Ouch! If Goldman is correct in their assessment, I predict another recession!
Goldman Sachs, which in April predicted this week's major correction in oil prices, said on Friday oil could surpass recent highs by 2012 due to supply tightness.
Saturday, May 7, 2011
Ouch! If Goldman is correct in their assessment, I predict another recession!
Friday, May 6, 2011
by Cal Thomas at NewsBusters:
First quarter profits for American oil companies are jaw dropping. Exxon earned nearly $11 billion, up 69 percent from a year ago. Royal Dutch Shell PLC, Europe's largest oil company, announced it made $8.78 billion in the first quarter, a 60 percent increase over last year. Much of it, but not all, is due to higher gas prices, over which the companies have very little control due to our heavy reliance on foreign oil.
Some in Congress -- mostly Democrats, but a few Republicans -- are calling for an end to tax breaks enjoyed by the oil companies and in some cases, higher taxes on their profits. But the Obama administration is contributing to higher energy prices, which inflate the companies' bottom line.
The Environmental Protection Agency has prevented Shell from proceeding with its Northern Alaska drilling project after Shell reportedly invested more than $4 billion in the project. How can companies make costly investments when they are uncertain that policies allowed in one administration will still be allowed in the one that follows?
In March, when visiting South America, President Obama promised that the United States would help Brazil develop its offshore resources. But he won't allow much new drilling in the Gulf of Mexico, or Alaska. So we are going to help Brazil drill for oil, and then import it? Gas prices have nearly doubled since Obama's inauguration and yet the media don't blame him for it, as they blamed his predecessor when prices soared to current levels.
What about taxes? Oil companies are already heavily taxed. According to the energy research firm Wood Mackenzie, between 1998 and 2008, the oil and gas industry paid $1 trillion in total income taxes. That's in addition to the $178 billion the companies sent the federal government in rent, royalty and bonus payments between 1982 and 2009. What oil companies pay in taxes is higher than the average American manufacturer, more than their "fair share."
Wood Mackenzie also found that should taxes be increased on oil companies by $5 billion a year, that "would result in a $128 billion loss in government revenue and would reduce domestic production by 400,000 barrels per day by 2025," with an additional 1.2 million barrels per day at risk. "This tax increase would increase, not decrease our reliance on foreign sources of oil."
As for those large profits, the American Petroleum Institute (API) reports that in the latest published data for last year's third quarter, "the oil and gas industry earned 6 cents for every dollar of sales in comparison with all manufacturing, which earned 8.6 cents for every dollar of sales."
This administration gives lip service to the successful, while punishing them and subsidizing the unsuccessful. If the president is serious about reducing the cost of oil (and given candidate Obama's frequent statements in favor of increased energy prices to force more of us (but not him) to drive hybrid, even electric cars -- he can emulate George W. Bush.
In July 2008, President Bush lifted an executive order banning offshore drilling, a token gesture since a federal ban on offshore drilling remained in place, but his action caused oil prices to drop, as suppliers believed we were getting serious about obtaining more oil from domestic sources. The argument from the anti-drilling side is that new drilling projects would have no effect because of the time it takes to find and then refine the oil. If new drilling had begun five or 10 years ago we would be pumping far more oil than we are now. If we begin now, in five or 10 years we'll see the results.
Demonizing the oil companies won't produce one more drop of oil. Neither will higher taxes, which will affect employment and create many more negative consequences.
Last week, former President George W. Bush reiterated his support for more drilling: "I would suggest Americans understand how supply and demand works. And if you restrict supplies of crude, the price of oil is going to go up."
President Obama either doesn't understand supply and demand, or he is deliberately ignoring it in hopes of imposing his radical environmental views on us all.
They're right about this. Well said!
via Zero Hedge:
From Goldman Sachs
1. Nonfarm payroll employment increased by 244k in April, more than expected, and previous months were revised up by a net 46k. Stronger retail employment accounted for much of the acceleration: this sector added 57k jobs after losing 3k in March. Partly this may reflect seasonal effects due to the timing of Easter, but most reports from the retail sector have been strong, and we therefore think the number is mostly clean. Total service-providing employment growth accelerated by a smaller amount - to 224k from 194k - due primarily to weaker gains in temporary employment (the hiring event by McDonald's Corporation would have appeared in leisure and hospitality employment, which grew at a similar pace as in March). Good-producing employment gains were roughly in line with recent trends, with a sizable increase in manufacturing and small but positive growth in construction employment. Government subtracted 24k from total payrolls; total private employment rose by 268k - the largest monthly increase since 2006. We see some reason to believe that seasonal effects could have added a little to nonfarm payrolls, but this does not look to be the dominant reason for the strong result (see yesterday's US Daily for details).
2. Results from the household survey were disappointing. Total household employment fell by 190k, and the unemployment rate rose to 9.0% (8.96% unrounded) from 8.8% previously. Results were somewhat better after adjusting for methodological consistency with the nonfarm payroll data; on this basis the household survey measure of employment would have increased by 50k. However, the labor force participation rate was unchanged during the month, indicating that the rise in the unemployment rate reflected job losses rather than an influx of persons into the labor force. While the news was discouraging, it follows four months of declining unemployment, and the level of the unemployment rate remains down 1.1 percentage points from its peak. The employment-to-population ratio fell slightly to 58.4% from 58.5% previously.
3. Finally, average hourly earnings rose by 0.1% mom, slightly less than expected. However, growth in both February and March was revised up. The payroll gains and better growth in average hourly earnings - plus the sudden drop in oil prices - should support consumer incomes and spending later this year.
4. After the Employment Report, our Current Activity Indicator (CAI) showed growth of 2.3% in April, down from 4.0% in March. The deceleration mostly reflects weaker survey-based data (e.g. the non-manufacturing ISM and Philly reports), and indicates a cooling in overall growth early in Q2.
