A Brief Diversion

I’ve written extensively on topics concerning the US economy over the past several weeks. Today I’d like to step off of that path for a little side trip. If we stipulate, for the sake of this argument, that the US economy is going to suffer an irreversible decline, then what would be the potential effects in the world? For a moment I’m going to think some great thoughts.

First of all, as I believe I’ve shown already, the US dollar would cease to be the global reserve currency. That means that the nations of the world will do business with each other by exchanging some currency other than the US dollar. That is easy to say, but what exactly would that mean to the average American? Initially the US economy would follow a path that could be described as “inertial”. That is, what is in motion will try to stay in motion. So we’d continue to consume, as individuals, and we’d continue to spend, as a nation, as though we had all the money we wanted. But eventually we’d come to recognize that the US dollar wasn’t getting the proper respect we think it deserves. Oil from the Middle East will cost more than it used to. Trinkets from China will cost more than they used to. Cars from Japan will cost more than they used to. The world will be less and less eager to accept US dollars in exchange for the tangible goods and services that it has to offer. Of course, this leads to price inflation in the US. It leads to higher interest rates on US government debt. The US economy, 70% dependent upon consumerism, will slow down even further. Tax revenues will drop. The deficit will grow. It is a vicious cycle that reinforces itself. There will be tremendous political pressure on the US government to mitigate the impact of these negative forces. Not only that, the current administration has the mindset that it can, and should, try to mitigate these “bad things”. So things will continue to get worse, for awhile. Nevertheless, reality will set in.

At some point, however, the US government will be forced to acknowledge that they must reign in spending. More accurately, they will discover that they must reduce the magnitude of the deficit spending. The first step will be to increase taxes, because they are ideologically unable to reduce spending. But higher taxes, along with the global economic changes that are outside of their control will eventually force them to abandon massive social spending, and we’ll eventually see a federal budget that is lower, year-over-year. By the time we get to that point it will be far too late.

One of the areas of the federal budget that I expect will see the most active trimming will be in defense. In fact, I believe we’ll see real defense budget declines from the start. It won’t have to wait until the crisis hits. But I don’t see the defense budget going to zero. I do see the budget shifting away from deployment, away from production, away from an active military. I expect that we’ll continue to spend on R & D. Think about it (that is what this is all about, after all). Congress will resist any decrease in spending that will impact their district. At the same time, the administration will recognize that defense dollars are just about the last federal spending category that creates high-value US jobs (you know, the ones that result in tax payers). There are literally millions of tax-paying workers that are supported by the US defense budget. So I do not expect the defense spending to go to zero. I do expect to see fewer and fewer programs transition into production (production is threatening, R & D isn’t). I do expect to see less and less US troop deployments around the world. I do expect to see more and more US troops pulled back from foreign stations.

These things will happen because of economic necessity and because they are in perfect alignment with the ideological leanings of the current administration. This is the closest we’ll come to a sure thing. But what will it mean, globally? That answer will have to wait until my next posting.

"One Mark to Rule Them All"

Nowadays I see many people of all stripes sporting tattoos—on their ankles, on their backs, arms, legs, faces, and I'm certain, on unmentionable parts. I see tattoos on young goths and punks, and I see them on apparently average young mothers pushing baby carriages. Even middle-aged men and women are beginning to visit the parlors—now becoming ubiquitous due to demand—to permanently scar their bodies with oftentimes strange and occultish symbols.

From whence originates this relatively recent rise in the popularity of bizarre images indelibly etched on such a diverse cross section of the American populace? Has the Maori culture of New Zealand somehow infiltrated our liberal and susceptible pop culture? Are we witnessing an inexplicable resurgence of centuries-old western seafaring traditions?

No, I propose that the rise in popularity of tattoos does not lie with man and his mores. Certain groups of people are, in fact, being attracted to the notion and acceptance of tattoos in preparation for the ultimate reception of the "mark." We are witnessing the willing softening of resistance to a special tattoo that will someday be mandated by governing authorities and uncritically accepted en masse by the fallen, most of whom will already bear the semblance of such a mark on their bodies.

I'm not suggesting that every mommy in the grocery store wearing a colorful butterfly on her ankle will someday be unyieldingly coerced into receiving the mark. Nevertheless, if you're already accustomed to permanently wearing strange symbols on your body, what's one more?

