February - 2009 Economic Brief

"If you have fiscal stimulus without fixing the banking system, it will be like a sugar high," said Robert Zoellick, president of the World Bank, and Dominique Strauss-Kahn, managing director of the International Monetary Fund.

The contagion has now hit Main Street!

Unemployment has gone through the roof in almost every industry. This also means that the value of almost every bank asset is greatly overstated whether it be 50 cents on the dollar or 20 cents on the dollar, who knows?

Can the U.S. government bailout Citigroup and Bank of America? Can it do this even as thousands of large and small retail companies, air transport firms, auto companies and others file for Chapter 11, even as Europe and Asia keep sinking? And that’s not all, did you know how this crisis is spreading overseas to other banks? The Royal Bank of Scotland (RBS) announced recently that its losses for 2008 would be a staggering 28 billion pounds (41.3 billion U.S. dollars)!

If you have been following my blog then you already know about Bank of America’s $2.4 billion loss, Citigroup’s $8.3 billion loss, but did you know JPMorgan Chase's derivatives could double the size of the banking crisis overnight. On the day that JPMorgan Chase needs to join the ailing Bank of America and Citigroup in Uncle Sam's intensive care unit, the derivatives mess doubles immediately. In fact, the International Monetary Fund raised its estimate of bank losses on U.S.-originated loans from $1.4 trillion just this past October to $2.2 trillion just three months later-- and that does not cover the cost of capital needed to allow banks to resume normal lending. No wonder these bailouts keep failing! All this is in addition to the Obama administration discussions on the need for a second round of bank bailouts that could cost U.S. taxpayers an additional $1 trillion to $2 trillion. Hold on to your hat.

Does this sound like a B-grade movie? Well, they're actually trying to do it.

Congress has approved the second $350 billion from the original 700 billion TARP bailout even though according to the Congressional Budget Office (CBO), taxpayers have already lost at least $64 billion on the first 350 billion on that “investment’ into the banks. And while the Treasury has abandoned its plan to buy up “bad bank” assets, the Federal Reserve has gone ahead with another $500 billion program that does precisely that through a massive entity that acts like a giant insurance company, picking up most or all of the bank losses. Go figure? And yet, despite all these efforts, the economy is still collapsing. Why? Because this debt scenario is on top of all the other debt scenarios.

You must expect that each new incarnation of the debt crisis will be a bigger threat to your wealth and your income.

Take a look at the more than 2.6 million families who lost a paycheck in 2008. This may not be you, but this is sure as heck represents your patients. That means the total number of unemployed workers are now over 11 million — fully 74% as many as were unemployed in The Great Depression. Obama himself has warned that the unemployment rate will explode to at least 10% in 2009, more than 15 million workers will be without a job — more, even than during the depths of The Great Depression. Wage freezes and outright salary reductions
are already spreading like some kind of new economic plague!

Two Competing Expectations For the Future

They are:
1. That uncontrollable money-printing and excess spending on bailouts and stimulus will breed a new, super-inflationary environment, or

2. The change in capital flow as evidenced by shifting consumer confidence is ushering in a period of deleveraging and deflation that will force a global economic rebalance. Psst, don’t tell any one, but we are already in a depression.

Consumption is obviously on the decline. The declines in credit market have made a huge impact on consumer demand. Investment is likely heading in the same direction. A labor expert said there is "a vicious circle of depression, where job losses lead to falling consumption, which lowers industrial confidence."

The result of uncertainty in expectations has created hoarding of cash; not just by individuals, but also by banks and institutions that are not willing to lend. That means the U.S. government plans to make up for the shortfall in consumer demand and institutional credit by increasing its spending. How can it do this? It can do this because the U.S. government has one weapon no other country has – the world's reserve currency.

Inflation is not a short-term concern, if you're looking at the U.S. on a relative basis, relative to competing economies and currencies, thus the story for the ongoing bull market for the U.S. dollar begins to make sense. For example, the British pound just hit a new 23-year low against the dollar which is a good sign for the U.S. dollar. Add to this mix that China is also facing pressure from President Obama to allow the Yuan to rise in value which would be the equivalent to economic suicide. Timothy Geithner, Obama's pick for Treasury Secretary, said that "China is manipulating its currency." How about a currency war, anybody?

Nevertheless, the last thing China can afford is to allow its currency to rise and make its exports more expensive. So I foresee that the currency-valuation issue will probably turn into some sort of political battle down the road, threatening to make things worse for both the U.S. and China. It is getting ugly out there.

