Welcome To A Trillion-Dollar Deficit, Mr. President

If you are a typical citizen, you like deflation. You want your wages and investment income to stretch as far as possible. Falling prices, or rising purchasing power, are a sign of economic progress – the progress resulting from productivity gains and competition.

If you are a modern central banker, anxious to implement your ivory-tower theories, deflation is enemy No. 1. (For the sake of clarity, by “inflation,” I mean rising prices, and by “deflation,” I mean falling prices).

Central bankers must be the only people who celebrate a 3 or 4% annual reduction in purchasing power.

Why is this? Because “moderate” inflation tends to be good for bankers. Too much inflation and debtors will repay loans in increasingly worthless money. With too much deflation, debtors will be more likely to default. The Federal Reserve wants to stay in that sweet spot.

If you were Bill Gross, you also would not like too much deflation. As chief investment officer at PIMCO, Gross manages $130 billion in fixed income investments. Gross thinks like a banker. After all, he’s essentially loaning his clients’ money to governments, corporations, and households (via mortgage securities). Spiraling deflation could push his bonds into default.

Gross’s good long-term track record owes a lot to the “great moderation” in inflation since the early 1980s.

You can generate very high returns by buying high-yielding long-maturity bonds when inflation is high and holding them while inflation cools off. This was the best strategy for bond investors from the early 1980s until today.

Rather than deflation, Gross should worry about a decade-long resurgence in inflation. But surprisingly, he fears that deflating house prices will drag the U.S. economy into a Japanese-style slump. His solution? He wants the government to print money and Treasury bills to prevent it.

In his July 2008 investment outlook, available on PIMCO’s Web site, Gross writes an open letter to Democratic presidential nominee Barack Obama. Presuming Obama will be the next president, Gross urges him to dramatically expand the federal budget deficit until it reaches a trillion dollars. I quote:

“While the Republicans will blame you for years and label you “Trillion-Dollar Obama” in future campaigns, there is, in fact, not much that you or any other president can do. You’ve inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender-of-last-resort liquidity provisions that have managed to support Ponzi-style prosperity in recent years.”

The U.S. economy “will need an additional jolt of $500 billion or so of government spending real quick,” pleads Gross. His comically simple formula for GDP, this $500 billion “jolt” to the slowing real economy, is as follows:

“Some quick math for you, sir: Gross private domestic investment (machines, houses, inventories) has declined by $200 billion since its peak in late 2006. Due to higher unemployment and energy costs, domestic consumption will soon be $300 billion less than it should be if we are to return to historical economic growth rates. According to that old C [consumption] + I [gross investment] + G [government spending] formula (scratch the trade deficit for now), when C + I is reduced by $500 billion, then G should increase by that amount in order to fill the gap. The G, sir, is you – the government deficit, the fiscal stabilizer popularized by Keynes following the Depression. And since the fiscal deficit for 2008 is likely to press $500 billion even before you take the oath of office, well, there you have it: $500 billion + $500 billion = $1 trillion big ones, probably by sometime in 2011 or so.”

Only a Keynesian could argue that such an extraordinary waste of capital is a good thing. And only a Keynesian would believe that the simple GDP equation could summarize a vastly complex, adaptive economy.

I’ve always been skeptical of GDP as a measure of economic progress. It treats dollars spent and dollars invested equally (a dollar invested adds to capital formation, while a dollar spent subtracts from it). The GDP equation also treats government spending as a good thing. It is not. Aside from spending on the occasional “public good,” it just sucks capital out of the efficient, adaptive private sector and doles it out to politically powerful voting blocks.

Gross’ prescription to “save” the economy through wasteful spending would do much more harm than good. He aptly notes that the U.S. depends on foreigners to continually reinvest U.S. dollars back into the U.S economy and government.

As OPEC knows, many of the dollars recycled back into the U.S. were originally exchanged for oil imports. Gross acknowledges that the U.S. economy has an “energy cost” problem. But what does he think oil exporters’ reaction to an extra $500 billion spending “jolt” will be?

