Debt, Demographics & Debasement are Destiny
Debt, Demographics & Debasement are Destiny
BY KURT KASUN | FEBRUARY 04, 2008 | 8:46 PM |
Historical Perspective...Where We've Been and Where We're Going: Three Landmark Years Have Marked Our Course
Historical Perspective...Where We've Been and Where We're Going: Three Landmark Years Have Marked Our Course A. 1913
1. United States Revenue Act of 1913 (from Wikipedia)
The United States Revenue Act of 1913 imposed the first federal income tax following the ratification of the Sixteenth Amendment. The incomes of couples exceeding $4,000, as well as those of single persons earning $3,000 or more, were subject to a one percent federal tax. Further, the measure provided a progressive tax structure, meaning that high income earners were required to pay at higher rates. It would require only a few years for the federal income tax to become the chief source of income for the government, far outdistancing tariff revenues. Less than 1 % of the population paid federal income tax at the time.
2. Federal Reserve Act (from Wikipedia)
Created in 1913 by the enactment of the Federal Reserve Act, The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States is a quasi-public (part private, part government) banking system composed of (1) the presidentially-appointed Board of Governors of the Federal Reserve System in Washington, D.C.; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors; (4) numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks; and (5) various advisory councils. "How do open market operations actually work? Currently, the FOMC establishes a target for the federal funds rate (the rate banks charge each other for overnight loans). Open market purchases of government securities increase the amount of reserve funds that banks have available to lend, which puts downward pressure on the federal funds rate. Sales of government securities do just the opposite-they shrink the reserve funds available to lend and tend to raise the funds rate. By targeting the federal funds rate, the FOMC seeks to provide the monetary stimulus required to foster a healthy economy. After each FOMC meeting, the funds rate target is announced to the public."
B. 1933
1. Executive Order 6102: The Gold Confiscation Of April 5, 1933, subsequent dollar devaluation and abandonment of the gold standard. (Wikipedia)
In an attempt to address the causes and effects of the Great Depression, Executive Order 6102 was signed on April 5, 1933 by U.S. President Franklin D. Roosevelt. It prohibited the "hoarding" of privately held gold coins and bullion in the United States. The Order was given under the auspices of the Trading with the Enemy Act of 1917, as recently amended. The government required holders of significant quantities of gold to sell their gold at the prevailing price of $20.67 per ounce. Shortly after this forced sale, the price of gold from the treasury for international transactions was raised to $35 an ounce. The U.S. government thereby devalued the dollars (which it had just forced citizens to accept in exchange for their gold) by 41% of its former value
2. The New Deal (from Wikipedia)
The New Deal is the title President Franklin D. Roosevelt gave to a sequence of programs and promises he initiated between 1933 and 1938 with the goal of giving relief, reform and recovery to the people and economy of the United States during the Great Depression. Dozens of alphabet agencies (so named because of their acronyms, as with the SEC), were created as a result of the New Deal. Historians distinguish between the "First New Deal" of 1933, which had aimed at short-term recovery programs for all groups in society, and the "Second New Deal" (1935-36), which aimed at a more radical redistribution of power away from business and toward workers, farmers and consumers.
C. 1971
1. The "Nixon Shock" (from Wikipedia)
By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit (for the first time in the twentieth century). The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade deficits. In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs. In the first six months of 1971, assets for $22 billion fled the U.S. In response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price controls, a 10% import surcharge, and most importantly "closed the gold window," making the dollar inconvertible to gold directly, except on the open market. Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed the "Nixon Shock". The surcharge was dropped in December 1971 as part of a general revaluation of major currencies, which were henceforth allowed 2.25% devaluations from the agreed exchange rate. But even the more flexible official rates could not be defended against the speculators. By March 1976, all the major currencies were floating-in other words, exchange rates were no longer the principal method used by governments to administer monetary policy.
2. The decline of U.S. monetary influence and the decline of the dollar (from Wikipedia)
Reinforcing the relative decline in U.S. power and the dissatisfaction of Europe and Japan with the system was the continuing decline of the dollar-the foundation that had underpinned the post-1945 global trading system. The Vietnam War and the refusal of the administration of U.S. President Lyndon B. Johnson to pay for it and its Great Society programs through taxation resulted in an increased dollar outflow to pay for the military expenditures and rampant inflation, which led to the deterioration of the U.S. balance of trade position. In the late 1960s, the dollar was overvalued with its current trading position, while the Deutsche Mark and the yen were undervalued; and, naturally, the Germans and the Japanese had no desire to revalue and thereby make their exports more expensive, whereas the U.S. sought to maintain its international credibility by avoiding devaluation. Meanwhile, the pressure on government reserves was intensified by the new international currency markets, with their vast pools of speculative capital moving around in search of quick profits.
