Rehab Revisited

In my September 2010 post “Busting Out of Rehab” I compared our situation in the U.S. Economy to that of a drug addict forced into rehab against her will, only instead of being addicted to drugs the U.S. was addicted to debt. In 2009, I was hopeful our addict would stay in rehab and get off the debt drugs. Individuals were reducing their debt (both through repayment and default) and state governments began drastic spending cuts. The historically low tax rates that were initially sold as being temporary were set to expire. Maybe we could get clean.

But by September 2010 it had become plain that the addict would only stay in rehab as long as she was forced to stay against her will. The addict still liked being an addict. As I wrote then:

“But wait! There’s a tapping at the window. It’s the addicts’ old pushers – China and Japan. ‘Don’t worry,’ they say, ‘We are here for you. We will supply your habit no matter what! In fact, we have some new really good stuff for you – better stuff than we have ever given you before. Remember when all we had for you was ten year five percent stuff? Well now we’ll supply with you with ten year two percent stuff!’ Also outside the window are the addicts’ old friends from a place called ‘Congress.’ Some of them say, ‘Hey, come on out – I’ve got some more of that stimulus stuff for you.’ Others from Congress say, ‘Forget that nasty stimulus stuff. You know it leaves you with a nasty hangover. What you really need is some more of these tax cuts! That’s the good stuff!’ (Those Congress guys fight a lot with each other, but the one thing they have in common is they all just want the addicts to come out and party.) Then the addicts look outside and they can’t believe their eyes. It’s Dr. Bernanke and Dr. Obama. They’ve gone over to the dark side. ‘We’ve got even more good stuff for you,’ they say. ‘I’ve got some quantitative easing that you’re going to love’ says Dr. Bernanke, and Dr. Obama adds, ‘And I can help those Congress boys get you even more stimulus and tax cuts!’”

I wrapped up that post with the following:

“As a result, it suddenly appears that the party may start again… [but] the addicts are still far from healthy. They can’t party like they used to, and besides, they will claim they have all learned their lesson. In fact, if the addicts aren’t careful they may end up right back in rehab very quickly, or even worse (that Greece guy really doesn’t look healthy enough to be partying again!). And even if the addicts keep the party going for a long long time, they will still be addicts. Eventually the day of reckoning will come, and it will be all the worse for having been postponed this time around. But that could be years, maybe even decades, away. After all, pretty much everyone and every government on earth has a vested interest in keeping this party going. So for now, the addicts say, ‘Let’s eat, drink and be merry! And put it on our tab.’”

So how is our addict doing now, nine months later? While in rehab, the doctors (Dr. Bernanke and Dr. Obama) had prescribed some of their low interest rates and TARP to help wean our addict off the drugs, but the withdrawal was still too painful. So our addict busted out and started partying again, bingeing on more of the same debt drugs that put her in rehab in the first place. Unfortunately, as with all addicts, our addict needed bigger doses of stronger drugs just to get the same high. Low interest rates and low tax rates used to be enough to keep our addict flying, but no more. Our addict had to start taking ever bigger doses the deficit drugs, bigger than she had ever tried before. And still that was not enough, so she had to start main-lining the really hard stuff – quantitative easing (the “Q.E.”). Lucky for her, Dr. Feel Good (aka Bernanke) was more than happy to comply.

But our addict still doesn’t feel so good. That Q.E. is good stuff when added to all the other drugs, but our addict is paying the price for partying too hard for too long. Our addict seems to need more and harder drugs each time, but still her highs aren’t as good as they used to be. When you get right down to, even though she’s now taking more drugs than ever, she still feels pretty lousy. So what happens when our addict can’t get high from all the drugs she can get? When the drugs just don’t work anymore? What now?

If our addict was thinking clearly (she isn’t) she would realize she can’t just keep taking more and more of the same drugs. For starters, her suppliers are tenuous at best. First and foremost, that China guy has been pushing so much stuff, some wonder if he can keep up being the main supplier for just about everyone else. What if that guy gets sick for a while and can’t supply everyone? Plus that China guy doesn’t even like our addict! He keeps spying on her and breaking into her house and snooping around her room, hacking into her computer, and stealing her DVD’s and the plans for her new F-22 stealth fighter jet. Not really the kind of guy our addict should be depending on. And those Congress guys that used to be such reliable suppliers of the deficit and stimulus drugs (good stuff!) – now a bunch of those guys are going all teetotaler on our addict, lecturing her about the evils of using all this stuff and threatening to cut off her supply completely. Even Dr. Bernanke seems to be having some concerns about the side effects of any more of that Q.E. stuff.

