Fiscal Toboggan Ride Assured

The news from tonight's WSJ web site is that a deal has been struck to avoid the "fiscal cliff."  As previously predicted, it changes little in the grand scheme of things, other than my debt clock at right will continue to move in the upwards direction for a decade or more.  Here is the analysis of the results.

The deal doesn't do much to control the U.S.'s long-term budget woes, which are driven largely by entitlement spending, especially on health care, which were left untouched in this agreement. And depending on the budget math and the ultimate fate of the spending cuts, it may not do much for the short-run deficit either. 

By waiting until the last minute, and reaching a deal on a much smaller scale than either side once envisioned, Washington also deferred many of its thorniest questions for perhaps as little as a few weeks. In late February of early March, the Treasury Department will run out of extraordinary measures to deal with the government's borrowing limit—which it reached on Monday—and Congress would need to approve an increase.

Welcome to government by crisis, lurching from one deadline to the next with no plan to solve the long term issues and not even a budget against which to measure progress.  By ensuring a series of legislative crises, the Congress and the President are guaranteeing that a real crisis will develop.  With public and private debt levels high and inflation heating up, there are no reserves to deal with fresh economic pressures.  I went grocery shopping for New Year's supplies, buying things I haven't bought in a while, and I was shocked at how much prices have risen on some items.  I don't care what the official numbers say, my experience is telling me that they are understating inflation right now.

Next crisis, the debt ceiling increase.

The Most Dangerous Easing Yet

And I don't mean Obama's mideast policy, whatever that is; I can't figure it out. I am talking about the Fed's latest Quantitative Easing (QE3) which was announced today. This is the most dangerous move yet by the Fed, as Bernanke has committed to buying up mortgage debt. From Reuters:

The Federal Reserve said it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month in a third round of quantitative easing as it seeks to boost growth and reduce unemployment.

Mortgage debt? This seems a straight up political move designed to lift the stock market and prop up the housing market prior to the election. I summarized the futility of zero percent long term interest rates as explained by David Einhorn some time ago. The method by which the Fed pumps liquidity matter little. A quick recap:

• Low interest rates make it harder for retirement eligible to actually retire, they are getting little return for their money.
• Interest rates are a measure of the time value of money. By setting it at zero, there is no urgency about investment decisions.
• Because those who live on fixed savings, have less to spend, they spend less, harming the economic recovery.
• Investment isn't increasing at zero rates, because once rates fall below the rate of inflation, the only consideration is whether the principle can be paid back. If inflation is at 2.5%, then reducing interest rates from 2.5% to 1.5% or even zero percent will have no effect on investment, so there is no offset to the fact that savers have less to spend.
• Zero rates allow otherwise worthless loans to appear to be performing, as the borrower can make nominal payments. But it delays the necessary economic unwinding necessary for real economic recovery.

Even George Will got the memo. In today's WaPo he quotes Esther George of the Fed's regional bank in Kansas City:

Very low interest rates discourage saving, punish retirees living off interest-bearing assets and, George says, “incent people into riskier assets.” These include commodities, farm land (for the first time on record, prices of cropland in George’s district have risen more than 20 percent for two consecutive years) and equities. Fed Chairman Ben Bernanke evidently thinks that driving up the stock market will quicken the animal spirits of the affluent 20 percent who own 93 percent of equities, and this “wealth effect” will spur economic activity, eventually benefiting others. So, the interest rates Barack Obama favors are a form of the trickle-down economics he execrates.

But of course real unemployment stays stuck at historic high levels. Consuming more and more jelly donuts isn't giving us more energy, its just making us sick. Of course, gold, oil and stocks all moved higher on the announcement. Those assets have in common that they are related to tangible goods whose value stays constant while the value of money falls.

Here is the price of gold as anticipation of the easing built:

The price of gold is the inversely proportional to the real value of money but prices in the expected future value of money as well. Gold is not bullish on the dollar. As the fed has performed other market interventions over the last five years, look what has happened to the price of gold.

Gold Standard Debate on the Right

One of my favorite economists and bloggers, John H. Cochrane, argues against the gold standard in today's WSJ.