So let me get this straight.
Micky D's -- +62,000 jobs
Birth/death assumption -- +175,000 jobs (NOT real jobs -- ASSUMPTIONS)
BLS -- +244,000 (included birth/death assumptions)
Grand total net jobs from private sector less McD's -- +7,000 (and that's for an entire MONTH?)
Household Survey -- -190,000 (that's MINUS 190k)
Meanwhile, U-6 showed that unemployment worsened to 15.9%.
Shouldn't we just change BLS to just "BS"?
But Dow stock futures jump 150 points! Where's the good news I missed?
Wall Street has a Pollyanna complex!
Thursday, May 5, 2011
I really expected the market to rally and sustain it. This is why I must relentlessly work hard to maintain control over my biases and trade what the market and the charts say instead of what my bias or opinion is.
We are seeing a full-scale commodities rout over the past few days, that is accelerating today.
Jobless claims rose for one of the largest disappointments to consensus in memory. Stocks taking a hit, despite that Goldman is trying to makes excuses and brush this miss aside. If it is all due to "seasonal adjustments", then why didn't the consensus take that into account also? And ECB President Trichet is sounding dovish, sending the Dollar higher and Euro plunging. Meanwhile, the True Finns party, who just took power, is saying that Greece must default and is refusing any more bailout to the EU.
Dollar -- much higher
Euro -- much lower
Stocks -- moderately lower
Commodity -- significantly lower
Gold and silver -- significantly lower
Also: commodity margins have been raised by exchanges over and over again over the past few weeks and months. Silver has been raised four times in less than two weeks. One silver contract on May 9th will require a margin of about $38,000 -- for ONE contract!
Wednesday, May 4, 2011
Gordon Long is another favorite. He always gives me a different perspective that I need to heed.
From Gordon T. Long of Tipping Points
Debt Saturation & Money Illusion
Most of the clearly evident financial problems that surround us today stem from one cause - Debt Saturation.
Most, intuitively, sense this to be a correct assessment but few can either prove it or articulate it to the less sophisticated. Let me arm you to be the "Nostradamus" amongst your friends and colleagues in explaining the problem and what the future therefore foretells.
However, let me make it very clear, this will not make you popular. Smart maybe, but highly likely to make you unwanted at the social gatherings of the genteel.
The first thing you will need in your role of 'all seeing' is the back of an envelope, or a somewhat clean napkin at your next luncheon. You will need only a few simple facts to go along with your prop.
THE FACTS MAME, JUST THE FACTS!
First, if you could total the world's balance sheets you would find that it would approximate $200 Trillion. In putting together this total you would discover that 75% of all financial assets are debt assets worth $150 Trillion. To most of us, debt is the epitome of a liability. To banks, however, it is not. It is considered an asset and recorded as such a banks ledger. Your liability is their asset.
The historical debt payment over a long period of time is 6% per annum. The Federal Reserve's dividend payment to its holders of capital was originally established in 1913 at precisely this 6% and is still accrued accordingly. Remember also, in a fractional reserve, fiat based banking system money can only be loaned into existence.
Today we have approximately $9 Trillion (6% of $150T) in annual debt payments that must be absorbed annually by increased productivity of the working classes.
Consider that the US Economy at approximately $15 Trillion is 25% of the global economy. Therefore the global economy approximates $60 Trillion ($62T officially, but we will use round numbers so we don't lose anyone in the arithmetic).
The working class therefore has to increase productivity by $9T divided by $60T or 15% annually to absorb the current global usury charges.
In the last few years of explosive debt growth we have passed the point of the global economy being able to grow and improve productivity at a fast enough rate, not to be literally consumed by this existing debt burden.
Unfortunately, it gets worse.
One of the problems in using GDP as a measure of growth is that it includes government spending. In the case of the US, it is approaching 25% of the output of the country. Within that, approximately $3.7 Trillion is $490B in interest payments or 13% of US expenditures. This actually means that there is an additional 3% that must be added to the 15% or nearly 18%.
This is called Debt Saturation.
DIMINSHING MARGINAL PRODUCTIVITY.
A very unpopular chart to deficit spending hawks is the chart showing the change in GDP as a ratio to the change in debt. The easiest way to understand this chart is to consider how much the economy will grow for every dollar of increased debt. As you can see, the effect of increased debt has been steadily losing its ability to increase economic growth and since the financial crisis has decidedly turned negative.
The Korean Times recently illustrated that despite a booming Asian environment, technology firms are now struggling to cover interest payments. One in three firms on the Kosdaq failed to earn sufficient money to cover interest payments in 2010. The interest coverage ratio, otherwise dubbed times interest earned (TIE), refers to the measure of a firm’s ability to honor its debt payments. 280 out of 876 Kosdaq-listed outfits, or 32 percent, could not reach the benchmark reading of one in the interest coverage ratio.
TELLTALES OF DEBT SATURATION:
1- Non Performing Loans
The mal-investment is just too large to contain and is showing up in ever-increasing levels of non-performing loans. This is despite rolling over loans at false asset values.
Equally concerning is what is happening in Central and Eastern Europe where the change is 7%. I personally consider Central and Eastern Europe to be the unaddressed 'sub-prime' problem of Europe. I suspect it will eventually replace the PIIGS in financial media news coverage.
2- Chronic Unemployment
The money lenders look at unemployment in a different fashion than the average person and would have us easily confused by its adjustments, birth-death models and other deceiving statistics. To them it is not about how many of our fellow citizens are unemployed, but rather simply how many net new jobs are being created to pay for the annual usury assessment fee of the $9 Trillion we previously discussed. Herein lies their problem.
