December 3, 2024

The Stimulus Plan Condemns Us To Further Wealth Destruction

January 21, 2009 by 1 Comment

Will Spending Borrowed Money Create Wealth?

There seems to be near universal agreement at all decision making levels of government that we can borrow and spend ourselves into prosperity.  Let’s consider some worthwhile contrary opinions.

Leave the New Deal in the History Books

When Barack Obama takes office on Tuesday, his first order of business will be a stimulus package estimated to be close to $1 trillion.   Sages nod that replicating aspects of FDR’s New Deal will help pull the country out of a recession. But the experience under FDR largely provides a cautionary tale.

Mr. Obama’s policy plans are driven by the conventional economic wisdom that the New Deal economic programs ended the Great Depression. Not so. In fact, thanks to New Deal policies and programs, the U.S. economy faltered for years longer than it might otherwise have done.

President Roosevelt came to office much as Barack Obama will, shouldering an economic crisis that began under his predecessor. In 1933, Roosevelt’s first year, unemployment hit nearly 25%, as people lost jobs and homes in towns across the country. Believing that government played a key role in restarting growth, FDR, within his first 100 days as president, created an alphabet soup of new agencies that mandated actions or controlled public spending and impacted private capital flow within the U.S. economy.

At first, it seemed to be working.  Then things turned for worse again: By the fall of 1937, the U.S. entered a secondary depression and unemployment began to rise, reaching 19% in 1938.

By 1939 Roosevelt’s own Treasury secretary, Henry Morgenthau, had realized that the New Deal economic policies had failed. “We have tried spending money,” Morgenthau wrote in his diary. “We are spending more than we have ever spent before and it does not work. . . . After eight years of this Administration we have just as much unemployment as when we started. . . . And an enormous debt to boot!”

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson have been correctly focused on shoring up financial institutions to prevent a collapse of the financial system, and stave off a severe decline in the general price level. If that were to occur, the unspoken fear has been that the U.S. and global economy could go into a deflationary death spiral that would cause the collapse of the international financial system.

As a short-term matter, the moves of the Fed and other central banks have been correct, but in the long term a return to growth will depend on dynamic job creation by American business — not the U.S. government.

As a result, the New Deal forced the allocation of money away from the private sector. As economist Henry Hazlitt wrote back in 1946, New Deal programs prevented the creation of the types of jobs which have the multiplier effect of successful businesses. Creating “work” prevented innovation and new jobs that would create other jobs.

Governments cannot create wealth by taxing and borrowing to fund make work jobs.  The expenditure of massive amounts of money on politically inspired spending will simply deprive the private sector of needed capital.  Central economic planning has never worked nor will it work now.  The fact that there appears to be near unanimity in Washington that we need to borrow and spend our way to “prosperity” is enough to cause grave concerns since at a minimum it implies that there will be little constructive debate on the merits of the consensus view.

The Obsession With Government Spending

Despite adverse experience, the Keynesian stimulus idea has a viselike hold on policymakers

The U.S. is enacting a “stimulus” program of gargantuan peacetime proportions to rejuvenate our recessed economy. We are not alone in this. Japan, China, Europe and numerous other nations are doing the same–not yet as big as our program but based on the idea that governments can rekindle growth.

It’s all mostly wasted effort.

Despite its sheer size, the impact of the new President’s fiscal program, after the initial euphoria, will be painfully limited. Instead of a jolt like from downing a six-pack of Red Bull, we’ll get the economic equivalent of a tepid cup of decaffeinated tea. In fact, the waste and misuse of much of the money–inevitable in any quick, massive government-managed or -directed program–will negate much of the good in parts of this infrastructure-spending package.

The blunt truth is that government spending is a poor substitute for private business and consumer investing and spending. Were it otherwise, the Soviet Union would have won the Cold War, and Japan, which had numerous Obamaesque stimulus packages in the 1990s, would have boomed instead of remaining dead in the water in what was a 12-year recession.

Why this belief in government spending? After surveying the wreckage of the Great Depression, British economist John Maynard Keynes posited that markets left to themselves were inherently unstable and that government intervention could prevent debilitating economic slumps.