So what is our addict to do? At least she’s not as bad as her friend Greece. That guy’s whole life was consumed by his addiction to the debt drugs. He can’t hold down a job or make any money, and he has spent everything he has, so he can’t afford rehab even though he is finally realizing maybe there is no other way. Lucky for that guy he has a bunch of rich brothers to bail him out. Even though some of them are griping about it, they seem to realize that the family had better stick together, for now at least. Even his family will abandon him and kick him out if he doesn’t get his act together soon.

Our addict doesn’t have any family members rich enough to bail her out and keep financing her habit, or her rehab. She doesn’t realize it yet but there are no good options left to her. She is trying to continue with the status quo, but she is getting sicker and sicker from too many drugs. Her former suppliers in Congress may realize this and cut her off for her own good, or that China pusher may get sick or hit by a bus, but either way if she is involuntarily cut off from her debt drugs without a good rehab program in place the withdrawal will be horrible, long lasting, and involve much pain and suffering. She might never fully recover. Even if China and her other foreign suppliers don’t cut her off, they will start worrying more and more about collecting payment for the drugs they supply, and so will start raising prices (also known as interest rates). As she has to spend more and more to keep the debt drugs coming, she will have less and less to spend on other things, like health care and education, all of which will impact her ability to pay for more drugs in the future, in a viscous cycle that can only lead back to being cut off completely.

As I said last September, our addict can still party for the time being, and maybe for quite a while still. Her foreign pushers don’t want to lose their best customer – even that China guy seems to understand that. Her best friend (England) is still in rehab and still kind of shaky, so she’s no fun anymore, but her friends the BRIC brothers still want to party all the time. They are healthy and feeling good, and seem willing to drag her out with them each night. She even has a designated driver (that guy Germany – he’s not much fun, but always helps Greece and the other addicts get home safe, at least he always has so far). But our addict may have blown her last chance for a nice orderly rehab. She is living on borrowed time.

***

Like the addict in our story that is still trying to party like the good old days, we have way too much debt in the US, but our federal government continues to spend far more than its revenues. Amazingly, this year our federal government is spending the MOST money as a percent of GDP for any year in the last 50 years, while simultaneously collecting the LEAST in tax revenues as a percent of GDP for any year in the last 50 years. But also like our addict, we may shortly be in for the extremely unpleasant experience of going cold turkey quickly, or in that direction at least. Witness these (seemingly obvious) facts:

1. Individuals continue to reduce debt (through both repayment and defaults), reducing consumption, which is bad for the economy in the short run.

2. Both democrats and republicans now agree we must cut federal government deficits – republicans say cut spending (a lot!) and democrats say cut spending (not as much) and raise taxes – either way fiscal policy is becoming more restrictive.

3. State governments continue to cut their budgets (they can not deficit spend), also contributing to restrictive fiscal policy.

4. QE2 is ending this month – i.e. monetary policy is becoming more restrictive.

5. All of this while the economy is still far from strong, with low growth, high unemployment and low capacity utilization.

So in the face of a struggling economy, fiscal policy is tightening, monetary policy is tightening, and consumers are trying to pay down debt. Unfortunately, like the addict, we have binged on debt to the point where we may not be healthy enough to survive such harsh remedies. Add to this the risk of a serious disruption, such as a Greek debt default, or the bursting of the Chinese real estate bubble, or a major earthquake in California (don’t laugh – in the past year or two there have been major quakes on the other three corners of the pacific plate – Japan, New Zealand, and South America – and these things tend to occur in cycles as movement on one side of the plate affects the other sides as well) and the short term outlook for the U.S. economy looks bleak.

Of course, many emerging markets are still a bright spot for the world economy. Germany is doing quite well. China, with a control economy and a huge incentive to preserve the status quo, may be able to continue driving global growth for many years to come. Uncle Ben could serve up QE3, and maybe that will drive the markets up again, just as with QE1 and QE2. So the market could do quite well for months, maybe even years. I am just saying that the risks are skewed to the downside in the near term.