"Put on the full armor of God so that you can take your stand against the devil's schemes. For our struggle is not against flesh and blood, but against the rulers, against the authorities, against the powers of this dark world and against the spiritual forces of evil in the heavenly realms." Ephesians 6:11-12

Real Data, Not Spin

Here is a link to some disturbing info on the future mortgage reset possibilities.


http://www.businessinsider.com/henry-blodget-coming-soon-the-alt-a-mortgage-reset-bomb-2009-8

I think it is essential that we look at the hard facts rather than the hopeful pronouncements that come from Washington or the various talking heads on TV. Home sales may have increased month-to-month over the last few months, but they are still dramatically lower than they were a year ago, which was already seriously depressed from levels a year before that. So we aren't really in a good place. And "cash for clunkers" may have made car dealers busier than one-armed paper hangers over the past few weeks, but the sales they made have come at the expense of potential sales in the near future. This did not have a lasting good effect on the economy. The list goes on. So I urge you to look at the data and draw your own conclusions.

McClintocks - Is It Worth It?

Well, I'm now officially on board and ready to share my thoughts. It was quite the process - it actually has taken months! (of course I wasn't working it very hard ... O.K. not at all). Sooo, my first comment will be something easy - a restaurant review! I made reservations at McClintocks in Saguaro Ranch for my Mother-in-Laws 77th Birthday. My daughter-in-law and my grandson also attended. We all crammed into one vehicle and headed up Thornydale. I had never been north of Moore road. Upon entering the Saguaro Ranch community (over 1100 acres) we went throught the tunnel... magnificent! Upon exiting we entered an very green and uninhabited area filled with saguaro's - thus the name. We came upon the security gate and they were very nice. They checked their board and saw that we did actually have reservations at 5:30pm and another gentlemen (mexican cowboy) offered to be our guide up the winding road to the end of the street, where McClintocks is located. The drive was beautiful .. probably 1.5 mi drive or so. We saw a few built homes and a couple under construction. We later found out that there are only 11 home sites in Saguaro Ranch that have actually been built (or are in the process of being built) and of these there are only two permanent residents - the rest just come and go since it's the second, third, or "pick a number" home. One of the eleven homes has been there for ages...probably the original squatters.

We were met at the restaurant by a number of waiters/waitresses who eagerly greeted us as we approached the front porch. Upon entering the atmosphere was expectantly western and rustic. We were the first guests of the night. We were sitted at one of the front tables with a direct view to the South peering through the hills of the Tortillito mountains. It was an extradinary vantage point that grew even more exceptional as the sun began to set and the Tucson valley darkened, except for the millions of twinkling city lights and the lights from above. We observed some protesters during the early part of the experience. It appears there is still some quarreling over the land by certain environmentalists. They were promptly escorted off the grounds.

Our waiter was exceptional. We later found out that he has spend many years in the restaurant business and had prior work experience at Flemings, McMann's, and some other reputable and more high end establishments. We also learned he was a mortgage loan officer and working at Saguaro's was just a side job. He took great care of us throughout the night...we had his undivided attention. The menu was typical and presented the normal steak and seafood varieties. My Mother-in-law ordered an onion appetizer...not sure of the actual name, but she loved it. She devoured it all by herself...but then she loves onions (and garlic)! We all ordered and ultimately split between steak and seafood (salmon) dishes. The food was good... receiving a 7 out of 10. The prices were expectedly high, which after finishing dinner I surmised was mostly due to the atmosphere rather than the menu selection/creativity/taste.

After finishing dinner we took the elevator up to the top floor (2nd floor) and walked out on the upstairs open dining area. It was not is service this night, but mirrors the size of the first floor, which provides them great overflow capacity, but is mostly used for special occassions (i.e. weddings, ...). Our waiter followed us up and answered all our questions and enjoyed the calm of the desert night with us. Often people just come to the restuarant and get something simple w/ some coffee (or a drink) and sit on the 2nd floor and stare at the Tucson valley.

Overall, we had a great time! In the end, Saquaro's were very hospitable and extended us a very warm and personable experience. We had a respectable dinner w/ exceptional care and attention. We spent some quality time w/ our loved ones and took in the beautiful desert surroundings and viewed the awesome night lights of the city and the heavens. I'd recommend Saquaro's anytime for that special occassion.