The internet has had a profound impact on the increase in productivity. Schumpeter's creative destruction is an engine running at full throttle. Vast swaths of jobs are being made obsolete through the adoption of new technology. The 'clerical' industry has almost disappeared in the span of 15 years through operational innovations such as supply chains. This has been tremendous for corporate profits allowing them to maintain highly leveraged balance sheets. The problem is that it has been solely at the expense of real job growth. No matter what a corporation does to make money, it eventually comes down to a consumer having the money to pay for the goods or services it produces.
We have reached the saturation point where we have insufficient real income growth to maintain the leveraged balance sheets of corporations. Government social nets are becoming burdened with making up the difference in either transfer payments (i.e.45 Million on food stamps in the US) or subsidies ( North Africa paying 28% of country budgets toward food subsidies for the unemployed population to survive). There are examples everywhere if you care to look. I have written extensively on this in my series on Innovation and in articles such as "Fearing the Gearing".
Debt Saturation occurs when aggregate income no longer supports debt burdens. When governments print money, eventually Money Velocity increases as people incorporate inflation expectations into their buying behavior. When we examine the Federal Reserve's Money Velocity statistics we see that something is very different this time.
Despite increases in MZM, M1 and M2 money velocity maintains its downward slope with little suggestion of wanting to reverse trend.
We presently have inflation in what people NEED along with shrinking real disposable incomes. Since people must pay for their NEEDS with short term money (cash, check or credit card), there is little ability for them to adjust to inflation when they are living from paycheck to paycheck. If their disposable incomes were higher they would stockpile and turn their money over faster. Additionally, money as a multiplier would flow through our society. Instead, today the money does not move through multiple hands but is returned almost immediately to the banks as debt payment, since most intermediaries are also burdened with debt.
WHAT YOU MUST BE AWARE OF
First, You must understand the impact of mal-investments and the brake that debt is now applying to the Global Economy.
World Real GDP, adjusted for inflation on a year-over-year basis has plummeted. According to the World Bank this growth indicator has gone negative with the world's real GDP actually shrinking Y-o-Y.
The global growth engine has not only stalled but has clearly hit an unexpected brick wall.
Secondly, You must understand the significance of the stalled and possibly fatally ill "Shadow Banking" Credit Engine.
Similar to moving about on an airplane or train it is hard to determine the speed you are traveling, because you have a limited frame of reference. In a casual conversation with your fellow travelers it is easily forgotten or unnoticed that you are moving at a rapid speed. This is the situation we find ourselves in as the Shadow Banking System fails to rebound and the debt it once created is not being replaced. The liabilities of the Shadow Banking System are shrinking. These leveraged liabilities are now shrinking the global money supply despite every effort of central banks to combat it. The Central Banks are losing the battle. Like glacial tectonic shifts they are undermining the abilities of financial institutions to continue to carry and roll-over non performing debt.
The overlay below of the Nominal and Real (ShadowStats inflation-adjusted) Dow illustrates the concept of Money Illusion, the tendency of people to think of currency in nominal, rather than real, terms. Below the Dow series is the Consumer Price Index (CPI) from 1913 and with estimates for the earlier years.
The chart above is adjusted for inflation based on published CPI numbers. If ShadowStats inflation numbers are used, as is the case in the above chart, then the chart to the right would more clearly resemble longer term secular bear markets already experienced.
There is nothing magic in any of this and it has all been well documented, unfortunately by the Russians when they studied the capitalist system to identify its fundamental weaknesses. The Kondratieff long wave shows that the capitalist system suffers the build up and purging of debt on a generational basis on the frequency approaching 55 year cycles. We have extended this natural cycle by means of un-natural acts which I have written about in my extensive "Extend & Pretend" series of articles. Even in the days of old the king resorted to "jubilee" to cleanse the system. Of course we are much too sophisticated for such a simple solution today.
We have papered over the realities of "Too Big to Fail" by not allowing the proven tenets of capitalism to work. We have Anti-trust laws under the Sherman act to address 'too big', Control Fraud Laws to address questionable ethical behavior for the sake of profit (like mortgage fraud, liars loans etc) and Bankruptcy laws to liquidate failed enterprises to force debt holders to take haircuts and swap debt for equity. Instead we allow the prevalent game of Regulatory Arbitrage to run without restriction or detection. Existing laws are not being exercised in an attempt to protect what amounts to the emergence of a crony capitalist system. Benito Mussolini had a somewhat different world for the merging of corporate and government interests that I will leave for readers to recollect who have a historical penchant. It is not a word easily digested in the polite 'cocktail chatter' of today's genteel upper middle class.
Welcome to Kondratieff's Long Wave Cycle
In your new role as 'Nostradamus' to your friends you can safely predict a decade ahead to be a secular bear market in financial assets, in real terms. Nominal values may not show this clearly but it will be very evident in the reduced standard of living most Americans will experience.
You are going to have to work harder and harder, for less and less to survive at a lower and lower standard of living.
This will all be required to support the annual $9T debt bondage we have assumed as our politicos add additional 'stimulus' to a suffocating and debt saturated global economy.
also from Zero Hedge:
CEO of largest hog producer in the U.S. said this today:
"There are record prices for livestock but farmers are exiting the business!" he exclaims. "Why? Farmers know they won't make money."
We are just one bad weather event away from potentially $10 corn, which once again is another 50% increase in the input cost to our live production."
Mr. Pope recalls what happened the last time there was a surge in corn prices, in 2008: "The largest chicken processor in the United States, Pilgrim's Pride, filed for bankruptcy." They "couldn't raise prices, so their cost of production went up dramatically." Could it happen again? "It darn well could!" Mr. Pope exclaims.
- Food prices are up a lot and going higher in the future.
- Despite high food prices, farmers are quitting farming (lower supplies are coming).
- Food companies will be going bankrupt (even lower supplies are coming).
