HowWealthWorks.com

[Suresh]

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HowWealthWorks.com Investing Big Picture for April 2009
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Overview
Our macroeconomic perspective and Primary Trend analysis have sharpened a bit since our last Investing Big Picture commentary in August 2008. We look for multi-year trends, and we question the validity of our premises and identify more data points supporting the premises that seem to hold. Three big topics have emerged in the last seven months or so. First, the response of the Federal Reserve and U.S. Treasury to the U.S. crisis increases the likelihood that the U.S. will experience a deflationary period followed by a period of high inflation followed by a deflationary period. Second, China is unloading its U.S. dollar-denominated foreign exchange reserves. Third, an emerging market debt crisis centered Europe is becoming a second global financial crisis epicenter.

Federal Reserve and U.S. Treasury Response
Before we discuss the response, let's briefly review the current and future setting for the response to see how we arrive at our expectation that the U.S. will experience a deflationary period followed by a period of high inflation followed by a deflationary period. We had estimated a $12 trillion loss in household wealth, which we then assumed would have a roughly $500 billion negative wealth effect on spending, which would cause a 3-4% GDP drag.

Merrill Lynch's David Rosenberg provides an even more grim estimate: a $20 trillion loss in household wealth. Using his estimate would yield an $800 billion negative wealth effect, causing a GDP drag of almost 6%. This drag is happening right now. In 2011, ordinary income tax rates and capital gains tax rates will revert to pre-Bush administration levels. This large tax hike will cause a GDP drag of unknown size. We expect it to be fairly significant because no drag would mean that the federal government's tax and spending is frictionless, which it is not. The following year in 2012, a new 4-5% GDP drag caused by implementation of a cap and trade program for carbon emissions will be added, according to John Mauldin. Looking at the GDP drags collectively, the current administration's estimate of real GDP growth rates between 2010 through 2013 of 4% is pie-in-the-sky nonsense.

Turning to the response by the federal government and the Federal Reserve to the current financial crisis, we see deflation is the primary concern as the rate of money and credit creation is falling faster than the rate of consumer, corporate, and government spending in the aggregate. Based on our study of money & credit supply creation and Harry Dent's demographic studies in The Great Depression Ahead, we expect that deflation will continue through roughly 2012.

Back in November 2008, we mentioned to you our concern about the bourgeoning annual federal government deficit in the United States, estimated to hit $1.95 trillion in 2009 alone. (By way of comparison, the 2009 federal budget is estimated to be around $3.1 trillion). That deficit must be financed with issuance of U.S. Treasuries, and is expected to grow larger. Even assuming that there will be investor demand for a growing supply of U.S. Treasuries, consider what that means for investor demand for any competing debt. More likely than not, the additional US debt will cause demand to fall for a commensurate amount of competing sovereign bonds and corporate bonds. Countries and companies that can't self-finance will go bankrupt.

But, here's the kicker. At some point, because of the increasing size of the federal government programs and decreasing tax revenues, either the U.S. federal government will not be able to service its debt, or investors will anticipate that the U.S. cannot afford its debt-servicing obligations and will stop purchasing U.S. Treasuries. Either event will lead to a U.S. bankruptcy. The soonest we can see this happening is 2Q2011. Because a tax hike is on tap for 2010, potential Treasuries investors may hold out to see how tax revenues compare to the federal government's debt servicing requirements. But, afterward, all bet's are off. The end of 2Q2011 (federal income tax day falling on April 15th) would probably be the earliest time there would be any indication that potential Treasuries investors lost faith in the U.S. federal government's ongoing ability to service its sovereign debt. Note: this does not mean that in June 2011 a debt default or investor strike will occur. We believe that this is the earliest time we could get either scenario.

If 2011 is an inflection point in the U.S. Treasuries market, where bond investors finally start getting nervous about sovereign debt default, then bond investors will start buying less Treasuries and dumping more Treasuries, forcing even more debt monetization by the Federal Reserve. How long can Federal Reserve debt monetization continue? After all, if debt monetization works indefinitely, why are any of us being forced to pay taxes? Here's what we think: debt monetization will work so long as we all hoard our cash.

