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Explanation: The Economy Q1

April 1, 2011

Explanation: The Economy

A Congress that enacts punitive legislation.

A Fed Reserve that pursues misguided Monetary Policy.

An Administration that mandates through Executive fiat.

A President that embraces constant hostility toward the private sector.

A Congress and a White House that escalates out-of-control spending.


Our government has become a mis-managed business. We need to reduce the government footprint. The nation is on an unsustainable path to fiscal bankruptcy. Our unfunded liabilities are at least $100 trillion – more than twice the economic output of the entire world.

The global economic downturn, the sub-prime mortgage crisis, investment bank failures, falling home prices, and tight credit pushed the United States into a recession in mid-2008.

Obama’s assertion that most future deficits will result from the 2001 and 2003 tax cuts, the wars in Afghanistan and Iraq, and the Medicare drug entitlement is based on faulty methodology, but is still wrong even using that methodology.

Spending is the problem, not too little taxation. Those who blame the past decade’s deficits on $1.7 trillion in Bush tax cuts have been oddly silent about the $5 trillion in new spending over that same period.

I read where Bush’s last deficit of $1.19 trillion was actually about $400 billion since most of TARP has been paid back – with interest…with only about $100 billion still outstanding. Nevertheless, Obama inherited a 1.3 Trillion dollar deficit and a deteriorating economy.

Soaring spending impacts – not low taxes – are driving the budget deficit. Presently, we are only $37.5 billion to go before the National Debt hits $14.3 trillion and the Debt ceiling is maxed out.

There is always some confusion between ‘budget deficit’ (deficit in one year) and ‘national debt’ (cumulative deficit). No more.

Federal Debt = $14 Trillion… US GDP = $14 Trillion… % of Debt to GDP = 100%. Boys & girls, that spells BIG trouble.

So, what’s going on?

Government spending has an abysmal track record of stimulating the economy. History shows our economy has soared highest when the federal government was shrinking, and it has stagnated most at times of government expansion.

You just can’t borrow your way out of recession & you can’t spend your way out of debt. In fact, it is a mathematical impossibility to get out of a credit recession with more debt.

We are approaching a double dip recession. But the thing is, this is not a business cycle caused recession. This is a bursting credit-bubble recession. Debt.

Trying to re-inflate a credit bubble with more borrowed “stimulus” or ‘printed’ money is basic economic insanity destine for major failure. A debt problem isn’t fixed with more debt.

All government stimulus spending requires first borrowing dollars that would have otherwise been applied elsewhere in the economy. The only exception is money borrowed from “idle savings.” Once it becomes clear that government spending only redistributes existing demand, the case for “stimulus” spending collapses.

Consider this: Every dollar Congress injected into the economy must first be taxed or borrowed ‘out’ of the economy. No new spending power is created. It is merely redistributed from one group of people to another.

It is intuitive that government spending financed by taxes merely redistributes existing dollars. Same is true with borrowed debt. Spending financed by borrowing also redistributes existing dollars. . The fact that borrowed dollars (unlike taxes) will be repaid some years later (with interest) does not change that.

Fiscal Policy

Obama is implementing a Keynesian model. The Keynesian theory (and thus, the Keynesian ‘multiplier) is every dollar the government spends produces more than a dollar in spending throughout the economy and, in turn, a greater increase in national income.

Keynes’ believers insist that sometimes shifts in the economy don’t right themselves. The economy goes into a downward spiral. The usual dynamic of supply and demand breaks down, people don’t spend enough money, and there’s no way for the economy to automatically adjust. So, Keynesian prescription theorizes, that if all else fails, the government needs to spend money to right themselves.

And, Obama’s entire economic plan is grounded in the belief that massive new government spending is the key to economic recovery.

Yes, government spending can recirculate through the economy via the Keynesian multiplier effect. But the same dollars would have recirculated through the private economy had they not been lent to Washington to start with.

Yes, in a recession, Washington can spend $814 billion putting idle factories and people to work. But that requires first borrowing $814 billion of spending power out of the private sector, which — by the same logic — will result in idle factories and workers in the locations that financed the stimulus.

In that sense, government spending is the equivalent of removing water from one end of a swimming pool, dumping it in the other end, and then claiming to have raised the water level.

If you tax, the dollar the government spends is a dollar some taxpayer couldn’t spend. If you borrow, the dollar the government spends is a dollar that wasn’t available for someone else to borrow.

If you “print money,” there’s more money chasing the same amount of goods, so prices go up (“inflation”) and the dollars are worth less. So people spend more “dollars” but they can’t actually buy more stuff, since prices are higher.

