with constantly adjusting prices to achieve equilibrium.

This view sees the 5.9% GDP growth but looks at the longer-term implications. For example, in 2010 we are going to get another peak in mortgage resets (July) at a very high level of about $97 billion and remain high through September of 2011. Once this second wave of resets begins (which was in November of 2009) it takes about three months to get delinquencies reported and another three months before we get foreclosure notices. How many mortgages actually go into foreclosure we can only guess? But it will be in the millions.

The government could forestall some of these foreclosures through various programs (loan modification, not letting homes go into foreclosure until they have been rejected by a loan modification program, continuing to allow buyers to make 4% down payments and subsidizing them with $8,000 cash, etc.)

Also, bank credit remains very tight. Banks are not only restricting loans, the Federal Reserve is telling them not to increase dividends or buy back stock so they can continue to build up reserves. If this doesn’t make it difficult to get loans, the a new accounting rule that goes into effect in the first quarter of 2010 which requires banks to disclose their off balance sheet investment vehicles, will make it even more difficult. The only company we’ve heard from so far is Freddie Mac and they said they may be considered insolvent when they report. They are however; going to continue buying mortgage backed securities that are at least four months delinquent (no worry, they are tax payer owned.)

Are our woes behind us or ahead of us?
We don’t know. If the government continues to kick the can down the road on mortgages and allows the banks to continue to increase assets, it could keep the economy going in the short term. But if mortgage foreclosures become a major problem (number of, no credit, continued unemployment, etc.) we could get another step down. Watch the GDP numbers, watch the delinquency filings, and watch the first-quarter bank results.

Do We Need Another Jobs Bill?

Most everyone agrees that the unemployment problem is bad (unemployment at 17%, black men at 25% and youth at 30%.) The problem is affordability. There is plenty of work to do; it is just too expensive to pay for the work to be done.

However, since the $800 billion stimulus package was passed, employment has deteriorated. Now, the President wants a new “Jobs Bill” using temporary tax credits of $13 billion to create jobs. The president wants this bill passed immediately, so I thought its time to take a look at the bill from all three points of view.

From the Keynesian (more government) point of view, they say the original stimulus bill was aimed at increasing GDP and from that growth, creating jobs. The problem was that the stimulus package was not big enough to fill drop off in consumer spending. Therefore, we need an even bigger stimulus bill this time. Unfortunately, that would be difficult to get through Congress at this time.

Paul Krugman, in an article in the NY Times, argues that government must help. It can’t just do nothing. He suggest that for a few hundred billion dollars, we could get things going by:

1. Transferring monies to state governments so they can continue to maintain and/or create new jobs,
2. Hiring people to work for the government directly like they did in the 1930’s with programs like the Workers Progress Administration (WPA),
3. Giving companies temporary tax credits (for example, pay employers share of payroll taxes up to $5,000 for each new hire.)

The Supply-Side (less government) economists have a different point of view. Brian Wesbury, Chief Economist at First Trust in Chicago, argues that the labor market is improving and will continue to improve in the year ahead. That unemployment is simply a lagging indicator. His argument is based on the following reasons:

1. Civilian employment, based on the household survey, shows that 785,000 jobs were created in December (second month of job creation.)
2. Hours worked increased over the past three months and increased hours are an early indicator of future employment.
3. Unemployment has fallen from a peak of 10.1% to 9.7%, and
4. Employment has expanded into more industries recently.

Therefore, I conclude from his argument that permanent tax reductions would help make companies more globally competitive, but more stimulus money at this time would only fuel inflation.


The third point of view, the Capitalist view, sees the unemployment problem differently, according to Henry Hazlitt, Austrian economist:

1. The goal should be maximizing production, not employment. With full production comes full employment. By separating production and employment, you make employment the goal. That’s what they did in the 1930’s with the WPA. Projects were selected by how unproductive they were or how much labor they required.
2. We need to help the unemployed get into other growing industries,
3. We need to eliminate as many barriers to employment as possible. Here are a few of Liewellyn Rockwell’s suggestions:
A. Get rid of the minimum wage,
B. Payroll taxes rob employers of resources,
C. Laws that threaten firms if they fire an employee,
D. Unemployment subsidies that pay people not to work.

Over the next few weeks as the debate begins in the House and Senate over the type of jobs bill we need and the amount of money (we need to borrow) to pay of the jobs bill, you may need to adjust your plans accordingly.