In contrast, upon the creation of Bretton Woods, with the U.S. producing half of the world's manufactured goods and holding half its reserves, the twin burdens of international management and the Cold War were possible to meet at first. Throughout the 1950s Washington sustained a balance of payments deficit in order to finance loans, aid, and troops for allied regimes. But during the 1960s the costs of doing so became less tolerable. By 1970 the U.S. held under 16% of international reserves. Adjustment to these changed realities was impeded by the U.S. commitment to fixed exchange rates and by the U.S. obligation to convert dollars into gold on demand.
In sum, monetary interdependence was increasing at a faster pace than international management in the 1960s, leading up to the collapse of the Bretton Woods system. New problems created by interdependence, including huge capital flows, placed stresses on the fixed exchange rate system and impeded national economic management. Amid these problems, economic cooperation decreased, and U.S. leadership declined, and eventually broke down.
FAST FORWARD TO TODAY
An easy conclusion to draw from the past century, in terms of the most powerful forces which direct our country, is that we have become far more reliant on government and that the chief barrier to the aggrandizement of government, the gold standard, has been totally removed. What's more, the actions of the Federal Reserve, while serving the short-term interests of politicians, have resulted in the slow and steady decline of the US dollar and in inflation.
So what, you might ask? Life has been pretty good for many Americans since 1971 (we have bigger and better houses, cars, gadgets, and portfolios) and doomsters who have been sounding the sirens of collapse have looked foolish over this 37-year period. In order to fully understand what has been unfolding I find the following chart provided in a commentary titled "Lessons in History" from David Galland very useful:
The first thing that leaps out at me is the obvious unsustainable nature of the gap between world industrial production (which I refer to as real wealth) and money growth (which I refer to as vapor wealth). This gap represents nothing less than a measure of excess money creation. It is also clear to me that the slope of the curve for money creation is increasing and is close to becoming asymptotic. Vapor wealth is found in asset values be it real estate, equities, or bonds. Real wealth is created by businesses whose new products and services are demanded at sustainable market prices through increased innovation and productivity. The latter is why we see a nice steady upward climb in world industrial production since World War II. Looking at the graph, you could probably make the case that money was actually too tight up until 1975.
But then things really changed. US figured out how to truly abuse the privilege of holding the world's reserve currency. You see, if the US comes up short on its balance sheet it merely needs to create more US dollars by monetizing its debt. No other country on the planet has this luxury (a blessing that will soon become a curse). If Japan or Europe, for example, needs to purchase oil, it needs to have reserves in US dollars in order to do so because oil (as almost every other commodity) can only be purchased in US dollars (this is changing as some countries are slowly beginning to ask for Euros). The US, on the other hand, merely needs to crank up the presses and print more dollars if it wants more oil (or pick your commodity). This removes much of the incentive to balance budgets.
The other effect is that it stokes inflation. All of these dollars need to go somewhere and it is clear from the graph that they are not all going to productive use as the huge gap indicates. Jim Rogers noted US-multi-categorical perma-bear (bearish on US dollar, economic prospects, bullish on inflation) has it right in my view when he says that: "Inflation damages everything. It distorts all economic planning, all economic decision making....But once you start embedding inflation into the entire nation's economy, that's one thing. Then it changes everything. It changes currencies. It changes foreigners' perceptions of their own economy, their own currency, their own cost of doing business."
But you might ask why we haven't seen inflation? The answer is that we have seen it...only is has manifest itself in different ways. In the 1970s it was most visible in the price consumers paid for goods and services. In the 1980s through 2005 inflation was most present in rotating asset bubbles be they stocks, bonds or real estate. You see it was foolish to think that the asset prices accurately reflected the sustainable underlying value for the particular asset. This is pretty evident when you measure stock prices in terms price-to-earnings multiples (which peaked in 2000 and have been declining since in the US). In residential housing some ways to measure a "true value" or "non-inflationary value" of a home is to compare monthly mortgage payments to rent-equivalents (the price the same home could charge to rent it), to compare house prices to historical incomes, or to create a mean-reversion chart for home values over the past 100-years. By all three measures this asset classes' best inflationary days are behind it. The last bubble to pop will be the bond bubble which I will discuss later in this commentary. We are also beginning to see the return of inflated prices in goods and services, especially in non-tradables (goods are services we can't purchase from abroad).
