Just 3 days into the new administration (Friday Jan 23, 2009) gold is up $40 or so to $897 per oz.  The most interesting thing about this rise is the surprise among gold bugs that the Commitment of Traders report shows the bullion banks reversing their previous position and going long.   

Gold Bugs:  Wake up.  Everybody should know by now that the New Guys are Keynesians and love a lot of what FDR did.  This means they will do everything they can to stop deflation and one thing they will almost certainly copy is FDR’s devaluing of the dollar against gold as an anti-deflation device.  FDR moved the dollar from $20 to $35 per oz, a 75% devaluation, so if the New Guys just copycat this pattern gold will go above $1600 per oz fairly quickly.

Many people state that the New Guys will not devalue gold right away because first they will have to make it illegal for US citizens to own gold like FDR did.   FDR had to get gold out of use as currency before he devalued it which is why he outlawed ownership.  This is not needed today as we don’t use gold coins or scrip. 

One more reason that the New Guys will devalue gold: physical gold owned by citizens is a plus because increasing the value of gold will offset some of the other asset value declines in stocks and housing. 

As this is purely a manipulation, I bet that gold will not go above the old inflation adjusted high of $2000.

Yesterday I was told that 42% of people did not pay taxes. I commented back that everybody paid at least 15.3% because of Social Security (FICA) and Medicare Taxes. These are just another tax because they are not placed in a dedicated pool and are used to reduce the deficit. I count the employer contribution as a tax on wage earners as they could be given to the wage earner if not sent to the government.
This raised the question of who paid the most tax if SS and medicare were counted in. The taxes stop at $102000 of income so lets compare that marginal tax rate to that of a $1 million earner. Using a tax calculator for the income tax shows that the $102,000 wage earner pays an average of 34.9% and an incremental rate of 43.3% in total taxes versus an average of 34.1% and an incremental rate of 35% for the $1 million earner as detailed below: 

Wages	Average Tax Paid	Tax Bracket	Marginal Rate
$102,000
Income Tax	19.6%	28.0%	28.0%
SS and Medicare	15.3%	15.3%	15.3%
Total Taxes	34.9%	43.3%	43.3%
$1,000,000
Income Tax	32.6%	35.0%	35.0%
SS and Medicare	1.5%	0.0%	0.0%
Total Taxes	34.1%	35.0%	35.0%

This is the 2nd of a 3 part series on:

1.        How the current economic crisis occurred,

2.        What needs to be done to fix it and

3.        Tracking how successful the government is in taking the needed steps

 “Eyes Wide Shut” Economic Plans won’t stop the Greater Depression

My businessman’s mind is amazed by the lack of fact based, goal oriented solutions from our political leaders for the current economic crisis.

What’s been done so far to fix the economy duplicates the efforts of Hoover as the economy spiraled downward from 1929 to 1932 and it is easy to project that if this keeps up we are heading to the “Greater Depression.”  In the calendar of the Great Depression, today (January, 2009) is January, 1931 and the worst is yet to come – in 1932 GNP fell 13.4%. 

Secretary of the Treasury Paulson has failed to prevent the crisis because he tried to save the stockholders in current banks and investment firms (just like Hoover) and did not implement the regulatory structure needed to rebuild confidence in our market system. Banks are toast because of huge exposure in unregulated derivatives (Credit Default Swaps, just one type of unregulated derivative are $54 trillion, that is 12 zero’s, compared to a bank capital base in the billions.)  As soon as a regulated market is established for these derivatives, banks that hold them will go bust and need direct investment from the government that will wipe out stockholders.  If we do it quickly we might avoid the “Greater Depression.”

Many politicians are standing in the way of any program that does not contain at least a dash of their political ideology.  Republicans seem to accept any stimulus program as long as it involves tax cuts even though the last 8 years have proved these are unaffordable (tax cuts only give, at best, 50 cents on the dollar of stimulus.)  Democrats are pushing for jobs programs, infrastructure building, welfare extensions and some consumer mortgage relief that seem to mostly be the things that didn’t work for Japan during the 90’s and start to raise “welfare society” issues.

