Betting on Inflation: Divorcing Inflation

Dan Denning explains how the US has been Betting on Inflation to deal with our debt, also touching on China, Pensions, and the prospects of a General Motors bailout.

The Locality Must Yield

  • Divorcing Inflation
  • Odds of a GM Bailout
  • Owen Roberts and the Birth of National Socialism in America

“A tendency to get married to positions. There is a saying that bad traders divorce their spouse sooner than abandon their positions. Loyalty to ideas is not a good thing for traders, scientists, or anyone.” — Nassim Taleb, Fooled by Randomness

“The longest stretch of consecutive increases since Alan Greenspan became Fed chairman more than 17 years ago still has done little to curb an economy fueled by low-cost money. Data through March show median home prices surged to a record, bank lending accelerated, and consumer prices rose more than 3% on an annual basis for six straight months.” –Bloomberg, May 3, 2005

Dear Reader,

Just a quick digital apology to Byron, who’s been out on the high seas for a few weeks. Today, I shamelessly encroach on his turf: the law and FDR. I’m not a lawyer like Byron. And it was Byron who first introduced me to John Flynn’s great book about Roosevelt, As We Go Marching.

But if you’ve been following the plot of the last few days in Strategic Investment and W&G, you’ll know we’ve been hot on the trail of what happens when a funded national debt puts down deep roots in a government. You get spending. Lots of it. And of course, you get new programs, which justify new spending.

The real heart of this regime goes back, as Byron has showed, to the creation of the income tax and the Federal Reserve. But in 1935, prompted by the Great Depression, the other proverbial shoe finally dropped: the introduction of publicly funded pensions, first for the railroad unions and later for everyone with Social Security.

Below, I take you through the legal history of Social Security. Its early opponents on the Supreme Court correctly forecast that giving the federal government the power to levy taxes and regulation for the promotion of the “general welfare” would inevitably lead to unlimited requests by firms and political groups for special favors. Federal power — and spending — would expand, at the expense of the states and the individual, you and me.

I’ve quoted extensively from the important decisions, especially by Justice Owen Roberts. Roberts was the youngest justice on the court when he delivered the opinion that struck down the Railroad Retirement Act as unconstitutional on May 6, 1935. Then, in the U.S. v. Butler case in 1936, Roberts thundered down on Roosevelt’s entire New Deal premise.

I don’t know much else about Owen Roberts other than what I can find on the Internet. Like Byron and Bill Bonner, he’s from Pennsylvania. Roberts graduated from the University of Pennsylvania Law School and made a name for himself prosecuting the Teapot Dome scandal in Wyoming after Warren Harding appointed him to the job.

Roberts spent 15 years on the court, from 1930-1945. He wrote 21 majority opinions and 53 dissenting opinions during his time on the bench. Much of his time was dominated by New Deal legislation.

Early on, Roberts aligned himself with the court’s conservatives and voted against many New Deal programs. He was often the swing vote on cases (an early version of O’Connor and Kennedy). But in a series of three rulings that validated the New Deal and Social Security as constitutional, Roberts seems to have switched from his earlier opinions.

Was he promised something by Roosevelt? Was the court itself intimidated by the packing scheme? Or did Roberts just change his mind? We don’t really know. Roberts burned all of his notes and correspondence shortly before he died in 1955.

It’s a shame. As you’ll see below, his eloquent expression of the proper role of federal power — and the consequences of expanding it through taxes and regulation — ought to be revisited today for the debate about Social Security and Medicare. There used to be powerful advocates for individual liberty in American public life. So until we start hearing their voices again, we’ll just have to rely on the great voices of the past and publish them right here in Whiskey!



Divorcing Inflation

The Fed’s action yesterday hasn’t done a thing to change real interest rates. That is, adjusted for inflation, real rates are still virtually zero. If the Fed were really worried about inflation, it would be hiking much faster.

It can’t do that, of course, because of the havoc it would wreak on homeowners and borrowers. Something will have to give eventually. But right now, the Fed is hoping its measured crawl up in rates will cool inflationary pressures in the energy market without causing too much pain for leveraged borrowers.

Much more likely is a market-based rise in rates. This is what I’ve been saying for over a year now. And I’ll say it one more time before speculating below on an alternative scenario. First, though, to put it in perspective, take a look at the chart below, courtesy of The Chart Store. It shows that for interest rates to even begin reaching a “normal” level, the Fed will have to double nominal interest rates from their current level, from 3% to 6%:


The Fed is unlikely to do that. And foreign bondholders are not exactly demanding higher interest rates anyway. In fact, earlier this week, in a Strategic Investment e-mail, I speculated that foreign buying of U.S. bonds might never slacken — unless a U.S. politician does something incredibly stupid. Politicians do stupid things every day. But in this case, what would the specific stupid thing be?

