June 3, 2009

Economic Characteristics of Third World Economies

Posted in Uncategorized at 6:22 PM by Robert Barone

How the U.S. Stacks Up

Four economic characteristics of third world economies are discussed in conjunction with what is occurring today in America.  These characteristics are: Debt, Nationalization of Vital Industries; Taxation; and Inflation.

Debt

Third world government can’t seem to raise enough revenue, so they borrow money, at least at first.  When they run out of borrowing capacity they print money.  Today, Zimbabwe’s estimated rate of inflation is 231 million percent (231,000,000%) per year.  It costs more for the paper and ink than the currency is worth.

According to CNBC, U.S. debt is 95% of its GDP.  The debt is more than $11.3 trillion ($11,300,000,000,000 or $11.3*1012), is growing at a rate of $3.82 billion per day ($3,820,000,000 or $3.8*109).  Each American comes into the world already in debt by about $37,000.  The federal budget calls for a $1.84 trillion deficit and then deficits in excess of $1 trillion throughout the next decade, for an estimated addition of $8.9 trillion.  This doesn’t include the cost of whatever the national health care plan will entail.  The national debt, which took 200 years to build to where it is, will double in less than a decade.

Anyone critically analyzing the current situation would conclude that the U.S. economy is suffering from too much debt.  For years, Americans lived well beyond their means, importing goods from around the world, especially China, and paying for those goods with IOUs.  They lived in an asset bubble from the mid-90s to 2006.  Prices of commodities like oil, cement, steel etc. rose rapidly.  Worst of all, the prices of homes rose and the American consumer used his home like an ATM machine, buying all sorts of luxury goods and spending as if the ATM would never run out of cash.

Now that the assets have deflated leaving many with debt on their homes that is higher than the market value, those homes, which we used to call assets, have now become liabilities.

American businesses with high levels of debt are struggling to make interest payments as their revenues have fallen.

Since it was debt that got the economy into its current state, how in the world will policies that encourage more debt get it out?  The mantra from Washington D.C. is that “credit is the lifeblood of the economy”, and they are urging banks to lend anew.  But if Americans are overleveraged, how will more bank lending help?  And how will the budget deficits be repaid by a population without the capacity to do so?

With already too much debt, the U.S. is on a path that has called into question the credit worthiness of the dollar.  A weaker dollar translates directly into rising prices (inflation) leading directly to rising interest rates, rising at precisely the wrong time as the economy is weak and weakening.

Nationalization of Vital Industries

The second characteristic of third world economies is government control of strategic and vital industries.  In addition, within those industries, the government chooses the winners and the losers.  In our own hemisphere, in Venezuela, Hugo Chavez started his nationalization process with the oil industry.  Now he controls nearly everything.  What about all of the prosperity nationalization has caused in Cuba?  During the Peron era in Argentina, the banks were the first to be nationalized.  So, I suppose you can say America is following the Argentina model.

Last winter, Paulson and Bernanke threatened Ken Lewis of Bank of America, literally forcing him to absorb Merrill Lynch.  TARP money was forced on institutions that didn’t want it.  And when they ask to pay it back, the government says “not so fast”.

Meanwhile, the government has restricted compensation at TARP institutions and is now talking about restrictions on compensation at all financial institutions (whether TARP or not) through the regulatory process.

In September, we were told that the billions of taxpayer dollars that went to Chrysler and GM would save the companies from bankruptcy.  But, both are now bankrupt.  Why did the American taxpayer have to throw taxpayer dollars at them (current estimate: $70 billion)?  Answer: so the government could get control.

Once in control, the government removed wealth from the bondholders of Chrysler to the benefit of the UAW.  Some think these actions were illegal and unconstitutional.  Here is the way they did it: 1) the taxpayer bailout last September gave the government say; 2) the four large TARP banks who held the bonds dared not oppose the government’s plan, so they pulled out of the lawsuit that challenged the government actions (as an aside, Obama justified this as giving back the company to its “rightful owners”.  In my youth, I read that phrase in the book, Das Kapital by Karl Marx); 3) the remaining small secured debt holders couldn’t possibly stand up to government threats, (everything from IRS harassment to DOJ lawsuits) and the unlimited resources of the federal government.  Thomas Lauria, attorney for the secured creditors stated that the bondholders retreated in the face of “the enormous pressure and machinery of the U.S. Government”.