But all of that misses the more important point, because even if we survive the next few years relatively unscathed, the piper will still have to be paid. Unless our economy starts consistently growing at around 4% real GDP growth (not likely), we will not be able to grow ourselves out of this mess (showing this requires a rather extensive analysis – too much for this short piece but available in the article linked at the end of this blog entry). Unemployment will stay high, and the economy will still have excess capacity, and eventually we will have another recession. Only this time the starting point will be an already weak and over-leveraged economy. Tax receipts will decline and demands for social programs will increase. Our deficit will widen further. We will start to look even more like Greece.

When any country, such as Greece, gets to the point that its debt and deficits are unsustainable – i.e. the country can not grow its way out of the problem (the addict is beyond rehab) – its options become severely limited. In fact, the only good option is to find some richer bigger countries to bail you out. That may work for Greece, but it won’t work for the United States. No country is big enough or rich enough to bail us out. For the USA, we are left with five options (or some combination thereof):

1. The first option, and until recently the only option we had pursued, is to pretend that we are NOT at the point where our debt and deficits are unsustainable – i.e. we CAN grow our way out of this problem. The addict’s first line of defense is to deny she has a problem. She will cut back, and everything will be fine. This option is not a permanent solution. It only works as long as the addict’s suppliers (in our case, the foreign countries that lend to us to finance our debt and deficits) believe it, and eventually they wise up. When they do, this option is no longer available, and if we try to stick with this option we will be involuntarily kicked to option #2. But this option has worked and can continue to work for a surprisingly long time, because everyone on all sides has a vested interest in maintaining the status quo.

2. Option 2 is to continue to run deficits, and continue to borrow from foreigners to do so, even as these lenders become more and more concerned over our ability to repay our debts. As a result, the price we must pay for debt (the interest rate) will rise. This will have two impacts. First, rising interest rates equates to restrictive monetary policy, choking off the productive lending of our economy, causing recessions and reducing tax revenues. Second, more and more of the government’s revenues must be devoted to interest payments, leaving less for education, health care, roads, infrastructure, etc., which also will hurt the economy, leading to lower tax revenues and higher need for social programs. All of this will widen the deficit further and harm economic growth further, putting us right back to where we started with too much debt and too little growth, only even worse. In other words, Option 2 not only doesn’t solve the problem, it makes it worse.

3. Option 3 is the seemingly direct approach that many in Congress now favor, and that is to reduce deficit spending in a big way – either cut spending or raise taxes or both. Unfortunately, no matter how you do it (spend less or tax more), that is like a kick in the gut to our weak economy. It will kill what little growth we have, causing a recession which will raise unemployment, decrease tax revenues and increase the need for social programs. As with option 2, this will widen the deficit and harm economic growth further, again putting us right back to where we are now with too much debt and too little growth, only even worse. In other words, Option 3 is not a solution either. It makes the problem worse, just like Option 2. The addict is far too weak to take this tough medicine. (As an aside, if we had tried this option sooner, when our debt and deficits were smaller, we could have done it gradually over time so that it would not kill our economy, but at this point our debt and deficit are so big that the gradual approach to deficit cutting is unlikely to work in time, and you end up back at Option 2.)

4. Option 4 is to just refuse to repay our debts. After all, if you take the interest expense off the ledger it makes it much easier to balance the federal budget, and once the budget is balanced we won’t need to borrow anymore anyways. And for a small peripheral country like Greece they might even be able to get away with it, but not us. The entire world economy is built on the dollar (specifically in the form of Treasuries) as the world’s reserve currency. If all those Treasuries become worthless then that will literally mean the destruction of the foundation of the entire world economy. Think Lehman Brothers’ collapse was bad in 2008? Try multiplying that by about a thousand. The turmoil would quite literally threaten civilization as we have come to know it. Think Mad Max movies.

