Austerity or Money Printing?

February 14, 2010

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Austerity or Money Printing?

I was asked to write a once-a-month Market Observation for Financial Sense. Here’s the first one (posted today, Feb 10):

From time to time, I think it’s a good idea to stop squinting at the short-term market wiggles and pull our heads back for a wide-angle view. Now would be a good time, so that’s what we’re going to do. For the record, I also happen to believe that close-up market analysis loses some of its potency during times of immense official intervention. As with any subsidy program, prices become distorted and often fail to tell the real story, which is absolutely true with respect to interest rates and, by extension, the risk premium for stocks.

Back to the story. Where the current crisis has been described using millions of words in thousands of articles packed with arcane acronyms (such as TALF, CDO, and CMBS), perplexing regulatory lapses and with a degree of complexity that dwarfs the Apollo moon mission, I can explain why the whole thing happened using just three words.

Too. Much. Debt.

Total credit market debt in the US doubled between 2000 and 2008, while incomes stagnated and jobs were not created.

When your debts are skyrocketing, but your means of servicing those debts are not, you are on a path to a credit crisis. And that’s exactly what we got.

That’s all there is to it, and we’d have a better shot of crafting an enduring recovery if we better understood the difference between causes and symptoms. Too much debt was the cause; virtually everything else was either a symptom or a contributory factor. The main contributory factor was Alan Greenspan’s monkeying around with interest rates between 2002 and 2004 to create ultra-cheap money to fight the effects of his prior monetary and regulatory mistakes.

Which entirely explains why I am so dismissive of world efforts to stoke an economic recovery by deploying even cheaper money and even more debt. As earnest as these efforts are, they spring from the very same flawed thinking and practices that got us into the mess in the first place. Plus, they’ve never worked before.

I’ve analyzed this situation nearly to death, and I arrive at this one very simple conclusion: The US is insolvent (and so are many other governments around the world).

We all know the numbers. The US government has over $12 trillion in direct debt obligations, but another $40 to $60 trillion in unfunded liabilities. Collectively, the nation has $52 trillion in credit market debt, up from $26 trillion in 2000, but also many more trillions in unfunded pensions scattered throughout various corporations and state and local governments. Taken together, including all liabilities, debts, and other obligations, the US has a total shortfall that exceeds GDP by more than 1000% (not a typo; I meant one thousand percent).

In short, we’re broke.

The Way Forward

At this point, all investment strategies must align themselves with the proposition that the nation is fundamentally insolvent. Either by rejecting the idea, hopefully with sound analysis and evidence beyond mere belief that the situation must be otherwise, or by accepting it. Ignoring the 5,000 pound elephant in the room is not really an option, especially for long-term or generational investors.

Assuming one comes to the conclusion that our debts and liabilities cannot be paid back out of future production, then investing becomes easy; all one has to do is select between one of two possible official responses and tailor their holdings accordingly.

Option #1: Austerity

Option #2: Money printing (inflation)

Under option #1, austerity, the government trims expenditures by a third, the economy shrinks by the amount that it was supported by excessive debt growth (roughly 30% or so), and powerful and politically well-connected holders of debts take massive losses. Such a program continues until the entire credit bubble is unwound, which means roughly another $25 trillion of deleveraging. At the end, we get the chance to rebuild from a solid base. I personally assign this option a 0.1% chance of being selected and followed.

Under option #2, money printing, a determined government seemingly gets out of its self-inflicted economic predicament by printing money. Such a program appears bold, creates the illusion of (temporary) prosperity, protects the assets of the wealthy and well-connected, and provides interventionist bureaucrats with unlimited employment. By simply understating actual inflation (to lower entitlement COLA increases) while collecting inflated tax receipts, the fiscal gap can be closed up. At the end, it is all revealed to have been a sham, one can’t actually print true prosperity out of thin air, and we get to rebuild from a shattered base. I assign a 99.9% probability to this course of action being chosen.

Of course, I am cheating here, because we have been pursuing "option #2" for a year and a half already. It is really not a terribly bold ‘prediction’ to suggest that we’re going to continue on that path.

More tellingly, as I recently wrote in a recent article entitled The Emperor Has No Clothes, when we examine the 2010 federal budget, we discover that 94% of all revenues will be consumed just by the mandatory entitlement and interest-payment categories. Ninety-four percent. Think about that for a minute.

No matter how earnest our current politicians might be about controlling spending, there’s really not a lot of maneuvering room left in that equation. Not when there’s only 6% left over to fund the entire rest of our government operations.

(Pro tip: Your future taxes are going to go up. A lot. Count on it. A 15% capital gains tax rate is going to seem like a distant dream before too long. Please take that into consideration if you find yourself hesitant to lock in current capital gains because of the potential tax bill.)

For austerity (option #1) to have any hope at all, there has to be some way for the story to work out, but given our budget/fiscal realities, that path is amongst the most painful that can be envisioned. Spending would have to be cut, taxes raised, and dreams dashed. Everybody would feel like a loser on that path, so I just don’t think it has any chance at all of being seriously considered.

Which leaves us with money printing as the preferred course of action.

For investors, then, the main decisions rest on guessing the market impacts of continued stimulus, bailout, and monetary printing. Which markets will benefit most? Where will the vast pools of distorting money flow first?

Disturbingly, the best way to answer these questions over the past year and a half has been to ask which companies have had the best lobbyists and best connections to high-level politicians.

Making matters worse, many companies, especially financial institutions, have been allowed to fudge their income statements by using mark-to-fantasy asset models. So we often don’t really know the true financial condition of many companies or where the risks remain.

Which means that a good investor today needs to be part cynic, part prosecutor, and part forensic accountant.

Conclusion

We experienced a massive, obvious, and ill-advised credit bubble that is in the process of bursting. Rather than rip the band-aid off quickly, our fiscal and monetary authorities are pulling it off as slowly as possible. Along the way they are actually compounding our problems by offering even cheaper money and running up massive public debts. Nothing is being solved, only deferred.

If all goes well, we can expect an anemic economic recovery. If not, we face the prospect of a massive public fiscal crisis and/or a currency crisis. That is, the risks and rewards are completely asymmetrical.

Because I am the type of investor that hates losses more than I fear missing out on gains, I routinely counsel that "better safe than sorry" is a viable investment strategy, and that keeping one’s investments in highly liquid forms makes a lot of sense. Further, given the currency risks involved, keeping some money entirely out of fiat money is a prudent course of action. Physical gold is my preferred investment of choice, both because it is a monetary asset and because it is not simultaneously somebody else’s liability. That’s a hard combo to replicate.

Yes, there are some signs of economic life out there, but we are not out of the woods, by any stretch of the imagination. While I fully expect our financial markets to bounce up and down in response to the massive walls of liquidity being routinely thrown at them, I remain troubled by the obvious disconnect that exists between our fiscal condition (‘insolvent’) and current prices for far too many financial assets, especially those that represent somebody else’s debts.

A fair number of people out there think that we’ll simultaneously experience both money printing and austerity, which will be brought on by deflationary forces. I don’t completely discount this possibility (or any possibilities for that matter), but so far the lesson seems to be that there’s no line our fiscal and monetary authorities are unwilling to cross, so I wonder how much more can be swept under the rug. My guess is "a lot more."

So, that’s my investment outlook made easy. Will it be austerity or money printing?