Now that the UAW owns 55% of Chrysler, how will Management be able to stand up to the unions when contract negotiations come around?   Forecast for the auto industry in the U.S.: 1) the government will tell Chrysler and GM what to build, sort of like it was done in the Soviet Union in the 1960s, 70s and 80s – an example of this – on May 19, Obama announced new mileage per gallon requirements by 2016; 2) because it isn’t market based, most people won’t want what they build – so they will purchase what the independents build (Toyota, Honda, Hyundai, etc.) until the Congress taxes these products out of existence; 3) Chrysler and GM will continue to lose money and will be subsidized by the taxpayer.  Meanwhile, Ford, who made some correct moves early in this decade and appears to be able to survive, won’t be able to compete with a subsidized GM and Chrysler, but will have to pay something near the UAW wage and benefit package negotiated between UAW controlled Chrysler and the UAW.  Ford won’t be able to survive under these conditions.  What we now have is a system that rewards the failures (Chrysler and GM) and penalizes the successful (Ford).

Other examples of the government choosing the winners and losers: Lehman Brothers and Bear Stearns are gone, but Goldman Sachs, who should also be gone, somehow survived.  For Goldman to survive, it took $10 billion in TARP funds directly plus about $180 billion to AIG.  Goldman had a huge amount of Credit Default Swaps (CDSs) with AIG as the counterparty.  Hank Paulson used to be Chairman of Goldman.  The credit default swaps were paid 100 cents on the dollar by AIG with taxpayer funds.  These circumstances leave the impression that the whole AIG bailout was to save Goldman.  Nevertheless, this is an illustration as to how the government picks the winners and the losers in the industries that they nationalize.  Doesn’t this feel third world?

Taxation

The third characteristic of third world economies is the insatiable appetite for taxation.  The U.S. is already among the most oppressive nations in the world when it comes to taxes.  The U.S. taxes its citizens on all of their income whether or not it was earned in the U.S.  Almost no other country does this.

It was amusing in early May when Geithner characterized the legal loopholes that allow sheltering of foreign earned income from taxation as “illegal” and later, when Obama characterized them as “un-American”, as if paying unnecessary taxes is a patriotic duty.

This appears to be a step in a planned process.  The percent of GDP controlled by the federal government has typically been 15-20%, that is, the G in the C+I+G=GDP equation has been in this 15-20% historical average since World War II.  But with the proposed spending and fiscal budget deficts, the government share of GDP will rise to the 35-40% range.  On May 14, President Obama, himself, acknowledged that deficits of the trillion dollar level are unsustainable.  There are only two things that can be done: 1) spend less to balance the budget, or 2) higher taxes.  The first alternative isn’t on the table.

Since Americans that pay the majority of taxes already pay in excess of 50% of their income in taxes of one sort or another, it will be impossible to collect what they need from significantly higher “income” taxation.  So, the Obama Administration is now considering a European style VAT (Value Added Tax), sort of like a National Sales Tax.  This appears to be in addition to, rather than in place of, the current income tax regime.  (The other alternative appears to be an asset tax.)  The appetite for taxation from Washington D.C. has always been an issue – now it is a major threat to economic health.

Look at California.  That economy has the potential to be the most prosperous in the world.  Yet, today, the state is insolvent.  It is so obvious that their inability to control spending and their propensity to impose ever higher and higher levels of taxation is the problem.  But they refuse to recognize that their model is broken.  Think about the calamity that will occur in state finances if the federal government imposes a significant VAT or National Sales Tax!

Observers have noted the high correlation between the magnitude of state budget deficits, their tax rates, and their unemployment levels.

Inflation

The fourth characteristic of third world economies is inflation.  Zimbabwe was mentioned earlier.  213 million percent inflation.   There are many examples of hyperinflation in economic history, all resulting from the same malady – the government runs the monetary printing presses.