At this point it is helpful to look back in order to see the future. Regarding income taxes, we have come a long way from a 1% top marginal tax rate and although we witnessed a growth in tax revenues when we decreased taxes in the 1980s, 90s, and 2000s by gradually lowering income, dividend, and capital gains taxes, this trend is set to reverse immediately after the 2008 elections. A slight increase would have minimal impact (much as the Clinton raising the top tax bracket to 39.6%), but we are going to see tax hikes of enormous proportions. Regarding the New Deal, the first New Deal signed into law in 1933 was relatively benign (we will call this New Deal 1.0). The second new deal (New Deal 1.1) was, as the Wikipedia reference states, "a much more radical redistribution." I believe that, had it not been for World War II, would have seen New Deal 1.2, 1.3, 1,4...each iteration giving the government greater control over the economy and our lives.
I think that Americans should now be preparing themselves for New Deal 2.0. This will make New Deal 1.0 look like draconian economic Darwinism. For this we will have the Baby-Boomers and the "Millennials" (aka "Generation Debt") largely to thank.
You see the Boomers are the generation who, as the Wikipedia reference states, squandered the U.S. producing half of the world's manufactured goods and holding half its reserves and demanding the government expenditures for the Great Society and other social programs. They were very altruistic in spending other people's money weren't they? This group wouldn't know the meaning of self-sacrifice if it came up and beat them over the head. You could argue that their call for government sponsored intervention and programs designed to help the poor were a result of guilt associated with their narcissistic, indulgent lifestyles. But not only did they squander the economic position and superior standing of the US, they also took the used the excess money depicted in the graph and used it as collateral against which they leveraged and borrowed against the future wealth of the country. Their final coup de grace will be bankrupting the nation when the rest of us will be forced to pay for their unfunded entitlements (Social Security and Medicare). I am thinking of forming the AAWP (American Association of Working Persons) in order to combat the economic violence that is about to be thrust upon us by members of the AARP (though based on last Friday's job report, the ranks of this cohort might soon be dwindling).
The Boomers basically left "Tricky Dick" with no other alternative but to fully take us off of the international gold standard in 1971 (the groundwork of which was laid by FDR in 1933). There was simply no other way to finance "guns and butter" and only a President who could provide both would have been held in good-standing with the American public. There was a brief period of monetary discipline imposed on the American public during the period which Paul Volker was Chairman of the Federal Reserve and there was even a time when some of the supply-side "Reagan revolutionaries" fought for a return to the gold standard. In a passage from "Advancing the American Idea Into the 90s," a pamphlet prepared by Jack Kemp when he was running for the 1988 Republican Presidential nomination included an article titled "Kemp's Glittering Deficit Cure" written by Warren Brookes:
Every candidate talks about the federal budget deficit-but only one has a real solution: Republican Rep. Jack Kemp of New York. His solution: Put the United States back on the gold standard. Mr. Kemp would ‘reopen' the Federal Reserve "gold window." From 1947 to 1971, under the Bretton Woods Accord, the dollar was pegged to gold at $35 an ounce. But in 1971, President Richard M. Nixon closed the window. Since then the dollar has been "floating." What does that have to do with the deficit? Everything. The gold standard not only enforces monetary, and fiscal discipline, it holds down the two things that drive up federal spending most: inflation and interest rates.
Interestingly, Republican Presidential front-runner John McCain has enlisted the help of Kemp in firming up his questionable economic credentials. Something tells me that there is a zero-chance of Kemp recommending reopening the "gold window" to McCain. It is much easier to pass tax cuts (though laudable in and of themselves) than to digest the painful medicine returning to the gold standard would involve.