So the increase in government spending is canceled out by a decrease in the purchasing power of all the money in circulation, so there is still no actual stimulus. There is no “Keynesian multiplier.”

But it’s actually worse than that, because taxation, borrowing, or inflation is itself costly. They distort incentives and complicate business and personal financial planning – so the spending reduction by taxpayers is actually MORE than the amount spent by the government.

So the Keynsian model is flawed. And, as inflation increases, the Fed will push interest rates up in order to keep oil and other commodity prices down since they are tied to the dollar. As the interest rates start to increase, the economy here in the U.S. will go even further into tailspin.

Government debt is the only thing growing. Yet, it is mathematically impossible to get out of a credit recession with more debt.

So, this government “activism,” including fiscal stimulus, extended unemployment payments, mandates, arbitrary regulations, executive orders, housing subsidies, and stalled credit creation in the capital markets is holding back the economic recovery.

The US and world economy is too complicated for central planners and controllers to operate it.

Monetary Policy

From the moment the financial crisis took hold in 2008, Fed Chairman Ben Bernanke has looked to lower the dollar’s value and cause asset prices to rise – especially in real estate. But his pitch has been wildly off the mark.

Real estate will be the last asset class to respond to the Fed’s dollar debasement strategy.

Now, the Feds can’t control the ‘exact’ rate of inflation, nor can it direct where inflation will be distributed across the economy. In other words, inflation is like throwing a paper airplane: once you let it loose, you’re never really sure where it’s going to land.

Rising prices is usually caused by an increase in the money supply or more commonly known as government money printing. And… the recent increases in the prices of energy and other commodities are currently putting upward pressure on ‘inflation.’

Simply put, Inflation is often defined, as “too much money chasing too few goods”.

As it right now, we are seeing rising prices everywhere except where Bernanke really wants them – real estate. Commercial and residential real estate is vacant.

As housing sales fall – so will big bank balance sheets. That means we could be facing another credit collapse. Unless the Fed starts to create credit to buy houses directly off the market, and remove mandates and regulations, it will be very difficult to get real estate values to move higher.

Commercial real estate properties are hemorrhaging and in order to short-circuit major commercial defaults, what we might see is the government attempt to step-in with another TARP-like funds or TARP-leftover funds.

  • Housing is choked. Copper prices are in the toilet. Copper, is an indicator of new construction which means there is no new construction. Without an up tick in construction, the economy can’t really get much better
  • If people were working again, they would be gobbling up housing foreclosures. Some are over 50% off their high. No one is touching them.
  • Data released last week shows that the median price of existing homes declined 5.2% in February compared to the previous year. New home prices fared even worse; tumbling 9%!
  • 11% of homes nationwide are being left vacant, causing nearly 25% of mortgage holders to be without any equity in the home.

Bernanke and Obama have other problems…

  • Manufacturing reports are a mixed bag. Heavy equipment is doing well but they have over seas markets to rely on in a US downturn. 30% of every refined barrel of oil is used directly (as an ingredient) or indirectly (provides machinery energy) in the manufacturing of products, as the price of oil goes up, so does the cost of manufacturing.
  • The American consumer, who makes up 70% of GDP, will be spending more and more disposable income they make on food and energy and necessities and less on luxury disposable income
  • Auto numbers are being skewed. Dealer inventories are up from 30 to 90 days. The auto industry, especially GM, is pushing 0% financing. That is a sure sign that you are not moving units; especially with spring in the air.
  • Economist uses bulk carload freight and transport indicators as one of the primary measures of economic activity. For the first eleven weeks of 2011, U.S. freight railroads originated an uptick of 5.3% from last year and trailers and containers were up 8.1% from the same point in 2010. That sounds like a nice gain — and it is — but to keep it in perspective, other than 2009 and 2010 it’s still the lowest March average since 1994. And, overall, intermodal traffic is the second slowest reading in over a year.

So…. by any reasonable account, Bernanke has failed. It is clear that by trying to channel his inflation into just one asset class, real estate, Bernanke has placed the entire US economy in severe danger.

He now faces a serious conundrum.

Does he raise interest rates significantly to fight inflation at the cost of a second housing market collapse, or does he sit idly by and watch the broader economy become just as unaffordable?

Neither choice is pleasant, but one thing’s for sure: if the bond vigilantes start to raise interest rates for him, his paper airplane is headed for a crash.