Debt monetization breaks down when a wage-price spiral is created. Once this happens, money growth exceeds the growth of consumer, corporate, and government spending in the aggregate. Some of the excess money and credit supply may flow into the asset markets, in which case we may see a bear market rally. But, we expect much of the excess money and credit supply to flow into the real economy because investors at that point will be gun-shy about returning to the asset markets. The asset bubbles of the late 90s and early 00s were the product of a long stable expansion of money, credit, and asset prices. The volatility in markets, as well as the recent solvency crisis (where asset prices fell below debt values) preclude a new bull market.

A wage-price spiral is hard for many of us to imagine. After all, workers have had flat inflation-adjusted wages for so long. But, something fundamental has changed. For the past two decades or so, a greater and greater share of wealth created went to capital holders (employers). We believe the pendulum has reversed, and going forward, labor will get a greater and greater share of wealth created, under the federal government's approval or direction. Once the wage-price spiral gets going, the cost of operating the federal government's myriad programs will accelerate, requiring more and more debt monetization. Based on the above, we expect the U.S. to experience high inflation between roughly 2012 and 2017. This date range falls around 2015, the very year that Barry Bannister suggested that new debt would have no incremental effect on U.S. GDP.

At some point, the U.S. Treasury will be faced with a choice: continue to save others (individuals, corporations, and states) or save itself. Debt monetization and the resulting price inflation will force interest rates higher.  The Treasury will attempt to issue greater and greater amounts of debt as costs spiral and interest rates rise.  Working to hold interest rates down, the Fed will monetize debt at an even faster rate.  Eventually, however, the Fed will no longer be able to monetize debt fast enough and will be faced with a choice.

The U.S. Treasury will look into the future and see threats to its existence: exploding debt dynamics due to rising interest rates, via debt default or investor strike. Either way, the federal government must choose between continuing to save everyone else (states, corporations, and citizens alike) through debt monetization (which will lead to the demise of the dollar), and saving itself through sound fiscal policy (ending bailouts, balanced budget, higher taxes). Because bureaucracies exist to serve themselves, we expect the U.S. Treasury to save itself. When that choice is made, deflation will resume, starting in roughly 2017 and continuing through 2020-2023. The rate of money and credit creation will fall more rapidly than the rate of consumer, corporate, and government consumption.

Once the choice is made, the key is how the Federal Reserve (and by extension the federal government) will save itself. We conjectured about one way in March 2009. Central bankers' business is to map the economic chess game out many steps ahead of where we are right now. They understand the danger of high inflation created by excess money supply. They anticipate the need for a tool to draw off excess money supply, when there is evidence of inflation in the economy. San Francisco Federal Reserve President Janet Yellen proposes such a tool: Federal Reserve-issued debt. The Federal Reserve would sell the Federal Reserve-issued debt to its primary dealers, drawing off excess money supply without affecting the prices of mortgage-backed securities or Treasuries. The reason for Federal Reserve-issued debt got a little clearer, when Deutsche Bank warned about an asset-liability mismatch on Fed's balance sheet forcing it to issue debt. When cash flow losses require a recapitalization and when the U.S. Treasury is unable to provide such recapitalization, Federal Reserve issuance of its own debt becomes viable.

However, this proposed solution may only deal with the supply of money, but not its velocity. That is, even if the Federal Reserve attempted to draw of excess money supply in, for example, 2011, by issuing Federal Reserve debt, increasing money velocity may foster accelerating consumer price inflation rates through around 2017.

Long term, the issuance of Federal Reserve debt could cause the Federal Reserve itself to suffer from exploding debt dynamics. More and more dollars would be required to service more and more Federal Reserve debt. So, the exploding debt dynamics problem of the federal government ultimately becomes the exploding debt dynamics problem of the Federal Reserve. How would the Federal Reserve's exploding debt dynamics be resolved? Two possibilities. The first possibility: public confidence is restored in U.S. currency backed by Federal Reserve debt. The Federal Reserve successfully removes excess money supply out of the economy by rolling over Federal Reserve debt indefinitely and only paying interest on the debt. We put scant weight in this possibility. Presently, U.S. currency is backed by the taxing authority of the U.S. federal government. A currency backed by the Federal Reserve debt is backed by . . . well, nothing, and that is its flaw. As such, there is no check whatsoever on how much money can be created. Once people understand that, they will try to get rid of such currency as fast as they get it. That's money velocity in action, the very problem that was attempted to be solved by the issuance of Federal Reserve debt in the first place.