As predicted, the US economy is now in free fall (even with QE2 still having two more months to go), validated by today's Services ISM (recall that the US economy is based on "services", not a manufacturing) which plunged from 57.5 to 52.8, taking out consensus of 57.5, and "growing" at the lowest rate since August 2010. As a reminder a number south of 50 means "contraction." From the report: "The NMI registered 52.8 percent in April, 4.5 percentage points lower than the 57.3 percent registered in March, and indicating continued growth at a slower rate in the non-manufacturing sector. The Non-Manufacturing Business Activity Index decreased 6 percentage points to 53.7 percent, reflecting growth for the 21st consecutive month, but at a slower rate than in March. The New Orders Index decreased substantially by 11.4 percentage points to 52.7 percent. The Employment Index decreased 1.8 percentage points to 51.9 percent, indicating growth in employment for the eighth consecutive month, but at a slower rate. The Prices Index decreased 2 percentage points to 70.1 percent, indicating that prices increased at a slightly slower rate in April when compared to March. According to the NMI, 17 non-manufacturing industries reported growth in April. Respondents' comments are mixed about overall business conditions; however, they are mostly positive. Respondents' comments also indicate concern over rising fuel costs, commodity costs and the lingering uncertainty about the economy." Virtually every index declined with New Orders plummeting from 64.1 to 52.7 - the biggest drop in history, excepts for Supplier Deliveries (this will certainly drop next month), and Imports.
A quick look at the commodity situation:
Commodities Up in PriceAnd respondents:
Air Freight; Aircraft Fuel; Airfares (5); Beef; Can Liners; Carbon Pipe; Copper (3); Copper Products (5); Corrugated; Cotton (6); Cotton Products (8); #1 Diesel Fuel (7); #2 Diesel Fuel (10); Freight Charges; Fuel (16); Fuel Surcharges (4); Gasoline (7); Ink Jet Toner Cartridges; Latex Gloves (4); Lube Products; Oil Products; Packaging Materials (2); Paper (6); Petroleum; Petroleum Products (4); Plastics; Plastic Products (2); Plastic Sheet; Polyester Garments (2); Polyethylene Bags (5); Polyethylene Film; Resins; Steel (5); Steel Pipe and Fittings; Steel Products (5); Textiles; Tomatoes; and Transportation Costs.
Commodities Down in Price
No commodities are reported down in price.
Commodities in Short Supply
Cotton (4); Cotton Products; Laptop Computers; and Servers.
- "Business conditions [remain] unchanged. No supply impact from the Japan earthquake/tsunami, but continue to track with the supply base." (Management of Companies & Support Services)
- "Revenues are picking up slowly, but the growth is positive as compared to last month and the same month last year." (Real Estate, Rental & Leasing)
- "Looking forward with reserved caution. Cost of goods by this fall are a big worry." (Accommodation & Food Services)
- "Continuing economic uncertainty will curtail or delay project spending for the immediate future." (Educational Services)
- "Fuel prices continue to be challenging and in addition to shipping, are influencing the cost of materials." (Public Administration)
- "We are seeing price increases in many areas, and the lead times are stretching out. Our business activities are improving at a moderate rate." (Wholesale Trade)
Tuesday, May 3, 2011
I believe John Mauldin and John Hussman are the best two writers on economics these days. They are friends (of each other -- but I consider them friends, too, despite that they don't know me from Adam). This is from John Mauldin. I appreciate his straight-forward talk.
The Endgame Headwinds
Before we can get to how I think the Endgame of the debt supercycle plays out in the US, we need to quickly survey the current environment, and revisit (at least for long-time readers) a few basic economic themes that I will call the “headwinds” of economic growth. So many leaders in so many countries think that with the right policies they can grow (export) their way out of the problem. As I have written, not everyone can grow their way out of a crisis at the same time. Someone has to buy.
And while the right policies will in fact help, growth is, in my opinion, going to be severely constrained in the multi-year period of the Endgame. But, jumping right to the bottom line here, one way or another we will get through this very difficult period. Really. And my personal view is that in the period following the Endgame cycle we’re going to see a very real economic boom, for reasons we will visit briefly in this series and at length over the coming year. I am quite optimistic longer-term, but the flight to get there may be very bumpy if you are not prepared for it. I will try to do my part to help you.
Briefly, for new readers, let me define what I mean by the Endgame, as dealt with at length in Endgame: The End of the Debt Supercycle and How It Changes Everything ( www.amazon.com
And make no mistake. I believe that the situation in the US is becoming urgent all too quickly. We are risking the health of the economic body of the US. While the republic will survive the crisis, the shocks and burdens it will place on all of us will be very great. For those not prepared it will seem like the end of the world, as jobs and safety nets might evaporate without proper restructuring. As I argue, the goal of fiscal sanity is to get the growth of the debt below that of the growth rate in nominal GDP. Failure to do so will result in the US suffering much as Greece or Ireland are today. Ugly.
The 2008 banking crisis showed us the limits of how much individuals can borrow, at least against their home equity. Since then, private debt (except recently for student loans in the US) has begun to shrink. But governments everywhere stepped into the breach by massively borrowing. But even governments, including the US, have a limit. We see that in Greece and Ireland, and are watching the debt crisis unfold in Portugal and Spain as well. It will soon become all too painfully clear in Japan. As I have often noted, Japan is a bug in search of a windshield. Japan is big enough that when it hits its own version of the Endgame, it will shake the world. It will not be pretty. (But there are opportunities for the nimble.)
As we will quickly cover here, the economic environment in which individuals and governments either willingly or are forced by the markets to reduce their borrowing and debt is significantly different from the period where they could create ever-increasing amounts of leverage. I call this period the Endgame. What we think of as normal gets turned upside down. Volatility increases, at a minimum. For many people this will qualify as a true crisis. But if you can see it coming and prepare, you can at least insulate yourself (somewhat) from many of the negative aspects of the Endgame. And volatility and crisis also mean that there will be opportunities for those prepared for them.
