“It is patriotic to accept to pay a supplementary tax to restore the country.”
-Francois Hollande, the Socialist Challenger for the French Presidency, after proposing a 75% marginal tax rate on earnings of over one million euros per year
“Patriotism is the last refuge of a scoundrel.”
-Dr. Samuel Johnson, distinguished eighteenth century man of letters and author of the influential A Dictionary of the English Language
“If this plan saw the light of day, it would end in catastrophe for French football.”
-Frederic Thiriez, head of the French Professional Football League, in response to Francois Hollande’s tax proposal
Don’t Fight the Tape – But Prepare for an Unhappy Ending
Central banks are printing money all over the world. New names have been given to what is really an age old phenomenon. Desperate governments have traditionally debased their currencies when they have no other way of financing their deficits. Quantitative easing, LTRO, Fed/ECB swaps, whatever. A new technocratic lexicon has been invented to cover what is really a time honored expedient of debasement and paper money printing.
Investors for the moment almost have no choice. Get out the surfboard, hitch a ride on the global tsunami of freshly minted central bank money and get long equities. In 2012 equity markets have rallied everywhere, particularly emerging equity markets, and will probably keep doing so. Short term interest rates are near zero and likely to stay that way for the rest of this year. Investment managers are tired of telling their clients that they earned zero and had to pay a fee anyway. The European crisis has been overcome by massive LTRO money printing and a friendly “borrow all the dollars you want” swap agreement between the Fed and the ECB. And the US is in the midst of a tepid recovery (better than nothing!) Lastly, China seems to be slowing but not crashing.
Money must head for risk assets. Tough luck for defined benefit pension funds and retirees who until recently lived off of nice, safe bond income.
Bernanke’s little head fake of last week in not mentioning a QE3 can be taken with a grain of salt. The US has another $1.3 billion projected deficit to be financed and the fragile US recovery cannot stand a rise in short rates. A war with Iran would make the US deficit so much worse. The US unemployment picture is not as pretty as the recent decline in the official U3 rate to 8.3 percent would suggest. For one thing the Labor Force Participation rate continues to move downward. The broader and less quoted U6 rate which includes people who have given up looking for work for January is 15.1 percent. Bernanke knows the numbers. And recent Treasury data show some fall off in Chinese buying of US Treasury securities. US short rates will not rise and Treasury auctions will not fail. Not if the Fed can help it. The Fed will print.
Historically, countries faced with financing wars would print paper money and eliminate convertibility into a commodity such as gold, silver or copper. This happened over and over from Sung Dynasty China facing northern invaders, to the Napoleonic Wars, to the American Civil War and of course to World War I.
But this time it’s not wars but democracies’ underlying tendency to inexorably move to bankruptcy which is the culprit. Citizens vote to obtain through the political process what they cannot obtain in the market. Modern democratic governments are expected to socialize risk and redistribute income from the smarter (you would probably say luckier if you are on the left) affluent minority. The welfare state grows and grows, its costs disguised in the complexity of the budget process and ignored by the public anyway. Public sector unions, whose existence and freedom of actions politicians elected by universal suffrage found impossible to oppose even though they knew better, have accelerated the process. We vote for you, you reward us, is the working relationship most public sector unions in most democracies have with their politicians. No greater conflict of interest hath any country. The public sector debts have built up. And nobody has to bother lifting the fetters of a commodity money conversion requirement that was so important in the age of the classical gold standard before WWI. Richard Nixon cut the last of those golden fetters in 1971 when the US ceased to honor its commitment under the Bretton Woods Agreement to sell gold for dollars at a fixed rate to other central banks. Since the demise of Bretton Woods, every central bank in the world can be its own ATM machine. And indeed they have.
So far the world’s central banks have been “lucky”. Thanks to the prior global bubble ending in 2008 and the realization that the so-called advanced countries are reaching the end of their borrowing capacity, the world is in a massive deleveraging mode which tends to be deflationary. For the moment the central banks can get away with printing all the money they want without massive increases in consumer price indexes. The public doesn’t connect increases in prices of commodities like gold or oil with the current bout of money printing. But if history is any guide, this money printing will matter and the age of deflation and deleveraging will be followed by an age of inflation. Deleveraging or no, entitlements already promised will grow inexorably larger. Inflation of course is one way governments can effect major defaults on sovereign debt and unaffordable entitlements.
Regarding the global equity markets, I am seeing various forecasts from vaunted gurus ranging from imminent collapse, to rally in the first half of 2012 then followed by collapse to rally all year. I lean towards the last view. But with a very low confidence level. And with a fear that the party won’t go on forever.
The American Problem
This week’s New York magazine carries an article by Jonathan Chait entitled “Why Republicans Fear This Year Could Be Their Last Real Shot.” The article lays out how the growing demographic ascendance of African American and Hispanic populations versus the heretofore dominant white population spells long run catastrophe for the Republicans. According to the article, each presidential election sees the non-white proportion of the vote grow by two percent.