All of the current solutions seem to be based on what politicians think are politically salable to their base.  The people are not fooled: The Conference Board Consumer Confidence Index™ reached a new all-time low in December 2008 of 38.0 (1985=100). 

What we need is economic leadership that will recognizes what is actually happening, kind of like Petraeus did when he used a different “hearts and minds” strategy to make the surge work in Iraq. (Note:  Petraeus led the 2^nd surge in Iraq – the first, with equal troop strength but using conventional tactics and strategies that ignored the realities on the ground, didn’t work.)

We’ve seen the type of leadership we need: FDR gave the leadership the USA needed in the Great Depression when he stated that “all we have to fear is fear itself” to calm public fears that were causing runs on banks and subsequent bank failures.  He combined this with a bank holiday (during which banks were suppose to be inspected for fiscal soundness, an impossible task) so he could implement FDIC insurance and give banks the stability needed to start lending again. 

Three areas need to be addressed to solve this crisis (see my previous post for reasons why.) These can be considered the nation’s objectives:

1.       Stop Deflation

2.       End the Banking Crisis and Restart Lending

3.       Rebuild Consumer Confidence to restart spending

There are a lot of ways to achieve these objectives and later blogs will track the government’s success. Here’s just a few ideas:

Stopping Deflation – The primary cause of deflation was the decline in housing prices.  Stock market declines have happened in the past and not led to deflation so they are not the cause of the current deflation. Below are 2 different tracks that can be taken to reverse deflationary pressures, one that is obvious and another that is less so:

1.       Demand and supply adjustments for housing:  

o   Reduce foreclosures/defaults to reduce the supply of homes for sale

§  Government Bailout of mortgages that are above current home values.    Rational homeowners should abandon houses where the mortgage is greater than the home value.  By bailing out homeowners with negative equity, bank balance sheet would be strengthened and the amount of distressed homes coming on the market would be reduced.

o   Government purchase and demolition of substandard housing.  The government should make an active program of purchasing distressed houses and demolishing those that are substandard.  A sub program could be the refurbishing of better houses for subsequent auction or low-cost housing usage.  These will increase employment as well.

o   Reduce mortgage rates. Reducing mortgage rate will increase the number of potential  buyers but may not be effective if the perception is that housing will continue to decline.

2.       Devalue the dollar by increasing the price of gold.   

·         This was one tactic FDR used to stop deflation during the Great Depression.  Devaluing the dollar against other currencies is what should be done but it is impossible because of manipulation by foreign governments.  Gold is a currency equivalent so an obvious rise in gold would mean that the dollar is declining and deflation has stopped.  What is great about gold is a psychological inflation indicator that is disconnected from the real economy:  inflation in gold will not cause inflation in anything expect jewelry. 

·         Note: Paulson’s Treasury appears to be continuing inflation control efforts that are keeping the price of gold it down!!  Simply removing the manipulation would probably allow a sufficient rise in the price of gold to reduced deflation expectations.

Ending the Banking Crisis and Restarting Lending-The banking crisis was caused by excessive leverage and poor regulations that allowed investment in unsafe assets such as collateralized mortgage obligations (CMO’) and resulted in reduced lending as bank’s capital bases were vaporized. Some solutions are:

·         Emergency legislation forcing bank lending-this can include government supplements on real estate and some business loans so that banks can be compensated for the greater risk of lending during a fiscal crisis.  This is necessary as we are currently in a “Liquidity Trap” where normal lower interest rate stimulus won’t work.

·         Establish regulated markets for all derivatives.    This is today’s equivalent of FDIC insurance.  Establishment of fair markets will eliminate fiscal instability but probably result in many Credit Default Swaps being worthless causing the bankruptcy of more investment firms and banks necessitating:

·         Rebuilding of bank capital bases with direct government equity investments.  The plan should include a requirement for the government to sell their equity ownerships once banks were stable.