5. Option 5 is less extreme, and it is the other option that we have been toying with lately. Unlike Greece and most of the other debt addicts, we have been able to issue all of our debt in our own currency. The Greeks have to repay in Euros. Third world countries have typically had to borrow and repay in U.S. Dollars. When these countries’ economies go down, repaying in Euro’s or Dollars becomes impossible. With their economy floundering they have no way to earn enough foreign currency to repay their debts. They are forced to default. But here in the U.S., where all of our debts are in dollars, we can quite easily get the money to repay all our debts and be debt free. Because we can print our own dollars! The Federal Reserve can literally print dollars and then use them to buy Treasuries, and voila! No more debt owed to foreign countries. The government just owes the money to itself! Does this sound familiar? It is because it is EXACTLY what we have been doing for the last nine months. It is called Quantitative Easing, or Q.E. No wonder the addict in our story loved the Q.E. – it seems like the easy solution to all of her problems.

Option 5 has been tried many times by many countries in past decades and centuries, from the Romans putting base metals in their gold coins so they could mint more, to Germany after World War Two, to several Latin American countries since then. Unfortunately, Option 5’s track record is pretty bad. The result has almost always been that once governments start manufacturing money, they can’t seem to stop themselves from going too far. If a little inflation helps a little, then surely a lot of inflation must help a lot! But the Germans who had to use a wheel barrow to cart cash to the grocery after World War 2, or the Argentinians who saw their life savings inflated away to nothing, would disagree.

So our politicians will ride Option 1 for as long as they can, slowly drifting toward Option 2, while also pursuing Option 3 as much as the voters will tolerate the pain, to buy time and credibility. But Uncle Ben knows, and eventually others will realize, that Option 5 is in fact the only solution that doesn’t automatically make our existing problems of too much debt and too little growth even worse. And in theory at least, if done to a limited extent, Option 5 could help things improve. It will cause inflation, but it will also spur economic growth (in nominal terms at the very least). This will increase tax revenues and help the deficit. Since the Fed will be the biggest buyer of Treasuries they can keep interest rates low, again helping both the economy and the government’s interest expense. All of this is an unfair wealth transfer from savers and lenders to debtors, since inflation and artificially low interest rates hurt savers and lenders, but that is the price of fixing the problem. And it is a risky course, as past history indicates, that if done poorly it could end in financial ruin for the U.S. (which would result in worldwide economic calamity). But what other choice is there?

That is why Dr. Bernanke has already been dabbling in Option 5, and why I believe when his first choice to date (Option 1 – pretend we can grow our way out) fails, and when Congress’s new first choice (Option3 – cut deficits) fails, he will fully embrace adding Option 5 back into the mix. And if he maintains discipline on Option 5, not printing too much money, but just enough, he might be able to get us to the point where a gradual use of Option 3 could work. This plan has its problems… SERIOUS problems… but when one’s choices consist of certain death vs. probable severe injuries that might not be fatal, one is wise to choose the latter.

***

As with everything in life and investing, timing is everything. As I mentioned above, everyone has a vested interest in keeping the train from careening off the tracks, so the status quo could be preserved for quite some time, perhaps longer than anyone expects. Perhaps, if our leaders are wise and disciplined, we can gradually inflate our way out of our predicament while gradually reducing our deficits, until we eventually are back to a sustainable situation. So in that sense, the longer this takes to fix the better, as long as we are actually spending that time fixing it and not making it worse. At the price of another “lost decade” or two we can, maybe, eventually dig our way out - lousy for investors, but not catastrophic for the world as a whole. Of course the longer this takes to fix, the greater the risk that the train will uncontrollably go off the tracks. Maybe there is some external shock (e.g. China’s real estate bubble bursts, or unrest in the Middle East sends oil up over $150/barrel), or maybe our lenders just lose patience and start demanding much higher interest rates, or maybe Greece defaults in an uncontrolled manner much like Lehman Brothers in 2008. The U.S. is in no position to pay for another round of rescues and bailouts. It could get ugly.

So the pain appears inevitable. If we are unlucky, or our leaders make bad decisions, we will take it all at once, in the form of uncontrolled economic catastrophe. But hopefully, with good leadership and a little luck, we could spread the pain out over another lost decade (hopefully just one), so that it isn’t so catastrophic at any one time, just a long slow dull pain.