The Last Resort

Some other things I want to touch on with regard to precious metals and inflation. First of all, precious metals are not the only way to hedge against price inflation. Any useful commodity that isn’t perishable could serve the same purpose. For example, you could buy a barrel of crude oil, or a ton of copper. Both of these would provide the same kind of hedge against inflation that gold or silver would. The problem becomes one of storage and exchangeability. You can usually go down to a local coin shop and sell your bullion bars or coins at any time, for the going rate (remember, you’ll always be stuck buying your coins at retail and selling them at wholesale). But where are you going to keep an economically significant amount of crude oil? And who will you sell it to when you need to raise some cash? And how will you transport it to the buyer? Gold doesn’t have these problems. And although it takes a whole lot more silver to equal the price of an ounce of gold, it is still a relatively compact way to store wealth. A barrel of crude oil for $60 can be equaled by 4 silver 1oz. coins or a 1/20oz. gold piece. A ton of copper will be good for $6000 (at $3/lb), and that can be matched by 400 silver coins (25 pounds) or 7 ounces of gold.

The other point I want to make clear is that gold or silver is useful as an inflation hedge, but only to the extent that we continue to live in a relatively stable environment that allows for the disciplined exchange of goods (at whatever price). If blood starts to run in the streets, if disruption of commerce and civil disorder becomes the environment, then you’re better off with a gun and plenty of ammunition than a bag full of gold coins. Of course, you have to face the question of whether you’d be willing to use that gun to take by force the things you need (which you might be able to otherwise purchase with a gold coin). Many people would be willing to use the gun to defend against aggressors, but are you just as willing to become the aggressor? So even in the worst imaginable circumstances it might be advantageous to have some precious metal coins on hand, along with the gun and ammo.

I need to say one more thing about precious metals. You have to think of them as a long-term core holding. You don’t want to buy a gold coin now, at $950/oz, with the thought in mind that you’d sell it for $2000/oz. That is not the point. Frankly, if the dollar tanks to the point that gold goes for $2000/oz, then the last thing you should want to do is settle for just $2000. So when/if you think about purchasing precious metals you really need to be in the mindset that this is a forever purchase. This is a lasting legacy you intend to pass along to your children.

Think about it.

This Just In!

I pulled this data today from the Treasury Direct website. This shows the interest rates for various maturities of the securities that have been auctioned this year. As they say, a picture is worth a thousand words. The Orange Line (10 Year Notes) is the rate used to set most mortgage loans (and mortgage rate resets, too). Maybe I’m missing something, but the trends in evidence here are not particularly encouraging.

Deflation vs Inflation

I recently read an analysis that made the argument for deflation rather than inflation. The analyst’s point was that the recently deflated credit bubble has resulted in over-capacity in all sectors of the economy. And this is a global phenomenon, not just a US problem. There are now too many factories, too many ships, too many trains, too many trucks, too many malls and retail shops of all varieties. Over the past few years it was just too easy to get the credit (debt) to build more and more. So if we go back to the economic basics of supply and demand, when there is too much supply something has to happen to either decrease the supply or increase the demand. This analyst makes the argument that prices will decline in order to stimulate demand, hence price deflation. And quite honestly, we are seeing this in many areas. Real estate and stock prices have been in decline, as we all know. There are lots of sales going on in the retail sector, airline ticket prices and hotel room prices are also in decline. The soft demand for these items has resulted in lower prices. The question to ask, however, is how far can this go? How long can it last? Is it of a magnitude that could possibly offset the government’s massive borrowing and spending?

Here’s the thing, this price deflation doesn’t happen by itself, without any corresponding effects that can be felt elsewhere in the overall economy. Sadly, a large percentage of the goods and services that the US economy is made up of have their origins overseas. Whether we are talking about Middle East oil or trinkets from China, so much of our economy results in US dollars going overseas. And, as I’ve already explained, many of those dollars end up coming back to purchase US Treasuries to keep the government running. So, let’s stipulate that the deflationary effects do happen. That will mean that fewer dollars go overseas. That will mean that fewer dollars are available to fund the activities of the US government. As we’ve seen, this will put upward pressure on interest rates. The Federal Reserve will be tempted to buy up the excess Treasuries in order to keep interest rates down, but that will be a big red flag to the foreign holders of US debt that the dollar is being debased. So in spite of what the Fed desires, interest rates will have to go up to attract buyers for the Treasuries that go up to auction. Higher interest rates will put even more downward pressure on the economy, resulting in less economic activity. The cycle will reinforce itself. So in this scenario we see price deflation, higher interest rates and higher unemployment. But does this lead to inflation?