Rebuild Consumer Confidence to Restart Spending:  Nothing lets people spend today than the feeling that they don’t have to worry about tomorrow. Today, all they have is worries.  They don’t really worry about the economy per se, it’s jobs and financial security concerns that are at record highs.  Here’s some potential fixes:

·         Jobs – are purely a matter of spending in the economy.  If consumers don’t spend enough to keep everybody working then the government can step in and spend without causing inflation, as long as it is on productive infrastructure and it is done while the crisis is still occurring.  Milton Friedman proved that most government stimulus doesn’t work because the crisis is over by the time it kicks in, so no tax cuts as they work really slowly, if at all.  Pick the wrong stimulus or do it too late, of course, and here comes inflation.

·         Financial Security– In China, where there is no social safety net, savings is a 30% of income and the government is trying everything it can to try to get them to spend more to offset the decline in export to the USA.  In America, consumers have started saving and paying off debt at an amazing rate due to rapid declines in their wealth that started with the housing and stock market declines and was brought into focus by the gas price spike.  Before they start participating in our debt, consumers need to secure about:

o   Paying for Gas/transportation:  Gas prices doubled in 3 months and are the reason that other retail spending plunged.  A stable long term transportation solution is needed.

o   Educating their kids:  College is necessary for kids to have a better future than their parents and the price has gone 247% in the last 20 years, making it almost un affordable.

o   Paying for Healthcare:  Illness and healthcare expenses are involved in half of all bankruptcies.

Next in this series will be evaluation of economic plans of the US government and their actual effectiveness in solving the crisis.

This is the first of a 3 part series on:

1.        How the current economic crisis occurred,

2.        What needs to be done to fix it and

3.        Tracking how successful the government is in taking the needed steps

How the Economy Failed Again or “Dragons We Know”

2 recent NY Times articles show the blindness that led to the failure of today’s economy. First, the No Instruction Manual as Stimulus Bill Takes Shape article stated that we don’t know how to develop a plan to solve the current crisis, ignoring the lessons of the fight against the Great Depression.  Second, Risk Mismanagement  showed how “quants” (the wiz kids who did the mathematical investment models that failed so spectacularly) underestimated the risk of low probability events.   One quant labeled the 1% probability tail as TBD, not standing for “to be determined” but rather “There be Dragons.”   This is a great analogy because not only does it illustrate that low probability events can kill the unwary but also that the really dangerous ones are identifiable.  Just like St. George, if you fight dragons you might survive and prosper but you will eventually be destroyed if you ignore the potential dragons.    

So what did we forget that caused the current financial crisis?  The primary cause is the deliberate avoidance of looking for “dragons” (potential problems) that resulted from the revival of Laissez-faire economics (called variously Austrian, Supply Side, or classical economics).   Laissez-faire advocates state that free markets will regulate themselves; therefore, there is no need to look for problems.  In fact, Dick Cheney stated that “I don’t think anyone saw it coming”.    Actually, problems were easy to see coming due to historic highs in stock Price to Earnings (P/E) and housing rent-to-own ratios.  Amazingly accurate predictions were made by many widely read individuals (such as Bill Fleckenstein, Doug Casey or Nobel laureate/NY Times columnist Paul Krugman).

 Historically, the idea that free or unregulated markets will have any sort of acceptable performance has been proven wrong by the Panics of 1873, 1884, 1890, 1893, 1896, 1907, and the Great Depression, among others. Besides, the concept of self regulating markets does not fit with human experience: 

If it takes 3 to 5 referees to regulate 22 people in a game of football (depending on which continent you are on) why would business people who are playing for real money not need supervision to prevent cheating?  (See End Notes 1 and 2 below)

The current crisis is almost identical with the Great Depression: 

National Deflation in overvalued assets (housing and stocks) leading to:

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Banking Crisis that reduces lending and financial liquidity which causes a:

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Consumption Recession (as opposed to a business cycle recession where business activity slows first) where:

·         Excessive consumer debt limits most consumers’ ability to borrow for current purchases and

·         Affluent consumers reduce consumption as they increase savings or pay off debt.