Let's start by clearing up some common misconceptions. Congressman Ron Paul's attraction to gold, and Federal Reserve Chairman Ben Bernanke's biggest criticism, is that a gold standard implies an end to monetary policy and the Federal Reserve. It does not.
. . .
A gold standard does not eliminate debt crises or debt-induced inflation. No monetary system can absolve a nation of its fiscal sins.
. . .
Why not the old version? Most of all because the value of gold is poorly linked to other prices in the economy, which is what we want to stabilize. Fixing the price of gold today would do little to control the general price level. There are two big reasons for the disconnection between gold and other prices.

I mostly agree with Cochrane's criticisms, but still a support a return to the gold standard. Cochrane proposes inflation indexed bonds that would be tied to the consumer price index. He states that the purpose of monetary policy is to ensure price stability. Since gold is not well tied to the prices of consumer goods in the economy, he argues that it is a bad choice as a standard vis-à-vis price stability.

My objection to the current regime is that the federal reserve can manipulate the currency to the benefit of the big banks, in a largely undetected way. A gold standard doesn't fully prevent manipulation, but limits the scope of debauchery. To use Cochrane's own example, if the Fed issues more currency than it has reserves to redeem, it will eventually provoke a run on convertibility which will require a public devaluation. Such devaluations would serve as a public shaming that the Federal Reserve had mismanaged the currency.

Further, gold is tied to significant commodities that make a up key portions of the CPI. For example, gold and gasoline prices have shown a much narrower range of ratios than either commodity has to the dollar. Under Cochrane's proposal there is no reason to believe that either the bonds or the CPI itself wouldn't be subject to manipulation. Since Cochrane's proposal is "rule" based, I have no faith in it. The federal government and Federal Reserve has shown a disdain for what we would regard as rules. For example, we know that the Federal Reserve has loaned money to non-bank businesses who quickly put together an "industrial bank" and who would have been otherwise ineligible. While technically not a violation of the Code of Federal Regulations, this also shows a Fed that is operating well beyond its founding parameters.

There should be no doubt that a gold standard isn't going to bring nirvana. We have had booms and busts with or without the gold standard. Since going off the gold standard hasn't brought price stability or the end of booms and busts, and has undermined our faith in fair play in the economy; a return seem in order.

Bracing for Stormy Economic Weather - UPDATE

Update at bottom.

The leader in the most recent issue of the Economist questions Europe's collective will to defend the euro.  The result of failure would be catastrophic, in that august publication's opinion.  I am not so sure, but it would be bad in the short term.  They recommend a number of steps in the unsigned editorial, most notably, printing more euros, although that's not how it is phrased of course.

That is because much looser monetary policy is necessary to stave off recession and deflation in the euro zone. If the ECB is to fulfil its mandate of price stability, it must prevent prices falling. That means cutting short-term rates and embarking on “quantitative easing” (buying government bonds) on a large scale. And since conditions are tightest in the peripheral economies, the ECB will have to buy their bonds disproportionately.

It is an open question whether the euro will survive in its present form, but regardless of the outcome, we can expect turbulence ahead.  Even if the euro is saved by the aforementioned actions, it will set in motion long term inflationary pressures as the euro loses value against the dollar.  This will have a negative impact on U.S. exports, putting more pressure on our tepid recovery.  However, if the euro zone can't be saved, and widespread defaults on government bonds outside of Greece get started, then a real liquidity crisis could trigger a second global recession.  America would not be immune to this outcome either.

Either way, we are going to see real pressure on our own government's deficit situation, as economic headwinds deprive governments at all levels of revenue.  At the same time another recession increases outlays due to unemployment payments and increased use of food stamps, medicaid and other parts of the social safety net. 

