The Futility of Tax Cuts Without Spending Cuts

Well… The dollar rally that was going on yesterday morning didn’t have the legs to carry on, and by mid-afternoon we were watching the currencies rebound… I truly feel that this time the currencies were led to higher ground by gold and silver!

The rallies in gold and silver yesterday were the things that legends are made of… Silver hit a 20-year high, and gold raced past its previous high water mark of $1,414.07 set on Friday… And the shiny metal is back at it again this morning, setting yet another record level of $1,426.30…

So… What got the risk assets all lathered up around mid-day yesterday, I hear you asking… Well… Can you say tax cut extensions? I knew you could! The agreement to extend the Bush tax cuts two additional years was reached yesterday… I guess during a recession with 25% unemployment, this is a good thing… But…

It doesn’t change a thing regarding the deficit problems of the US. So much for the Debt Commission’s months of work, eh? It was like a, “Thanks, but no thanks, Debt Commission”… I had a media guy call to interview me yesterday, and he asked me if the tax cut news was going to be good for the dollar… I told him that it might, but that it would only be short-lived, as this is not good news for the dollar in the long run. Well, the markets are looking at this differently than little old me… (HA!) I look at it in the long run… The markets are looking at it right here, right now, and what it does to promote growth.

Hey! Tax cuts (which these really aren’t, as they were cut eight years ago, these are extensions of those cuts), are nice on the pocketbook, eh? But go back eight years and track the dollar’s value since those original tax cuts were announced… You see, short term, the tax cut can promote growth, and bring in receipts… But unless there are spending cuts to go along with the tax cut, the nation’s debt picture is damaged… And since we’ve not seen a spending cut of any magnitude…we’re stuck with a debt picture that is more than damaged… It’s unsustainable!

And the “welfare state” continues to grow… Now, I know this is going to sound insensitive, but I don’t mean it to be… The unemployment benefits were also extended past 99 weeks… Just keep adding up the debts… Our grandkids will be left holding the bill… But that’s the mentality of kicking the can down the road… Just keep kicking it, so that it’s someone else’s problem… Unfortunately, that game can’t go on forever… And unfortunately for us that can keeps growing in size.

Ty sent me a note yesterday… “Greenlight Capital head David Einhorn says gold is going higher, interest rates are way too low, and the US government has no intention of paying its bills.”

So… Meanwhile, grandma’s holding off the Indians…and the dollar is on the run from the currencies and precious metals once again. This “risk on” trading this morning is so strong, that the Aussie dollar (AUD) is rallying toward parity again with the US dollar, in the face of a Reserve Bank of Australia (RBA) meeting that left rates unchanged (no surprise there), but just had to say that “rates are appropriate”…

An Aussie analyst that I read a lot, Sue Trinh, now believes the RBA will be on the sidelines of rate hikes until the middle of 2011. For now, I’m going to leave the light on for a rate hike in the first quarter of 2011…

But, despite the RBA’s statements, the Aussie dollar is nearing parity once again…

And so is the Canadian dollar/loonie (CAD)… The Bank of Canada (BOC) meets today to discuss rates, and like I said yesterday, of the central bank meetings this week (the ECB and Reserve Bank of New Zealand also meet) this is the only one that has a slim chance of a rate hike… But that’s not what’s lit the fire under the loonie… The price of oil reaching $90 has the loonie screaming higher versus the green/peachback.

There’s a meeting going on while I type my fat fingers to the bone, with Eurozone Finance Ministers meeting to discuss the mechanism and the size of the mechanism to combat the debt problems in the future… I was talking about this yesterday when I told you that the euro was getting sold on the fact that the Finance Ministers weren’t singing from the same song sheet… Well… I guess the markets gave up on that, because the euro (EUR) began to rally in the afternoon.

The Eurozone Finance Ministers will announce today the formal approval of the aid package for Ireland… And Ireland, in turn, is expected to vote and pass its 2011 budget…a budget that I’m sure contains a ton of austerity measures that will most likely not be well received by the Irish people.

Speaking of the Eurozone… I made the statement in my presentation in Cabo San Lucas last month, that we could see some of the members of the GIIPS leave the euro in the next few years… A gasp came from the crowd…and I then tried to assure the audience that while initially it would be bad for the euro’s value, that in the long run it would be far better for the euro to get rid of the rift raft… I’ve explained this before, but here goes again… It’s like the buffalo herd… The herd can move faster once the slowest member is killed…

But that’s not going to happen today, tomorrow, or even in the next year, I don’t think… So let’s worry about tomorrow when tomorrow comes… Today is what’s on our plate!

And so it goes… With the potential next periphery county in the Eurozone to have the media focus on their problems… Mario Draghi, governor of the Bank of Italy, said Italian banks have survived the financial crisis in relatively good shape, but some will need to strengthen their finances to comply with capital and liquidity rules outlined by the Basel Committee on Banking Supervision. “Some banks need to work more in order to quickly strengthen their capital base,” he said.

This is how it starts…and then people begin to look under the hood a little more carefully…

OK… Enough of that!

Well… I guess the Big Ben Bernanke talk on 60 Minutes didn’t get the bond guys too lathered up, for Treasury yields are back to rising again this morning, in the face of bond purchases that will be made by the Bernank through quantitative easing… I think we could see this continue, for if I were a foreign investor, I would certainly demand a higher yield in Treasuries before I would risk capital there.

It’s just like I always tell you about Mexico… Investors have been burned in Mexico so many times over the years that the Mexican peso (MXN) needs to pay an interest rate that includes a “risk premium.” Without the additional “risk premium,” investors balk at investing in pesos… And right now, Mexican rates are too low, with no “risk premium” at all… And… The peso wallows around 12.5. Twelve years ago, when I was in Cancun, the peso was less than 10… But back then interest rates included the risk premium.

Sorry for the long explanation, but that’s the kind of thing I think the US will head into in the future, as investors will demand a “risk premium” due to the size of the debt issuance by the US.

Then there was this… I saw this yesterday and I had to go yell at the wall! A study by Daniel J. Wilson of the San Francisco Federal Reserve Bank, suggests that the net job creation from the $814 billion stimulus bill passed in February 2009, was zero by August 2010. In the first year, the stimulus “saved or created” 2 million jobs (not 4 million as repeatedly claimed by the Administration), but this number proved to be short-lived, paying for temporary jobs, at a very high cost of $400,000 per job “saved or created.”

By August 2010, the impact of the stimulus on net job creation had disappeared. This is an astounding result, which destroys the Paul Krugman argument that the economy would be so much better right now if only Congress had approved much more spending in February 2009. Double the initial spending, double the number of temporary jobs, with likely the same net result by this point in time, or a trivial number of “permanent jobs created.” In fact, the unemployment rate is at a substantially higher percentage rate today at 9.8% than when the stimulus bill was passed.

And that’s using the hedonically adjusted BLS method of calculating unemployment… As I told you yesterday, the “real unemployment rate” is nearing 25%…

To recap… The dollar rally ended yesterday mid-day, as the US came to an agreement to extend not only the Bush tax cuts, but the unemployment benefits past 99 weeks. The risk-takers see this as great for global growth, and so it is a “Risk On Day”… Gold and silver led the charge against the dollar yesterday, with silver reaching a 20-year high, and gold setting yet another all-time record high. The RBA lefts rates unchanged and the Bank of Canada meets today.

Chuck Butler

for The Daily Reckoning

The Daily Reckoning