Now, let’s look at three graphs. The first is familiar to long-time readers. It shows the rise of debt in the US. And even with the recent pullback in consumer debt, because of the enormous government deficits, the rise is still there if we update this chart to last year.
The next two charts come from the Bank of International Settlements. They outline for 12 countries what happens, in terms of the debt-to-GDP ratio, if current spending and tax rates remain unchanged (the top dotted line), what happens if there are efforts to rein in spending with small gradual spending cuts and tax increases (middle line), and what would happen with serious spending cuts and significant tax increases (the lowest line). Some countries, even with measures that could be considered draconian, simply do not recover. While the chart shows what would happen if age-related spending were held constant, most seniors would think that getting ever-smaller pensions and health care would be drastic measures indeed. These countries are in an unsustainable spiral, which means drastic (the word used by the BIS) measures will be needed.
Note that there is only one example of a country that ever saw its debt-to-GDP rise over 150% and did not default, and that is Britain at the height of its empire and power, with long-term rates at a very low level and a completely different investment and bond climate. But notice how many of the countries are now on a path to twice that level in the very near future.
Look at the projected debt for the US, compiled last year by the Heritage Foundation, based on realistic assumptions, not with rose-colored glasses. This is a chart of something that will not happen. Long before we get ten years of multi-trillion-dollar debt, the bond market will being to require much higher rates than we currently experience, driving up the interest-rate cost as a percentage of tax revenues to very painful levels, forcing cuts in all sorts of things we currently think of as absolutely necessary, like military, education, and Medicare spending. Later on I will put a timeline on this prediction.
One way or another, the budget deficits are going to come down. As we will see later, we can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices result in entirely different outcomes.
In the US, the real question we must ask ourselves as a nation is, “How much health care do we want and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can radically cut health care along with other discretionary budget items or we can raise taxes, or some combination. Both have consequences. The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed, but still existent), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done.
The point of the exercise (reducing the fiscal deficit to sustainable levels) is to reduce the deficit over 5-6 years below the growth rate of nominal GDP (which includes inflation, about which more below). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.
Now, what typically happens in a business-cycle recession, as businesses produce too many goods and start to cut back, is that consumption falls; and the Keynesian response is to increase government spending in order to assist the economy to start buying and spending, and the theory is that when the economy recovers you can reduce government spending as a percentage of the economy – except that has not happened for a long time. Government spending just kept going up. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn’t just the stimulus, it was the absolute size of government that increased as well.
And now massive deficits are projected for a very long time, unless we make changes. The problem is that taking away that deficit spending is going to be the reverse of the stimulus – a negative stimulus if you will. Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. This is a short-term effect, which most economists agree will last 4-5 quarters, and then the economy may be better, with lower deficits and smaller government.
However, in order to get the deficit under control, we are talking on the order of reducing the deficit by 1% of GDP every year for 5-6 years. That is a very large headwind on growth, if you reduce potential nominal GDP by 1% a year in a world of a 2% Muddle Through economy. (And GDP for the US came in at an anemic 1.75% yesterday, with very weak final demand.)
Further, tax increases reduce GDP by anywhere from 1 to 3 times the size of the increase, depending on which academic study you choose. Large tax increases will reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there is a cost to growth and employment. Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with either the facts or the well-established research. Now, that is different from the argument that says we should allow them to expire anyway
The I in the equation is investments. That is what produces the tools and businesses that make “stuff” and buy and sell services. Increasing the government spending, “G”, does not increase productivity. It transfers taxes taken from one sector of the economy and gives them to another, with a cost of transfer, of course. While the people who get the transfer payments and services certainly feel better off, those who pay taxes have less to invest in private businesses that actually increase productivity. As I have shown elsewhere, over the last two decades, net new jobs in the US have come from business start-ups. Not large businesses (they are a net drag) and not even small businesses. Understand, some of those start-ups become Google and Microsoft, etc. But many just become small businesses, hiring 5-10-50-100 people, but the cumulative effect is growth in the economy and productivity.
Now, if you mess with our equation, what you find is that
Savings = Investments.
If the government “dis-saves” or runs deficits, it takes away potential savings from private investments. That money has to come from somewhere. Of late, it has come from QE2, but that is going away soon. And again, let’s be very clear. It is private investment that increases productivity, which allows for growth which produces jobs. Yes, if the government takes money from one group and employs another, those are real jobs, but that is money that could have been put to use in private business. It is the government saying we know how to create jobs better than the taxpayers and businesses we take the taxes from.
This is not to argue against government and taxes. There are true roles for government. The discussion we must now have is how much government we want, and recognize there are costs to large government involvement in the economy. How large a drag can government be? Let’s look at a few charts. The first two are from my friend Louis Gave, who will be speaking at my conference this weekend. This first one is the correlation between the growth of GDP in France and the size of government. This chart shows the rate of growth in GDP and the ratio of the size of the public sector to the private sector. The larger the percentage of government in the ratio, the lower the growth.
I know, you think that is just the French. We all know their government is too involved in everything, don’t we. But it works in the US as well. The chart below shows the combined federal, state and local expenditures as a percentage of GDP (left-hand scale, which rises as the line falls) versus the 7-year structural growth rate, shown on the right-hand side. And you see a very clear correlation between the size of total government and structural growth. This chart and others like it can be done for countries all over the world.