The silver lining is that Obama is unlikely to be re-elected in such a climate.  But many Americans and people all over the world are going to suffer.  The root cause of our troubles is clear; all over the western world, politicians have made promises that were going to be impossible to fulfill.  This is the central appeal of Chris Christie; he is the politician who has best articulated this truth.  The end result is that those dependent on the government, whether retired employees, social security recipients, or others, will not have the standard of living they thought.  Governments will not keep their promises, either through bankruptcy, inflation or abrogation, because the collective promises can't be met. This will lead to lowered consumption as the reality of reduced lifetime income sets in and long term re-adjustment in the economy.  We are not going to have a full recovery for a decade, in my humble opinion.  But the tea party movement is correct in focusing on getting the spending under control now, because the sooner we come to grips with the spending problem, the sooner the economy will recover.

UPDATE

Over at Zero Hedge, Phoenix Capital Research has this to say:

Indeed, with Europe’s entire banking system insolvent (even German banks need to be recapitalized to the tune of over $171 billion) the outcome for Europe is only one of two options:

1) Massive debt restructuring.

2) Monetization of everything/ hyperinflation These are the realities facing Europe today (and eventually Japan and the US).

Either way we are talking about the destruction of tens of trillions of Euros in wealth. The issue is which poison the European powers that be choose.

Personally, I believe we are going to see a combination of the two with deflation hitting all EU countries first and then serious inflation or hyperinflation hitting peripheral players and the PIIGS.

More Economic Headwinds - Rising Prices

The WSJ headline today, Global Price Fears Mount, signal more risk to the economic recovery. Steel prices are rising as the price of raw materials, coal and iron, rise. China and Brazil are noted for their increased consumption of commodities. Meanwhile, the recovery is barely underway in the United States, with factories still sitting with unused capacity. Global food prices are also rising. The impact in Europe is expected to be rising interest rates to keep inflation in check.

The tough question is how this will impact the United States. The Fed is currently committed to fiscal stimulus. But commodity price increases have a history of triggering broader inflation. My concern is that the Fed will "get behind the curve" in fighting inflation and let it get out of control. Even though we briefly dipped into deflation in 2009, during the 2000s we have seen more volatility in the inflation measures than the 90s. There is no reason to believe we won't have swing to relatively high rates of inflation quickly as the economy recovers and commodity prices rise. Don't be fooled by the graph below, the dark line is actually at the 2% inflation line.

Image courtesy of WSJ.

For all of the talk about deflation from the likes of Krugman, we haven't actually seen deflation for any prolonged period. Maybe its just my bad experience growing up in the 70s, but I worry much more about an inflation that will require high interest rates that will crush out recovery.

Inflation Nightmare?

Michael Kinsley, of all people, has a very interesting article on the possibility and danger of inflation. I say surprisingly because, in the years I have followed him, he has gone from being somewhat liberal to a solid lefty. Further, he himself states that every leading economist (whatever that means) is convinced that there is no danger of inflation. That by itself worries me, because economists, in general, were unable to predict our present predicament.

Kinsley makes sense too. Basically he is saying that since Volcker squeezed out inflation in the late 70s and early 80s, we have been living on credit ever since, and the government's response, Republican and Democrat has been to spend more borrowed money. How this cannot end in inflation is beyond me. The best paragraph:

My specific concern is nothing original: it’s just the national debt. Yawn and turn the page here if you’d like. We talk now of trillions, not yesterday’s hundreds of billions. It’s not Obama’s fault. He did what he had to do. However, Obama is president, and Democrats do control Congress. So it’s their responsibility, even if it’s not their fault. And no one in a position to act has proposed a realistic way out of this debt, not even in theory. The Republicans haven’t. The Obama administration hasn’t. Come to think of it, even Paul Krugman hasn’t. Presidential adviser David Axelrod, writing in The Washington Post, says that Obama has instructed his agency heads to go through the budget “page by page, line by line, to eliminate what we don’t need to help pay for what we do.” So they’ve had more than a year and haven’t yet discovered the line in the budget reading “Stuff We Don’t Need, $3.2 trillion.”

Here is where the Tea Party comes in. It is a central tenet of all of the various Tea Party movements to reign in government spending, to stop new spending and cut existing spending, even if the cuts are to popular programs. There is no other way out, except inflation.

