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10/15/2010 3:49:44 AM - The Economic Future of the United States

I continue to view America's future with a very skeptical eye.

For well over a year now, I've been saying that one of my largest concerns is that the United States stock market would eventually start moving up significantly, either as a result of the underlying economic fundamentals improving or as a result of government policy. Since I thought that the job market would remain very bad for years to come (and mentioned 8% as a new baseline for at least the next decade) - I thought that inflationary pressures (caused by bad government policy) would be the most likely reason why the stock market (along with precious metals, commodities, and many other asset classes) would rise. (The stock market typically suffers in an inflationary environment because companies can't raise their prices fast enough to compensate for their increasing input prices, but - very generally speaking - as more money is printed assets maintain their original equivalent prices. Thus, if a share of Target is $50 and all of a sudden the money supply is doubled, a share of Target might go for $100 - yay, the stock has risen - but you won't be able to buy any more than you originally could have with $50. This is also what I frequently refer to as a "stealth tax" because you'll be taxed for the $50 "gain" even though your purchasing power hasn't increased. Thus, inflation is a means by which wealth can be covertly transferred from savers and the wealthy to debtors and the poor.)

(The 8% unemployment figure that I noted above excludes part-time workers seeking more hours and discouraged workers that have given up looking for a job. Thus, an 8% baseline unemployment rate is still extremely elevated relative to US historical standards, and probably represents about 15% or so of the general population unable to find as much if any work as they would like. Basically, I'm saying that I expect US unemployment to remain about 30-50% higher than it has been over the last 30 years or so.)

I suspected that inflation would be the primary reason for asset prices to rise, but I didn't foresee - at least so soon - the US Federal Reserve recently telegraphing its desire to soon engage in a second round of so-called "quantitative easing." Quantitative easing - or "QE" for short - is the process by which the Federal Reserve purchases Treasury bills, mortgage securities (primarily from Fannie Mae and Freddie Mac, which are in conservatorship - controlled by the federal government, which has assumed their liabilities), and other assets. The primary reason for doing this is to drive down interest rates (if fewer Treasury bills are available on the open market, you don't have to offer as high a yield to attract investors to sell the remainder) and to degrade the value of the dollar. In essence, one branch of the government is "monetizing" the debt incurred by other parts of the government. It's all a big shell game, and you won't actually create wealth in this manner. American exports will - as the Federal Reserve hopes - surge as a result of the weak dollar lowering the effective cost of their goods and services in foreign markets, but the weaker currency will result in inflation (it will take more US dollars to purchase commodities and thus increase the price of many goods bought by American consumers) and higher interest rates (as foreign investors begin to shift their Treasury purchases to more stable currencies and/or assets that generate better returns) over the longer term.

What, then, concerns me so much about the stock market increasing significantly? Right now the US government - which is running huge annual deficits in the range of $1.2 trillion per year (excluding obligations like Social Security, but that's another story) - is able to pay for its largesse because the world is still concerned enough about the near-term global economic future that it continues to seek safe haven in the US dollar. The end result is that the US continues to pay amazingly low interest rates on its massive and quickly growing debt. Imagine a day, then, when the fear has subsided - when the world decides that the danger is largely past and that investing in Treasury bills paying all-time low rates makes no sense when the stock market, commodities, and other asset classes are generating double-digit returns.

The logical assumption is that, at some point, many investors will begin to demand higher interest rates from the US government. That's where things begin to look extremely unattractive to me (and you'd best have turned cautious in terms of your investments before everyone sees the writing on the wall.) The US government is running huge deficits with unbelievably low interest rates. So...what happens when the panic subsides and they have to pay "normal" interest rates...what happens as more and more investors recognize the precariousness of the situation and start to demand higher-than-normal interest rates? The US government will have to devote more and more of its tax revenues to simply paying the interest on its debt, and that will in turn mean that it will either have to dramatically raise taxes (which wouldn't likely generate nearly as much income as they'll be hoping, and would also likely choke off any economic growth, increase unemployment still more, and contribute to yet another significant recession), have the Federal Reserve monetize the debt to a further degree (basically, print money so that they can pay back their obligations with dollars that are less rare and, therefore, less valuable to anyone holding them), or dramatically curtail spending (which the political class won't have the stomach to do on a large enough scale to matter, and which would certainly throw the economy into a major recession if they did.) I predict that embarking upon either of these two paths will lead to the US eventually having to pay even higher interest rates on its debt, and thus the downward spiral begins.