Sidebar: Now, I would not argue, as some libertarians do, that we need almost no government. I do not. But we must recognize the cost-benefit. I think the benefits of police are clear. Schools. A professional military (its use can be up for debate). Financial regulation. Courts. Etc. Certainly, society functions better with these and other services, and in a broad sense you can say that increases productivity. We “buy” services collectively with tax dollars that are seen as essential public goods. Those services could be offered by private companies. But there is a limit in the minds of most people. Do you want your government to own the steel mills and airlines? Energy production? In many countries and at times in history, the answer was yes. But government-run businesses are rarely as efficient as private ones. And that efficiency is a direct component of productivity.
Next, (and finally for this week), let’s look at a chart from my good friend Rob Arnott. This is part of what will one day be an Outside the Box. (For new readers, this is a publication that goes out Monday night, which features the writing and thinking of someone other than your humble analyst, and which I don’t always agree with, but that does make us think. You can get it at www.johnmauldin.com
The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private-sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has been government.
Is it any wonder that we have no net new jobs over the last decade? I get that there have been two recessions, but in an effort to appear to be “doing something,” to “feel your pain,” government is slowly sucking the air out of the room. Not all at once. Just a bit at a time.
And it shows up in worker pay. The average worker has not seen their pay rise in real terms in almost 15 years. If they have a job. In fact, for the last decade, they LOST 5%.
Do you want more tax revenues so we can have more government services like health care? We have to grow the private economy. If we tax the private economy as it is now, that will just reduce the growth in the private economy and slow or reduce the growth of jobs. There is simply no way to get around that fact.
I will close here and start with part two next week. But the short take-away? The fiscal deficit and the national debt are a cancer on our economic body. They threaten to destroy the economic body of the republic. As a conservative, simply writing the words “tax” and “increase” in the same sentence makes me nervous. But I am even more afraid of what will happen if we do not get the deficit under control over time (next week we’ll explore why we cannot do it all at once). Sometimes, when they have cancer, people take drugs they would not normally want to be in the same zip code with, in order to increase their chances of surviving. But those drugs have side effects, some of them quite severe and long-term.
How we solve this crisis will determine the nature of the Endgame. But that is for next week.
Our nation's founders understood the difference between opportunity and entitlement. They believed in certain key values including the prudence of thrift, savings and limited debt. They took seriously their stewardship obligation to the country and future generations of Americans.
The truth is, we have strayed from these key, time-tested principles and values in recent decades. We must return to them if we want to keep America great and help to ensure that our future is better than our past.
Believe it or not, to win our independence and achieve ratification of the U.S. Constitution, the U.S. only had to go into total federal and state debt equal to 40 percent of the size of its then fledgling economy. Fast forward to today, when the U.S. is the largest economy on earth and a global superpower – but total federal debt alone is almost 100 percent of the economy and growing rapidly. Add in state and local debt, and the total number is about three times as much as the total debt we held at the beginning of our Republic – and it is headed up rapidly. As the below graphic shows, our total federal debt has more than doubled in just the past ten and a half years.
America has gone from the world's leading creditor nation to the world's largest debtor nation. We have also become unduly dependent on foreign nations to finance our excess consumption. Many of these foreign investors have shunned our long-term debt due to concerns over future interest rates and the longer-term value of the dollar. And PIMCO, the largest Treasury bond manager in the U.S., also recently sold their Treasury security holdings due to a lack of adequate return for the related interest rate risk.
And who is now the largest holder of Treasury securities? It's the Federal Reserve. I call that self-dealing. The Fed may be able to hold down interest rates for a period of time; however, they cannot hold them down forever. The Fed's debt purchase actions are just another example of how Washington policymakers take steps to provide short-term gain while failing to take steps to avoid the longer-term pain that will surely come if we fail to put our nation's fiscal and monetary policies in order.
The Fiscal Fitness IndexIn March 2011 the Comeback America Initiative (CAI) and Stanford University released a new Sovereign Fiscal Responsibility Index (SFRI) - or as my wife Mary refers to it, a Fiscal Fitness Index. We calculated each country’s SFRI based on three factors – fiscal space, fiscal path, and fiscal governance.
Fiscal space represents the amount of additional debt a country could theoretically issue before a fiscal crisis is imminent. Fiscal path is an estimate of the number of years before a country will hit its theoretical maximum debt capacity. (The U.S. will hit its maximum within16 years, but will enter a “fiscal danger zone” within 2-3 years). Fiscal governance is a value based on the strength of a government’s institutions, as well as its transparency and accountability to its citizens. Unfortunately, the U.S. ranks far below the average in all three of these categories – in particular, the fiscal governance category.
The overall SFRI index showed that the U.S. ranked 28 out of 34 nations in the area of fiscal responsibility and sustainability. And when you see which countries rank around us, it's clear that we’re in a bad neighborhood. We’re only a few notches above countries like Greece, Ireland, and Portugal, all of which have recently suffered severe debt crises. That report also showed that the U.S. could face a debt crisis as soon as two to three years from now, given our present path and interest rate risk. Below is the full list of rankings.
On the positive side, the CAI and Stanford report showed that if Congress and the President were able to work together to pass fiscal reforms that were the "bottom line" fiscal equivalent of those recommended by the National Fiscal Responsibility and Reform Commission last year, our nation's ranking would improve dramatically, to number 8 out of 34 nations. In addition, we would achieve fiscal sustainability for over 40 years!
So what are our elected officials waiting for? Do they want a debt crisis to force them to make very sudden and possibly draconian changes? If not, they need to wake up and work together to make tough choices. That’s what New Zealand did in the early 1990s, when that country faced a currency crisis. Due to tough choices then and persistence over time, New Zealand now ranks number 2 in the SFRI - second only to Australia, which the Kiwis are not happy about! If New Zealand can do it, America can too!
