Dec 07 2013

America’s fiscal situation, how to change it and how to protect yourself


Reform Party of California Commentary

When it came to dealing with the financial crisis of 2007-2008, there was bipartisan legislation and significant federal action in response. The responses included the Troubled Asset Relief Program, the Dodd-Frank reform law and some bailouts, e.g., GM, AIG and Fannie Mae. Although initially feared to be very high, the cost to taxpayers will be relatively low, about 1% of GDP. For comparison, the cost of the savings and loan crisis of the 1980s was about 3.2% of GDP. Federal action in response to the crisis also includes reduction of interest rates to near zero and quantitative easing (QE), which is the ongoing purchase by the U.S. Federal Reserve of about $85 billion per month ($1 trillion/year) of U.S. treasuries. In essence, the Fed prints money and uses it to buy federal debt. That adds the money to the U.S. economy, which stimulates economic activity.

The stock market has recovered and many corporations are doing relatively well. Despite that good news, it is obvious that the recovery for the middle and lower classes has not gone well. Recovery has come so slowly that it is fair to think that there is something fundamentally different compared to other recent recoveries. The middle and lower classes in the U.S. appear to be under sustained economic stress with a true recovery nowhere in sight. Growth of jobs has been very slow and wage growth has been nil for most Americans. And, there is another cost. Savers receive no or negative return for savings and in essence that amounts to about a 100% tax on income from savings.[1] That tax or real world consequence is real, not illusory, is what largely allows the Fed to continue to keep interest rates low and buy the debt needed to maintain the deficit spending status quo.

America’s fiscal situation is unprecedented and the ultimate cost of sustained low interest rates and QE, if any, cannot be assessed. From a non-ideological, common sense point of view, there appear to be two possible long term outcomes: Pretty good and really bad. The good outcome could occur if the Federal Reserve can slowly reduce quantitative easing, get annual inflation up to about 3%-4% and slowly inflate the value of America’s federal debt to a manageable dollar value. Annual inflation of 3% will cause prices to double every 24 years, so the process of getting a handle on debt[2] this way will take a generation or two. That would require real discipline by congress to restrain itself from its powerful urge to increase deficit spending. The good outcome would also require decades of investor confidence in U.S. debt and at reasonable growth in the U.S. economy.

Given the long-term stability and political discipline needed for that scenario to play out, it is unlikely that things will go smoothly.

The bad outcome is that investors lose confidence in U.S. debt, interest rates on U.S. treasuries go up and America goes into another fiscal crisis and probably a long, nasty depression. Loss of investor confidence could come after some triggering event, e.g., another endless war or recognition that congress is not serious or incapable of dealing with the debt and/or governance in general. Interest rate increases could occur after a change in circumstances that make treasuries less attractive, e.g., because interest rates are too low compared to other investment opportunities. If the bad scenario comes to pass, real social unrest could occur as people’s lives are destroyed because social spending will need to be diverted to debt service.[3] Our social safety nets could very well be sacrificed to service the debt.

How to get out

A controlled inflation out of the debt load seems to be the best, least painful option. That is how the Reform Party of California (RPCA) sees the situation we are in and our options for getting out.[4] America has been able to pull this off so far because the dollar is the world’s reserve currency and the Fed can simply print as much money as it wishes for as long as it wants to maintain economic stimulus.[5] It is also the case that U.S. debt (treasuries) are still considered the safest investment by many investors. That says more than a little about how investment opportunities, including debt of other countries, is generally seen. At the very least, things feel unstable and unsustainable.

There is no way to know how this will play out. We could come out with relatively limited pain or we could face real widespread hardship and possibly social unrest and violence. If things go well, the Fed and federal government will have pulled off an amazing feat. In that case, the two-party system will have, for a change, done well in fixing a serious problem.[6] In that scenario, going about business as usual might be the best option. If things do not go well, circumstances for average Americans could become harsh. Because no one knows how this will play out, we may have already passed a tipping point with bad times being triggered by an unforeseeable future event that leads to loss of investor confidence.

How to protect yourself

After careful consideration, there are a few things average people could do to reduce, but not completely eliminate, the pain if the economy does blow up again. The first is to invest in a home, if possible. The second is to invest in dividend-bearing stocks of large international companies that have strong balance sheets, i.e., relatively low debt. The third is to judiciously invest in gold.[7] Although gold prices can be volatile and irrational, over the millenia, the cost to buy and sell gold tends to follow the cost of gold production. Thus, some investors pay a lot of attention to how much it costs to produce gold, which is a very complicated endeavor. Buying gold at or near its production cost might be prudent if you believe that things are more probably going to head south sometime in the future.

If the economy turns sour all three investments should be helpful over time. If the government pulls things off without the economy tanking, the first and second investments (a home and big company stocks) should still be useful, while gold will likely not help any or could result in a loss. In the short run, gold can act as insurance against bad times. It generally has less value when the economy is good and more value when things are bad, even if that general trend is irrational or disconnected from gold production costs.