So why did such an approach fail so miserably in the 1930s?

What about Japan’s spending binge in the 1990s that still left its economy stagnant?

What about western Europe, which has had a massive government presence during the last 30 years but has created only a small fraction of the private-sector jobs that the U.S. has?

Despite adverse experience, the Keynesian stimulus idea has a viselike hold on policymakers, pundits and academics.

Events can also roil economies, as we experienced after 9/11. But most often, bad government policies bring on the most damaging downturns. The Great Depression was ignited by trade wars, high taxes and bad monetary policies. The great inflation of the 1970s was caused by the Federal Reserve’s excessive money printing. The current crisis was brought on by the weak dollar, the reckless extravagances of Fannie Mae and Freddie Mac and regulatory errors, such as mark-to-market accounting.

The fact that policy makers best solution is nothing more than a continuation of past failed policies reinforces the intellectually bankrupt theory of a borrow and spend solution.   Hurry up and do something, anything, would best describe the stimulus plan.

Final Steps To Insolvency?

Can Obama Make Government Solvent?

Mr. Obama has been handed an opportunity. He will put the welfare state on a path to solvency or he won’t, and we’re likely to find out soon. His stimulus spending plans will blow up in his face unless the bond markets (which will be called upon to finance them) are convinced the dollar will remain sound and spending under control.

Sadly, to those from whom much is expected, sometimes not enough is given. FDR can have been a great leader who sought the best for his country, and the ’30s still have been a succession of political disasters. Both things can be true. Presidents ride the tiger. Without apparent cognitive dissonance, Mr. Obama already has taken to denouncing Washington’s “anything goes” culture while simultaneously outlining plans to borrow perhaps $1 trillion to distribute to anybody and anything that happens to fit the wish list of some Democratic Party constituency group (and a few GOP ones too).

He certainly will meet with a gratifying success in the spending portion of his plan. The revelation will be whether he can deliver anything else.

Government solvency now has to be considered by serious minds as we see numerous countries headed down that path. The rush to spend  massive amounts of borrowed money is a sign of fiscal insanity.   Large government programs are always instituted in haste after a crisis has occurred.   Invariably, the government solution only makes the original problem worse.  Let us hope that at a minimum, any major government initiatives are properly debated before enactment and sharply curtailed.

Filed Under: Bailout, Economy, Stimulus Plan Tagged With: , ,

Job Losses Continue – “Unprecedented Economic Conditions”

January 7, 2009 by Leave a Comment

Job losses continue to dominate the headlines in 2009.

Logitech To Slash 15% Of Work Force

ZURICH (Reuters) — Logitech International SA, the world’s largest computer-mouse maker, said it plans to cut 15% of its workforce and withdrew its fiscal 2009 financial targets, citing deepening global recession.

“During the December quarter, the retail environment deteriorated significantly,” Chief Executive Gerald Quindlen said in a statement on Tuesday, adding that the company expects the economic environment to worsen in coming months.

Cigna To Cut 1,100 Jobs

LOS ANGELES (Reuters) — Health insurer Cigna Corp. said Monday it will cut 1,100 jobs, or about 4% of its workforce, and consolidate certain operations as it copes with the economic downturn.

“Given the unprecedented economic situation we and our customers are facing, these actions are essential to ensure we can meet their needs for high-value, cost-effective products and services,” Chairman and Chief Executive H. Edward Hanway said in a statement.

The Cigna news follows a similar announcement last month from No. 3 health insurer Aetna, which said it would cut 1,000 jobs, or about 3% of its workforce, by the end of 2008.

UnitedHealth Group Inc., the largest U.S. health insurer by market value, said in July it was cutting some 4,000 jobs, or about 5% of its workforce, over the course of a year.

Alcoa to Cut 15% of Work Force, Unload Assets

Alcoa Inc. announced the elimination of about 15,000 jobs, more plant closures, plans to sell assets and a 50% cut in capital expenditures to contend with the sustained recession.

“Many of these things are painful and many of these things are drastic,” Alcoa Chief Executive Klaus Kleinfeld said in an interview Tuesday. “We will continue to monitor the dynamic market situation to ensure that we adjust capacity to meet any future changes in demand and seize new opportunities.”

