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Thursday, November 4, 2010

Stockman is spot on!

Yesterday I saw the single best TV interview ever describing the realities of America’s financial plight. David Stockman’s (Ronald Reagan’s budget director) assertions during his appearance on CNBC with David Faber and Gary Kaminsky (link provided at the bottom of this page) was spot on. Every American should be required to see this interview before being allowed to vote. Granted Mr. Stockman has a book coming out soon, and he is trying to grab a few headlines, but the facts bare out his contentions. 
Mr. Stockman asserts, and I concur, that America is riding a monetary doomsday machine. During the interview Stockman uses a lot of industry lingo so I am going to attempt an interpretation.
As you may, or may not, know, the Federal Reserve announced today a plan to start buying US Treasury debt again to the tune of $900 billion. This is an effort to bring down long term interest rates. Usually the Fed dickers around with interest rates by changing the rate banks are charged to borrow money over night. Lower interest rates spur the economy by making everything cheaper. The Fed used all the bullets in this gun back in December of 2008 when it took the rate to zero in the midst of the financial crisis. 
Now the Fed is force to deploy a different strategy in order to lower long term rates. In the media you hear this plan referred to as “QE2”. “QE” stands for “quantitative easing” which is fancy language for increasing the money supply. QE1 has been tried and obviously didn’t work because we now have QE2. 
The eggheads at the Fed figure buying $500 billion worth of treasury debt is the same as lowering the short term rate by .5%. This is a really big move which will, theoretically, lower long term rates. To take such a drastic step these men behind the curtain must be awfully pessimistic about our country’s economic outlook. Upon closer examination (which they know is beyond most Americans) the move looks downright desperate if one considers the downside risk to this strategy. 
OK, so here is the downside:
A). Rates are at historic lows. Taking them lower will have a very limited effect. Proponents of the strategy admit the positive effect will be minimal but point out that the Fed can’t just sit by while unemployment is so high. They have to do something. This just proves that the Fed is not divorced from politics as it was designed. Making decisions this way just shreds the Fed’s credibility. When you have a fiat currency (not backed by gold or something like it) the central bank’s credibility is critical but this is a minor consideration at the moment.
B). The Fed is playing games with the world’s reserve currency, the US dollar. What I mean is that oil is priced in dollars, gold is priced in dollars and other currencies are measured primarily by their value compared to the US dollar. The Fed, by lowering interest rates, is trying to devalue the US dollar, which just happens to be the world’s reserve currency. 
When the dollar’s value is low the stuff we manufacture in the US is affordable to other countries. A low valued dollar brings tourist from abroad to spend money at US vacation spots. By the same token, if, for example, Brazil’s currency is strong relative to the dollar then we Americans won’t be going to Brazil on vacation or buying stuff they make. Brazilian stuff is expensive when their currency appreciates relative to the dollar.
During discussions about the financial crisis or studying the Great Depression in high school, some of you (who were awake) may have heard the term “beggar thy neighbor.” This refers to the practice of countries devaluing their currency to sell more stuff and grow their domestic economy at the expense of their trading partners. It is a short-sighted, selfish policy. 
Countries (Brazil is a good example) getting squeezed like this really only have one option and that is to have their central bank buy US Treasury debt. By having US Treasury debt on the balance sheet of the central bank, a nation’s currency has a value pegged closer to the US dollar. 
The Fed’s attempts to devalue the dollar is forcing these countries to buy a bunch of our debt they don’t really want. When these countries are forced to buy US debt, the price of the bond is bid up, the US dollar gains value and things balance out, theoretically. Unfortunately, the US government is borrowing, then spending money at such a rate that it doesn’t balance out. This, my friends, is a problem.
This discombobulated bond market also means that the interest rates on US treasury debt are contrived and artificial. These dynamics are allowing Congress to borrow trillions of dollars practically for free (really low interest rate). The lowest interest rates (the cheapest money) are on debt that comes due within 0 to 7 years. Americans are loading up on debt we must pay back pretty soon (smart business people are stretching out their debt to take advantage of these historically low rates). 
This practice reminds me of Wiley Coyote lighting the fuse on a stack of dynamite. It is definitely, no question, certainly, positively, going to blow up in our face. No one thinks borrowing in this fashion is sustainable. Our government is borrowing $100 billion per month but our economy is only growing by $50 billion per month. This is why Mr. Stockman is freaking out. This is why I’m freaking out.
Brazil is so angry about the deal, they boycotted the G 20 meetings in South Korea to protest the “currency war being waged against them.” Other countries are also taking steps to limit their exposure to the US deficit. Our global neighbors thought they were loaning money to Bill Gates but it was Fred Sanford in disguise. They don’t want to be forced to loan Fred any more money in order to protect domestic exporters and, by extension, their economies.
The blow up is going to come when (not if) interest rates rise. Since we have no idea what a true, market interest rate is, getting your arms around the problem is difficult at best. If interest rates were to increase by 5% (which is by no means out of the question) it is probable that the US government could not make the interest payment on the national debt with the amount of taxes being collected. In other words, the US would be flat broke. America would be unable to make payments on all this debt we are forcing down the world’s throat nor able to borrow any more. Defaulting on our debt will grind the global financial system a halt. Our global popularity is going to be right up there with the Black Plague. All those aircraft carriers we bought might come in handy.
C.) Problem B is the doomsday Mr. Stockman is rightfully concern about. But should the world survive the dollar being the “reserve” currency, the US might not. When interest rates increase, the value of bonds decreases. Since our central bank is loading up on bonds at very low interest rates, an increase in rates will destroy the Federal Reserve’s balance sheet. So what does this mean? The truth is no one knows, but it can’t be good. In all likelihood hyperinflation would make our currency worthless. This happened in Germany during the 1920’s. We all know what followed that escapade.
Mr. Stockman was asked in the interview by Mr. Kaminsky if there was a point at which our national debt would be just so large that we would be past the point of “no return.” Stockman, in a candid moment, said he thought we were already there. Later he back peddled as best he could but his true assessment slipped out. He tried to say that if Congress raised taxes and aggressively cut spending there might be a ray of hope. The chances of the Republicans raising taxes is just about as likely as the Democrats cutting spending. I have zero faith that Congress can act in any manner not motivated by the 2012 presidential campaign. We are up a smelly creek with no paddle.
What Mr. Stockman articulated is what I have been concerned about now for two years. I just needed to hear it from someone other than David Rosenberg. The Fed’s attempt to devalue the US dollar so aggressively is going to end badly, very badly. 
I will be blogging more on the implications of our monetary policy and provide a list of signals that the unraveling has started. Stay tuned.  

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