The following is adapted from this year’s Note 21 of The Kelly Letter, emailed to subscribers on April 7.
Let’s recap how the United States got into the financial mess it’s in.
In the modern era of Federal Reserve bailouts that began in the dot com bust of 2000, the Fed has expanded its balance sheet to $3.2T from $500B, a sixfold increase. This may have been worth it if the economy had also grown a commensurate amount, but it has done nothing of the sort. On the contrary, output is up only 1.7 pct annually on average during this stretch, an abysmal showing not seen since Lincoln was president and the country fought for its very survival. Worse, real median family income is down 8 pct and there are 6 pct fewer full-time jobs for middle class workers. Food stamps are distributed to more than 47 million people, a mass larger than the population of Spain. One in five Americans receives food stamps and/or disability.
The Bush/Obama one-two punch has been catastrophic for most Americans, highlighting the meaninglessness of our two-party system and the focus of political bankrollers on self-interest rather than national interest. We must also not forget that the stage for the Bush/Obama tragedy was set by Clinton, whose administration repealed the banking protections of Glass-Steagall which had guarded the financial system since 1933, thereby paving the way for banks to gamble with deposits and become too big to fail. When they did fail, both Bush and Obama rescued them with taxpayer money in a way that has left them even bigger and with the same exposure to exotic financial risk that cratered them five years ago.
Concomitant with Washington’s mismanagement of America’s financial system has been its submission to the military industrial complex identified by Eisenhower in his 1961 farewell address, one of the most prescient political speeches of the past hundred years. If only we could find similar substance in modern gaseous eruptions from Washington! The pointless Iraq War begun under Bush and continued under Obama is now estimated to carry a price tag of $3T.
Ever since FDR went the fiat money route in 1933, America has veered off on a guns-plus-butter financial fantasy from which it can’t recover. The early reasons were extreme and justified. Few would argue that the Great Depression of the 1930s didn’t require FDR’s stimulus programs or that World War II was not worth fighting. The problem is that the nation never stepped back from the path of extreme policies that were supposed to have been temporary. Beware “temporary” measures in Washington. They never go away.
About the only respite from the path happened under Eisenhower, a president who came to the White House with a resume of accomplishment behind him, then shaped up America’s balance sheet and social structure. He did more for civil rights than almost any other president, for instance, desegregating the military, making Washington a model of integrated schooling in the wake of Brown v. Board of Education, and telling his first secretary of the Navy flatly, “There must be no second class citizens in this country.” This same president delivered the nation sound money management and fiscal responsibility. Those were the days.
They came to an end with his departure, which ushered in a steady deterioration of the national balance sheet and an escalation of wars for nothing at ever-increasing costs. Johnson grew the Vietnam War without reducing social spending, then Nixon performed a de facto debt default by eliminating the convertibility of the dollar into gold. That was the starting gun of modern fiscal folly. Once the spendthrifts in Washington and elsewhere in the world’s halls of power found themselves in control of money backed by nothing, they were off to the races. “All we have to do is print it?” they asked. “Woo hoo!”
The following four decades saw America’s current-account deficit accumulate to $8T. The sum of its public and private debt is currently $56T, about $30T more than it would be if the ratio of debt to economic output had stayed at its historical 1.6 instead of ballooning to 3.6. The Fed of the 1970s began an expansion of America’s money supply that has not yet ended — though it was paused under Chairman Volcker in the 1979-1987 period. The infamous Chairman Greenspan of “Greenspan put” infamy followed, setting in stone the now standard policy of using Fed resources to rescue financial markets from falling asset prices.
Price inflation would have followed the explosion of the money supply if not for the rise of globalists who saw to it that cheap labor in Asia and elsewhere flooded economies with low-priced goods. If the abundance of money didn’t go into consumer prices, where did it go? Financial assets. The S&P 500 rose 500 pct from when Greenspan arrived at the Fed to its dot com peak in 2000. Take a look at its long-term chart. It’s done nothing but seesaw in multi-year patterns from that peak zone to the 800 zone ever since. Each rise and fall has followed the script created by Greenspan. The Fed sends prices up in a bubble that bursts, then is backstopped by the Fed with measures that create another bubble. We’re near the top of one now.