Alcoa lost much of its luster in the recent commodity boom, failing to match the profit rise of other mining and metals companies, including rivals Rio Tinto Aluminum and UC Rusal. Both of those companies have also announced major cuts, shutting operations and selling businesses such as operations in China.

About 15% of the company’s employees and contractors will lose their jobs. Alcoa also is freezing salaries and hiring.

One day’s results – 3 companies cut over 17,000 jobs resulting in hard times and unemployment for many families.  Job losses have been an ongoing event and promise only to get worse as the job losses ripple throughout the economy.

The common theme in many of the layoffs is the eye popping size of the job cuts and company statements that conditions deteriorated significantly.  The size of the cuts do not suggest a typical slowdown but rather a “falling off the cliff” economy.

The only possible positive view one can take here is that when the news is this bad, it has to get better.

Filed Under: Economy, Jobs Tagged With: , , ,

Consumer Confidence Crushed As Upward Mobility Dies

December 28, 2008 by Leave a Comment

No-Lay Off Policies Crumble, as reported by WSJ

Until recently, Enterprise Rent-A-Car Co. prided itself on a 51-year history of never laying off a U.S. employee. When competitors slashed fleets and shuttered branches after the Sept. 11 attacks, Enterprise kept hiring.

This fall, though, the nation’s largest car-rental agency said it would dismiss 1,000 of its 75,000 employees, as Americans curtailed driving and flying. “These types of declines are unprecedented,” says Patrick Farrell, Enterprise’s vice president of corporate responsibility.

The deepening recession is prompting layoffs at long-established employers that avoided job cuts in previous downturns. These layoffs demonstrate both the severity of the current recession and the continued erosion of workplace norms that once shielded many U.S. workers from permanent job loss.

Several of these employers are in hard-hit industries. Employment in the car rental and leasing sector, for example, fell 3.3% in October from a year earlier, according to the U.S. Bureau of Labor Statistics. Gentex Corp., a Zeeland, Mich., automotive supplier, conducted its first layoffs in 34 years this month amid plunging car sales. Declining gambling revenue prompted the Little River Casino in Manistee, Mich., to dismiss 100 of its 950 employees in November, the first layoffs in the resort’s nine-year history.

Waning Stigma

Some workplace experts say such layoffs show that the stigma associated with permanent job cuts — unthinkable to many employers three decades ago — continues to decline. They say companies find it easier to let go of workers when rivals and other employers also are eliminating jobs.

Kevin Hallock, a professor at Cornell University’s School of Industrial and Labor Relations, says as layoffs become more common, managers may find it easier to discount the human and business costs.

“It was a really difficult thing for them the first time,” he says. But “they got over that hump.”

Many of the employers conducting their first layoffs say they first tried other ways to cut costs, such as freezing salaries or drumming up work for idle employees.

This is not the type of post World War II recession the world has been accustomed to.  This recession, caused by a financial crisis, is distinctly unique in its global reach and appears to have no precedence.   To compare what is happening today to the Great Depression of the ’30’s is simplistic at best given today’s infinitely more complex global financial system.  The 30’s depression, as is the case today, was preceded by a booming highly leveraged economy  Beyond that similarity, there is little from the past which can guide us today.

Bernanke, a “student” of the Great Depression is finding out that his textbook solutions do not seem to be working.    The only certainty is that no one can say how long and how crippling the current economic downturn will become.  The speed of the collapse and the destruction of our conventional view of how things should work are causing the greatest harm of all –  the destruction of confidence caused by asset and job losses.

Assets

Loss of confidence works in many ways to confound whatever amount of fiscal stimulus the government undertakes.   Future financial action is predominantly rear view mirror based.   If stocks or housing have been great investments in the past, that view is extrapolated to infinity by most investors.   A rising market has many cheerleaders which reinforces the trend.

Confidence, once shattered by plummeting prices, needs many years to draw investors back into a broken asset class.   Having a job or a stimulus check is not enough to create the confidence to invest if you believe that you may not have a job tomorrow.

Jobs

Even more destructive to confidence is the abrogation of labor agreements once viewed as sacrosanct.