The causes are also similar (which is why so many people could predict it):

1.       National Deflation – is the result of asset bubbles caused by unregulated debt expansion outside on the regulated banking and investment areas. 

·         While all of banking had minimal regulation in the 20’s, today’s loose housing lending started around 2002 when

·   A new government program to help low income people get houses with no down payment

·   Intersected with new unregulated derivatives.

 The derivatives market allowed banks to lend to high risk borrowers and make money by selling (securitizing) these high default rate loans to investors.  Loosening of government regulation of Fannie Mae and Freddie Mac in 2005 accelerated the search for bad loans to securitize.   Rising housing prices and easy money brought in speculators which pushed prices above what wage earners could afford (a bubble.)  Prices declined once housing became unaffordable, bankrupting zero down payment speculators and starting the deflationary spiral.

·         Both the 1920’s and today’s stock market bubbles were caused by excessive and/or unregulated leverage (a form of lending) at hedge fund equivalents and investment banks which drove stocks to historic high P/E values (a bubble.)  Once housing started to decline and the economy slowed as a result, prices had to come down to match declining corporate profits.   The profit declines caused P/E declines so the decline in the stock market accelerated.

2.       Banking crisis – Deflation in asset values (housing, stocks and commercial bonds) caused some banks to become insolvent and lowered trust in all banks. Runs by consumer depositors on banks during the Depression have been eliminated by FDIC insurance. Today, banks are reluctant to lend to other banks due to uncertainty of their financial health causing more bank failures.  The ongoing deflation in asset values causes a Liquidity Trap, reducing all lending. 

·         A Liquidity Trap occurs when banks expect better returns by holding money instead of making loans.  Declining real estate, securities values and corporate profits and rising unemployment make banks tighten lending standards to the point that few consumers or businesses can qualify, thereby drying up the funds or “liquidity” that makes the economy work.  Normally, the central bank can increase liquidity by lowering interest rates but the expectation of deflation means that banks expect negative returns on loans so even a interest rate of zero (like today) won’t make them lend  – In a Liquidity Trap banks won’t lend until convinced that deflation will stop (that is, inflation starts) or they can pay back less than they borrow to make the loan (termed negative interest rates .)

3.       Consumption Recession – was caused by the failure of median income to keep up with consumption opportunities (as shown by GDP growth.)  In order to take advantage of consumption opportunities, consumers took on more debt with the aid of banks and retailers/manufacturers (GMAC, for example.)  This is what happens instead of Say’s Law² when production exceeds consumption capability in a modern debt generating environment.

·         Middle and lower class income growth stalled out in 1982 when the upper income tax rates were brought down from 50% to levels last seen right before the Great Depression.  With the tax disincentives on excessive compensation removed, executive pay and other compensation soared from 35 times the average workers income in 1978 to 262 times in 2005, a repeat of the Great Depression play book.  In the words of Marriner S. Eccles, FDR’s Fed Chairman, “had there been less savings by business and the higher-income groups and more income in the lower groups — we should have had far greater stability in our economy”

·         The decline is made worse by declines in consumer confidence to historic lows, which causes more affluent consumers (those with sufficient income and assets to be able to continue spending at previous levels) to reduce consumption in reaction to a world where economic opportunities are reduced.

The solutions to these problems are fairly cut and dried, having been worked out after the Great Depression.  For those doubters: 

Why didn’t the US economy experience another liquidity trap until the dismantling the checks and balances put in place in the 30’s was completed by the Bush Administration?

Read my next post to see what needs to be done.