For further evidence of the inflationary effects of leaving the gold standard in 1917 we turn to former US Labor Secretary under President Clinton, Robert Reich, who, in an editorial which appeared last week in the Financial Times titled, "America's Middle Classes Are No Longer Coping" writes:
The fact is, middle-class families have exhausted the coping mechanisms they have used for more than three decades to get by on median wages that are barely higher than they were in 1970, adjusted for inflation...Yet for years now, America's middle class has lived beyond its pay cheque. Middle-class lifestyles have flourished even though median wages have barely budged. That is ending and Americans are beginning to feel the consequences. In short, the anxiety gripping the middle class is not simply a product of the current economic slowdown. The underlying problem began around 1970. Any presidential candidate seeking to address it will have to think bigger than bailing out lenders and borrowers, or stimulating the economy with tax cuts and spending increases. Most Americans are still not prospering in the high-technology, global economy that emerged three decades ago. Almost all the benefits of economic growth since then have gone to a small number of people at the very top.
Reich both correctly identifies the problem and the solution which will be sought:
The candidate who acknowledges this and comes up with ways not just to stimulate the economy but also to boost wages - through, say, a more progressive tax, stronger unions and, over the longer term, better schools for children from lower-income families and better access to higher education - will have a good chance of winning over America's large, and increasingly anxious, voters.
This solution will come much to the discontent of Libertarians and modern day Adam Smith disciples who are more apt to view the same problem though the perspective I have presented and whose sentiments are best captured in a recent commentary written by Christopher Ketcham titled, "Trends for Downsizing the US: The Bright Side of the Panic of '08" in which he writes:
There is apparently an upside to the rottenness to come... if Americans dare to reinvent for the 21st century the free thinking and civic courage of their past. This good cheer as Rome burns is buried somewhat in Celente's report for 2008, but what it suggests is that, catalyzed by crisis, a fair number of Americans - a minority, likely, but still to watch - will begin this year a transformation of consciousness. Celente predicts that the smaller communities, the smaller groups, the smaller states, the more self-sustaining communities, will "weather the crisis in style" as big cities and hypertrophic suburbias descend into misery and conflict. "Like Katrina's victims that knew the hurricane was coming but didn't flee - and looked to Uncle Sam to save the day - those that don't take action before panic strikes or wait for Washington to lend a hand, will suffer the most from the calamity that follows," he writes. Economically, the new consciousness will recapture Yankee frugality Altogether, there will be a downsizing of America.
Gerald Celente, referenced in the article is a futurist and trends forecaster. The Libertarians will likely have their day, but not before the full effects of New Deal 2.0, 2.1, 2.2, etc., are felt upon the American economy and the world. Reich more accurately depicts the mood of the country, and though his prescriptions still fit within the confines of "Laissez-faire Lite" you can bet that we are going to get a double barrel dose of New Deal 2.0 when they are not enough.
In order to arrive at this conclusion I turn to the Millennials who will soon transition into being the largest demographic group as their Boomer parents meet their ultimate demise. Morley Winograd and Michael D. Hais write in an article titled, "The Boomers Had Their Day. Make Way for the Millennials that appeared in Sunday's Washington Post that:
Unlike the young baby boomers, millennials want to strengthen the political system, not tear it down. According to a study last year by the Pew Research Center, most millennials (64 percent) disagree that the federal government is wasteful and inefficient, while most older Americans (58 percent) think it is. A 2006 survey by Frank N. Magid Associates indicated that millennials are more likely than older generations to believe that politicians care what people think and are more concerned with the good of the country than of their political party. It also showed that millennials, more than their elders, believe that U.S. political institutions will deal effectively with concerns the nation will face in the future.
It should come as little surprise that the echo-boomers, the children of the guilt-stricken,self-indulgent Boomer generation who have been coddled from their cradle through college, have come to rely on the government for solutions. This after all is the generation who in large measure resisted summer jobs. They are the ones who weigh 'balance' in their lives over all other considerations when deciding on whether or not to accept a job offer. More telling in the editorial, Winograd and Hais believe:
Today's millennials look a lot like the GI generation, born between 1901 and 1924, which FDR described as having "a rendezvous with destiny" -- a phrase Ted Kennedy echoed last week in his endorsement of Obama. In 1930, the GI generation was nearly twice as large as the two previous generations combined. Today's millennials are the largest generation in U.S. history -- twice as large as Generation X and numbering a million more than the baby boomers.
These guys are looking for a rendez-vous alright...only it is with big government rescue programs designed to bail them out of their debts. So between the unfunded liabilities the boomers will require us to pay and the debt the millennials are asking to be forgiven, we can expect New Deal 2.0. Now this is at a point in our nation's history when the gap between inflation and real wealth creation has never been greater. Deflationists claim that we will see a reversion to the mean and a drastic reduction in asset prices to come down (perhaps somewhere near the existing world industrial production level). I agree that reversion to the mean will occur (as it always does) but not before a massive cycle of hyperinflation. The mother-of-all inflationary volcanoes is forming through the magma of fiat currency being created all over the globe and illustrated by the "inflationary gap" in the "Removal of the Gold Standard" chart. The last bubble to pop will be the bond bubble. The Mount Vesuvius of inflation is setting to explode on the Pompeii of every bond holder.
