December 27, 2013
Part II: The Long-Term Outlook – Even a Strong Economy Doesn’t Change the Ultimate Outcome
If you’ve read Part I of this year end outlook, you know that it is our view that the underlying private sector is healthy and, except for the fact that the real rate of inflation is much faster than the ‘official’ rate, we could well have a short period of prosperity.
Unfortunately, our long-term outlook is not as sanguine as our short-term view. The eventual recognition of the inflation issue, the dollar’s role as the world’s reserve currency, the bloated Fed balance sheet and the resulting excess bank reserves, and the freight train of unfunded liabilities and its impact on the debt and deficit are issues that have large negative long-term consequences. Remember, the long-term unfolds slowly, and we don’t expect that we will wake up one day to find that all has changed. Still, the changes discussed below could very well take place over the next decade, and investors need to be prepared.
The Dollar as the Reserve Currency
The dollar is currently the world’s reserve currency. Most world trade takes place in dollars, even if no American entity is involved. Because world trade has rapidly expanded over the past 20 years, more dollars have been needed than those required for the U.S. economy alone. As a result, the U.S. has been able to run large deficits without any apparent significant impact on the dollar’s value relative to other major currencies. Any other country that runs a large deficit relative to their GDP suffers significant currency devaluation. Current policy in Japan is a prime example. A weakening dollar has implications for the prices of hard assets.
In addition, the Fed’s policy of Quantitative Easing (essentially money printing) has disrupted emerging market economies. Zero rates and money creation caused hedge fund managers to leverage at low rates and move large volumes of money offshore to emerging nations where interest rates were higher. The initial fear of “taper” in May and June caused huge and sudden capital outflows from those countries resulting in massive economic dislocation in those markets. In India, for example, the Rupee was pummeled as the hedge fund investors, fearing that interest rates were about to suddenly rise, all tried to unwind their Rupee investments at the same time. And now that ‘taper’ has officially started and longer-term rates are expected to rise, these issues will continue. Those countries have all taken defensive measures. India, for example, imposed taxes on gold imports, which has impacted the gold markets but has reduced India’s balance of payments deficit.
As a result of such tone deafness on the part of the Fed, and because there now appears to be enough dollars in the world for the current level of trade, the international appetite for U.S. dollars is clearly on the wane. Japan and China, the two largest holders of Treasury debt, have recently reduced purchases. Most emerging market nations and large players like Russia and China have vocally called for an alternative to the dollar as the world’s reserve currency. This movement is alive and well.
The Fed’s Balance Sheet
As the economy expands, the size of the Fed’s balance sheet and the level of excess bank reserves will become a problem. There are $2.3 trillion of bank reserves in excess of what are ‘required’ under the law and regulations. (Required reserves for the U.S. banking system are $.067 trillion; so, the system has 34x more reserves than it needs.) Under ‘normal’ conditions, and the way the system was designed to work, if the economy got too hot, the Fed could sell a small amount of securities out of its portfolio which would reduce bank reserves to the point where banks would have to ‘borrow’ from the Fed. Because bankers are hesitant to do that, and because the Fed could raise the ‘discount’ rate, the rate charged for the borrowings, the Fed could control new lending and thus the economic expansion. This isn’t possible today as the Fed would have to sell $2.2 trillion to cause banks to have to borrow. Such a volume of sales would likely cause a crisis in the financial system, or even collapse. Today, the only way the Fed has to stop the banks from lending is to pay them not to lend – this is exactly the opposite of the intent of the original legislation and the opposite of how the Fed has worked for most of its 100 year history.
Furthermore, given the growing lack of confidence in the dollar as the world’s reserve currency, if fiscal budget deficits grow in the future, the Fed may end up as the major lender (i.e., lender of last resort) for the U.S. Treasury. That simply means more money creation.
The U.S. Treasury officially recognizes $85 trillion as the amount of unfunded liabilities of the Federal Government. Other professionals set this number near $120 trillion. For comparison, the annual U.S. GDP is about $16 trillion. The budget deficit reported in the media is a cash flow deficit (tax collections minus expenditures). The budget deficit doesn’t include promises made for future payments (Medicare, Medicaid, Social Security, government pensions) which have been running between $4 and $5 trillion annually for the past few years. These amounts simply get added to the ‘unfunded’ liability number.
As the population ages, these payments will have to be made, and the budget may become overwhelmed. (You see the relevance of the remark made above about the Fed being the lender of last resort for the Treasury.) This is the heart of the debate about ‘entitlements’ that has been front and center for the past decade.
Solutions (none of which you will like)
Philipp Bagus is a fellow at the Ludwig von Mises Institute in Europe. He is well known in Europe for his work on financial issues there. In a recent paper, Bagus says that there are several possible ways out of the current money printing predicament. Any one or a combination is possible. We have put them in an order of most likely to least likely to be used:
- Inflation – this is the natural outcome of printing money;
- Financial Repression – this is current Fed policy; savers and retirees bear a disproportionately large burden as inflation eats at their principle but there is no safe way to earn a positive real rate of return;
- Pay Off Debt – this means much higher levels of taxation, and is definitely a real possibility. In Europe, the International Monetary Fund (IMF) has proposed a one-time 10% wealth tax. As the unfunded liabilities push up the federal deficit, expect such proposals in the U.S.;
- Bail-In – In ’08-’09 we saw ‘bail-outs’ where the government saved GM, Chrysler, AIG and the Too Big to Fail banks by buying stock or otherwise recapitalizing them. A ‘bail-in’ refers to the financial system. Banks and other depositories have liabilities called deposits. The depositors do not consider themselves ‘lenders.’ But, in a ‘bail-in,’ it is the depositors who lose. Their deposits are ‘converted’ to equity in the bank. When they try to sell their bank shares, they find that it will fetch only a fraction of the value of their deposits. A variant of this is what happened in Cyprus in the spring of 2013. Because of the distaste the public now has for ‘bail-outs,’ if there is another financial crisis, this is likely to be the method used;
- Default on Entitlements – when we talk about ‘entitlement reform’ in the U.S., we really mean at least a partial default. It is likely that some people simply won’t get what they were promised. We put this low on the list because we have witnessed a political process that won’t deal with the issue;
- Repudiate Debt – Because the government can simply print money to pay it debts, this is the least likely of all of the possibilities in the U.S.
The long-term issues are serious. And not addressing them simply means a higher level of pain when addressing them is required. Remember, these are long-term issues. They are all not likely to occur at the same time, nor will they simply appear overnight. The first signs of trouble will occur when markets begin to recognize that the ‘official’ inflation rate significantly understates reality, or that the inflation data become so overwhelming that they can no longer be masked. Even then, markets may come to tolerate higher inflation, as after 100 years of fighting inflation, the Fed and the world’s major central banks have embraced it as a good thing.
Meanwhile, as set forth in Part I of this paper, the immediate outlook for the economy is upbeat. Enjoy it while it lasts.
December 20, 2013
Robert Barone, Ph.D.
Andrea Knapp Nolan