Federal Deficit of $1 Trillion+ in 2009 Now Certain

In order to finance the upcoming various and sundry bailouts, the US Treasury will be selling bonds. Lots of treasury bonds. Economics 102 tells us that an increase in the supply of bonds will cause bond prices to fall and interest rates to rise. The net effect will be inflationary. The dollar will be heading lower against other currencies. The good news is that the trade deficit should shrink, at least at the margin.

Moral of the story: Invest in companies that provide ink and paper to the US Treasury.

Why isn’t inflation worse than the data indicate? The data says consumer inflation is running at around 6%; for consumers it feels more like 16%. Conditions that have been a drag on inflation this year include:

• Falling home prices, with an attendant negative wealth effect. Most second mortgages are being used as ATM machines, and more and more people are going underwater, an inch at a time. Like proverbial frogs in the warming pot. These people now may expect a bailout if push comes to shove and will probably keep on spending. At some point, they will be asked, or rather directed, to stop.

• The recent, brief correction in crude oil prices. ( The guy who knows as much about real global reserves as anyone thinks $500 oil is a given.) Notice how we gleefully fill our tanks to the max when gas drops by 10 cents a gallon.

• Epochal distress in the automobile and airline industries and the industries that support them. A sea change in the way Americans shop for cars, which has blindsided American manufacturers and supported the business models of the Asian giants. Even Toyota (TM), Nissan (NSANY.PK) and Honda (HMC) got caught with some enormous SUVs and pickups.

• Rising domestic unemployment, with prospects for more. That old global economy thing again. No traction to raise prices in response to rising costs.

Credit card debt continues to rise at a 5.5% annual rate year to date, despite the tax rebate checks. The graph clearly shows the impact of the rebate checks in the spring. Consumers’ balance sheets are deteriorating, mostly due to the falling equity in their homes. The 2008 holiday shopping season is shaping up to be a bust.

 

Source - Federal Reserve

At some point in the foreseeable future, housing prices will bottom. The de-leveraging will have run its course. The shape and face of the banking, airline and automobile industries will have changed forever, and there will be at least one additional trillion dollars in debt left on the American balance sheet. Interest rates will be higher, and the dollar will be worth less than it is today. It is at that point that one should expect inflation to take off, fueled by:

• Secularly rising oil and commodity prices across the globe.

• Partial recovery of housing prices in a market that is probably oversold.

• The expansionary effects of a $1 trillion federal deficit in fiscal 2009. Perhaps $1.2 trillion.

• A foreign exchange deficit in the neighborhood of $700-800 billion a year, by which we export growth and import inflation.

• A weak dollar, falling in response to the sheer weight of bonds on the market. The first faint shadow on the US treasury’s ability to make good on its obligations since the mid- 19^th century.

When should we expect this time to arrive? My guess is in two years. The Fed will keep real interest rates negative for another 18 months, and then begin the process of raising rates. YOY inflation, which is currently running around 6%, may reach double digits by that time. And the meaning of that is this: As difficult as these times seem, they are likely to be viewed as salad days two years from now. When gasoline is $8 a gallon and mortgage rates are around 10%. When unemployment is 8%, and housing prices sit at 1999 levels. When the new president is running trillion dollar deficits.

And they call this the dismal science.

 

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A separate disturbing thought concerns the parallels between our crisis du jour and that faced by the Japanese in 1990. There, twin bubbles, in real estate and the stock market, burst simultaneously. Major Japanese banks teetered on the brink of insolvency, and the Japanese government rushed in with life support funding for the banks. The sector underwent a decade of painful incremental reform, never quite ready, willing or able to bite the market capitalist bullet. Beyond that, it is clear that the Japanese equity market viewed below, which today sits at around a third of its 1990 levels, has suffered as a result. A real negative compounded rate of return in equities over 18 years.

The New York investment banks that reaped billions and allowed corporate finance to become a parlor game deserve their fate. They will claim they were unaware of the risk involved in the CMOs and CDOs.

Rubbish. They were aware that they were in the class of businesses regarded as “too big to fail,” and they were right. We thought at the time they were taking enormous risks, but they knew they were effectively working with a net. Secure in the knowledge that if someone were going to be left holding the bag, that someone would be the US taxpayer. They had lobbyists, you see, that took care of all of this.

Speaking of collateralized obligations, they exist in consumer credit markets, too, and have received little attention. According to the Fed in September of 2008, 48% of credit card debt ($463 billion) has been collateralized, along with 13%, or $220 billion, of non-revolving debt. Grand total: $683 billion. Just as safe and secure as those good old CMOs were for the banks.

The graph below illustrates the general problem with taxpayer-assisted bailouts that forestall the Darwinian consequences of bad, massively- leveraged bets in a corporate capitalist economy. This shows the Nikkei average since 1970. Had the Japanese allowed more carnage in their markets in 1990, it is likely that the slope down to the bottom would have taken less than 13 years, permitting more years for the economy to return to health, with the result being higher investment returns in the end.

 

Nikkei Exchange closing averages, 1970 - present

Disclosure: None

Comments

[carey_jim:]

I'm wondering if your well-reasoned scenario might not be ignoring the psychology, sociology and economic policies of our major creditors whose economic systems are much closer to central planning than ours are, (hard as that is to believe after the last few weeks of federal activities.)

China has a long history of totalitarianism, not to mention a recent history of Maoist communism. It also has a history of currency exchange rate fixing.

Japan has has a long history of totalitarianism and could change to a completely managed economy on a dime (er, on a Yen that is.) Japan too has managed the value of the Yen without much regard for free market forces.

Europe and especially Eastern Europe has had a long peekaboo and hide and seek relationship with socialism, starting with French Revolution and picking up steam after World War I (and Britain should be included in this Europe if not in the "united" one.)

So with the bulk of investors financing the American financial party leaning towards socialism, at least in the recent past, it isn't unreasonable that they would see our weakness as an opportunity to "bargain" for much more control of world economic activity, which obviously includes American economic activity more than any other.

That control might include, for example, a mandate for a "stronger" dollar so America can continue to buy stuff from Japan, China and other exporters.

Middle Eastern and other oil producers are already getting nervous about the prospect of the bottom dropping out of the dollar and are threatening to move into Euros.

Seeking Alpha investors should review the excellent Wiki article on the Bretton Woods system, just to review what the possibilities are.

Whatever the case, your analysis is obviously spot on, given the laws of free enterprise, free market economics.

However ....

2008 Sep 25 05:04 PM

[Bruce Allen:]

Thanks for the thoughtful reply, Mr. Carey.
Whatever the outcome of the negotiations in Washington, there will be enormous pressure on the dollar in the next 12 months. The shorts are going to clean up. One can foresee additional Federal outlays in support of the dollar in currency markets in the hundreds of billions. Just like Japan. And now, owning great hunks of various financial businesses, becoming more like China. Very Naomi Klein.

2008 Sep 26 09:05 AM