Just about the time that money creation is approaching asymptotic levels, the fiscal effects of New Deal 2.0 will accelerate the paceat which the ratings on US bonds declines into the abyss as indicated in the chart below:
The chart above was produced by Standard & Poor's whose track record is questionable (along with the other two rating agencies) given their recen t ignominious failure to properly rate CDOs and other derivative instruments. Nonetheless, I think it is safe to conclude we America will face default as demographics catch up with us and we can no longer service our Social Security and Medicare obligations. The bond bubble will pop long before the chart indicates, most likely at the same time the pernicious inflationary effects of New Deal 2.0 begin to become priced into the market and money creation becomes asymptotic.
The most likely timeline for this to occur is early next decade. While I don't expect a crash, I do expect a short painful period of adjustment followed by a slow bludgeoning and decline of living standards in the US and most of the developed Western world. By the second half of the next decade Americans will become more reliant on the growth of the rest of the world for their economic well being. Instead of decoupling, we will be seeking recoupling, only our fortunes will be more tied to economic developments in China, India, and the rest of the emerging world who are aggressively adopting free market capitalistic principles and rapidlly growing their economies. As our living standards decrease and our currency declines in value, we can expect our exports to become competitive again by the second half of the next decade.
We will benefit from the key distinguishing feature which separeates the 1930s depressionary era, which saw no economic growth in any corner around the globe, and the 2010s which will present the largest economic boom in the history of the world (after short painful period of adjustment as the new decade is ushered in). Americans, for the most part, will be watching from the sidelines as the growth of the emerging world passes them by, largely surviving as a result of the palliative effects of New Deal 2.0. At some point, the world currency regime (US dollar standard) will likely change during this period, perhaps regional currencies will emerge with some tie to precious metals. But until that time, the US will be free to print money because, unlike the 1930s, the US is not restrained from money printing as it was when it was on the gold standard at the outset of the Great Depression. As the US hitches its wagon to the growth occurring in the rest of the world it will become clear that a great transformation of wealth is also developing.
This transition of the world's wealth is already occurring and is irreversible. The last bastion of an American noteworthy competitive economic advantage is collapsing before our eyes. The world's centers of finance are following the centers of commerce eastward. Dubai, Singapore, and Shanghai are in the early stages of displacing New York as the world's "capitals of capital. " Before this rotation has fully played out, you might see more hedge funds in Sierra Leone than in Greenwich, Connecticut. Lest you think I might be getting ahead of myself I recommend reading a February 4th Bloomberg article, titled "ICBC Deposes Citigroup as Chinese Banks Rule in New World Order" which reveals that:
There's a new world order for banks, and the Chinese, for the first time, are the biggest, with a market capitalization that has made perennial No. 1 Citigroup Inc. a distant also-ran behind Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. and Bank of China Ltd. ``The tables have been completely turned,'' said Daniel Yergin, the Washington, D.C.-based chairman of Cambridge Energy Research Associates Inc. during an interview at the World Economic Forum in Davos, Switzerland. The reversal of fortunes is the clearest sign yet that shareholders are betting on banks in the emerging markets rather than the U.S. institutions that dominated the financial landscape for most of the past century.
There is no altering the course of events. Individuals fortunate enough to have investable capital and not so foolish as to see it wiped out in bonds or other dollar-centric investments can position themselves to prosper and eventually reinvest your capital growth back into American assets. The appropriate strategy is to short assets which are depreciating and to go long assets which are appreciating. US stocks fit the former category while precious metals, energy, and commodities fit the latter. Emerging markets will be a buy after we make it through a rather tumultuous 2009-2011 period (or thereabouts). During this time you will want to overweight precious metals and heavily short US names.
To blame politicians, monetary authorities and other bureaucrats might seem cathartic, but is actually rather pointless. They are merely a reflection of the collective "us." And we are just following the inevitable course of history. The relative decline of the West and rise of the East and other emerging markets should be mostly non-violent which makes us luckier than the citizen's of other declining empires. Enjoy the rest of the decade.
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