There currently is little inflation in the U.S.  In fact, deflation is still around, especially when you look at home prices and retail sales.  But Helicopter Ben Bernanke, so named because he said in 2002 that the only way to cure deflation was to throw money out of helicopters, has done the equivalent by quadrupling the monetary base.  The chart of the monetary base is absolutely breathtaking.  A line with a slightly upward slope for 90 years from 1918 to 2008 suddenly goes vertical.  In 9 months, the monetary base has grown 400%!  Inflation is coming:  1) In the midst of one of the biggest deflations in history, the price of gold is rising.  Investors are expecting inflation.  2) Bernanke says “the Fed is working on an exit strategy”.  That means that there currently isn’t one, nor was there one when he initiated the program.  Interest rates are at historic lows and the economy continues to falter.  Unemployment is high and rising.  If inflation begins to appear and the Fed has to begin selling assets in its portfolio, they will be removing liquidity from the markets causing interest rates to rise. Higher rates slow the economy.  It simply won’t be politically acceptable to raise rates when unemployment is high.  To keep rates down, they will have to print more money; inflation will result.  3) The deficit is another reason to fear inflation.  The Fed has embarked on a program they call “quantitative easing”, fancy words that mean printing money to purchase the debt that can’t be sold in the market without interest rates rising significantly.  On May 6th, the Treasury had to pay up 30 basis points to place one of their issues.  This is unprecedented.  Normally, Treasury auctions occur within 1 or 2 basis points of the prevailing yield in the secondary market.  This is a sign.  The Treasury has barely begun to issue the debt that the 2010 budget will generate, with some estimating the weekly auctions to average as much as $100 billion.  To prevent rates from rising, the Fed will have to print the money to buy the debt to keep the rates from going up.

Already, China and the Middle Eastern oil producers are talking about a “basket” of currencies as the world’s reserve currency in place of the U.S. dollar. China has begun purchasing oil, copper and other vital commodities with their excess dollar holdings, reasoning that the prices of those commodities will hold their value better than the dollar will.  Beginning the week of May 18th, the equity markets became very worried about interest rates, inflation, and the credit rating of the dollar.

During Giethner’s visit to China, there were chuckles from the Chinese when Geithner spoke of fiscal restraint!

What to Do

Most of this can only be solved at the ballot box, which is another worry.  When more than 50% of the voters don’t pay taxes and politicians promise them that they will take from the rich and give it to them, it is too late.  We are awfully close to this today in the U.S.  However, you can still strengthen your portfolios against these forces.  1) Lower your exposure to equities, say to no more than 40% of your portfolio or less if you are at or near retirement.  Your equities should have the following characteristics: a) positive cash flows; b) low or no debt – credit markets are unreliable and as rates rise, interest becomes a bigger and bigger burden; c) avoid companies with large unfunded pension liabilities; d) choose companies with substantial dividends that are unlikely to be cut and avoid companies considered “too big to fail”.  2) Follow China’s example and make sure you have gold and strategic commodities in your portfolio. Since Americans deal in dollars, such strategies will be a hedge. 3) Fixed income should be a bigger part of your portfolio than in the past.  However you have to be aware of the two significant risks in fixed income.  The first risk is the one that is apparent – credit risk.  The failures of the rating agencies have made analyzing risk more difficult – so an investor has to do his/her own homework on credit. The second risk in fixed income is called interest rate risk.  It is more subtle.  When interest rates rise, a long term bond gets hammered.  There is a notion called “duration”, basically related to time to maturity.  If the duration is 15 years, and interest rates rise 1 percentage point, the value of the bond will decline by 15%.  Thus, the shorter the duration or maturity, the lower the risk to rising interest rates.

Today, the first order of business in your portfolio is the return of principal, not the return on principal.   Since interest rates are at historic lows with nowhere to go but up, and since inflation may be on the horizon, you will want to keep the duration of the fixed income portion or your portfolio quite short – say no more than 3 years.  Do this even if it means taking a much lower current yield.  In a couple of years, you’ll be glad you did.

Robert Barone, Ph.D.

June 3, 2009

This presentation has been compiled from sources and data provided to Ancora West Advisors LLC that is believed to be accurate and credible.  Ancora West Advisors makes no guarantee to the complete accuracy of this information.  The mention of companies, market sectors and investment strategies in this article should not be considered as an offer to sell or a solicitation to purchase any securities of the companies or securities of the companies in the market sectors mentioned or to implement investment strategies.  Please consult an Ancora West Advisors Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Ancora West Advisors LLC is a Registered Investment Adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

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