It would be announcing to the world that the United States did not intend to make interest payments on its debt, or that the United States would ask for that debt to be forgiven. That, at least, is the premise of a book I picked up this weekend by Neal Stephenson and George Jewsbury called Interface.

Naturally, when the fictional president, hoping to score points with voters, announces in the State of the Union address that Social Security payments have a priority over interest payments on the debt, it sends the dollar into free fall and gold into the stratosphere.

Betting on Inflation: Some Anti-Inflationary thinking

At the beginning of this e-mail, I quoted from Fooled by Randomness by Nassim Taleb. He makes the excellent point that getting attached to a position is bad trading. Applied to the bond market, it’s entirely possible that despite mounting deficits and no fundamental change in the spending habits of U.S. consumers, bond yields may actually fall.

This possibility makes my brain reel. But for that reason alone, and the fact that most commentators are convinced yields are going up, it’s worth it to think through what might cause interest rates to fall and bond prices to rise. As much as I think bonds are in secular bear market, let us contemplate the idea of divorcing an inflationary forecast.

Fortunately, my friend Steve Belmont — senior market strategist for the Rutsen, Meier, Belmont Group in Chicago (800-621-0265) and the editor of Options Edge — did some of the anti-inflationary thinking for me. He asked the same question I tackled earlier: How can America’s enormous debts PLUS the rising price of raw materials mean anything but higher inflation, and thus higher interest rates in the future? Here’s what he wrote:

“As we’ve often mentioned, there are only two ways to deal with debt like this: (1) Inflate and pay it back in cheaper currency, or (2) write it off and endure economic collapse. Politicians always pick option one, because it transfers the burden to nonvoting future generations.

“We’ve been betting on inflation for the past four years. It has been a good bet so far. We expect the politicians to continue to err on the side of inflation, if for nothing else, to avoid the fate of Japan, whose economy has been stuck in a rut for over 15 years, despite more than a decade of ‘zero’ interest rates.

“However, what if inflationary monetary and fiscal policy cannot overcome the deflationary effects of cheap Asian labor? What if rising crude and commodity prices cause an unexpected global slowdown, and the massive debt accumulated by consuming Americans begins to go unpaid?

“What happens if the United States (or Israel) attacks Iran, or China attacks Taiwan? What happens to the global economy if the United States decides to blockade Iran in order to force compliance with nuclear disarmament or decides to punish a Chinese move against Taiwan by stationing a carrier group in the Strait of Malacca and choking off China’s access to Mideast oil? The price of energy may skyrocket, but the global economy could easily collapse.

“We are not saying that these things are going to happen, but the mere fact that these or another deflationary catalyst could send the overleveraged U.S. economy into a debt implosion means it might not be a bad idea to buy a little protection.

“We believe the surprising rally in the bond market is either (1) a reaction to the shrinking supply of agency paper due to governmental plans to limit the size of Fannie Mae and Freddie Mac, or (2) a shot across the bow, warning of a potential slowdown on the horizon. The problem with No. 2 is American are so leveraged up that even a mild slowdown could trigger a cycle of default.”

Betting on Inflation: Unintended Consequences

Steve makes a great point about one of the unintended consequences of limiting the size of the mortgage portfolios of government-sponsored entities Fannie Mae and Freddie Mac. In simple terms, take all that GSE debt off the market, and the supply of long-term bonds that yield over 4% declines…while the global demand for such instruments does not. Less debt issued by Fannie and Freddie is U.S.-bond bullish, it would appear.

It could also be that the oil producers of the Middle East are big Treasury buyers in the hope of keeping U.S. interest rates down, thus keeping U.S. consumers solvent and on the roads in their gigantic cars. Either way, the demand for Treasuries seems to be outstripping the supply.

This is a point originally made by Richard Duncan, author of The Dollar Crisis, last October. Duncan wrote:

“Today, the interest rate on the U.S. 10-year Treasury bond is determined primarily by the relationship between the demand for money from the U.S. federal government and government-sponsored enterprises (like Fannie Mae) and the amount of paper money created by the United States’ trading partners, which, in turn, is generally (but not always) determined by the size of their trade surplus with the United States. Capital markets were stunned in recent months by the sharp drop in 10-year Treasury bond yields. The explanation for the unexpected decline is simply that the supply of paper money outstripped the demand for it as government debt expanded less than the U.S. current account deficit.”

