The Great Disconnect

September 24, 2010

I have been asked recently about my failure to blurt out my observations of life, the economy and the financial markets recently, but frankly, I have been puzzled. No more; often wrong but never in doubt! I will title this issue, The Great Disconnect.

The economy and the fate of most Americans is about to diverge from financial markets. Let's start by examining the economic realities, (as I see them). To plagerize shamelessly from PIMCO, we are entering the new normal, at best: low growth, deflation, deleveraging, high unemployment, falling home prices and mindaltering levels of debt. Many thought that I was insane, several years ago when I said that we were heading the way of Japan. We should be so lucky. Remember that when the shit hit the fan in 1990, Japan had a huge current account surplus,(we have an enormous deficit), personal savings,(the American public is pathetically insolvent), and a strong global economy to support it's export driven economy, (Americans consume and do not produce). The majority of Americans naively assume that the federal government holds the keys to reverse this process, if only we could elect the right guys to implement the correct policies.

As I have stated previously, revisionist history leads to widely accepted misconceptions which leads to failed policies. Americans hold FDR, the New Deal, John Maynard Keynes in high regard for ending the Great Depression. For the most part, these policies were abject failures and we owe our recovery to the policies of Adolph Hitler. Nonethless, the Keynsians reign in DC,(as opposed to Europe where they have run out of money), and we await with baited breath, our next stimulus and more quantitative easing. Heaven forbid that markets be allowed to function, to clear the debris of bad debt and overvalued assets.

Americans, a profoundly illiterate group, know nothing of the Great Depression, let alone the economic history of the nineteenth century. We had economic calamities in the 1820's, 1830's 1870's 1890's and early 1900's. Why don't most people know of these events? Because they were relatively short. Why were they short? Because the government did not interfere in the economy. An interesting historical tidbit: Martin VanBuren lost the 1840 election because he refused to intevene in the downturn of the 1830's. Shortly after his loss, the economy returned to vigor. We operated under the principles of Australian economics in the nineteenth century, experienced several viscious short term economic downturns, but were able to create in aggregate, enormous economic growth, employment and a general increase the standard of living for the citizens of the country.

Many of our ancestors, including my grandfather immigrated to the US because it was a global source of jobs. These ramblings are irrelevant; our politicians,(don't doubt that Bernanke is a politician) don't subscribe to free markets and will intervene. Additional stimulus is uncertain given the Nov. elections rendering the Fed more central to the government's push to reinvigorate our economy. The consensus is that they will purchase another trillion bucks worth of Treasuries come November. What effect will this risky strategy accomplish? Sure didn't work in Japan. Conceptually, forcing interest rates down another 25 basis points will allow those who qualify to refinance, improving their monthly cash flow. Theorectically, the cost of capital will decrease for business. The reality is that printing $ will decrease the purchasing power of the $. Will that alleviate our deflationary concerns? Probably not. There will be no wage increases in the face of a glut of labor. The prices of consumer goods will continue to decline given the oversupply of productive capacity. Housing will continue to decline in value,(rental rates, under pressure, make up 1/3 of core CPI.)

What will go up in price as the $ falls? Stuff. Gold, silver, but more importantly, oil, gasoline,copper, iron ore, wheat, soybeans, etc. In short, with high unemployment, stagnant wage growth, the cost of survival, ie. the cost of food and energy, will rise. Conveniently the Fed doesn't include food and oil in their calculations of core CPI. Americans are going to get poorer. Interestingly, the financial markets will do well. If I am completely wrong, the economy takes off, the Fed doesn't intervene, the equity markets will do well.

If I am correct, all financial markets will prosper. The Greenspan put has been replaced by the Bernanke put. Hence the title, the Great Disconect; financial markets will do fine while the American public will suffer.

-Guga