The second possibility: public confidence is not restored, and currency backed by Federal Reserve debt is rejected by the public, which demands every higher interest rates on the Federal Reserve debt. In that scenario, consider what the Federal Reserve may do with the dollars it accumulates through its Federal Reserve debt sales. The Federal Reserve is not going to turn around and buy Treasuries or mortgage-backed securities. That would defeat the purpose of Federal Reserve debt. A possibility then is precious metals, such as gold. With a growing balance sheet of U.S. dollars and no other place to put them, the Federal Reserve can be price-insensitive with respect to gold; no price will be too high. The Federal Reserve may be using the issuance of Federal Reserve debt to resolve the federal government's exploding debt dynamics problem and simultaneously accumulate gold. What would be the point of the Federal Reserve accumulating gold? A way to resolve the Federal Reserve's own exploding debt dynamics would be to issue new U.S. dollars backed by Federal Reserve-owned gold, ushering in a mild deflationary recession/depression between 2017 and the early 2020s. The Federal Reserve has found a way to recapitalize itself. As a side note, central banks with large U.S. dollar-denominated reserves may use the Federal Reserve's quantitative easing to sell U.S. dollar-denominated financial assets and buy precious metals, such as gold to recapitalize their own banking systems.

China's Divestiture of U.S. Dollar-denominated Foreign Exchange Reserves

In March 2009, when China's Premier Wen Jiabao conveyed his worry about China's U.S. dollar-denominated foreign exchange reserves worth around $740 billion, we couldn't help but be reminded of Warren Buffett's parable of Thriftsville versus Squanderville. If the value of the U.S. dollar dives because of monumental amounts of new federal debt creation threatening U.S. federal government solvency, then China will do the logical thing: divest and lock up resources necessary for their economy. In point of fact, the Chinese National Congress and the People's Bank of China both have insisted that the percentage of U.S. dollar-denominated foreign exchange reserves must fall to 50% of total reserves. Such a fall would entail a divestiture of $450 billion worth of U.S. Treasuries and/or GSE securities. We've mentioned the possibility of use of China's forex reserves to lock up natural resources in January 2006 when forex diversification was discussed, in April 2006 when purchase of strategic commodities was discussed, and in June 2006 when the purchase of non-depreciating assets was discussed. More recently, in February 2009, we noted that the global recession has let China use forex to lock up energy resource supplies. We can well imagine why. As we noted in October 2008, Steve Dickinson of ChinaLawBlog suggests that China will run out of coal in 6 years: 2014. China currently gets 70-80% of its energy from coal. Perhaps, China is stock-piling foreign exchange reserves looking for opportunities to lock up strategic resources such as energy resources in view of the coming shortage in domestic coal production. One can imagine that as 2014 approaches, China will either import more coal driving up the price of coal, and/or build more non-coal power plants and buy whatever fuel is required for those non-coal plants. By way of analogy, if China's Spending Wave peaks in 2015 as Harry Dent expects, then China's economy will need more and more natural resources at least through 2015. To this end, China has purchased $50 billion worth of natural resources stocks. The Chinese government has offered low interest rate loans for Chinese companies to buy foreign natural resource companies.

Consider what China's forex diversification means for U.S. Treasuries. Without China as a huge buyer of Treasuries, the Federal Reserve will be forced to monetize more and more Treasury debt.

$25T European Bank Exposure to Emerging Market Debt Crisis
Back in October 2008, Telegraph writer Ambrose Evans-Pritchard tied together two story lines that we've been following that up until then we hadn't realized were connected. One story line was the emerging market debt crisis in Europe (e.g., in Iceland and former Soviet bloc countries). The other story line was the emerging market debt crisis in Latin America and Asia. The two story lines are connected by the fallout is Europe will feel. At the time, we thought you should be interested because the Bank of International Settlement's estimate of European bank exposure to $3.5 trillion dollars worth of emerging market debt. Only a few months later in February 2009, the European Commission's estimate of credit losses at European banks, in part due to their exposure to emerging market debt, was $25 trillion! That astonishing figure is so huge that it rightly raises doubts as to whether European countries can afford a second bank bailout, this one larger than the entire GDP of Europe.