The believers in big government, which essentially are the members of both political parties (Republicans and Democrats both believe that government action is called for to solve our economic ills, they differ only in the magnitude of the action they propose) will naturally turn to more and more government intrusion into our lives. These government handouts will have to be funded by debt and that will increasingly be supported by the creation of dollars by the Federal Reserve. The dollar will become less and less desirable to foreign companies and governments, which means that more and more of them will be required in order to purchase goods and services from those foreign companies and governments. That, my friends, will be inflationary. And by the time we reach that point in the drama that is unfolding before us there will be no stopping it.

So I’ve made the argument for both deflation and inflation. The big question is which force will win the tug-of-war? I’m betting on inflation. Why? For a couple of reasons. One, the loss of US dollar purchasing power is a nearly uninterrupted trend since the creation of the Federal Reserve in 1913 (see the chart from a couple of posts ago). This is the natural trend for fiat currencies (currency that only has value because a government says it has value – fiat is Latin for “let it be done”). They seek their intrinsic value, which is zero. What complicates the situation today is the fact that every currency in the world is a fiat currency. So we are privileged to watch this global race to the bottom, which I believe the US will win because we have the political will to achieve this goal (sadly, this is not a good thing). Two, inflation will win because the US Government has only two options with respect to the massive debt it is raising. They can either default or they can inflate.

Default would be quick, enormously painful and globally disruptive. But it would also be effective, in two ways. The criminals responsible for the pain will be evident to all (I’m talking about the US politicians who trigger the default). They’ll never hold another public office, they’ll go down in history as the criminals they are and they might very likely suffer prosecution from several plaintiffs, if not actually be in physical danger. And, after the mess of default is cleaned up the US dollar will be out of the position of being the world’s reserve currency. That will result in a complete inability of the follow-on government to pursue similarly destructive public policies. We’ll be forced to live within our means, which will be much smaller than we’re used to, by the way.

On the other hand, inflation will allow the current political criminals to continue living in their imagined splendor. As long as inflation doesn’t get too far out of control everything will appear to be “fine” and “normal”. Since inflation preserves the political status quo it is the option to bet on. Quite frankly, I am hoping for mild inflation instead of Zimbabwe style inflation. If inflation were to get out of hand the end result for the US will look very much like the default option. But in either case hard currencies will do well, i.e., a store of physical commodities. I urge you to re-read these past several posts. Think about everything I’ve said. Consider what a proper response to current events should be, particularly as it relates to your savings. Do you really want your savings to be in a stack of pathetic, worthless slips of paper? Shouldn’t you consider putting at least a small portion in something tangible?

A Quick Look at Deflation

This table shows the annual increase (or decrease) in the value of consumer credit and real estate loans in the US since 2005, in billions of dollars.

2005 +$613B
2006 +$452B
2007 +$743B
2008 –$1168B
2009Q1 –$532B

So you can see that over the past 5 quarters nearly all the credit that had been given out in the preceding 3 years has been obliterated. Now I must remind you that this is credit and until it is spent it isn’t debt. So it represents only the potential for dollars in circulation. I don’t know how much of this credit has been turned into debt, but I suspect that the majority of it has indeed been spent (otherwise why are so many people paying monthly minimum payments on their credit cards?). Nevertheless, given that 70% our economy is driven by consumption, when you take $1.7T out of potential circulation that is going to have an effect.

And deflation is simply the result of fewer dollars in circulation to chase the amount of goods and services that are available. Those dollars can disappear from circulation for two reasons. First of all, they can disappear like the table above shows. Banks can eliminate lines of credit, etc. Second, people can voluntarily take them out of circulation by saving instead of spending. This concept is important to understand for the next post I will be writing.

Inflation, then, is just more dollars in circulation to chase after a fixed amount of goods and services. Where do those dollars come from? Well, they can come from credit that is turned into debt when consumers spend it. This has been the major driver of our economy in the recent past. Secondly, the dollars can come into circulation when they are pulled from savings.

Strictly speaking, when the Federal Reserve puts dollars into the economy they do it by depositing it into Banks to then be offered as credit for businesses and consumers to then turn it into debt when it gets spent on goods and services. Right now we are seeing large sums of money going to the Banks, but they aren’t yet offering credit. This is one reason why the federal stimulus efforts aren’t currently yielding results. At some point, though, that pressure will build to the point of rupturing the dam and the money will flood the system.