With lower- and middle-class jobs gone overseas and interest rates kept artificially low so nobody wanted to keep cash in bank accounts, Americans stopped saving and started borrowing and spending. They were deluged with credit cards and financing plans for everything from cars to college to homes, and they used every one of them. The Fed, China, and Japan financed the national binge with Treasury purchases. That’s about when Bush the younger arrived, launching his two unfunded wars and expanding Medicaid in tandem with reducing revenue through tax cuts for the wealthy.
It came to a head in the subprime crisis when a population unacquainted with basic financial knowledge after a generation of easy credit and low interest rates found itself unable to pay the mortgages it signed onto. Since they’d all been securitized, the deadbeat borrowers begot insolvent banks holding the toxic assets of securitized mortgages in default. This somehow surprised the financial geniuses who devised the mortgage-backed securities on the assumption that unqualified borrowers wouldn’t default.
This brings us to the Lehman Brothers bankruptcy of 2008. Had I been president, I would have let all the banks fail and let the housing market fall into chaos for about a year, giving speeches about lessons learned the hard way and the good things that follow a thorough housecleaning. I also would have summoned Bill Clinton and his cronies to explain in a public forum why they gave into banking demands to dismantle Glass-Steagall and throw the country into crisis less than a decade later.
The only backstop I would have kept in place is the one protecting depositors, the FDIC, and I doubt even that would have needed much help. Contrary to the Wall Street press blitz saying the country would go off a cliff if the government didn’t save investment banks, Main Street was never in danger. I believed this at the time, and I still believe it. For proof that this is not something I dreamed up in retrospect, see my September 20, 2008 article Overheard At The Wall Street Bar & Grill.
But no, instead of standing strong and letting the guilty receive their just rewards while protecting the innocent, Washington kowtowed to its Wall Street overseers, first under Bush and then under Obama. It wasted $800B in fiscal stimulus, some 95 pct of which disappeared into state and local government sinkholes, and capricious tax cuts.
That was nothing compared to what the Fed rolled out. It pinned interest rates to the floor and began spewing free money to speculators so they would buy Treasuries and toxic assets. If the Fed tries reversing this policy now, it will trigger a sell-off to avoid losing the delicate profits that depend on bond prices never dropping. This is why most of the liquidity created by the Fed has once again avoided pushing up consumer prices. Instead, it went into Wall Street vaults where it’s working overtime to inflate another asset price bubble. The money has to go somewhere. If not into real goods, then into financial ones. This has been the situation for two decades.
Meanwhile, politicians are making no progress at defusing the fiscal time bomb. With more than $17T in federal debt alone, the situation is urgent yet even fiscal hawks can’t propose measures in proportion to the task at hand. They’re declared dead on arrival, so dependent has the nation become on unsustainable spending.
Private analysts now question some of the assumptions coming out of the Congressional Budget Office, which is one of the better sources available. For instance, its most recent forecast assumes more than 16 million new jobs in the coming decade despite the past decade producing less than 3 million. It further assumes a 10-year deficit of only $7T, but it’s probably at least twice that. With no change in trend — a reasonable assumption given the stasis of politics and the preponderance of lackluster leaders who craft grand speeches on trifling topics instead of plans to address these colossal challenges — we’ll see federal debt ramp from $17T and 105 pct of GDP to $30T and 150 pct of GDP in 10 years.
Even worse, this is if there’s no new crisis that requires emergency funding with money we don’t have. If there is another crisis, they’ll digitally print more or confiscate some of ours, or both.
What has gone wrong is easy to spot.
Debt is not always bad. Used wisely, it creates something worth more than the value of the principal and interest combined. This is why responsibly bought homes work well with mortgage debt. When all is said and done, a $500,000 asset that cost just $225,000 in mortgage fees is a good move on the part of a household. On the other hand, a $200 pair of designer shoes financed on a credit card at 20 pct that end up being worthless, is a bad move. The United States as a nation has gone the credit card route, not the responsible mortgage route.
Our debt could have bought better industries and better infrastructure that created higher output that could have been taxed to repay the cost of the debt. Instead it went to Wall Street gamblers, wars for nothing, corporate cronyism, and unnecessary tax cuts. At this stage of our borrowing and spending spree, the nation is worse off than it was a generation ago. Reprehensible.