Regardless of how bad things might get, people always need a place to live. Over time, the value of a home in a “solid” location will usually mostly or completely recover.[8] Big company stocks should do relatively well in bad times because their products and services are still needed, regardless of how bad things get. That doesn’t mean that big company stocks won’t take a hit because they will. Despite the hit, it is reasonable to believe that a big multinational corporation will recover faster than smaller, debt-laden companies who might not survive at all.

Those are the best suggestions the RPCA has for trying to prepare for bad economic times, assuming they come at all. That also assumes that people are economically well-off enough to invest. Tens of millions of middle and lower class Americans aren’t in a position to invest of much of anything at present, which speaks volumes about weakness of the U.S. economy. The economic stress on average people is intense and it has been going on for years. With any luck the government and Fed will be able to get us out of the debt mess without a major economic setback or two along the way. If things turn out well, the investments mentioned about should be positive or neutral, unless there is too much investment in gold. It would be nice if there were guarantees, but there aren’t.


1. The RPCA presumes that essentially no one in government will see that a reduction in interest rates to ~0% amounts to a 100% tax on savings interest because saving money earns almost nothing. Value is lost at a rate that is somewhat less than the rate of inflation. Low interest rates allow banks to make consumer and commercial loans at low rates while still making money. Regardless of whether savings subsidize some or much of the load for our current monetary policy, savings nonetheless are essentially worthless at present. When people do not save and then retire, they live in poverty. That unhappy but undeniable trend is happening now. It is reasonable to argue that, directly or not, economic stimulus from low interest rates imposes real, current costs on real people. One way or another, the debt will need to be repaid and right now, savers are paying a high price.

2. Federal debt includes the admitted $17 trillion and the approximately $80 trillion that the two-party system pretends isn’t owed because it isn’t due now, can be altered by congress or is otherwise too nebulous to be taken seriously. Publicly traded  companies have to account for their future debt obligations but the federal government refuses to do that mainly because it looks so bad and partly because there is real uncertainty in what the liabilities will amount to over what period of time. The private sector has to put their liability and the uncertainty on their books while the federal government simply ignores it.

3. Destruction of people’s lives might be mostly avoidable if America defaults or in some other way makes its debt holders take a loss on their investment, i.e., they get a “haircut”. Giving investors a haircut would lead to unforeseeable long-term consequences, which would be in a range from very bad to mildly bad. At present, no one advocates stiffing investors and thus Americans are likely to take the brunt of the hit.

4. This assessment will be revisited when or if circumstances arise that would force a reconsideration. America’s economic situation is fluid and is entwined with the global economy. On one cannot predict with certainty where we are going. Libertarians and Tea Party folks generally seem to want to pull the plug of deficit spending soon or overnight. The RPCA understands that that option could very well have been the best thing to do and that we should have never bailed anyone out of anything after the 2008 financial crisis. The problem with that is that there is no way to know how going cold turkey would have played out. There could have been be real social unrest with blood in the streets from that option. The RPCA simply looks at the situation we are in now and is trying to find the least painful way out with the least harm to the public interest, including the U.S. economy. That way out may take decades but it appears to be the best solution for the public interest and therefore that is what the RPCA advocates.

5. The Fed has real power and real options. It can continue buying U.S. treasuries at any rate it wants. The money it pays to the U.S. treasury to buy bonds goes into the economy as an increase in the money supply. When the bonds mature the Fed can simply redeem them, which reduces the money supply and reduces the stimulus effect of that monetary policy. If the Fed tapers or completely stops QE, the U.S. Treasury will still sell bonds and that will draw money from the economy by decreasing the money supply. Despite the trillions that the Fed has pumped into the U.S. economy via QE, the effect has not been inflationary so far. It appears that stimulating inflation will require (i) a wage shock such as an increase in the minimum wage to $10-$15/hour or maybe more and/or (ii) importing inflation via lowering the value of the dollar. Wage stagnation and high unemployment appear to have limited money velocity and inflation until now. The obvious concern is that if inflation does take off, it could spiral out of control, which would drive up the price of servicing the debt and that would crash the U.S. economy. There are lots of ways that things could go wrong.

6. The two-party system bears much responsibility for getting us into our fiscal situation and debt in the first place, but that is a different topic.

7. That recommendation is made with trepidation and a full awareness of the scams, con artists and odd survivalists that seem to flock to gold and give it a bad name. Nonetheless, over human history, and as irrational as it is, humans always value gold, more so when times are bad. The rational part is that the value tends to track the cost of production. Today, the cost of production is pegged to the dollar. Gold needs to be looked at over long time periods like centuries or millenia, not over the short haul. Both rational and irrational fluctuations in the price arise from human activity and laws, e.g., reduced production costs can decrease the price and new uses in industry can increase the price. Part of the danger with gold is that people (ideologues, tyrants, etc.) will inject irrationality into something that does not need to be irrational. That is unpredictable.

8. Some home locations may not recover in a lifetime. Detroit is an example. Home price in some rural locations can remain flat if the local economy is weak and the population, i.e., housing demand, is low. By and large, home values in most urban areas, especially along the east and west coasts, seem to be relatively safe, especially where population increases tend to prop up demand and home prices. And, buying more than one can afford makes no sense.