But, and this is the major “but” in this scenario, it seems improbable that this level of deficit spending can continue without sparking a run on the dollar via foreign governments selling U.S. Treasury bonds. In the last 6 weeks the Treasury market was hit harder than it's been hit since 1987 and further, there is not sufficient global savings to buy more than 30 percent of the proposed extreme spending programs. Only the Treasury market can spend freshly minted money like this because it is vastly larger than the stock market and also, by the way, this kind of money is way too big for effective internal Federal Reserve control. Why?
Simply, our creditors, other foreign governments and investors will not allow us to print money forever.

Two cases in point, 1) South Korea's economy contracted a painful 5.6% last quarter — twice as bad as had been expected. The problem, China is South Korea's biggest export market. And exports to China are nose diving. South Korea is also one of the largest holders of U.S. Treasury bonds and on January 19, the head of investments for South Korea's government pension service, Kim Heeseok, told Bloomberg, "It's time to sell U.S. Treasuries" because the ongoing stimulus is going to cause inflation. 2) In December, investors who were buying the longest Treasury bond in existence — the 4.5% "long bond" expiring May 15, 2038 ended up with only 2.52% and since then the bond value has lost $1,890. In other words, they lost the equivalent of more than five years of interest in just six weeks. So don't count on Uncle Sam to save your bank, your business, or the economy.

Still not convinced? Add to this equation the fact that China's exports have plummeted so they don't have the money to lend us anymore. With the U.S. economy in the dumps, these government bonds aren't as attractive as they used to be. China has already said they want to diversify away from them. Recently, China's Premier Wen Jiabao laid the responsibility for this global crisis squarely on Washington's doorstep: The financial crisis, he said, is "attributable to inappropriate macroeconomic policies and their unsustainable model of development characterized by prolonged low savings and high consumption; excessive expansion of financial institutions in blind pursuit of profit." The reality is the world’s biggest investors in US Treasury bonds — China and Japan — need the funds to help offset their own economic slide.

Did I mention that oil prices have dropped sharply, so OPEC doesn't have as much to lend us either. The same can be said for other major investors in Russia, Western Europe and Latin America.

What to do?

Keep up to 90% of your money in cash (short-term) or gold bullion (long-term). Why gold? It’s an inflationary hedge, its supply is limited. All the gold that's ever been mined in the history of the world can fit into two Olympic-size swimming pools. At the end of last year, the total paper money and IOUs of the entire globe totaled more than $600 trillion. That’s 10 times the GDP of the WORLD. Gold, at its 2008 year-end price of $869.75 an ounce, equals just $831 billion — less than 1% of the total outstanding paper in the world.

Simply Put:

The U.S. banking system is toast. It's bankrupt in every sense of the word and in every number you can imagine. The U.S. Government is also broke. Think of the implications of creating more debt to pay off existing debt ... printing more paper money to circulate in the economy ... and then spending trillions of previously non-existent dollars to try and stimulate the economy.

Then printing trillions more to save the banking system ... to pay off eventual Social Security obligations as they come due ... to pay Medicare liabilities ... to fund failing pensions ... and more. I’ll put it to you this way, if you or I spend hundreds of thousands more than we earn each year ... and then borrow nearly every penny we need to pay our bills, it's called "insanity." When Washington does it, nobody bats an eyelash.

So what's left?

Cash and Gold —

Gold performs admirably in deflations as well as inflations!

We could be facing multiple years of adversity before our economy rids itself of excess leverage, before bad debts are liquidated, and before a sustainable recovery can begin.

We are witnessing nothing less than a sea change in the way Americans think about their spending, savings, investments and debt.

Want some good news?

If you look at the last 12 months or the last six months, health care has been the best-performing sector. So far, so good.

Want another perspective?

Chris Buckley's satirical novel "Boomsday” is more than satirical, it is prophetic.

It says:

In the long term, Obama's adding a $1 - 2 trillion stimulus package on top of what Nobel economist Joseph Stiglitz calls a "$10 trillion hangover" of debt left over by former President Bush from the economic meltdown, two wars... and then adding to that the fact that Pakistan and India are ready to go at each other, plus the wild card that is Israel, plus melting ice caps on both poles, plus reforming out-of-control economics of retirement entitlements, like Social Security, (which eat up 40% of the federal budget), all this, will be like rearranging deck chairs on the Titanic because the real problem is population growth.