The Recent Budget Policy ProposalsIn order for us to begin to restore fiscal sanity to this country, President Obama has to discharge his leadership responsibilities as CEO of the United States Government. He got into the game with his fiscal speech on April 13, in which he largely embraced the work of his National Fiscal Responsibility and Reform Commission, although with a longer timeframe for implementation and less specifics on entitlement reforms. The President also endorsed the debt/GDP trigger and automatic enforcement concept that CAI had been advocating. Under this concept, Congress could agree on a set of statutory budget controls that would come into effect in fiscal 2013. Such controls should include specific annual debt/GDP targets with automatic spending cuts and temporary revenue increases in the event the annual target is not met. In my view, a ratio of three parts spending cuts, excluding interest savings, to one part revenue would make sense.
House Budget Committee Chairman Paul Ryan recently demonstrated the political courage to lead in connection with our nation's huge deficit and debt challenges. His budget proposal recognizes that restoring fiscal sustainability will require tough transformational changes in many areas, including spending programs and tax policies. Chairman Ryan's proposal includes several major reform proposals, especially in the area of health care. For example, he proposes to convert Medicare to a premium support model that will provide more individual choice, limit the government's long-term financial commitment and focus government support more on those who truly need it. He also proposed to employ a block grant approach to Medicaid in order to provide more flexibility to the states and limit the governments' financial exposure. These concepts have varying degrees of merit; however, how they are designed and implemented involve key questions of social equity that need to be carefully explored. And contrary to Chairman Ryan’s proposal, additional defense and other security cuts that do not compromise national security and comprehensive tax reform that raises more revenue as compared to historical levels of GDP also need to be on the table in order to help ensure bipartisan support for any comprehensive fiscal reform proposal.
The President and Congressional leaders should be commended for reaching an agreement that averted a partial shutdown of the federal government and resolved funding levels for fiscal 2011. While it took way too much time and effort, this compromise involved real concessions from both sides and represents a small yet positive step towards restoring fiscal responsibility. But this action is far from the most important fiscal challenge facing both the Congress and the President. After all, Washington policymakers took about 88 percent of federal spending, along with much-needed federal tax reforms, "off the table" during the recent debate over the 2011 budget. In essence, they have been arguing over the bar tab on the Titanic when we can see the huge iceberg that lies ahead. The ice that is below the surface is comprised of tens of trillions of dollars in unfunded Medicare, Social Security and other off-balance sheet obligations along with other commitments and contingencies that could sink our "Ship of State". It is, therefore, critically important that we change course before we experience a collision that could have catastrophic consequences. As you can see in the series of pie charts below, mandatory programs like Social Security and Medicare already take up the largest share of the federal budget and, absent a change in course, will continue to do so in increasing amounts in the next several decades.
The Federal Debt Ceiling LimitNow that the level of federal funding for the 2011 fiscal year has been resolved, there has been an increasing amount of attention on Congress’ upcoming vote to increase the federal debt ceiling limit. As is evident by the chart below detailing the debt ceiling limit per capita adjusted for inflation since 1940, the U.S. started losing its way in the early 1980s. Fiscal responsibility was temporarily restored during the 1990s, when statutory budget controls were in place, but things went out of control again in 2003, the year after those budget controls expired.
In essence, raising the debt ceiling is simply recognizing the federal government’s past fiscally irresponsible practices. But while federal law provides for the continuation of essential government operations even if the government has not decided on a budget or funding levels for a fiscal year, such a provision does not exist in connection with the debt ceiling. Therefore, if the federal government hits the debt ceiling during a time of large deficits, which is the case today, dramatic and draconian actions will have to be taken to ensure that additional debt is not incurred. This would likely include a suspension of payments to government contractors, delays in tax refunds, and massive furloughs of government employees. In addition, since Social Security is now paying out more in benefits than it receives in taxes, the monthly payments may not go out on time if we hit the debt ceiling limit. That would clearly get the attention of tens of millions of Americans, including elected officials.
However, although failure to raise the debt ceiling is not a viable option given our current fiscal state, we must take concrete steps to address the government’s lack of fiscal responsibility. We must also do so in a manner that avoids triggering a massive disruption and a possible loss of confidence by investors in the ability of the federal government to manage its own finances. Such a loss of confidence could spur a dramatic rise in interest rates that would further increase our nation's fiscal, economic, unemployment and other challenges.
In order to begin to restore fiscal sanity, Congress could increase the debt ceiling limit in exchange for one or more specific steps designed to send a signal to the markets, and the American people, that a new day in federal finance is dawning. To be credible, any such action must go beyond short-term spending cuts for the 2012 fiscal year. The debt/GDP trigger and automatic enforcement concepts I advocate above are one specific step Congress could take.
The S&P's revised outlook on the long-term rating for U.S. sovereign debt should be yet another wake-up call for elected officials and other policymakers in Washington. S&P's action serves as a market-based signal that independent ratings agencies believe the U.S. is on an imprudent and unsustainable fiscal path and that action is needed in order to maintain investor confidence. In my view, this action should have been taken place some time ago; however, it is now likely that other rating agencies will reconsider their ratings positions on U.S. Sovereign debt.
Moving Past Partisan PoliticsThe American people need to understand that doing nothing to address our deteriorating financial condition and huge structural deficits is simply not an option. Failure to act will serve to threaten America's future position in the world and our standard of living at home. Therefore, both major political parties must come to the table and put aside their sacred cows and unrealistic expectations. As John F. Kennedy said, “The great enemy of the truth is very often not the lie — deliberate, contrived and dishonest — but the myth — persistent, persuasive, and unrealistic.”
Given President Kennedy's admonition, liberals need to acknowledge that we need to renegotiate the current social insurance contract. For example, contrary to assertions by some, Social Security is now adding to the federal deficit and is underfunded by about $8 trillion. As you can see below, it will face escalating annual deficits beginning in 2015.
