Americans Choose Greater Depression

It has been interesting watching and listening to the commentary on the US budget stand-off, which has been resolved, at least for another few months. Democrats and Republicans have blamed each other, naturally enough, and the overwhelmingly left-wing mainstream media have blamed the Republicans, also naturally enough. But an interesting fact arose during the debate, which the media did not play up because it shows perhaps where the weight of blame really lies.  The US Senate has not passed a budget resolution since 2009.  Every budget appropriation bill since then has been what is called a "continuing resolution," in effect an emergency measure to keep the government running for a short period, as indeed is the case with the latest funding bill (which only funds the government until January 2014).  

The real blame for the lack of a proper budget does not lie with Congress, however.  The reason there has not been a proper budget bill since 2009 is that President Obama's Office of Management and Budget has not proposed one.  The United States follows the procedures of its Westminister origins in the executive branch putting up a budget, which the legislative branch votes on. So you can't blame the Republican-controlled House of Representatives or the Democrat-controlled Senate for failing to pass a budget, because there hasn't been one to vote on for the last four years.  The blame lies fairly and squarely with President Obama.  This article, from the (liberal, pro-Obama) Washington Post, tells why.

Irrespective of the blame, there is a lack of political will to address what is actually an expenditure crisis.  The US Government spends around a third more every year than its takes in revenue and without expenditure cuts, massive tax increases, or a significant surge in economic growth, this will continue to grow.  The federal debt stood at a little over $10 trillion when President Obama took office and he has now increased it by two-thirds to over $17 trillion.  It will almost certainly have doubled by the time he leaves office in 2017. Democrats say George W Bush was just as bad but this is not true - the debt rose 38% under Bush (and 34% under Clinton).  

How is the US federal debt funded?  For the most part, new debt is funded by issuing Treasury Bonds. Who buys the Treasuries?  Well, last year 70% of them were bought by the Federal Reserve. And where does the Federal Reserve gets its funds from?  It creates the money out of thin air through entries in its accounting systems. This is the modern-day equivalent of rolling the printing presses to create more money. We all know what happens when you do that - there are plenty of examples such as Germany in the 1920s and Zimbabwe in recent years.

So why is the US not suffering from hyperinflation? The answer is twofold.  Firstly, actual inflation is not as low as the US Government claims it to be.  If we use the same methodology to calculate inflation as in 1980, current US inflation would be nearly 10% rather than the official rate of 1.5%. Secondly, prices are being held down by a combination of consumer behaviour, which is to pay off debt rather than increase spending, plus artificially low interest rates (ordinarily the latter would discourage the former).  Interest rates are being held down by precisely the situation discussed above - the Federal Reserve buying Treasury Bonds at the low interest rates.  The reason the Federal Reserve is buying most of the T-bonds is that no one else will take them at such low rates.  Chinese investors, for example, who were the main purchasers of T-Bonds up until a couple of years ago, are no longer interested in buying them at the current coupon rate of 1.9% because they believe the risk premium is a lot higher than that.  To get some idea of how the market views the risk of US government bonds, one only has to look at the longer term yields, which are up to 4%.

The US Government can get away with this 'borrowing from Peter to pay Paul' scenario just as long as the US Dollar continues to be regarded as the world's primary exchange currency.  In other words, it can continue to 'print' Dollars to lend to itself because other countries still regard the Dollar as sound. But under this scenario the US Dollar must start to fall, as indeed it is has been doing for the last few years against more stable currencies such as the New Zealand Dollar.  Many commentators believe there will come a tipping point at which confidence in the US Dollar will be eroded sufficiently to see it plummet, and when that happens US inflation will rise and US interest rates will soar.  Of course, that will mean the US deficit will increase even further as the interest on Federal debt rises and the whole vicious circle will send the US economy back into significant decline, a scenario that some commentators are calling the 'Greater Depression'.

The US is unlikely to grow its way out of its current economic situation through more of the same policies. Government borrowing to drive consumer spending has not worked. The alternative is encourage greater capital investment to grow production, jobs and incomes, and the way to do this is to lower taxes, reduce disincentives to investment such as government regulations, and to significantly decrease government spending to balance the Federal budget. Unfortunately, we have a socialist in the White House, who would rather see his country suffer further economic decline rather than free up the economy.  A proper budget that showed the true state of the government's finances, would be a good start.

Frailty of Global Economy is Obvious

This week we have seen the signs that the global financial crisis (or "GFC" as it has become known after five years of familiarity) is far from over.  The US stock market lost more than two percent of its value on Thursday, the Australia market suffered similar losses, China is reporting that business purchasing for the year is much lower than expected, and here in New Zealand our own stock market was down 1% (on top of news that GDP growth is an anemic 0.3% for the March quarter instead of the predicted 0.6%).

What caused the market jitters?  Well, US Federal Reserve chairman, Ben Bernanke, made an announcement on Wednesday that set the cat amongst the financial pigeons.  Those of you who follow the US economy will know that the Federal Reserve has been 'printing' money and injecting it into the economy at a rate of $85 billion per month (that's a trillion dollars, or around $3000 for every man, woman and child in America, per year).  Ordinarily, printing money at that rate would produce fairly massive inflation but Bernanke, who is almost too clever by half, has been buying huge amounts of Treasury Bonds and mortgages (to the extent that the Federal Reserve is by far the largest purchaser of both), thereby keeping interest rates down and containing US Dollar inflation. 

Of course, all this money printing and economic sleight of hand can't go on forever.  You can't keep writing yourself cheques and expect everyone you buy stuff off to keep honoring them - well, not unless everyone else is completely stupid.  There have been signs recently that the world is starting to regard the US economy as much too risky and the US Dollar as something less than the iron-clad reserve currency it has been for many decades.  The reason the Federal Reserve has to buy all those Treasury Bonds is that China no longer wants them - not at the low interest rates the US Treasury expects to pay at any rate - and we're seeing the impact in the declining value of the US Dollar.

So what did Bernanke say that spooked the market?  Did he call an end to his trillion-dollar a year printing of money? Well, not exactly.  He signaled that he might start reducing it towards the end of this year with a view to ending it by the middle of 2014.  Hardly what you would call cold turkey, but enough for the markets to suffer their biggest fall this year.

I've been predicting in this blog that the world economy is going to get a lot worse before it gets better.  The economic situation in Europe is not improving and the US is plainly addicted to printing money.  There is no way out of this except for a major correction that restores equilibrium between the money supply and real market demand for capital.  Interest rates must go up signficantly to bring about this correction and that will force a corresponding correction in asset prices, particularly in major capital markets such as real estate and stocks.  This loss of equity will have huge flow-on effects for a while on on business investment.  In other words, before this is all over many more people are going to lose their savings, their houses and their jobs and we're all in for more pain before things get better.