Those who claim Keynesianism are bastardizing the concept. Keynes did not advise governments to spend without limit and never pay down the debt. He advised higher spending at low points in the economic cycle to spur economic activity, and then higher taxation at high points in the cycle to repay the debt accumulated in the last spending phase and stash a surplus in preparation for the next one. Somehow, the second part of Keynesianism is always left out. We have the debt spending part down pat, though.
Now, we find ourselves in a situation where the Fed buys the bulk of Treasury securities to keep the government funded and interest rates at almost zero, on its way to a $4T balance sheet by the end of this year. The Treasuries are bought with money concocted from thin air, but they pay more than $50B per year in interest from the Treasury, which the Fed then turns over to the Treasury. This is how a snake eats its tail, and how modern governments play with money to keep themselves supposedly solvent, but in a way that strains the meaning of the term.
One day, non-Fed buyers of Treasuries are going to decide that what they’re holding are shells in a game or cards in a house or, in any event, unreliable stores of value, and stop buying Treasuries at unfairly low interest rates for the risk being assumed. That would leave just the Fed buying, which would further unveil the ruse, which would lead to an auction failure, which would bankrupt the government. It’s hard to predict the bedlam that would follow, but it would probably involve plunging stock prices, soaring gold prices, and spiking interest rates on Treasuries. People who bought bond funds for safety would see a loss, go to withdraw, then find that redemptions were too widespread so access was frozen. This is how most financial panics go.
Interest on the national debt was $360B last year, and that was with interest rates at lifetime lows. Getting back to more than 5.5 pct, where rates have spent most of the past two decades, would see the debt interest fatten to $1T and consume all personal income tax revenue. Unemployment would move much higher than 10 pct to join euro zone levels, and there we’d be in a perfect environment to watch the economy collapse.
Imbalances can hang on far beyond the point of recognizing that they can’t last. In fact, mass ownership of Treasuries by the Fed has happened before, in the 1940s, the World War II decade. It owned all short-term issues and almost all long-term. Then, as now, the Fed’s involvement sent stock prices higher even as the economy suffered recession in 1945. Then, as now, the Fed’s main tactic was to peg interest rates at low levels. During the war, Congress enacted wage and price controls, too, which are credited for keeping consumer inflation low.
The first takeaway this suggests is that the Fed has long enjoyed sway over financial markets. Just as it artificially propped up stocks in the 1945 recession by compressing interest rates, so it has artificially propped up stocks after the subprime mortgage crash and ensuing recession.
The second takeaway appears when researching how the 1940s Fed unwound its bloated balance sheet. When Truman passed anti-inflation legislation in 1948, which was similar to current moves to cut spending, it sparked a new recession and a bout of deflation. That spooked investors out of stocks into bonds, which provided the Fed with the demand it needed to sell off its bond portfolio. Will it take a similar spooking of investors to generate demand for the Fed’s current portfolio of bonds?
The third takeaway is that the great secular bull market of the 1950s and 1960s was not able to take off until the Fed stopped its policy of artificially suppressing interest rates. Market historians disagree as to why this was so, but the most convincing argument I’ve seen is that investors know when something can’t last and are naturally wary of committing too much capital to a temporary impetus. That should sound familiar. The reason most investors have been underinvested in this latest bull market is that they’re aware of its artificial origins, and fear the repercussions when the temporary prop lifts.
On the second takeaway, it will be much harder for the current Fed to sell off its portfolio of toxic bonds because it’s too big and nobody wants them. It may just hold everything to maturity, and keep expanding its balance sheet by $1T per year to finance Washington, engage in currency manipulation, and so on. The value of a dollar will erode so that citizens take the hit — as is already happening — until the bloated balance sheet doesn’t appear as bloated anymore.
Unwinding the balance sheet this time around will be tricky, as there appear to be just two options. The Fed can wait for another recession and then hope to sell its portfolio into higher demand, or sell its portfolio in advance and cause the recession. Either way, recession is in the cards.
Stepping back to a bigger level, we find that the Fed has tripled the amount of money in circulation since 2008 and that the Bank of Japan just announced its plan to double its money in circulation within two years. The fiat frenzy is on. The stakes are rising. The situation is not improving.
What to do?
Accumulate real property. This is my preference for surviving the great reset. Land is better than gold because it offers utility beyond its price. Gold is only worth what you can get for it. It’s a great coincidence that now is a fine time to finance cheap property with low interest rates — one of the only good uses of debt.
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