Complicating the situation, the higher interest rates that the government will have to pay will cause mortgage rates to rise, commodity prices to rise (which will sap consumer spending capability, which is about 70% of the US economy), business borrowing costs to rise (hampering their ability to expand and hire), et cetera. The basic problem is that the US - and many other countries - should really be deleveraging - reducing their debt load - but they can't bring themselves to take the harsh medicine that they should (which would likely lead to a worse recession now, but - I'd argue - a more secure and prosperous future.) Instead, they are artificially reducing interest rates (via, ironically, taking advantage of people's concerns about the recently volatile markets and concerns about the economic future.) When the interest rates rise, the US government (and others) won't be able to borrow at affordable rates and that will hammer confidence, government spending, the value of paper currencies, consumers' and businesses' ability to borrow, and many other things.

That, in essence, is my concern. Whereas many people's spirits will be buoyed by a rising stock market in the US, it will only increase my concern. I've left out how other economies such as Japan will try their best to prop up the dollar (because they want to keep the value of the Yen relative to the dollar in check so that their export-oriented economy won't be hobbled), but I think that they'll only be partially effective and, in the end, the US will wind up, at some point, having to pay significantly higher interest rates than it is now and that will, in turn, hasten the day when the US has to devalue its currency even more than it's been doing in order to allow it to repay its debt. (Japan is a disaster waiting to happen as well, so I certainly wouldn't recommend exchanging your dollars for Yen.) If you can stomach extreme volatility, I think that you'll look back in 20 years and wish that you had loaded up on commodities. In a world where currencies are inevitably going to have to decline in value relative to physical goods, you'll want to own the physical goods. Commodities will go through boom and bust just like the currencies, but whereas I think that the general trend for currencies (including the dollar, Yen, and Euro) is down, I think that the general trend for many commodities will be up.

One last significant point of concern that I should mention is that, over the next several years or more, you'll see most governments - countries, states, cities, counties, etc. - worldwide trying their best to cut spending while simultaneously looking for ways to increase the amount of tax revenue that they receive. Taken together, those two trends will be extremely negative for worldwide growth - the governments themselves will try to take more from their private sectors (which typically do a much better job of efficiently allocating capital) and will spend less themselves. I think that it means that we'll see a prolonged period of slow worldwide growth by historical standards, with only a few places (such as India and some Asian countries) registering significant outperformance (which is largely true only because so many of their citizens are still extremely poor and thus economic growth comes more easily than in other far more highly developed economies.)

Slow economic growth doesn't necessarily mean that stock markets won't outperform over various time periods (as profits may still rise due to productivity increases and the remaining investment options such as bonds, real estate, and raw commodities have plenty of risks of their own), but I suspect that it will keep a lid on their rise. In the end, though, I think that we're going to see more economic turmoil and volatility worldwide than we've seen in the past. Prepare yourself for it.

Lastly, on a tangentially related note, I wonder what the ultimate societal effects of the current economic situation will be? Will there be an entire generation for which a significant portion have far less job experience than has traditionally been the case? Will the millions upon millions of formerly employed workers find that they won't be able to rejoin the workforce at anywhere near their former levels due to extended periods of unemployment (that will cause their skills to deteriorate, potential employers to look upon them with more concern, etc..) I think that this is, yet again, another issue that will have negative repercussions far into the future.

- TZ

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