Sensibly, European policy makers focused the public's attention on the immediate problem: how much emerging market debt must be rolled over in 2009. Unhappily for such policy makers, that amount is $400 billion. A $400 billion problem sounds much more manageable, but for the fact that the IMF has only $200 billion in its war chest to bail out countries with financial crises. That's why IMF creditor countries have sought to increase the IMF war chest to $750-800 billion. But, even such a move would only delay resolution of the problem. Sooner or later, losses must be realized.

This emerging market debt crisis interests us because resolution thereof will take years. Unfortunately for most of continental Europe, its Spending Wave according to Harry Dent peaks in 2010 and falls for decades thereafter. Going forward, continental Europe's economic and investment asset experience will be very similar to that of Japan post-1990. That is, there is no huge Millenial (or Echo Boomer) Generation in continental Europe that will drive economic growth and investment asset prices higher.

HowWealthWorks.com Model Investment Portfolio
We use the prevailing macroeconomic environment to suggest holdings for our own 401(k) plan and/or brokerage account. A deflationary environment through 2011, for example, would benefit a bond fund. A deflationary environment would benefit precious metals, as investors flee to safety; a subsequent high inflation environment between around 2012 and 2017 would also benefit precious metals as investors seeks stores of wealth. Peak Energy would benefit energy plays.

There are two portfolios, one for brokerage accounts and one 401(k) because many if not all 401(k) plans do not include a precious metals vehicle, and consequently, there is no way to execute on the HowWealthWorks.com strategy solely using 401(k) accounts.

401(k)
Bond fund: 100%
Russell 2000 Index fund: 0%
S&P 500 Index fund: 0%
MSCI EAFE Index fund: 0%

Note: If a 401(k) account includes precious metals, energy, and natural resources fund options, then those funds may be substituted for the 100% bond fund allocation.

Brokerage Accounts
Precious Metals: 50%, split between a physical bullion vehicle, a large cap precious metals fund or ETF, and a junior exploration mutual fund or ETF

--CEF – an example of a physical bullion vehicle

--American Stock Exchange Gold BUGS Index (^HUI) fund or AMEX Gold Miners Index (^GDM)- to get diversified exposure to junior exploration companies
Energy: 50%, split between an oil & gas drilling and exploration index fund like IEO, an oil equipment and service index fund like IEZ

(Given the secular commodity bull market, there are a number of different sectors to play. Our positions in precious metals are not intended in any way to disparage agricultural plays (e.g., MOO) or water plays (eg., PHO), for example, both of which have long term growth potential).

DISCLAIMER: THIS WEBSITE IS IN NO WAY A SOLICITATION OR AN OFFER TO SELL SECURITIES OR INVESTMENT ADVISORY SERVICES. THE INFORMATION ABOVE IS INTENDED FOR DISCUSSION PURPOSES TO GENERATE A BEST-OF-BREED MODEL INVESTMENT PORTFOLIO. IT DOES NOT CONSTITUTE SPECIFIC INVESTMENT, LEGAL, TAX, ACCOUNTING OR OTHER PROFESSIONAL ADVICE AND SHOULD NOT BE RELIED UPON FOR PERSONAL OR FINANCIAL DECISIONS EXCEPT IN CONJUNCTION WITH SPECIFIC ADVICE TAILORED TO YOUR SPECIFIC SITUATION PREPARED SUBJECT MATTER-APPROPRIATE PROFESSIONAL(S).
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Thoughts from the Frontline: Back to the Future Recession
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Let's survey the economic landscape. We have an unstable economy. Housing doesn't bottom until 2011 or 2012, unless, as I wrote the other day, we give immigrants a green card to come here.
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And this being a different type of recession -- because we are hitting the full credit-cycle reset, it's going to take longer. I think the recession -- the actual, honest, mark-to-market numbers --will be negative through 2009. Then we'll start to improve.
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But in 2010 we could start seeing slow growth again, maybe Muddle Through. There might be a sluggish recovery in 2010, but we have to put an asterisk on that possibility because the Democrats are going to push through the largest tax increase in history.