There are also two “fat tails” to this risk curve, one at the positive end, and one at the negative end. For a description of the negative extreme, the brave of heart can read a recent piece (http://www.itulip.com/forums/showthread.php/19599-The-Next-Ten-Years-%C2%96-Part-I-There-will-be-blood-Eric-Janszen?p=200282#post200282)by economics uber-geek Eric Janszen, who predicted (among other things) the tech bubble burst (in a 1999 newsletter), the housing bubble burst (in multiple mid 2000’s newsletters) and the decade-long rise in gold (in 2001). Janszen does a great job of showing why it is now too late to grow ourselves out of our current predicament. Unfortunately, he goes on to conclude that like the great depression of the 1930’s, the only way out this time is World War. I hope he is wrong. But even though he is not a polished writer (he is too busy making points to fix all the typos, mislabels on charts, and the like), I regret to say he makes a pretty convincing case.

But I will end with the positive fat tail. The obvious (although by no means easy) way out of our predicament would be a technological breakthrough on the energy front. If we suddenly figure out, for example, how to make solar energy for the equivalent of $30 per barrel of oil. The resulting growth and benefit to the U.S. economy would be so huge that our problems would be over (economically at least – the resulting chaos in the Middle East could result in all sorts of problems for U.S. security, but at least would be able to afford to protect ourselves).

Reverse Psychology

I just saw Dennis Gartman (aka the world’s most pompous commodity trader and author of a commodities trading newsletter) on CNBC. He expressed his shock and disbelief that the Euro has stayed strong against the dollar. This probably means Gartman is short the Euro, and therefore losing money, which is why he can’t believe it, but on the surface I would have to agree with him. If there is one place in the world with bigger financial problems than the U.S. it has to be the EU. The market for Greek debt is clearly pricing in a default, and the logical solution for Greece is to leave the Euro and devalue a new Drachma. The ECB keeps reiterating that any default (technical or otherwise) on Greek debt will make it no longer eligible as collateral for European banks at the ECB. Irish voters seem to slowly be awakening to the fact that letting their banks default on their debt to the rest of the EU would probably work out pretty well for Ireland (although likely not for the rest of Europe). Spain and Portugal aren’t far behind. Voters in Finland and Germany are already revolting over the potential cost of bailing out these spendthrift nations. Etc. Etc. How can the Euro be going up?!?!?

Well, what is likely to happen to resolve all this? At the macro level, either Germany and the other strong Euro nations bail out Greece and the weak Euro nations, or else they don’t. Clearly the rates on Greek debt indicate that the market is betting they won’t, so let’s look at that scenario first. If Greece defaults, the government will not be able to borrow any more money. Since they can’t balance their budget, and they can’t print Euros. They will have to reinstitute the drachma and set an artificially low official initial exchange rate at which to convert Greek debts from Euros into drachmas. If you own a 1,000 Euro Greek bond, you will get drachmas in repayment that are worth 600 Euros on the open market. If you have 1,000 Euros in a Greek bank, you will be given drachmas in their place that quickly become worth 600 Euros. There will be riots in streets. Tourism to Greece will plummet. It will be ugly for Greece. Spain and Portugal will see this and either get their act together, or else decide to leave the Euro on their own terms before it is forced on them in the same disastrous way it was forced on Greece.

If this occurs, the ECB will have to bail out many banks in the rest of Europe that hold Greek, Spanish, and Portuguese debt, but it would be more palatable to Germans to be bailing out German banks rather than the Greek government.

In this scenario the market disruptions and dislocations would be huge. It is not hard to imagine the Euro getting hit by 10% or 20% against the dollar in a single day. But maybe not, because the market might realize that once the smoke clears you will be left with the core of the EU in much better shape than today’s EU, with just the healthier economies and government balance sheets remaining. All of that would seem to argue for a stronger Euro.
What about the alternative scenario, where the EU does bail out Greece et al? This would equate to printing Euros, which will stimulate demand and the money supply. To avoid inflation in Germany and the other healthy growing economies, the ECB might have to raise interest rates at least a bit. Rising interest rates vs. the near-zero rates in the U.S. would again argue for a stronger Euro against the dollar, not a weaker one.

So while the EU is indeed a mess, the short-Euro trade is not such a no-brainer… as Dennis Gartman has apparently learned as well.