It won’t be pretty. Major oil exporters will demand higher oil prices and higher interest rates to offset what they know will be an ever-growing supply of U.S. dollar assets. Would you invest in an asset if you knew the future supply of that asset were guaranteed to increase at a rapid rate?

I have a more constructive suggestion for the next president:

DON’T dream up creative new ways to suck $500 billion in capital out of the private economy and redirect it into vote-buying programs. DO take a crash course on how the energy supply chain works, and invite Congress. Energy ignorance is the biggest immediate obstacle to the government being part of any sort of solution.

Inflation is here to stay, albeit with occasional “deflation” scares. Adjust your portfolio accordingly.

Regards,

Dan Amoss, CFA
for The Daily Reckoning
Ouzilly, France
August 28, 2008

Gold rose $3.50 – to $831. We may have just had – and may still have – a great opportunity to buy into gold. The yellow metal seems to have bottomed out. Time will tell, of course…

“You never know what will happen or when, but things always happen the same way…”

We were trying to explain the mysteries of market cycles to a neighbor at last night’s dinner. We might just as well have been trying to describe the Holy Ghost or tell him precisely where to find a photon. Our interlocutor was a practical man – a developer who had begun a huge project, building hundreds of new apartments on France’s Mediterranean coast. He wanted practical answers.

“Is there enough demand for those new apartments?” we asked mischievously.

“Well, there used to be…until recently…”

Throughout much of the world the story is the same. Lenders are more reluctant to lend than they were a year ago. Buyers – who can’t get ready credit – are less able to buy. Demand, and prices go down.

From the LA TIMES comes a report that prices in the Golden State have fallen 40% since the bear market in housing began. A year ago, the typical house cost $587,000, says the Times report. Now, you can buy it for $350,000.

A blogger on the Times’ website said that he had found a house marked down 77% – and still no buyer. We looked at the photo of the house. No wonder it had found no buyer. It is a shack, not a real house. Unfortunately, many of the houses on sale in California are shacks. At least, now they’re selling for less money.

“We’re going to have to cut prices,” said our developer friend, “or just put the project on ice until this situation turns around.”

Then came the obvious question: “When do you think things will return to normal?”

Our answer slipped out as easily as a silk handkerchief: “Things ARE normal now,” we replied.

As we explained yesterday, the eagerness of lenders to lend and the value of their collateral tend to rise or fall together. When mortgage lenders compete to give out money so people can buy houses, you have to expect prices for housing to go up. Eventually, houses become so expensive that even though people can still afford to buy them, they can’t afford to pay for them. This is when the lenders begin to have second thoughts. And once the lenders get scared, prices fall. All perfectly normal.

So far, everything is working just as it should. Boom follows bust, which follows boom. Over and over again, the same mistakes are made – but by new people.

But people don’t like to admit they’ve made a mistake. So, when markets begin to turn against them, they imagine that the turn is just a fluke. They expect things to return to ‘normal’ quickly, not realizing that it is normal for them to make mistakes and lose their money.

When housing first began to go down, at first people didn’t believe it. They’d learned that “property always goes up,” or that “you can’t go wrong with real estate.” Naturally, they took the first signs of a downturn as a buying opportunity. Later, they realized that it was a selling opportunity – the last chance to get out before the roof collapsed.

Likewise, when banks, hedge funds and mortgage lenders began to send out alarums, the problems were thought to be temporary and modest. “Containable,” is how Hank Paulson described the first little cracks in the sub-prime debt market. But the cracks widened. And now, some of the biggest financial edifices in the country – Bear Stearns, Lehman Bros., Fannie Mae and Freddie Mac – have either already fallen down or are leaning dangerously.

One in four junk bonds is in distress, says CFO.com. And the credit crisis is far from over. It has continued for more than a year, but with the value of the collateral still dropping, there are probably hundreds of billions in losses that have not yet been discovered, acknowledged and written off.

But maybe the collateral will stop falling in price…? And maybe, then, lenders will be more willing to extend credit…? And maybe the good times will roll again…?