First of all, the tax increase is the Republicans' fault. They didn't make the tax cuts permanent when they had the chance, so consequently they go away in 2010. US taxes are going to go way up, whether there is no compromise, so that we go back to the pre-Bush years, or there is some compromise because the Obama Administration realizes that putting in that type of a tax increase will throw us back into recession.
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Obama wants to impose this new carbon credits program, which sounds benign. We call it a credit and not a tax. Here's the issue. It gives us two bad possibilities, one of which is going to happen. Number one, he is assuming there is something like $800 billion coming in over the next decade from these carbon credits, and he's put that as income in his proposed budget, like it's going to get passed into the system. He is assuming that revenue. If he doesn't get it, deficits are much higher in the near term.

But if he gets it, it's even worse, as US industry becomes uncompetitive with Third World industries that don't have the same carbon credits and energy costs. Do you think China or India will pass the same legislation? They are building more coal-fired plants every month than we build in a year.

We are going to be seeing factory after factory shut down and moved off-shore, because they simply won't be able to compete. Either way, we go back to that economics technical term I used earlier: we're screwed.
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I think the country could re-enter a recession in 2010 and 2011; we would go right back into it when those tax hikes start to hit.
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At some point inflation starts to show up again, because when you start running two-trillion-dollar deficits and you start trying to borrow it, at the same time the Fed is printing money, at some point in this process the bond markets (and the currency markets) are going to rebel. An unsustainable trend will keep going until it stops. I don't know when that day is, but the current policies mandate that we will hit the proverbial wall. One day it will be just like August 2007. Someone is going to ring a bell and the Treasury bond market is going to look the deficits and wonder how they will fund them, and they are going to let out a huge gasp and then throw up. Because you can't run two- to three-trillion-dollar deficits as far as the eye can see.

As Woody Brock so capably points out, the key to watch is the debt-to-GDP ratio. You can grow debt fast; but at some point you start to have to grow the economy faster than you are growing debt, or you become an economic basket case, where the dollar is devalued and interest rates go up fast. At that point, the Fed will have lost control.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

John Mauldin correctly notes that the U.S. survived the 1970s. However, I don't think anyone was worried about exploding debt dynamics or a currency crisis leading to loss of global reserve currency status back in the 1970s. I don't think the U.S. had gone through an equity market bubble, followed by a bond market bubble, followed by a housing market bubble. Household balance sheet repair, if any was needed, was minimal; now, such repair will take years. Back in the 1970s, a common solution to add household income was to encourage a spouse to work -- not really a solution this time around with so many double-income households already. Times are different.
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Thoughts from the Frontline: The New, New Normal
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Last week I outlined three possible paths for the economy based upon the political choices we make about the budget deficits.

First, there is the benign path, where we more or less roll back the Bush tax cuts, and do not increase spending for new programs. The fiscal deficit falls into a manageable range. We repeat the Clinton years where spending is help below increase in revenue so that over time the budget gets balanced. While a large tax increase would have negative consequences for the overall economy, it is far better than the other two paths strictly from the perspective of growing the economy as much as possible. This path also has a very small probability.

The second path is that the Obama budget is passed, the Bush tax cuts go away and we have a decade of projected trillion dollar deficits. By the way, those deficits assume 3% growth rates, low unemployment, low interest rates and very large health care savings, and a withdrawal from Iraq and Afghanistan. The deficits are likely to be MUCH larger then the CBO forecasts. This on top of exploding entitlement expenditures in the middle of the next decade, which are underscored in the opinion of more conservative analysts (including me).

The third path is the same as above except that large new taxes are passed in order to bring the deficit to a manageable size relative to the growth of GDP. This means that a tax increase over and above those projected by the Obama administration of around $700 billion a year (about 5% of GDP!). Deficits would still be in the $3-400 billion range, but from a funding perspective, it could be done.

The second path is one that will end in heart ache. I do not think that the world or even US investors can buy multiple trillions of dollars of debt for more than a few years without rates rising significantly. That, as Gross points out, will affect both businesses and mortgage borrowers. It is a disastrous train wreck.

The third path is the more likely. I think (hope?) there are enough economically conservative Democratic that will realize the problems of trillion dollar deficits. But they do want a fully nationalized health care, and thus they will pass enough in taxes to pay for it. If they are going to do it, this is their one chance, as Republicans are likely to do better in the 2010 elections and get enough votes to push back any real tax increases other than letting the Bush tax cuts expire.

As outlined last week, it will be a combination of a VAT and taxes on health benefits. There is no other real source for the massive amounts of money needed. It will be a disguised tax on the middle class.