Compared with raising taxes or cutting spending, just letting inflation do the dirty work sounds easy. It will be a terrible temptation, and Obama’s historic reputation (not to mention the welfare of the nation) will depend on whether he succumbs. Or so I fear. So who are you going to believe? Me? Or virtually every leading economist across the political spectrum? Even I know the sensible answer to that.

And yet …

But inflation will wreck the country more surely than Obamacare, this is why we must continue to beat the drum for less spending now.

UPDATED Looming Inflation: A Public Service Announcement

The nation is struggling with recovering from the current recession, which recovery does not seem assured. However, thinking longer term, I see looming inflation on the horizon. Both The Economist and the Wall Street Journal devoted significant column inches to the tricky subject of how the deficits and rising debt of the United States federal government will result in crisis. Allan Meltzer in the WSJ pins the problem on the Federal Reserve monetizing the debt, printing money to buy Treasury bonds. Both he and the Economist agree that inflation may take a while to take off, but on current trends it is unavoidable. If that happens, prior to the 2012 elections, then Obama will go the way of Jimmy Carter. Although both articles end optimistically, I don't think our politicians have the will nor the insight to do much about the problems. Look at the dilemma they face and ask yourself if you believe they have the stomach for the tough options.

Japan’s experience illustrates the excruciating dilemma facing American policymakers. The White House acknowledges the deficits it projects are too high. But slashing spending or raising taxes too soon could snuff out recovery and leave America with even bigger deficits. Asked on October 15th when the administration would tackle the deficit, Tim Geithner, the treasury secretary, said: “First, growth.”

And from the Journal:

The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.

I think we are in for some pain that will only be solved through high interest rates and deficit reduction. I also don't think that will happen under a Democrat controlled government.

More pressing for my readers might be what to do about this situation. Fortunately, we have lived through this movie before. First, mortgage holders should take advantage of the current low interest rates to get into a fixed mortgage. I know this will cause most home owners to increase their monthly payments, but Mrs. Daddy and I have gone this route to reduce future uncertainty.

Second, if you have an investment portfolio, you should own precious metals (gold, silver) as part of that either outright through coins, my preference, or through mining stocks. These hedge inflation well. I don't overloading on precious metals is a good idea, we strongly believe in a balanced portfolio.

Finally, there are Treasury Inflation Protected Securities, or TIPS, are Treasury bonds that provide another inflation hedge.

TIPS pay a fixed coupon plus a rate that rises with inflation and falls during deflation. The portion that adjusts for inflation gives investors protection against erosion in the purchasing power of the greenback. TIPS are indexed to the Consumer Price Index, or CPI, which is released monthly and tracks prices paid by consumers for a representative basket of goods and services.

Ultimately, inflation is a tax that ravages everyone, but not equally, and it is hard to avoid all of its ill effects. The last thing we can do is continue the fight against all of the ridiculous budget busters this administration has proposed, and start voting in real conservatives in 2010.

Graph of public debt forecast The Economist.

UPDATE

KT has an excellent comment that I liberated as an update:

I'm with you up to a point. I don't like gold or other precious metals. When you buy them, you buy rocks. Instead, I'd buy mutual funds from well-run countries, such as Australia. In fact, if you want to invest in commodities, Aussie mutual funds would be a good way to do it - the Aussie economy is, to a great extent, a commodities economy. Plus, they're the supplier of choice for China for lots of minerals. Lastly, the Australians have nothing like the kind of debt problems we have.

I agree that this strategy will also hedge inflation, but I admit I still like owning a small amount of actual metal. Finally, I am partial to Aussies, as Mrs. Daddy's mum hails from down under.

More Spending, More Debt

The Senate passed Obama's budget 55-43 today. After eight years of spending excess under Bush, the Democrats are going piling in for seconds thirds and fourths. This will certainly solve our long term problems:

The Obama budget would borrow an estimated $9.3 trillion over the next decade, according to the Congressional Budget Office, doubling the public debt as a share of the nation's output from 41 percent to 82 percent. The budget calls for nearly $4 trillion in deficits over the next five years.

So where will all this cash come from? KT has been all over this. There are really only two sources left, the Chinese and printing it. The Chinese have indicated they aren't happy with us debasing their investment, so count them out.

