I am preparing this post on our drive back from a four-day birthday celebration in and around Washington, D.C. The location was picked first because it was convenient for four of the celebrants, and second that the Metro (DC's subway) made it easy for what could have been sixty people to meet for various activities. On Thursday, I was able to go from Pentagon City to the middle of the District for a business appointment in under 15 minutes. On Friday night the return trip took one hundred and five minutes. This “performance disparity" strikes at the efficiency of the government in Washington, albeit a local government responsible to the US Congress. In a related thought, I am fearful of what will be the middle-of-the-night debt ceiling compromise. I cannot predict the outcome, but what I can do is think about the inevitability of the conflict.
Unwritten elements in all constitutions
Whenever there is an unexpected crisis in a family, tribe or nation, a plaintive cry goes out to"do something." The leadership group fears that if they do not do something quickly, they will be replaced. One of the continual crises that governments attempt to address is the need for jobs. (Look to last week's blog addressing the need to focus on work, not jobs.)
The Bad Manual
Since the 1930s, almost all governments have been instructed in the writings of Lord John Maynard Keynes, a University of Cambridge scholar and British civil servant/speculator who advocated for governments to lower taxes and increase spending during poor economic times, and to raise taxes and cut spending in good times. Any realistic analysis will show that the first part has not worked most of the time. The second part (particularly reduced spending) has not been tried, thus rainy day surpluses have not been created in any sizable amounts. The theory is still widely taught and believed by economists. Economists like the theory because it places card-carrying economists in senior powerful government positions. The theory rests on the wisdom of the government elite to manipulate the economy for the benefit of the less fortunate who did not study under them in an ivy-covered hall. Early economists were professors of philosophy centered on ethics. Their thinking was based on the thought that rational humans would do the right thing if they were presented with all of the facts. The latter day economists and their political masters did not totally trust the populace to do the right thing and thus they manipulated the facts to force people to do what the politicians wanted.
Three clear examples of this current trend toward manipulation are first, the bailing out of those entities that were deemed too big to fail. Strangely, they did not realize that after every bankruptcy, the sun came up; new or different entities undertook many of the same functions at appropriate price/wage levels. The managements, equity holders and some debt holders became wiser as to the risks they were taking after experiencing their losses. The second current example is the Federal Reserve, buying treasuries to lower overall interest rates and thus stimulate lending. The result of quantitative easing was to make investment in emerging economies and commodities more attractive. Just as prior Fed manipulations created the dot-com and sub-prime bubbles, this time we may have created the biggest bubble yet in the form of significantly overpricing US Treasuries. The third manipulation was created by actions at both ends of Pennsylvania Avenue (the White House and the Halls of the Congress)for the last seventy years. The current impasse caused by the debt ceiling curiously comes as a surprise. The truth is that in deciding what is good not only for our own people, but many overseas, we have been bribing them with assets that that they couldn't afford.(Yet we treated these debts as good assets that would be repaid until periodic write-offs occurred.) We should have known that we had a government that we and the rest of the world could not afford.
What is going to happen now?
As I have already indicated, I do not know, but I fear that the result will not be well thought-out and efficient in terms of our resources, taxes and debt capacity. What should be happening is to examine the implications of an eventual default. First, at some point the risks overseas will appear to moderate, and the flight into the "safe currency" of the US dollar (and therefore our Treasuries) will become less intense and could reverse as higher and perhaps sounder interest rates will become very competitive to US paper. We should not blame only the scared foreigners for forcing up the price and lowering the yields on Treasuries. A good bit of the demand is generated by sophisticated US investors. These investors are looking for both the combination of higher return and escaping the presumed forthcoming wave of inflation. These smart guys/gals are buying commodities and other assets on margin. Guess what? They are supplying treasuries as the collateral for their leverage bets. A default could crunch the value of their collateral which supports leverage multiples of 50 times or more. If temporarily the value of the collateral should decline, unless they have other uncommitted assets, they will be forced to sell. I am hardly the only analyst to see this connection, thus any dramatic fall in the price of commodities may not be a function of inflation but a need to reduce leveraged positions. Less exposed, but tied to the US credit, are the assurances of various government agencies, e.g., FDIC,FHA, FNMA, SBA, etc. The prices of their paper also might react violently if the market really believes in a long lasting default.
Why is this happening now?
Around the world people are turning on their ruling political leaders because what they did in their attempt to do something is clearly not working. They are not producing new jobs. People want all of the benefits "promised," but they want someone else to pay for it. Their ability to achieve the retirement of their dreams is in tatters. For some time now I have questioned whether there are any truly popular governments, better than the other party or parties. However, all ruling political leaders are, or should, feel threatened.
This brings us to the current UK headlines on hacking. I am certainly not a defender of violating the privacy of individuals (including disclosures of the illness of a former Prime Ministers’ child). While there has been some apparent breeches of non-political leaders’ privacy, the strident calls for the hackers' heads is coming from the politicians and in some cases politically-oriented entertainers. If all of these people were as pure as the driven snow, they would have nothing to fear of the disclosures about their public positions or indiscreet activities. Clearly, they are human just like you and me. They must have some private feelings and doings which they would choose not to share. Apparently, that is not what the hackers in general are seeking. They want to catch the "Big Man or Big Woman" in a compromising situation which could cause the exposed person to lose face, if not power. If the people in power were secure in their popularity, probably no disclosure could unseat them. The focus on hacking in some respects is good for the powerful, in that it diverts immediate attention away from the continuing fiscal imbalances, the desires for current/enhanced services, and the unwillingness to pay for them.
What to Do?
Having the above thoughts, I am questioning the next steps in terms of our clients’ portfolios. Perhaps some of you in this blog community will share your thoughts. In the meantime, I will be patrolling the periphery of the markets to try and catch a fundamentally changing trend.
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