I do not believe they will want to wait until 2010 and an election year. Passing such a huge tax increase is very problematical from the standpoint of a growing economy. It will almost surely put us back into a recession. But it will not be a train wreck. As investors and businesses, we can survive and figure out how to deal with the realities of the new, new normal economy. It will be one in which growth is lower than what we are used to and unemployment is higher. Think Europe.

It will be difficult to ever go back. Perhaps new technologies and industries can develop and help get us back on a path to higher growth later in the next decade. We did survive the 70s, after all.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

David Tice among other market pundits have made the point that China has been rebalancing its dollar-denominated foreign exchange reserves out of U.S. agency debt and into short-term Treasuries.

By short-term Treasuries, I take this to mean Treasuries with maturities of, for example, one year or less. (Such an allocation may explain in part why a 12-month Treasury sports only a .35% yield and why shorter term Treasuries have even lower yields). The benefit to China of such a tactic is that when the debt matures, by definition, there is no need to sell the assets crushing their prices. For instance, upon maturity, China takes the principal and buys commodities such as gold. Prior to maturity, any interest on the Treasury debt could be reinvested in short-term Treasuries or could also be used to buy commodities.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

John Mauldin gets religion, as he comes to grips with the likely effects of higher future taxes and continued deficit-spending on future economic growth prospects for the U.S economy. He now believes the U.S. economy will experience a double-dip recession in 18 months -- by 2011Q2 or so.
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Thoughts from the Frontline: Muddle Through, R.I.P?
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I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.
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However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.

And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics.

Savings Equal Investments

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

(For the wonks out there, GDP is usually termed "Y".)

You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.
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Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.

In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth.

Who Will Buy the Debt?

Now, let's go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. ... So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.

Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate?



The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks' lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.



So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.

And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. ...

Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral.
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As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. ... But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.
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BP 2009Q4
_________________
Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

MarketWatch: 'Death of American Capitalism:' The 10 final scenes
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[Charlie Munger recently wrote a parable in Slate entitled "Basically, It's Over."]
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[L]isten to our translation of Munger's drama as a 10-scene crime-thriller about America on the "road to ruin."
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Scene 1: Power and wealth create false sense of invincibility

Significantly, Munger says 2012 is the turning point, a signal, the moment setting up the final crisis scene. We've often made a similar timing prediction, one tied to the 2012 election, and a reminder of the warning made by Jared Diamond in "Collapse: How Societies Choose to Fail or Succeed." In the late stages of a nation's cycle: A crisis hits. Everyone, leaders and citizens, act surprised. But it's too late: "Civilizations share a sharp curve of decline. Indeed, a society's demise may begin only a decade or two after it reaches its peak population, wealth and power." Just 20 short years to ruin?

Munger warns: "Even a country as cautious, sound, and generous as America could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of America had created a peculiar outcome: As their affluence and leisure time grew, America's citizens more and more whiled away their time in the excitement of casino gambling." Yes, Main Street "feels battered" while Wall Street gambling casinos generate billions.

Scene 2: Greed consumes America: Gambling replaces real work

In Munger's brilliant parable "the winnings of the casinos eventually amounted to 25% of America's GDP, while 22% of all employee earnings in America were paid to persons employed by the casinos" and "many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called financial derivatives."
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Scene 10: Politicians love Wall Street's derivative casino: Game over!

The 86-year-old Munger is himself a metaphor for America's version of the classic historical cycle: He was an optimist as he and Warren built their $267 billion company over four decades. But sadly, his parable, his vision of America's future, has no optimistic finale. Rather it's reminiscent of Diamond's "Collapse," Bogle's "Battle for the Soul of Capitalism," and so many other recent reminders about how America just went over a cliff and how Wall Street's casino-banks will soon drive us off a bigger cliff into the Great Depression II by 2012.

Munger's parable is more than a Hollywood suspense-thriller, it's another example of the classic historical life-cycle of a nation.

In the final scenes "politicians ignored the Good Father one more time," the casino-banks returned to gambling in derivative "securities with extreme financial leverage. A couple of economic messes followed, during which every constituency tried to avoid hardship by deflecting it to others. Much counterproductive governmental action was taken, and the country's credit was reduced to tatters. America is now under new management, using a new governmental system. It also has a new nickname: Sorrowland."
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Suresh

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