The greatest assault on our economic foundation is not the collapse of the banking system or investment banks on wall street.  The harshest economic reality of today is the realization that our long held belief in upward mobility has come to an end.   No longer can we assume that our children are entitled to earn more than us.   The American dream is becoming a nightmare as highlighted by pay and benefit reductions and job losses.  Job losses become the ultimate negative feedback loop.   Unemployed people do not spend.  Those with jobs are not confident that they will keep their jobs and spend frugally.

The number of companies announcing job cuts has so far been on a par with our last recession.  The number of companies announcing salary and benefits reductions is unprecedented.   Corporate America’s actions foretell a bleak economic assessment going forward.

It will take many years of economic improvement until the shattered confidence of both employees and employers is restored.   The upside of this downturn is that the urge by consumers to take ridiculous leveraged risks with borrowed funds will be curtailed.   Going forward, banks will price risk properly and the financial system will become sound again.   The hard part will be getting there.

Filed Under: Confidence, Economy Tagged With: , ,

The Collapse Of The American Consumer

December 26, 2008 by Leave a Comment

Retail Sales Plummet

2008 is winding up as one of the worst holiday sales seasons on record.   Overall sales for December declined by 4% and selected sales categories showed huge declines.

Luxury goods, once considered immune from economic turmoil, were hardest hit, with sales falling 21.2%, Including jewelry sales, the luxury sector plunged by a whopping 34.5%.

A final burst of spending retailers hoped for last weekend never came. Shopper traffic fell 27% compared with the same time last year,

No retail sector was spared. Among the biggest losers were electronics and appliances, which fell a combined 26.7% versus a 2.7% gain last year. Women’s apparel slid 22.7% compared with a 2.4% drop a year ago.

The season’s dismal results have left stores with mountains of inventory to clear

Luxury retailer Neiman Marcus Group  offered 40% off already reduced merchandise. Two weeks ago, Neiman’s reported its net profit dropped 84% for its fiscal first quarter as affluent shoppers cut way back on discretionary purchases.

Circuit City holiday sales were down 50%, nearly twice what the chain had expected.

The great American spending binge is over, a victim of its own excess.  A plunge in spending on luxury goods reflects the economic reality that no income class is exempt from a collapsing economy.  Electronics, jewelry and apparel are the ultimate discretionary purchase and easily postponed.

The government can encourage us to spend money we don’t have but consumers have to deal with economic reality.   When confronted with job losses and pay cuts, most consumers are wise enough to cut spending and increase savings.

One possible positive spin to what looks like dismal holiday sales is that the discounts offered this year were huge.  If a retailer is offering goods at 50% off compared to last year and retail dollar sales are down 4%, that implies unit volume was roughly the same as last year.  At the right price, the consumer will buy but is being very frugal, and big savings for consumers will mean big losses for retailers.

State Lotteries Show Big Declines

The sour economy is striking the one source of government financing that had been widely regarded as recession-proof: lotteries

Across the U.S., many state lotteries are reporting hefty declines, with ticket sales down nearly 10% in California

The decline in lottery sales “is an unusual phenomenon,” said John W. Kindt, a gambling critic and business professor at the University of Illinois. A big proportion of lottery tickets are bought by people with gambling problems who are likely to play more in bad economic times

In past recessions, players continued to buy tickets, but not this time, said Jack Boehm, director of the Colorado Lottery. “Now they are thinking, ‘My retirement is gone, I might lose my job, I’d better start putting money away’ — that means fewer dollars for lottery tickets.”

But Jose Torres, a disabled forklift driver who lives nearby, said that if anything, the recession has prompted him to spend a little more, maybe $2 a day instead of $1. “We need the money — we’re broke,” he said.

The ridiculous number of state sponsored gambling games reflects the states’ insatiably lust for revenue.   Most studies show that a large proportion of gambling tickets are bought by those with gambling problems and lower income groups looking for that one in a billion chance to get rich.   The lotteries are a tax on those least able to afford it and least able to properly budget their incomes.   My advice to Mr Torres is to stop wasting $730 per year.