End Notes:

1.       Laissez-faire economists counter that markets are self correcting if governments don’t interfere and need the “creative destruction” that comes from corrections to grow.  Unfortunately, modern markets (where information is quickly distributed) are not self correcting as proved by The Great Depression and Japan’s stagnant economy in the 1990’s.  Lots of reasons why today’s markets can’t self correct without government help but it’s irrelevant because democracies are for the people and the people have spoken:  The “creative destruction” of the unregulated Panics of the 19^th and early 20^th Century caused unacceptable hardships therefore there is going to be government intervention and regulation to try to smooth them out.  Live with it and make sure government intervention works.

2.       As a business man, I find it fascinating that Laissez-faire economics depends on an 18^th century theory called Say’s Law that essentially states that “if you build it they will buy it.” No way this works in a market based economy with rapid technology change and environmental laws.  In the 18^th century, any manufactured product had some utility, if only for scrap so inventories could be cleared by market pricing action.  Nowadays, you can build the wrong thing and it can not only be unsalable but also be toxic waste that costs money to get rid of, becoming a burden on the government when the manufacturer goes bust.

This is the first post for the One Eyed Guide© and what could be more fun than trying to answer the number 1 economic question: What’s Happening and will Obama be able to fix it in his allotted 4/8 years?

According to many Gold Bugs, we are headed to the “Greater Depression” and prudent investors should buy physical gold, guns and build a bunker as the entire global economy is about to collapse.

One Eyed Guidance: Bunkering is probably not a good idea as it just makes you visible to the survivors. Besides, who wants to live in a bunker?

The truth is probably different because:

1. Markets (even with government interference) are self correcting so the end result of what is going on now should give a better growth opportunities for most people than what we had before. After all, most people did not have significant real income growth in the last 20 years.

2. The Government has a playbook on how to fix the current crisis. All the current economic problems started around 1982 when a concerted effort was made to dismantling the controls and transparency put in place by our grandparents to prevent a reoccurrence of the Great Depression. Granny and Pappy were pretty smart and when their 1930’s regulations were eliminated and not replaced by new ones designed to handle modern issues…well, here we are in 2008 -Post to follow (PTF) on this. There was a lot of experimentation in the 1930’s and a few things clearly worked and should be implemented by the new administration:

1. Transparent markets, companies and government actions

2. Level playing field regulations ( a.k.a. fair markets in commodities and other areas)

3. Stable financial markets (1 & 2 above plus significant insurance for depositors/investors against financial company failures -$250K does not cut it.)

4. Social Safety nets to encourage consumer spending (healthcare is today’s issue)

5. Stimulate like crazy (lots of ways to do this with housing and infrastructure)

6. Don’t worry about balancing the budget until excess capacity has been pulled out of the system and consumer psychology on the economy is positive (Yes, we will be in a pure Keynesian environment in 2009.)

3. Currently, Secretary of The Treasury Paulson has made things worse as he seems to be channeling Hoover and is making the same mistakes that Hoover did (see Rothbard’s book America’s Great Depression for a description of what Hoover did wrong – just don’t necessarily believe Rothbard’s solutions.) For such a bright man it’s amazing: if the markets need reassurance that financial institutions are stable, why wouldn’t you publicize exactly how the government is supporting them to eliminate any questions?

In any case, he’s gone on January 20, 2009 and we will assume for forecasting purposes that Obama administration will do what they say which is more or less what’s outlined above.

Here’s what this means for your personal investments:

One Eyed Guidance:

• 2009 will be a good time to do long term investments in almost anything. However, holding periods, particularly for value stocks, will be 5 to 10 years and market swings will give a worrisome, rough ride.
• Speculative investments will primarily be items that will react to government action. Things like gold, gold stocks, corporate bonds and commodities that are good investments in early 2009 will require exiting some time before 2016, possibly as early as late 2009.
• US Government Bonds of all types will be a terrible long term investment due to the need for interest rates to adjust to reflect actual cost of money. Many groups who are buying them right now will head for the exit as once when interest rates start up and the exit will be jammed, spiking rates.
• International investment in China should not be done until after the potential for a political meltdown due to slow growth has been resolved.