Let me place this inflation discussion in more practical terms…

Business operators believe that future prices for many goods and services will be higher next month than they are today. So, those companies and households with savings and capital that can afford to do so will buy the supplies they’ll need in the future today.

This buying activity, which is driven by expectations of higher prices in the future, results in a transfer of future economic activity into the present. While some industries and companies enjoy pricing power, most do not. Those without pricing power will see weaker profit margins as higher raw material prices flow through the chain of production.

It’s the type of activity that Keynesian central bankers like Ben Bernanke want to encourage. But the transfer of future economic activity into the present hardly materializes and carries with it the same problems we saw during the housing and credit bubbles: when the “borrowed-against” future finally arrives, we see a collapse in demand for the pre-bought items.

Pushing consumers and businesses to “buy now” with the expectation of higher prices in the future is hardly different from subsidizing the reckless growth in debt.

All this has lead to Bernanke’s quantitative easing experiments. Since last November, Bernanke has expanded the monetary base by over $325 billion and he’s not through. In all, it will be more than $600 Billion.

The result? We’ll see sugar rushes in economic activity, followed by hangovers. When the hangover sobriety settles in. The government prints more money. More sugar high.  His reckless monetary policy is driving down the dollar and driving up commodity prices.

Central banks and the Obama government remain blind to the inflationary consequences of their policies. Based on his public comments, Bernanke seems to view rising energy and food prices as a deflationary shock to the US economy – which would, in his mind, necessitate even more money printing.

He sees no connection between the expansion of the Fed’s balance sheet and rising prices for everyday necessities. And, some fear that interest rates are being kept too low from the central bank.

The result will be stagflation.

Stagflation, in simple terms, can best be described as ‘elevated inflation and high unemployment’.

Almost all the growth we have seen to date is from government orders. I’ve always been dubious of the inventory rebuild scenario. No one ever seems to have solid numbers on it which makes it suspicious


The weaker the political will to enact painful budget reforms, the faster the federal debt will grow. The faster the debt grows, the more the Fed will be pressured to monetize, which boosts the money supply. The greater the money supply, the faster inflation sets in. The faster inflation sets in, the higher commodity prices spiral upward.

The further the money supply grows, the more urgency investors around the globe will feel to buy gold, silver, and other hard assets. And, investment capital, required to kick-start the economy, goes elsewhere. And, who’d want our bonds?

It’s hard to imagine a reversal of this trend until we see much more political support in Congress for handcuffing the Fed or changing its so-called “mandate” and Congress’ spending habits.

The fundamental root of the problem is the Fed’s devotion and Obama’s devotion to vulgar Keynesianism, the idea that if you print enough money the economy will right itself and that government intervention  i.e., government spending – increases economic activity.

The US and the world needs to return to some form of monetary discipline and adopt a rational and prudent Volcker-style monetary policy which guards against inflation and currency debasement.

And many people are not aware that the money supply is all cash – plus all credit.

We have a credit-based economy. In fact, we have the largest credit-based economy in world history, and some people still forget the entire ‘credit’ half of the money supply when checking to see if the money supply grew (inflation) or shrank (deflation). Hey, the cash grew! Oops, the credit shrank. Which event was larger?

The credit creation model, which comes from banks, traditionally accounted for 50% of loans. Finance Co’s and securitization firms were the other 50% – which is motoring near idle.

All this affects trade flows and capital flows and new capital investment opportunities when half the engine of new credit creation is gone. Businesses can’t grow and expand.

With both engines nearly evaporated, the combined crisis of consumer consumption coupled with limited credit creation in a credit-driven US economy has created market-sector-wide chaos in both, our consumer and business economy.

In the last 10 years, the engines of growth have been spawned primarily from consumer spending and credit creation. Without either, we are tapping at the door of crisis levels.

In simple terms, a crisis is caused by banks being too nervous to lend money to us or each other. Where they will lend, they charge higher rates of interest and cash deposits to cover their risk. In the real world, that means more expensive mortgages, and in the worst cases, repossession and bankruptcy of businesses and foreclosures.

Uncertainty’ stifles creativity, kills jobs, offers up more crises.You can’t boost the economy by confiscating the money from the productive sectors of the economy and handing it out to the unproductive sectors… Or to big Dem donors?  In Obama’s world, businesses exist only to pay taxes and fund unions, who then fund Democrats.

This economy is out of gas and will not rebound until it is unleashed from gov’t suppression. Free the American people and small business from an obtrusive government and good things will happen.

UNCERTAINTY is the bane of business success.

I discussed this topic on Blog Talk Radio’s Liberty Underground/The Moretti Report. Click link to listen.

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