This demographic shift along with the overall aging of the population and decline of the worker/ beneficiary ratio (not mentioned in the New York Magazine article) will intersect with the coming need to deal with America’s burgeoning sovereign debt and entitlement crisis. Republicans in theory stand for smaller government, lower taxation and faster economic growth. Practice is another matter—Republicans often do the opposite of what their supposed ideology would recommend. The underlying populist dynamic of universal suffrage forces them to join the Democrats in expanding government and socializing risk. Today’s Democrats stand for bigger government, higher taxation and don’t worry as much about economic growth.
The coming American sovereign debt crisis—whether it’s next year after the election or ten years from now—will involve some mix of higher taxes and defaulting or reneging on government debts and entitlements. Just what the solution mix will be in terms of overt default/reneg, inflation, financial repression and tax increases remains to be seen. But unlike many other more homogeneous countries which face the same problem, the American version will in a part take on a racial/ethnic hue, i.e., older and more affluent whites vs. African Americans, (non-Cuban) Hispanics.
The data show that Hispanics and African Americans on average tend to be underperformers when measured by educational achievement or family incomes. Whites and Asians are outperformers. Obviously this kind of divide is not a healthy situation. Just why these gaps persist is a matter for educators, historians and policy makers, who unfortunately thus far have yet to come up with an uniformly agreed upon explanation much less a solution. Discussions of these issues often leads to anger and recriminations. But all that matters for the purpose of forecasting government spending and the conflicts that lie ahead is that the assumption is reasonable that this underperformance will continue for the intermediate future.
Presumably underperforming groups are greater users of government services, especially those programs like food stamps and Medicaid which are pure wealth transfers not camouflaged by phony trust programs like that financing Social Security. And, as the Republicans are fond of pointing out, only fifty percent of Americans pay income taxes. I have not seen data breaking this out along racial/ethnic lines but it is likely the profile of non-income tax payers and the income tax payers is quite different.
A preview of the way the coming American budget disaster and race will intersect in America can be seen by the reaction Newt Gingrich got when he labeled President Obama a “food stamp president.” Gingrich was himself labeled a racist for this although he never explicitly mentioned race. But his accuser implicitly assumed that minorities were the major food stamp recipients and that this was obvious to Gingrich.
The coming battles over solving the problems of the bankrupt American government will not be pretty. It will be a bit more difficult for an American president to preach patriotism to the affluent in these circumstances. Although, if there is a war with Iran, he might try.
The Future – There Is a Bright Side
I have been accused of being too dismal, and not optimist enough. So allow me to make a few at least semi-optimistic points:
- For investors globalization and the acceleration of technology offer significant rewards. I recommend to everyone a book by Ray Kurzweil called The Age of Spiritual Machines. While you might not agree with Kurzweil’s views on artificial intelligence, the central theme of this book is his law of accelerating returns. Under this law, technology is a continuation of human evolution and technology itself is speeding up at an accelerating rate. A more prosperous and healthier world lies ahead. As I see it, all those Chinese and Indian and other “third world” brains that have recently been added to the global economy will benefit everyone. And provide investment opportunities for Western investors.
- The world is not running out of energy or food. Technology is taking care of that and again investment opportunities will abound in these areas. In the energy area fracking and horizontal drilling have opened a bonanza in terms of natural gas and oil. If only the US and China would stop wasting money on so-called green energy boondoggles like solar and wind and ethanol in the case of the US. And again in the case of the US, get rid of arbitrary environmental obstacles. And let the market made the investment decisions! In the case of food, biotechnology will feed the world. Serious studies don’t find the Franken food scares to be valid. Again. Let technology do its work and let the market decide!
- A major fiscal crisis a la Greece and Iceland is coming to the advanced countries including Japan. Investors should be preparing now for the eventual major debasement of the dollar and the euro. Look to place funds in alternative assets like gold and in countries which won’t have a fiscal crisis like Australia, Singapore and Russia. There are alternatives.
- The US has been the land of technological innovation and economic progress. The world has benefitted. It would be a global tragedy if this were to change. But there is a risk that the US fiscal crisis will be “solved” by more taxes, financial repression and cutbacks in services that that the government should be providing. The cutback in funding to the world renowned University of California system is an example of a bad decision. Education is cut back in order to pay outsized pensions to retired California workers. Parenthetically, this hurts members of minority groups for whom the University of California system was one avenue out of “underperforming” status. (Fortunately for-profit education may fill some of the gap.) US technological and military superiority is threatened not by China or India but by US fiscal profligacy. It is up to the US and the other advanced countries to make the right choices to deal with the fiscal crisis. It will not be easy but they can do it.
- Capital goes where it is welcome. This is true not only of physical and financial capital but also of human capital. It is a big globalized world out there. In the past the US was the big welcoming country. It still can be. But if the US and other advanced countries “solve” their fiscal problems with taxes and other growth stunting measures, then well-trained professionals and young people from these countries will think about emigrating to countries that don’t have major fiscal problems and won’t try to squeeze them for their last penny. Singapore and Australia are two countries that come to mind. Already it appears that Greek citizens are emigrating to Australia, as they did in the past. Smart people don’t have to stay where they are exploited. Smart countries will try to attract them. The Statue of Liberty in New York Harbor has a plaque that reads “Give me your tired, your poor.” That’s not the new migrant. Maybe someone will add a new plaque, somewhere at a spanking new airport in what used to be called a third world country or an advanced country that made the right choices. “Give me your brains, your ambitious.”
Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.
Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.
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