Plastic Green Shoots
Most investors and pundits are celebrating the green shoots of economic stabilization and the belief that there will be a "V" shaped recovery in GDP growth. I believe, however, that what we are experiencing is just an artificially derived respite and that we have only entered the eye of our debt induced hurricane.
There should be no mistaking what was the progenitor for near collapse of the economy late last year. It was clearly the overleveraged consumer and financial sectors, which was the direct result of artificially induced low interest rates and excess money creation. If one can understand and accept that premise, then the idea that a recovery achieved by zero percent interest rates and a doubling of the monetary base becomes an untenable one. Add in a dose of anti-capitalist programs (cap-and-trade), government takeovers (GSEs, Detroit, Banks, Healthcare) and tax increases; what you arrive at is something far from an economic recovery.
Now I'm not saying that things don't appear better off than they were just six months ago. There are indeed many green shoots. First time jobless claims and Non-Farm Payroll numbers are less bad (our new measure of achievement in this economy), consumer confidence has ticked up and many of the regional manufacturing surveys have shown signs of improvement. But the impetus for these small victories is based on the fact that we have temporarily bailed out the economy by taking down the costs of borrowing across the board.
In the summer of 2006, Helicopter Ben finished his three quarter point rate increases on the Federal Funds target rate and stopped at 5.25%. His belief was that it was enough to vanquish the serious problem of inflation which had risen by 4.3% from a year earlier. However, in July 2007, commodity prices were still surging and year over year inflation had increased by 5.6%. Meanwhile, the debt of our nation had grown to record levels. Household debt as a percentage of GDP reached an all time high of 97% while total debt reached $30 trillion. The trenchant need to deleverage shut down credit markets and by the fall of 2008 had caused economic chaos across the globe.
The Fed chairman then realized debt levels could not sustain higher borrowing costs and quickly turned in his wings for fruit. The new and improved Banana Ben Bernanke subsequently took the overnight bank lending rate to zero percent in short order. In addition to manipulating rates, he has expanded the Fed's balance sheet to over $2 trillion by purchasing Mortgage Backed Securities and treasuries, all the while instituting a myriad of lending programs designed to keep borrowing costs low.
Can it really be any wonder why the economy has shown signs of stabilization? Significantly bringing down debt service payments has caused a brief period of relief. But while the symptoms of distress have been removed, the real issue remains unresolved. The facts are that we have not deleveraged as a country at all. In fact, as a direct result of government's actions we have exacerbated the problem.
The resulting interruption of free market impulses to pare down debt has caused household, corporate and public debt to reach $33.9 trillion as of April 2009 -- an all time record high.
I do not know how long this ersatz recovery in the economy will last. What I do know is that even though there is diminished demand for money on the part of the private sector, the necessity of the government to issue 3.6 times the amount of debt this year as compared to fiscal 2008 will cause the Fed to monetize a good portion of that debt. And with the Fed Funds target rate remaining at 0-25bps since December 2008, the chances of producing a rate of inflation that meets or exceeds that which we experienced in 2007 are highly probable.
My belief is that the green shoots will be killed off by inflation and/or higher interest rates. The fact is that interest rates must increase dramatically, which will either put us in the same situation as the summer of 2007 thru the spring of 2009, or the inflation tactic will be sought to lower the value of debt.
The former scenario will lead to a deflationary recession/depression which will be favorable to cash and the dollar. The latter scenario -- which the Fed and Administration have shown conclusively to favor--will send gold above $1,500 an ounce and oil to $200 per barrel just for starters. It will also mean the end of the US dollar as the world's reserve currency. In either case, the resulting economic shock will be severe and the difference it will make to your investment strategy is impossible to overstate.
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