Today the United States has an economy with a capacity to produce about $20 trillion of goods and services that is only producing $16 trillion of them. As a result unemployment is high, tax collections are down, virtually every government is running a deficit, and, of great significance to investors and would-be retirees, many businesses are generating profits and stock prices far below those that would exist if the economy was prosperous.
The congress, the White House, and the Federal Reserve all claim to be addressing the problem. But are they really? And what does it mean for investors in 2012?
As the nation's central bank, the Federal Reserve’s basic job is to provide our economy with whatever amount of money and credit results in our employers having enough customers so our economy has full employment without inflation - not too much liquidity so there is excessive customer spending to cause inflation nor too little liquidity so there is inadequate customer spending and our economy's output falls below its full employment potential.
To put it mildly, the Federal Reserve is failing today, as it has so often failed in the past - because its presidentially appointed and senate-confirmed governors have neither appropriate educations and professional activities nor appropriate real world experience in business and commercial banking.
Today the governors' failures seem to falling into three very broad categories, all of which will have to change if 2012 is to be anything other than another miserable year without a bull market:
1. Concentrating their efforts on helping the big financial trading houses such as Goldman Sachs (GS) and AIG and naively assuming their resulting prosperity and trading profits will trickle down to the deposit-seeking commercial banks and on to their customers and the employers who actually make the economy go - by employing people and producing goods and services. If we have learned anything from the current crisis it is that the Fed and Treasury concentrating their assistance on keeping a handful of big financial traders profitable doesn't do much, if anything, for our economy's consumers and employers and the commercial banks that serve them.
2. Believing they will somehow change the ability of consumers and businesses to get money and credit if they change the overnight rate of interest one bank charges another for reserves to meet their reserve requirements. It is a strange article of faith/common knowledge that the Fed can affect the economy if it increases or decreases interest rates. It is strange because, unlike in Europe and the UK, for all practical purposes our central bank only sets the overnight rate one bank charges another for overnight loans.
In the real world outside of Wall Street and the Beltway a commercial banker will laugh if you suggest he will make or renew loans such as working capital lines because he can borrow money that he has to repay the next day for a few basis points more or less than yesterday. (the source of the Fed's interest rate fixation naivete is probably the fact that years ago most economic texts were written by Brits such as Keynes - in the UK, unlike the US, the central bank does set an interest rate that is effectively the wholesale price of money.)
In the real world, outside the old textbooks, the Federal Reserve's main weapon is to increase or decrease the reserves of our commercial banks. (That's why its called the Federal Reserve.)
3. Believing generally higher prices (inflation) is caused by an increase in the money supply so that inflation will occur if the Fed expands the money supply instead of tinkering with the overnight rate of interest between banks. This is an idea, "the quantity theory of prices," that was taught in economics classes many years ago and is still taught in some schools with older faculty and quasi-mathematicians posing as economists.
The quantity theory of prices is an old idea that has long since been disproved: in the real world there are numerous reasons why individual prices in an economy rise, and thus push up the economy's overall general level of prices (inflation). Among them: government regulatory agencies set government regulated prices higher in response to lobbyists; government regulations push higher costs onto employers so they must increase their prices to stay in business; labor unions negotiate higher wages; governments increase certain taxes such as the tax on gasoline so that gas costs more; interest rates rise so that car payments increase, etc.
Even today numerous quasi-mathematicians posing as economists rigorously run correlations and write scholarly articles about the correlation between the size of the money supply and the general level of prices. They inevitably report a fit and suggest again that this "proves" higher prices are caused by increases in the money supply.
What these "economists" ignore, probably because they never bothered to study the economy's institutions or its real-world complexity, is that the correlations they find might explain something very different - that increases in an economy's level of prices causes the money supply to increase instead of the other way around. This occurs when the higher prices cause the Federal Reserve to put more money in circulation to handle the increased monetary size of the economy's transactions. (the standing order to the FOMC is to maintain the status quo - thus, if the level of prices increases in the US economy the FOMC instantly and automatically increases the money supply so the economy can continue to have the same levels of production and employment.)
Moreover, other things besides the money supply also correlate well with inflation - such as population increases and the distance airplanes are able to fly. These too have gone up over the years as prices increased. This suggests, with the same certainty as the quantity theorists, that we can also fight inflation by banning sex and reducing the size of airplanes' fuel tanks.
(If you think the preceding is absurd, and it is, how do you think a real economist feels when he reads about some naive pundit or quasi-mathematician claiming general price increases are only caused by increases in the money supply or by deficits or not using gold or that the Fed is doing something significant when it cuts the overnight interest rate?)
In contrast to the Fed's principle job of keeping the constantly changing "right" amount of money and credit in circulation, the economic job of the Congress and the White House is twofold:
1) to spend whatever is needed to get the defense and other federal programs the elected officials determine the country needs.
2) to tax at whatever levels are needed so that business, foreign, and consumer customers leave enough unbought production capacity in the economy so government spending can buy whatever our representatives determine are "enough" roads, national defense, justice, etc without causing inflation from too much total spending (excessive total spending is one of the many reasons inflation can occur).
The men and women of congress and the White House make a lot of speeches about fiscal policy (federal taxes and federal spending) and how they can use it to do good things such as fighting unemployment or fighting inflation. But that's all political talk, and economic garbage, because whatever the Congress and White House do takes lots and lots of time. Sorry, Keynesians - in the real world it takes so much time to raise or lower taxes and spending that in the United States fiscal policy really doesn't matter in terms of fighting inflation and unemployment - because the Federal Reserve can and does instantly offset whatever they have done.
Thus, for example, if after weeks of debate the Congress cuts taxes so people have more money to spend the Federal Reserve can that very day take steps so that all the "more money to spend" from the lower taxes is instantly soaked up and total spending does not rise. Indeed, in the absence of an order to the contrary the FOMC will adhere to its standing order and instantly soak up the effect of the tax cut in order to maintain the status quo.
What should an investor do in 2012 in response to federal tax or spending changes? Nothing. Because so long as we have a viable central bank a rational investor should only worry about the federal government stifling the private sector either by taxing too heavily and imposing costly employment-discouraging regulations and entitlements, or by taxing too little such that the Fed has to clamp down hard on bank lending and the money markets.
What an investor should not do: believe that some action of the Congress or White House will yield full employment or fight inflation or cut deficits.
Where are we headed in 2012?
The basic answer is nowhere - because the same old people making the same old speeches and pursuing the same old policies are absolutely certain to get the same old results.
But 2012 could change in an instant and become the start of what might well be the greatest bull market in history - if the Fed summons up its courage, overcomes its members' collective naivete, and a) reorients its thinking to finally start channeling loanable liquidity to commercial banks and spenders, and, b) again require commercial banks to fund consumers and employers instead of funding the government and the big Wall Street trading firms.
Not only would that jump-start the economy but, given Americans' high propensity to consume and our current tax rates, it is likely that there would be no federal deficit today if we were collecting taxes at today's rates on the $20 trillion of production and jobs that would exist at full employment instead of the $16 trillion of production and incomes we actually have.
Why is all this important for investors and retirees? Because only if this happens will corporate profits soar, and the pressure for tax increases collapse. And when the revenues and profits of corporations soar the value of their shares and safety of their bonds will soar.
Want to have a bull market in 2012 so you can book big capital gains and end the deficits and tax increase pressures and retire with a bigger income and more assets? Don’t call your Congressman, call the Federal Reserve and the President who appoints then. But expect continued stagnation in 2012 until such calls are both made and acted upon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