Filed Under: Economy, Retail Tagged With: , ,

Signs Of A Bottom In Real Estate

December 18, 2008 by Leave a Comment

The Federal Reserve would like us to believe that lowering rates will reverse the decline in housing values.   They have brought interest rates to virtually zero  providing some payment relief to selected borrowers.  In the long run, however, efforts to prop up the price of housing with rate cuts and loan modifications will merely prolong the slide in values.   If the Fed had the power to prevent a decline in housing prices, they would have done so.  In a free market economy, prices will eventually reflect the reality of matching home ownership with income.   The Fed can lean against the primary trend but it cannot change it.

The lending distortions of the past that created the bubble in housing are now gone.   It is no longer enough to say that you make $150,000 – you need to prove it.   It is no longer possible to get 100% financing with poor credit.  The poor lending decisions of the past are causing pain for both borrowers, banks and the economy at large.  Lower rates alone will not clear the market.

The free market has solutions to over leverage and poor lending decisions.   The solutions are called write offs, bankruptcy and foreclosure.   As painful as these measures are, they are the mechanism for building a financially strong base of homeowners who will be far less likely to default on their mortgages.

During the height of the housing bubble several years back, only 10% of California households qualified for a conventional 30 year fixed rate mortgage.  The bubble prices were nurtured and sustained by exotic lending programs with no income verification.  Fast food workers bought $1,000,000 homes.  Now the bubble has burst.  The positive side is that prices are reverting to levels where real buyers with real income can now buy and have an affordable and sustainable payment.

Evidence of a healthier housing market is also seen in the National Association of Realtors housing affordability index.  This index shows an all time high of housing affordability based on income.  The Case Schiller data on price to income ratios also shows a marked improvement of affordability although it is still 20% over the long term average prior to 2000.  This is all good news which is being masked by the ongoing  housing bust.

Hints that we are finally arriving at fundamental values in housing can already be seen in San Diego.

Forbes reports that intrepid investors are buying houses out of foreclosure and renting them out at a profit – often to neighbors who lost their own homes.

Randy L. Perkins amassed a nice fortune in real estate, life insurance and investment banking in southern California over the past 30 years. Since May he has sunk $5 million of it into the one place most investors least want to be: housing.

Perkins has bought two dozen homes in the San Diego area through his Westview Financial Group. One was a dilapidated three-bedroom stucco in Escondido for which Westview paid $158,000–a 61% discount from the previous selling price of $408,000.

Westview eventually spent $40,000 on acquisition costs and improvements. Then it rented the home for $1,800 a month, netting about $18,000 in annual profit after property taxes, maintenance and insurance. That’s a 9% return on the acquisition cost before income taxes…

Currently one in every 32 San Diego homes, a total of 34,854 units, is in foreclosure. That ranks it as the 21st-most-troubled housing market in the nation.

Now first-time buyers and investors like Westview are offering a glimmer of hope. In September the number of San Diego homes sold rose 56% from a year earlier to 3,366, according to DataQuick. More than half were bought out of foreclosure, indicating that Perkins is far from alone in seeing promise amid the wreckage.

Priced properly anything will sell.  Time and price will accomplish what the Fed cannot.  There are oceans of private money looking for an adequate return on capital.  Let the free markets do their work – and the pain of the housing bust will soon be solved.

Filed Under: Economy, Housing, Interest Rates Tagged With: ,

Deflation Everywhere As Credit Unwinds

December 17, 2008 by Leave a Comment

Motorola Tightens Belt Again – Wall Street Journal

Motorola Inc. announced most employees won’t get raises next year and put a freeze on its U.S. pension plan and matching 401(k) contributions as the struggling cellphone maker continues to cut costs.

The moves are on top of $800 million in cuts announced two months ago that include 3,000 job cuts and suspending breakup plans.

The telecom-equipment-maker said it will permanently freeze its U.S. pension plans, preserving vested benefits accrued by employees and retirees but eliminating future benefit accruals, effective March 1. The company said it intends to continue to provide funding to meet its pension obligations to present and future retirees. The 401(k) match suspension begins Jan. 1.