There is no debate that last year's health care reform legislation will result in higher federal health care costs as a percentage of the economy. (See the chart below). In addition, according to Medicare's independent Chief Actuary, based on reasonable and sustainable assumptions, last year's health care reform legislation will end up exacerbating our deficit and debt challenges rather than helping to lessen them. He estimated that the cost of the health care law to the Medicare program could be over $12 trillion in current dollars more than advertised.
Conservatives need to acknowledge that we can't just grow our way out of our fiscal hole. They need to admit that all tax cuts are not equal and there is plenty of room to cut defense and other security spending without compromising our national security. And while conservatives are correct to say that our nation's fiscal challenge is primarily a spending problem, they must recognize that some additional revenues will be needed to restore fiscal sanity. The math just doesn't work otherwise.
All parties must acknowledge that we can't inflate our way out of our problem and that we must take steps to improve our nation's competitive posture. This means that some properly targeted and effectively implemented critical infrastructure and other investments may be both needed and appropriate even if they exacerbate our short-term fiscal challenge.
Washington policymakers need to understand that the same four factors that caused the recent financial crisis exist for the federal government's own finances. And what are those factors?
First, a disconnect between those who benefit from prevailing policies and practices and those who will pay the price and bear the burden if and when the bubble bursts. Second, a lack of adequate transparency and accountability in connection with the true financial risks that we face. Third, too much debt, not enough focus on cash flow, and an over-reliance on narrow and myopic credit ratings. Finally, a failure of responsible parties to act until a crisis was at the doorstep.
There is growing agreement that the greatest threat to our nation's future is our own fiscal irresponsibility. In fact, as I noted in 2007 and Joint Chiefs Chairman Admiral Mullin stated last year, our fiscal irresponsibility and resulting debt is a national security issue. After all, if you don't keep your economy strong for both today and tomorrow, America's standing in the world and standard of living at home will both suffer over time – and waiting for a crisis before we act could also undermine our domestic tranquility.
So where should Washington go from here?First, Congress and the President should reach a compromise agreement on an appropriate level of spending cuts in 2012 while also providing for some additional properly designed and effectively implemented critical infrastructure investments. Second, they should agree to re-impose tough statutory budget controls that will force much tougher choices on both the spending and tax side of the ledger beginning no later than 2013. Third, they should authorize and fund a national citizen education and engagement effort to help prepare the American people for the needed actions and to facilitate elected officials taking them without losing their jobs. Fourth, they should create a credible and independent process that will provide for a baseline review of major federal organizational structures, operational practices, policies and programs in order to make a range a transformational recommendations that will make the federal government more future focused, results oriented, successful and sustainable.
Spending levels certainly need to be cut. After all, the base levels of federal discretionary spending increased by over 30 percent between 2007 and 2010 during a time of low inflation. At the same time, all parties must be realistic regarding how much should be cut and how quickly it can be achieved. In my view, we should be targeting greater cuts than have been recently considered, but over a longer period of time: for example, real spending cuts of $125-$150 billion over several years. If we did so, the related savings would be significant and would compound over time.
As the National Fiscal Responsibility and Reform Commission, CAI, The No Labels political movement (of which I am a co-founder), and others have noted, everything must be on the table – and all political leaders need to be at the table – in order to put our nation on a more prudent and sustainable fiscal path. This includes a range of social insurance program reforms, defense and other spending cuts, and comprehensive tax reform that generates additional revenues, including both individual and corporate tax reform. We must keep in mind that the private sector is the engine of innovation, growth, and jobs. In addition, many businesses are taxed at the individual, rather than the corporate, level.
Realistically, it will take us a number of years to get back into fiscal shape. And while it would be great if we could do a "grand bargain" and enact a broad range of transformational reforms in one step, that just isn't realistic in today's world. Therefore, what is a reasonable order of battle to win the war for our fiscal future?
First and foremost we need to enact budget process reforms, re-impose the type of budget controls and engage in the fact-based citizen education and engagement effort referred to previously. The next order of battle items should be corporate tax reform and Social Security reform. Why corporate tax reform? Because it can help to improve our competitiveness, enhance economic growth and generate jobs.
And why Social Security reform? Because we have a chance to make this important social insurance program solvent, sustainable and secure for both current and future generations. We can also exceed the expectations of all generations and demonstrate to both the markets and the American people that Washington can act before a crisis forces it too.
The above efforts should be followed by broader tax reform and Medicare/Medicaid reforms. We will then need to rationalize our health care promises and focus more on reducing health care costs in another round of health care legislation. We must also begin a multi-year effort to re-baseline the federal government's organizations, operations, programs and policies to make them more future focused, results oriented, affordable and sustainable.
In summary, the truth is that the government has grown too big, promised too much and waited too long to restructure. Our fiscal clock is ticking and time is not working in our favor. The Moment of Truth is rapidly approaching. As it does, let us hope that our elected officials must keep the words of Theodore Roosevelt in mind: “In any moment of decision the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.” And "We the People" must do our part by insisting on action and by making the price of doing nothing greater than the price of doing something We must insist that our legislators offer specific solutions to defuse our ticking debt bomb in a manner that is economically sensible, socially equitable, culturally acceptable, and politically feasible We need to recognize that improving our fiscal health, just like our physical health, will require some short-term pain for greater long-term gain. The same is true for state and local governments.
We'll soon know whether Washington policymakers are up to the challenge and whether they will start focusing more of doing their job than keeping their job. They need to focus first on their country rather than their party. And yes, the President and Congressional leaders from both political parties need to be at the table and everything must be on the table in order to achieve sustainable success. Let's hope they make the right choice this time!
All of us who are involved with the Comeback America Initiative (CAI) will do our part. All that we ask is that you do yours. The future of our country, communities and families depends on it.
For more information about the Comeback America Initiative and No Labels, check out www.tcaii.org and www.nolabels.org.