As America's biggest creditor, Beijing is now worried about its over-investment in U.S. Treasury debts. "We have lent a huge amount of money to the U.S.," Premier Wen Jiabao said last month. "Of course, we are concerned about the safety of our assets." He called on the Obama administration to "maintain its good credit, honor its promises and guarantee the safety of China's assets."

Stand by for inflation, hopefully sooner than later, so we can turn out Obama like a one term Carter type Presidency that we deserved for electing such an unprepared fool.

Cost of Iraq War

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Current Cost of War in Iraq The little clock you see is from Zfacts, showing the current estimated cost of the war in Iraq based on congressional appropriations. My experience in that realm tells me that it is an undersestimate.

The current economic mess reminded me of an earlier time in my life when a drawn out war became a drain upon the U.S. Treasury and was financed with deficit spending. That time was Vietnam, and I was convinced then and remain so today, that the cost of that war directly resulted in the ruinous inflation of the 1970's. Coincidentally, that was also a time of fundamental shifts in world economic exchange arrangements. In 1971, the Bretton Woods system which had governed central bank exchanges after World War II, finally came undone due to the deficit spending of the U.S. government on social programs and the Vietnam war. Essentially, the policy of pegging the dollar to $35/ounce came undone and the reality of the dollar's falling value was recognized. Wikipedia article here. However, floating the dollar against gold was a new experience for America's central bank, the Federal Reserve. As a result. they lacked knowledge of the tools needed to combat the ensuing inflation.

Fast forward to our decade. Nowadays, central banks purportedly understand the relationship between deficits and inflation. However, cost inflation was contained because of a new phenomenom, that did not escape the central bank's notice, but was seemingly beyond its power to influence. I am referring to the practice of consumers in China to save at high rates and for their bankers to invest those savings in American assets such as Treasury bonds or commercial bonds. Full article here. This sopped up the extra liquidity in our system and hid the normal effects that would have resulted in price inflation. However, the inflation did show up in asset price inflation, primarily real estate. Meanwhile, both nations seemed to benefit. China strong export growth was fueling those savings and making the citizens feel more prosperous, even though the economy was not really producing benefits to consumers. The United States didn't have to deal with the tough choices that such high deficits would normally require.

The outgoing administration and the Republican party has much to answer for. Spending like drunken sailors on both the war and social programs reminds us of the Democrats of the LBJ era. But I also object to the cost of war. Yes, I supported the invasion of Iraq. However, our nation had a proven and successful blueprint for fighting overseas ground wars called the Powell doctrine. Among its tenets was that war required overwhelming numerical superiority in order to prosecute to a quick conclusion. The doctrine also calls for a well planned exit strategy. Enter Donald Rumsfeld, a patriot, visionary, and a man who turned out to be too smart for the nation's good. I was on active duty when he was sworn in as Secretary of Defense and remember his vision pre-9/11 vision of a much smaller military with much greater emphasis on special forces. The war in Iraq gave him the chance to test that vision. But to my thinking, this was the wrong time to make such a gamble. The war in Iraq was always a gamble, in some ways a hail-mary to change the trend line in the middle east, to show the Muslim world that democracy and prosperity can coexist. To make a side bet on force structure under those circumstances seemed foolhardy to me. Ultimately a force leve was sent that could of course remove Saddam from power, but was insufficient to impose order on a post-Saddam Iraq. In hindsight, the widespread looting was a tipping point that showed the criminal and Islamofascist elements that we were not up to the job of pacifying the countryside. So here we are, over $600 billion later. Only the surge, which is a direct rebuke to Rumsfeld's arguments has saved the day. Ultimately, prolonging the war has had a direct cost to the national treasury that is calculable and has contributed to our current predicament.

Now we will be faced with tough times for many years to come. The war wasn't the only cause of increased deficits, but it hasn't helped. This kind of financial overhang is very difficult to unwind. It wasn't until 1982 that inflation got under control in the United States. The current practice of adding more government debt to go along with all the private debt doesn't seem likely to help in the long run. Might as well bite the bullet now and start focusing on efforts that will encourage saving by U.S. citizens.