Messrs. Brown and Jha have agreed to have their 2009 base salary cut 25%. Mr. Brown also will forgo a 2008 cash bonus and Mr. Jha’s bonus will be cut by the amount Mr. Brown is forfeiting. The remainder will be taken in the form of restricted stock units.

We will be seeing many more headlines similar to this as the great credit unwind continues.  The panic moves by the Federal Reserve to lower credit costs and increase lending are at the margin as demand and spending continue to spiral lower.  Lower demand, lower incomes and asset destruction due to defaults are all deflationary.

Pay cuts, job losses and salary freezes are spreading throughout the economy with increasing speed and frequency.   As this self perpetuating cycle of lowered demand continues, lower interests rates may have only a marginally beneficial affect.  Employees receiving pink slips, pay cuts and lowered benefits are not likely to be spending more regardless of the level of interest rates.

The Federal Reserve is doing what it is supposed to do by stabilizing the economy, but they will not be able to change the economic fundamentals of a market economy that is attempting to correct past credit excesses.

Filed Under: Economy, Interest Rates Tagged With: , ,

The Illusion Of Prosperity Ends

December 17, 2008 by 1 Comment

Every day brings more examples of the failed strategy of fostering economic growth through the use of easy credit.  Modern economies need credit to grow and prosper.   Applying credit growth on an exponential basis ultimately fails when borrowers become so leveraged that any hope of repaying their debts becomes impossible.

The Perils of Consumer Debt on Display in South Korea

After the Asian financial crisis hit South Korea a decade ago, the government helped the export-dependent economy recover by pumping out money and convincing people to borrow and spend more.

But this time around, the high household debt that accumulated in the past decade is depressing spending — an experience that has relevance around the world as governments seek ways to get consumers to help lift their economies.

As exports drop and South Korea’s economy slows, a high level of household debt is keeping consumers from spending more and the government — like others elsewhere — is wrestling with the question of how much to intervene.

“Everybody is too much in debt, so they cannot consume,” says Kim Kyeong-won, a senior vice president at Samsung Economic Research Institute.

Consumer debt in Korea expanded 350% over the last decade trailing average yearly economic grow of approximately 5%.

Korea is not just one example of reckless lending; it is a worldwide problem.  Ironically, the amounts of debt and leverage are so unsustainable that to cease lending to the overextended risks a collapse far worse than what we have seen to date.  We have reached the classic debt trap and the Federal Reserve acknowledges as much by extending virtually unlimited credit in every direction.

Bernanke Goes All In (Wall Street Journal)

If the current Fed believes there are limits to monetary policy, you can’t tell from yesterday’s Open Market Committee statement. The 10 members voted unanimously to take its target fed funds rate down to between 0% to 0.25%, from 1%. With Treasury bills already trading at close to zero as the world flees toward safe investments, the practical impact of this rate cut is negligible.

With the velocity of money collapsing as the recession deepens, the Fed is trying to put a floor under the economy by pledging an unlimited supply of dollars. Another goal is to fight the risk of deflation, or falling prices, as long as the economy continues to shrink. And judging from yesterday’s rally in stocks and bonds, many investors like the idea.

Now the Fed is embarking on a further monetary adventure and asking the world to believe that this time it will work. We sincerely hope it does. And if a lack of liquidity is the problem in some credit instruments, the Fed’s direct purchase of those assets should contribute to a credit thaw. It has already contributed to a decline in mortgage rates.

However, the larger economic problem today isn’t an overall lack of liquidity. It is fear and uncertainty. Banks, consumers and business are dug in their foxholes, conserving their cash until they believe the worst has passed. Meanwhile, investors around the world are deleveraging to reduce risk and cut their losses, a process that the Fed can do little about.

It would appear that whatever victory the Fed may achieve will do little to enhance the future financial stability of the consumer or the government.

Filed Under: Bailout, Economy Tagged With: , ,

A World Of Zero Interest Rates

December 11, 2008 by Leave a Comment

We have arrived at 0 interest rates and the reasons we are at this point are all negative indicators for where we are and where we are heading.

