Every day there is a barrage of information -- news stories, blog posts, print ads, and television ads -- with two different (but equally bearish) themes:
- The central banks of the world are running the printing presses and debasing their respective currencies. The result is incipient and inevitable inflation. Gold is the best refuge.
- The world economic leaders have no plan nor ability to avoid a global economic collapse. In the deflationary environment, gold will be the best choice.
Let us call these the "golden goal posts." Thanks to The Reformed Broker for posing this "riddle."
The two arguments, inconsistent at the base, are argued in the alternative and even simultaneously. There are many people making money from selling fear and selling gold. (Full Disclosure -- I frequently hold GDX in client accounts for one or more of our four different strategies. We are long GDX right now). While there is nothing wrong with investing in gold, the most radical proponents create an excessive emphasis on extreme economic scenarios.
Let us take a deeper look.
The Best Analytic Framework
I take an approach that involves four steps:
- Analyzing the problem
- Identifying an acceptable goal
- Considering paths to the goal
- Evaluating probabilities
Can this approach shed any light? Let me consider each step in turn.
Analyzing the Problem
The overall debt level is large and growing. For a great presentation of the problem, take a few minutes to watch this video from the Kauffman Foundation's Economic Bloggers Conference. World-class economist Robert Litan chairs the panel and sets the stage. There are strong presentations from the intellectual and objective Donald Marron, the highly-regarded Angry Bear, Ken Houghton, and economic journalist Ryan Avent. We were all pretty depressed about the prospects, and that was even before we heard from Mish!
If you can take a few minutes -- and you should -- watch the entire panel for some great background on this issue. I thought that they needed a public policy guy to suggest a possible path out of the woods.
An Acceptable Goal
To establish a reasonable hypothesis, I am going to suggest that a surplus in the federal budget is an acceptable goal. I realize that there is increased globalization and the we have state and local governments to consider, but we must start somewhere.
Wouldn't we all be delighted to see headlines that showed a federal budget surplus?
Is There a Path to This Goal?
If you want to understand how governments (or large private organizations) deal with problems, you need to quit thinking in terms of your family, your small business, or a chess game. This is not a situation where you see a problem, analyze alternative, identify a solution, and make a choice. It is decision making under extreme uncertainty. Most observers get this wrong.
Here are the paths that I see as plausible, and even likely:
- The economic rebound will increase tax revenues, reducing the non-structural part of the budget deficit. (The structural deficit (simplified) is what we would still face if we were operating at full employment).
- The consideration of the Bush tax cuts will lead to a number of compromises. Taxes will be increased, but some of the cuts will be preserved -- at least in part. Like all compromises, everyone will hate the result. The final tax rates will be lower than we had in the Clinton era.
- Entitlement benefits will be cut. This will require success from the Deficit Commission. Once again, most will hate the result, but these commissions are the only way to achieve change.
At the outset, I want to make something very clear.
The chance of success is vastly under-estimated by the media, by bloggers, and by the financial markets.
The basic reason is that the problems are easy to see and the solutions are not. People are not used to thinking in terms of government policy. The governments involved may make some mistakes, but they will keep trying.
From Doug Short (see the full article for alternative views) we can see the dimensions of the problem ().
It is obviously a tall order. This is information that everyone sees: The problem.
To evaluate the probability of improvement, we need to keep the mainstream projections in mind.
The OECD sees 3.2% growth for the US in the next two years.
The Wall Street Journal Panel sees 3%.
There are many pundits, mostly non-economists writing about economics, who have more pessimistic forecasts. They often cite a "laundry list" of problems. None of them provides any long-term forecasting records of their own. Mostly they just criticize professional economists. Meanwhile, you should keep in mind the following:
The OECD economists, and the 53 pros in the WSJ survey are constantly following the markets. They know about and have considered every "headwind" identified by your favorite bearish pundit.
So what is the chance of a result that is neither wild inflation or deflation?
My own estimate is in the 90-95% range. The extreme outcomes might occur, but are very unlikely. The bonds and TIPS don't show it. Meanwhile, the attentive investing public places far too much weight on these alternatives. CNBC recently ran one of their silly polls asking whether gold or the S&P 500 would do better in the next three months. The majority of respondents voted for gold. No doubt the rationale was split between those voting for each upright.
I see gold prices as an excellent reflection of market fear, skepticism, and doubt about future earnings.
The key to following progress is understanding that economic improvement is not a "light switch." At the time you see a headline that all is well, it will be too late to invest. I follow many economic indicators and challenge each results. You should, too.
Separate the Structural Deficit
Here is a nice discussion of the Bernanke concern via Colin Barr.
There are currently five workers for every retiree in the country, Bernanke said. That stands to shrink to three workers by 2030 -- at a time when "expenditures on health care for both retirees and non-retirees have continued to rise rapidly as increases in the costs of care have exceeded increases in incomes."
The path of success is a Keynesian one...
The Keynesian Logic
Brad deLong argues that these times call for unusual measures.
It is a time for not normal economics but rather “depression economics.” The terms on which the U.S. government can borrow now are exceptionally advantageous. And because of high unemployment the benefits of boosting government purchases and cutting taxes right now are exceptionally large.
The result is that the costs of borrow-and-spend policies are overturned for the short run—indeed, for as long as the current economic crisis of high unemployment lasts, which may well mean that the short run is not very short.
Think of it as a kick between the uprights. There is enough economic growth to avoid deflation, a relatively timely reduction in the Fed balance sheet, and a reduction in Federal deficits. From the daily media barrage and from gold prices one would think that the "between the goal post" result was unlikely.
He explains in more detail, and it is all worth reading. It is an outline of what to observe.
The political dimensions are easy to outline. The deficit questions will not be resolved before the mid-term elections. Compromises on taxes and spending will happen in 2011.
Until then we can depend upon the political environment to distract the investor with extreme arguments.
As usual, I recommend political agnosticism. This is an environment where investors can do very well if we make gradual progress toward solving problems. The key word is "gradual." I predict that the combination of economic improvement and compromise over taxing and spending will move us in the right direction.
With this article I am also introducing a new feature requested by readers -- the Resource Page. When I do an update on a topic (like today's article) I will also introduce a resource page that shows summaries and links to former articles that provide additional depth. I invite reader suggestions for any old favorites that we have missed.
Today's Resource Page is Debt Crisis?. (Thanks to Derek Miller for a nice job of analyzing old articles).