Debt and Money

A lot has transpired since I wrote Train Wreck Ahead back in April, and now the whole world is wise to what a disaster the U.S. debt problem is. Republicans and Democrats alike are sticking to their partisan guns so far and refusing to act for the greater good. None of this is news to anyone not living in a cave the last few weeks. Neither is the likelihood that, at the very last minute, they’ll probably find a way to compromise and avoid the debacle of defaulting on the nation’s debt come August 2^nd.

What form such a compromise will take is easy enough to guess. Most likely, there will be major cuts to discretionary government spending, some historic reductions in Social Security, Medicare, and other entitlement programs, and some new taxes. My brother-in-law just told me about a proposed tax of 1% on every bank transaction we make; is that for real? Real or not and whatever the eventual mix of spending cuts vs. tax increases, the bottom line is that the struggling U.S. economy will take a pretty big hit. Virtually any conceivable deficit deal will be a big negative for the economy, at least in the short run. In economics-speak, reduced government spending and higher taxes are called contractionary fiscal policy, which normally lowers the country’s GDP while increasing unemployment – at least in the short-run. This is a very troubling prospect, given the economy's fragile status these days.

But the hope is that, even with the negative short-run impact of such a policy, it will send the message that the U.S. is serious about getting its financial house in order. If that message is believed, then foreigners, businesses, and consumers will all breathe a bit easier and (we’re all hoping) be more willing to invest and spend in the U.S. That, in the long-run, will finally pull the country out of the current “growth recession” and confirm its position as the world’s premiere economy and best credit rating. That’s the plan, anyway.

The big risk, however, is that implementing contractionary fiscal policy at this point could send the nation into an economic tailspin, long-term hopes notwithstanding. Politicians simply cannot allow this, as it would result in most of them getting voted out of office in response to the soaring unemployment and another housing market crash that would ensue. Additionally, a swooning economy would make the country’s deficit and debt problems that much worse, undoing all the good accomplished by whatever deficit deal they’re able to come up with now.

But the Federal Reserve will not allow such a scenario; Fed Chairman Ben Bernanke has made it clear many times over the years that he’ll do whatever it takes to keep the economy afloat. So it is very clear that there’s only one solution to this apparent dilemma: the Fed will balance this contractionary fiscal policy with its own expansionary monetary policy. In other words, while Congress and the President are stepping on the fiscal brakes, the Fed will be stomping on the monetary gas pedal. In plain English, that means the Fed will be sending hundreds of billions of dollars out into the country and keeping interest rates near zero, hoping that all that cheap money will keep people buying and, therefore, keep Americans working. If everything works just right, then the debt and deficit are handled (somewhat), without the economy careening back into a serious recession. Winning!

That’s if everything works just right. Misjudgments, unexpected market reactions, unwelcome world events, or just plain bad luck could easily muck thing up, however. How? Well, maybe all the dollars the Fed pumps out aren’t enough to keep the economy chugging along. Or maybe all the dollars end up causing high inflation. Maybe China’s economy implodes, as some worry. Or maybe another of a dozen possible things goes wrong. Of course, we can hardly rule out the possibility that Congress doesn’t come up with an debt agreement in time, and the nation defaults on its debt. But the most likely problem is similar to what I laid out back in April.

Backed into a corner and forced to pump hundreds of billions of additional dollars, the U.S risks people losing faith in its currency. The more money out there, the less each unit of money is worth. Here’s a very over-simplified example to explain: Suppose a country has 100 loaves of bread and nothing else. And that country has $100 in money supply. Loaves of bread will sell for $1 each ($100 divided by 100 loaves).

Now suppose the money supply increases to $200, but there’s still only 100 loaves of bread. People have extra money; they’ll want to buy more with it. But there is no more. So they’re willing to pay more for the limited amount of bread and before you know it, bread will cost $2 a loaf. One dollar, which used to be equal to a loaf of bread, is now only worth half a loaf. The dollar is worth less simply because there are more of them.

And that means, getting back to the real world with the Fed pumping out God-only-knows how many more dollars to keep the economy afloat, that U.S. dollars will probably be worth less. This will probably make people (especially foreigners) less willing to hold them and – well, look back to what I wrote about that in April.

True - it doesn’t have to end up this way. Perhaps the Fed's increase of cash is nicely balanced by reduced demand from government and consumers, and the actual supply of dollars out there doesn’t change much. Or perhaps, even with the dollar losing its value it is still seen as the least horrible option, considering the problems with Europe’s economy and currency, and uncertainties elsewhere in the world. Neither the stock market nor the bond market seem worried about a default or a declining U.S. dollar, after all, as both are close to multi-year highs. Stock and especially bond investors are known for seeing trouble coming long before it materializes, so if they’re not worried, maybe we shouldn’t be either?

Fine; fair enough. But I’d rather be safe than sorry. And even as the stock and bond markets signal that all’s well, have you noticed that gold, silver, and the Swiss franc have resumed their relentless moves higher? Remember that in April I suggested investors the world over would be buying those more and more as our financial “train wreck” gradually unfolded. After a sharp drop in price (predicted back in April), silver is now marching higher again. Meanwhile, gold and the Swiss franc have been persistently making new all-time highs. That’s “safe haven” buying; neither gold, silver, nor Swiss francs pay interest or dividends, unlike stocks and bonds. Investors around the world are buying them simply out of concern for the eroding value of dollars and euros; they see gold, silver, and Swiss francs as among the very few safe options available anymore.

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Let’s bottom-line things here now, combining ideas and themes from several of my recent blogs. The U.S. is in a terrible financial mess and will not be getting out of it anytime soon. Our standard of living for the last few decades, which actually meant living way beyond our means, is about to change dramatically. To everyone who was used to “having it all” the last 20 or 30 years and who is downright outraged at how that life is being “taken” from them now – wake up! We, as a nation, didn’t deserve – hadn’t earned – all our material prosperity, and now are simply being presented with the bill. March in the streets, complain bitterly about our traitorous politicians, hold your breath ‘til you turn blue – but none of that will change this reality.

Maybe the debt will finally be dealt with intelligently; maybe the U.S. dollar won’t continue its inexorable decline with all that implies for the nation and for us. Maybe the stock and bond markets have got it right, and you still don’t have to figure out how to invest in gold, silver, and the Swiss franc.

Or maybe not.

JSS

July 25, 2011