“US home sales show signs of recovery as price declines ease,” is a headline in yesterday’s International Herald Tribune. The gist of the good news is that house prices fell less in June than they did in May (though the 12 months through June showed the biggest drop in housing in US history) and in July, sales of new and used houses actually went up!

At least 3 or 4 times over the past year, stock markets have rallied on news that “it’s over.” Eventually, of course, it will be over…but probably not before people have stopped looking for the end.

*** When will housing stop falling in price? Remember, housing is a consumer item, not an investment. It needs to be affordable. That is, the average fellow has to be able to buy the average house – and pay for it. Otherwise, prices must come down. How much must housing come down now so that the average person can buy a house? We saw estimates of about 30%-40%. And generally, there’s a little over-shooting. Nationwide, prices are down about 18% from their peak. We’d expect about as much more.

*** But while things are happening in a perfectly normal way in the housing market, in the broader world economy we are in the realm of the extraordinary. Never before have so many people in so many places had so much money. The Chinese are earning billions. The Arabs too. And Russians…

“This story coming out of Ossetia is very revealing,” said a fellow diner last night. “The region is much more complex than I realized. These people have been at each others’ throats for centuries. You know, they have about 50 different languages – and none of them related to any of the others. It is only when there is a strong imperial power in place that they settle down and behave themselves. The Tsar pacified the region in the 19th century. Then, the different cultures lived side by side. There were Catholic churches next to Orthodox churches next to mosques. And people mostly got along. And then, Stalin took over. He tried to erase a lot of the ethnic divisions…making them all communists…and forcing them all to learn Russian. But the Russians – either from the time of the Tsars or the time of the Soviets always had trouble along the southern periphery of the empire. They could never very easily bring the Muslims under control. That’s what the Crimean war was all about…and then, in Afghanistan, the Muslims kicked them out.

“But what I think is most interesting about this story is the way Russia is asserting itself. I don’t know what was going through the Georgian president’s head. You don’t attack Russia with just 17 tanks. He must have thought he had support from the U.S. and Europe. But what could the U.S. or Europe do? We know that the Russians can cut off natural gas to Europe anytime they want. They have the energy; we don’t. If they cut off the gas, it will be a long, cold winter for us. And the United States? Putin knows that the U.S. is bogged down in Iraq. And he knows too that the U.S. doesn’t have any money. In geopolitics, the country with the energy and the money wins. And right now, that’s Russia.”

Yes, dear reader, Russia looks like a winner. And China. And India. And all the countries that seem to be on the way up. Who knows which will succeed…or when? But it looks to us as though these countries are catching up – first in economic terms…later in military terms – to the United States.

What does this mean for investors? It probably means that, over the long run, shares in growing, developing countries are a better bet than those in the United States. And it probably means that the dollar is a bad way to store wealth – since it is tied to an economy in (relative) decline.

It probably also means that limited resources – gold, copper, land, water – will become (relatively) more expensive, because there are more and more people who want them and have the purchasing power to buy them.

And this situation with Russia most definitely put a spotlight on how dependence on foreign oil can be a country over a barrel…and the race is still on in the United States to find a viable alternative to the black goo. Our intrepid correspondent, Energy & Scarcity’s Byron King tells us of an untapped energy source that lies underground just north of San Francisco.

“It is a ‘slow volcano’,” explains Byron, “brewing under the Earth’s surface, unable to erupt, but spews heat. It actually pumps out 750 megawatts of electricity…enough to power 750,000 homes, or a city the size of San Francisco.”

A recent piece of California legislation states that by December 2010, at least 7.6 million Californians are slated to get all of their electricity from renewable sources like “slow volcano” power.

“And I’ve found a small company – a share costs less than a newspaper – that is the only ‘pure play’ on California’s government-forced explosion in renewable energy.”

You can take advantage of Byron’s ‘slow volcano’ research, and all of the rest of his Energy & Scarcity Investor recommendations for 4 months. If you aren’t satisfied at the end of this time period, you will receive a full refund – no questions asked.

Regards,

Bill Bonner
The Daily Reckoning