So, the forecast for the next 8 years that this is based on, with some minimal justification (posts will follow with supporting details) and assuming aggressive government stimulus, is :

By the end of 2016:

· Everybody will have had a rough ride having dealt with slow job growth, deficits, inflation, and general worry about would the government get it right. This assumes they more or less do. As the 2009 economy mostly required spending like crazy for 3 years they probably will.

· Inflation will have been controlled after some ups and downs as the money that was created to solve the financial crisis is pulled back. There is no long term negative from the massive infusion of cash into credit markets due to the much greater destruction of wealth from P/E and asset (mostly housing) deflation.

· Stock Markets will not have recovered to the highs of 2000/2007 due to P/E deflation to historical levels of 12 to 15 on the S&P 500.

· GDP Growth will have recovered to levels from before the 80’s (80’s to 2008 growth was below historical average due to underinvestment in infrastructure) as the effects of infrastructure building kick in.

· Unemployment will still be high by historic standards due to continued job turnover caused by rapid technological change from infrastructure building.

· Housing prices will have recovered to be in parity with costs of construction in most markets. In most markets this will be an increase from 2008 levels

· “Peak oil” will be decreasing the availability of crude but prices will be stable as gas usage declines due to increased efficiency of vehicles and limited expansion of alternative fuel vehicles (either Natural Gas or Fuel Cells unless technical battery problems are solved.)

· The dollar will trade at roughly current levels versus the Euro, and down versus most Asian currencies as long term trade imbalances are corrected.

By Year assuming normal historical cycles (projections get less detailed the further out they are as only the broadest trends can be projected past 3 years):

2009

· The economy will start to recover in the third quarter as the effect of stimulus spending on infrastructure projects in the summer start to spread through the economy.

· Housing price declines will have stopped by this time but sales are weak.

· Markets will be flat to declining to at least mid-year due to declining corporate profits and continued P/E deflation. Lows for the year should occur in the third quarter.

· The credit crisis should significantly ease shortly after January when the new administration takes a large bat to banks and forces them to lend, at least to historical levels. One Eyed Note: It’s unknown which bat the government will use but they have a variety. You’ll know it is working when rates drop and banks start to complain about government interference. Banks that don’t take money from the Fed can complain but there are few of these.

· Consumer spending will have rebounded significantly as confidence has increased, gas prices remain low so non-energy spending can be done and extended food stamp, unemployment and Mortgage relief programs allow more discretionary spending.

· Business spending will be a drag on the economy until the end of the year due to over cautious management.

· The dollar will decline against most Asian currencies except Japan yen.

· The Trade Deficit will decline.

· The Fed starts to unwind monetary stimulus in the 4^th quarter.

· Republicans and some Democrats start to talk about balancing the budget.

2010

· The economy will start to grow and jobless rate will start to decline by end of year.

· Stock Markets will start to recover, however the best time to buy will have been before October 2009.

· The economy will declared officially be out of recession during this year with the date probably in late 2009.

· Stronger talk will be heard on balancing the budget and a tax increase on high earners will be passed. Much discuss will be done about avoiding repeating the Recession of 1937.

2011

· The economy will strengthen as will efforts to balance the budget.

· Broader tax increase will be passed to be effective in 2012

2012

· The economy will peak just before the election as the effects of budget balancing start to slow down the economy.

· Inflation will start again as shortages in raw materials occur due to increased demand and greatly decreased short term capacity.

2013

· The economy will significantly slow down; though probably not reach recession levels.

· Inflation will spike and decline.

2014, 2015

· The economy will gradually improve and deficits will decline.

2016

· The economy will peak shortly before the election and be declining on Election Day.

That’s what should happen if Obama does most things right – it’s pretty good but most “conservative” recommendations will derail this. Hopefully, politicians will heed the lessons of the Great Depression.

Get Ready for a Rough Ride and Good Luck for the New Year!