Theodore Ake, head of U.S. Treasury trading at Mizuho Securities USA Inc. in New York, one of the 17 primary dealers of U.S. government debt, said some investors bought three-month Treasury bills from his firm with negative yields of 0.01% to 0.02% Tuesday. By the end of active trade, the yield had inched back up to positive 0.02%.

In round numbers, the investors were willing to pay $100, knowing they would get $99.99 in return, in the belief that a small but guaranteed loss was preferable to investing in stocks, corporate bonds or other securities. Treasurys have been flirting with 0% yields since the Lehman Brothers bankruptcy nearly three months ago.

“The bond market is doing a much better job than stocks right now of telling you about the risks that are out there,” said Thomas H. Attenberry, a partner at First Pacific Advisors, an investment-management firm in Los Angeles. The high yield investors are demanding on anything other than Treasurys is particularly worrisome because companies need to refinance more than $800 billion worth of debt next year, according to analyst estimates.

The Telegraph.uk.co notes the extraordinary amount of risk aversion taking place as investors loss their confidence in the ability of anyone other than a central bank to repay their debts.

The investor search for a safe places to store wealth as the financial crisis shakes faith in the system has caused extraordinary moves in global markets over recent days, driving the yield on 3-month US Treasuries below zero and causing a rush for physical holdings of gold.

“It is sheer unmitigated fear: even institutions are looking for mattresses to put their money until the end of the year,” said Marc Ostwald, a bond expert at Insinger de Beaufort.

The rush for the safety of US Treasury debt is playing havoc with America’s $7 trillion “repo” market used to manage liquidity. Fund managers are hoovering up any safe asset they can find because they do not know what the world will look like in January when normal business picks up again. Three-month bills fell to minus 0.01pc on Tuesday, implying that funds are paying the US government for protection.

“You know the US Treasury will give you your money back, but your bank might not be there,” said Paul Ashworth, US economist for Capital Economics.

The gold markets have also been in turmoil. Traders say it has become extremely hard to buy the physical metal in the form of bars or coins. The market has moved into “backwardation” for the first time, meaning that futures contracts are now priced more cheaply than actual bullion prices.

The latest data from the World Gold Council shows that demand for coins, bars, and exchange traded funds (ETFs) doubled in the third quarter to 382 tonnes compared to a year earlier. This matches the entire set of gold auctions by the Bank of England between 1999 and 2002.

Credit markets may have thawed somewhat but after suffering horrendous losses on virtually every asset class, investors seem determined to put whatever cash they have left in the most risk free category possible – even if that means paying for the privilege via negative interest rates.

A desire for a return of capital rather than a return on capital, as the old saying goes, is what we are looking at here.  Of course, at some point, the disgust of receiving a zero return on your money is bound to drive at least a portion of the capital now in treasuries into another asset class.  Investors will be willing to risk some of their capital in another asset class which might be riskier but which also promises some good chance of obtaining a return on capital.

My guess is that one such asset class will be gold, as I previously discussed in  Gold, Cheap at $5000?
I view gold as the ultimate insurance hedge against a government’s propensity to spend itself into insolvency and, accordingly, I believe that gold should constitute 10 to 20% of one’s core investment assets.   Historically, governments  have regularly and repeatedly defaulted on their sovereign debts.  In every such case of default, the citizens of those nations would have been far better off holding gold rather than government paper.

Filed Under: Economy, Gold, Interest Rates Tagged With: ,

What The Fed Is Up Against

December 11, 2008 by Leave a Comment

A chart is worth a thousand written words.

As we behold this chart of debt growth in the US, we need to ask ourselves:

  • Has any trend similar to this in history ever been able to continue indefinitely?
  • This debt is backed to a large degree by asset collateral – will the ongoing destruction of virtually every asset class be the tipping point?
  • To prevent a totally horrific destruction of asset values, does this growth trend in debt need to continue?  The actions of the Fed would imply that a slowdown or reversal of credit growth would be catastrophic to the world economies.
  • Paper money is based on confidence which is becoming thinner by the hour.
  • This chart is probably in the back of the minds of those choosing to receive negative interest rates from the Government on short term paper to avoid credit losses.
  • When debts are so large that they cannot be paid back by the borrowers, then by definition they will not be paid back.

Filed Under: Economy Tagged With: