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Last week I published an article titled: The 11th Hour, Moments Before A US Economic Meltdown”. In my writing I laid out a theory to explain how the government makes choices in its attempt to solve the economic problems ailing the United States. I considered and wrote out my theory as a way to rationalize what had been happening within the financial markets over the last several weeks. As everyone knows, recently the markets have been on a tear upward. Much to my bewilderment, this run up has not been driven by powerful fundamental changes, key technical levels, or been followed by significant changes in trade volume. So what happened? How can we explain the irrational reasons for a market climbing when it should be falling apart? To get up to speed in this discussion, or to find out for the first time the reasons why I think we’re going forward even though we shouldn’t be, revisit my original story via the link above.

Now that the framework is in place, I want to touch in detail on each of the points in my original thesis. Today’s discussion will focus on points one and two of the ten step plan included in the original article. These points were:

1. GDP = (A) Private Consumption + (B) Gross Investment + ((NYSE:C)) Government Spending + (D) Exports - Imports))

2. The US Government directly controls letter C from above and thus 25% of GDP inputs.

Point Number One

Since the 1950s GDP has largely been used to measure the economic well being of nations. It is arguably the foremost statistical factor that economic growth is derived from. GDP is also the basis by which the world evaluates (to a certain extent) a country’s success amongst its peers. All in all, GDP could be one of the most important global economic figures for a nation. One might think, “What is there really to say about the mathematical components of GDP?” Well, for starters they could say that GDP is a poor way to measure a nation’s well being because it does not take into consideration how or why money is spent in a country to propel GDP.

To illustrate the idea of why GDP is a poor gauge of well being in a country consider this example for a moment. In the US, any money spent to re-develop the World Trade center in New York after September 11th has in one way or another counted towards GDP growth. The same goes for any other natural or manmade disaster throughout the country. Likewise, any money spent by the US government on any domestic service, regardless of merit, also goes into GDP. This clearly becomes problematic when considering the prospects of attaching the idea of “well-being” to GDP.

In the instance of ill advised government spending or a catastrophic event, a nation’s real overall progress or real well being is usually not advanced. On September 11th thousands of lives were tragically destroyed or lost. Furthermore, in many ways that day symbolizes a turning point in American and world security history. Over the last 8 years that singular attack has brought about a multitude of change within the United States and throughout the world. These changes have largely been restrictive, costly to implement, and the subject of countless hours of debate around the world. In this case, spending on security helped to raise GDP but did it really improve well being? This principal holds the same for other disastrous events around the world such as Hurricane Katrina, the Indonesian Tsunami, or any multitude of natural calamities. Certainly in disasters some good spending and changes come about, but they aren’t called disasters for nothing.

In the case of government expenditures, once again GDP can be improved by good spending or by bad spending. Here consider all of the pork that is attached to legislation; it raises GDP, but does it improve well being? How about bailouts or subsidies? Take for example cash for clunkers, that improves GDP; but is it really good for well being? The program will cost billions to taxpayers, pull forward future demand for automobiles only to leave a hole in demand later, and won’t accomplish much of anything. Therefore, since there is no calculated way to discern between good spending or bad spending in the GDP equation, where does the incentive to be fiscally prudent in the government come from?

There are a multitude of reasons for rethinking GDP; I previously and briefly hit on why letter D in the equation doesn’t really make sense. However, this discussion is not really about the principals of GDP so I’ll walk away from this for now. I will however touch on it a bit more when I explain point number four from the original article over the coming days.

Point Number Two

I could write an encyclopedia in regards to the reasons government spending in a GDP equation is not good for well being or the economy; but I don’t need to. I’ll sum this one up very quickly; from Barron’s Economic Research:

American Debt and Deficits

Latest Preceding Year Ago % Change

Federal Budget Deficit

407FY'09

410FY'08

162FY'07

151.23%

Budget Surplus/Deficit

-94.32

-189.65

+33.55

-381.13%

Trade Deficit

-25.96

r-28.79

-60.53

....

Treasury Gross Public Debt.

11,611.2

11,595.5

9,532.5

21.81%

Treasury Statutory Debt Limit

12,104.0

12,104.0

10,615.0

14.03%

To borrow a line from Ned Schmidt, a regular CNC contributor:

The amount of U.S. Treasury Gross Public Debt outstanding is $11.611 trillion. A year ago…that value was $9.533 trillion. In one year, the true deficit of the U.S. government was therefore $2.0178 trillion. That…is a true accomplishment! How does one spend Two Trillion Dollars more than one receives in a single year?