Could we be seeing the same thing today? The government, for its part, will probably keep running up huge debts and floating new bonds to pay for them. The Japanese, for their part, will keep plowing export profits right back into dollar-denominated bonds, taking advantage of the much larger American yield.

And the Chinese? Well, Chinese exports of $155 billion were up 35% in the first quarter, compared to $116 billion last year. China is actually running a trade deficit with Japan, Taiwan, and South Korea, countries from which China imports many of the goods it does not or cannot produce itself. But with Europe and the United States, the Chinese are racking up huge surpluses.

China ran a $21 billion trade surplus with the United States in the first quarter, up 73% from last year’s figure. It runs big surpluses in electronic goods and, since Jan. 1, textiles. U.S. imports of Chinese apparel were up 78% in the first quarter. That’s a lot of bathrobes.

In the context of 10-year Treasuries, China’s trade surplus generates the cash that becomes the demand for a limited supply of creditworthy U.S. bonds. Of course, the Chinese can do lots of other things with their cash, like stock up on commodities and raw materials. But as the chart below shows, the U.S. current account deficit doesn’t show any signs of abating. Short of a dollar crisis, it may simply keep growing as a percentage of GDP.


In the meantime, although I have an open put options position on TLT (a bet that yields will go up much faster than the Fed has thus far telegraphed and that bond prices will fall), I’m merely engaged with the position, not married to it.

Betting on Inflation: Odds of a GM Bailout

Last Monday, I met my friend Brian at a Belgian bar in Clerkenwell. Brian is a fellow expatriate, banker, and currency trader for a major international bank. When we’re not talking about the dollar, we’re usually talking about the designated hitter.

But last week, we were talking about GM and whether the pension obligation that threatens GM’s credit rating (one of several threats, actually) could be transferred. To whom? And what would be the repercussions be?

I directed Brian to a Whiskey & Gunpowder essay where I suggested that if push came to shove, the government might be more inclined to transfer the pension obligations into some new psuedogovernment scheme, rather than see GM lay off a lot of voters. That way, bondholders don’t get spooked, pensioners don’t lose their pension, and the obligation is successfully transferred to future, unborn voters.

Brian read that bit and wrote back a few days later:

“Just read my first issue of Whiskey & Gunpowder. Very interesting, I enjoyed it. Re GM and the idea that it may in the end foist its mammoth obligations off on the U.S. guv (and thus taxpayers): First, there’s no way the U.S. guv can take on GM’s obligations without also taking on Ford’s, and probably also DaimlerChrysler’s Chrysler division as well.

Second, I’d expect a MASSIVE storm of anger from other U.S. corporates who will be left out of the game.

Third, the act would create a big moral hazard problem in other U.S. manufacturing industries that have not yet failed but are deemed ‘strategic’ (think Boeing, Intel, Microsoft, etc.). In other words, these firms might be incentivized to take otherwise inadvisable risks on the theory that the guv will give them the same deal. Finally, the WTO would be up in arms over it.

“And I got through all of that without even mentioning those who would be screwed the most by it all: the U.S. taxpayer, who, if recent history is worth heeding, won’t do a d*mn thing about it.

“Do you think it can happen despite all of this? You bet it can. But the resulting trade wars would probably be very ugly. I believe we’re heading for protectionist trade wars anyway, but I doubt a complete bailout of GM/Ford is part of it. More likely, the companies will restructure existing pension funds and medical care agreements with the union. It’s lose-lose if the company fails, so the union will likely play ball, though guardedly.”

Is Brian right? We’ll see. But our conversation prompted me to think more about the origin of private and public pension schemes. The modern publicly financed pension system has its roots in Otto von Bismarck’s 19th century Germany, just as Germany was introducing the idea of federal power, with a strong, centralized bureaucracy, the welfare state.

But in the United States, the 10th Amendment to the Constitution was a thorn in the side of so-called progressives trying to introduce public pensions in America. The 10th Amendment states, “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.”

This amendment would be at the center of the debate over the proper role of federal power in levying taxes for the next three years. At stake, what kind of government would America have? How free would its people remain? More on that tomorrow, when we look at Owen Roberts and the birth of national socialism in America….


Dan Denning
May 4, 2005

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