If you are over 50 years of age you have lived 1/10 of the time since Columbus discovered America. If you agree the average life time is 80 years, then any 8 of those years represents the same 1/10 of your life time. In the year 400 AD the world’s population was 200 million. It took 1,000 years for the world’s population to double to 400 million in the 1400’s when Columbus first thought he had discovered Asia. Now it takes two years for the population to grow by 200 million, not 1,000 and that is the real problem that no one is talking about; bigger even than our current economic crisis!

Yes, population is the core problem that, unless confronted and dealt with, will render all solutions to all other problems irrelevant. Population is the one variable in an economic equation that impacts, aggravates, irritates and accelerates all the other problems. The point is more and more people are filling up our little planet.

A United Nation's study estimates the world population will continue exploding, from 6.6 billion to 9.3 billion by 2050! By 2050 America's then 400 million will be vastly out numbered by 8.9 billion others across the planet, all competing with America. In short, within four decades, half your life time, human demands will easily double. That makes population growth the key variable in every economic equation ... impacting every other major issue facing world economies ... from peak oil to global warming ... from foreign policy to nuclear threats ... from religion to science ... everything.

The focus for government, and for everyone, should be on how to minimize the risk that people will not freeze to death in their mortaged homes or are not poisoned by their own drinking water. Trying to save the banking system doesn't address that. Trying to save the banking system with the money that belongs to the people makes it more likely they will freeze to death. That in a few words is the choice before us.

How Much More Economic Pain Is Yet to Come?

The answer: A whole lot more!

The S&P 500's November low was 752, which amounted to a peak-to-trough loss of 52%; that makes this current downturn the third worst in modern stock market history, but not as bad as either of the Great Depression bears of the 1930’s, at 86% and 54%. However, the current downturn has already been deeper and faster than any other bear market in recent history. Why just last quarter, the U.S. economy shrank the most since 1982 as consumer spending recorded the worst slide in the postwar era. The means the US economy is shrinking at a 3.8% pace. Unadjusted for inflation, GDP shrank at a 4.1 percent pace, the most since the first three months of 1958.
The IMF dropped its forecast for global economic growth to a measly 0.5% for 2009 — the weakest pace since World War II. What's more, that's a drastic reduction from the 2.2% growth the IMF had predicted as recently as November.

The S&P 500 lost 8.57% last month, which was the worst January on record. In January, we saw gold climb nearly 5% and silver jump 11%. January was the worst January ever for the DOW and the S&P 500.

Lawrence Summers, director of the National Economic Council, said the country faces "a real risk" of slipping into deflation. ADP Employer Services said in a report that the U.S. private sector eliminated 522,000 jobs in January. Fitch Ratings said U.S. credit-card payments that are at least 60 days late reached a record 3.75% in January. We know from comments made by participants at the World Economic Forum in Davos that bankers the world over anticipate a huge wave of commercial real estate defaults that will begin later this year and stretch into 2010. Federal regulators have closed six banks this year already so we are well on pace to pass twenty-five U.S. banks that failed last year.

Still not concerned?

Did you know that the costs of the government bailouts of the housing crisis, the credit crisis, and the Wall Street bailout exceeds the costs of all US Wars, The Louisiana Purchase, the New Deal, the Marchall Plan and the NASA Space program combined!

Did you know that America’s massive accumulation of debts now totals $294 trillion.

That’s 420 times larger than the $700 billion TARP bailout program and nearly 300 times bigger than the largest estimates of the Obama rescue package. This icludes $52 trillion in interest-bearing debts tallied by the Federal Reserve; $60 trillion in government Medicare, Social Security and pension obligations estimated by the Government Accountability Office; and $182 trillion in derivatives, as reported by the Comptroller of the Currency.

All this in addition to:
•The Fed reports that say U.S. households lost $7.9 trillion in real estate, stocks and other assets.

•Plunging income in households

•Government rescues are slow, we are still waiting for the 2nd half of TARP

•Sinking confidence

•The cost of financing the rescues - already the price of long-term bonds are collapsing and yields increasing so much so that the average A-grade corporate bond costs 16.95%. I ask you, how can they or anyone afford this higher borrowing cost long-term?

•National Association of Realtors said the nationwide median price of an existing home fell 15.3% in December, the largest drop ever. And there is still an over supply of between 1.5 million and 1.75 million new and existing homes on the market. Yes, sales are going up, but prices are going down. Wholesale dumping is still ahead, forcing sellers to slash prices, driving millions more into foreclosure and swamping any foreclosure prevention efforts.

•Alright, I’ll stop, I know its too much to take in all at once, but stay tuned... and don’t get euphoric over the “bad bank” solution, the name says it all, or would you prefer to call it BARF, bad asset repository fund.