The answer to that last bit about “spending more than one receives” was reconciled by an AP story I featured last night at my blog. The AP story said this:

The recession is starving the government of tax revenue, just as the president and Congress are piling a major expansion of health care and other programs on the nation's plate and struggling to find money to pay the tab.

The numbers could hardly be more stark: Tax receipts are on pace to drop 18 percent this year, the biggest single-year decline since the Great Depression.

So what’s the problem with government spending influencing 25% of GDP? For starters economic or personal well being is almost never improved by government spending. In general, spending that originates from the government does not make sense for all but essential services. In this context essential services would be those which must be maintained in order to create an environment in which people have the opportunity to prosper. Prospering, when broadly defined, would include the right to our physiological needs (air, food, water, shelter, etc.) and national security needs (police, military, judiciary system, some forms of regulation/safety boards.) These services would not include fire protection, the mail system, 911, Amtrak, hospitals, control of certain utilities, or a slew of other current government programs. They would include critical infrastructure, the military, police, and other items pertinent to national security and our ability to prosper as defined above.

Without belaboring the point, the reality is that there is very little that truly qualifies as being essential to maintaining the ability to prosper. Thus, in most instances as a country we’ll always be better off in the hands of the private sector. How any person can feel that the government knows how to spend money better than they do is beyond me. Do these people forget that the only money the government has comes from them? Think about this for a moment.

Frequently the media touts all of the spending and good the government is bringing about through its stimulus and subsidy programs. These programs are never the best solution as a government cannot truly add any jobs or boost the economy in real terms via spending. All a government is able to do is implement policies which divert dollars away from the private sector through taxation in order to provide short sided solutions. Remember that every government in the world derives its ability to spend on the backs of its citizens. Understand what I am saying here, as I do believe there are government roles which are required and essential. I am certainly not voting for anarchism, but the vast majority of current government programs could be managed much more efficiently in the private sector.

After considering this, it is almost insane to think that 25% of GDP comes from government spending. How can it be that the world uses GDP to determine the productivity and well being of nations when this calculation can be so heavily influenced by poor government choices? It’s similar to saying a person whom uses balance transfers, and ever increasing credit lines to pay off debt has impeccable credit habits and a strong income. Remember that through GDP nations forecast future tax revenue, evaluate sovereign credit worthiness, and support debt auctions; yet this figure is moved by government spending?

Now, ask yourself what has happened to US GDP through the first two quarters of this year? Ask yourself what has happened to US government spending this year? Then consider our country’s well being and what GDP would like if government spending wasn’t so heavily rooted in the equation. If you answered GDP has fallen, our country is worse off now than it was 12 months ago due to our debt obligations, and government spending has distorted GDP which reflects economic growth you’d be correct.

So What Do I Do With This Information?

For starters, you can benefit by beginning to realize that much of the improvement in the economy as of late has come on the back of government spending. Spending which has been authorized in order to influence the “well being” reflected through positive GDP. Through the financing of bank balance sheets, use of tax stimulus, subsidization of first time home buyers and most recently subsidizing of auto purchases through “cash for clunkers” the government has pulled future demand forward via Federal spending. Home sales have improved due to incentives, auto sales have improved due to incentives, and CitiGroup (C), Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), and any other bank who failed the “stress-less” tests earlier this year are still standing because of government support.

You can benefit from knowing how governments around the world can move to influence GDP and by anticipating those moves. In the US government money will eventually run out for home buyer credits; it already did for the cash for clunkers program. Banks will eventually have to mark assets to market and debts will have to be repaid. To succeed you must begin to face the music and accept that the American populace cannot finance $2.1 trillion dollars in government spending every year to keep this thing afloat. Sure sentiment is bullish right now, but it won’t be forever. Get ready to pick your spot and prepare for the run downward. So how do you get ready?

Start considering what will happen to Ford (NYSE:F), Toyota (NYSE:TM), GM, Honda (NYSE:HMC), or any other auto manufacturer's sales when cash for clunkers or Chinese stimulus runs dry? Think about what will happen to residential real estate when the first time home buyers credit is gone. Ask yourself where banks like CitiGroup, Wells Fargo, JP Morgan Chase (NYSE:JPM), and Bank of America will be when they finally have to realize losses on residential and commercial properties? What will happen to demand for input commodities such as copper, platinum, palladium, or oil at that time? What will happen to bond prices? What will happen to the private sector and job market as tax rates are forced higher due to unsustainable spending? I know you know the answer to these questions, so in order to benefit begin to prepare for a major retracement in the markets.

What About Points Three Through Ten?

Stay tuned later this week and throughout the future for more details on point number three and the rest of the economic recovery list. Best of luck, and may your brain be with you.

Disclosure: No positions in any investment product at this time.