The Daily Reckoning PRESENTS
In the final installment of this two-part essay, Justice Litle explains what effect this year’s volatile hurricane season will have on consumer and government spending. Read on...

"Everybody came in here with every car they had and took everything we had in the ground."
                                                    - Kip Neuhart, Chevron station manager, Marietta, Ga.

As the linchpin of the global economy, much depends on the American consumer. With consumer spending representing more than two-thirds of U.S. economic activity, and consumer import consumption the engine that keeps Asia humming, money to spend and willingness to spend it are critical for turning the fiscal merry-go-round. In this regard, Katrina has had a sharp financial and psychological impact.

Consider the shift in perception of gasoline prices. An editorial cartoon from a few months back does a good job of illustrating the difference between then and now. A carefree motorist fills up his SUV at the gas pump, whistling aimlessly, with electrodes attached to the back of his head. Two scientists observe from behind a one-way mirror. One is manipulating a large dial - the price of oil listed in $10 per barrel increments - as the other takes notes. The first scientist has a look of surprise and concern as he tentatively turns the dial toward $60. The second scientist frantically observes, “It’s not having any effect!”

Fast forward to the present: That carefree, “what-me-worry” mood is long gone. It has been replaced with anger, anxiety and fear as prices break the $3 per gallon mark nationwide, with outliers as high as $6 reported at gas stations in the Southeast. There is real pain at the pump. The governor of Georgia has publicly denounced gas gouging, President Bush has asked drivers not to horde gas and fears of shortage become self-fulfilling prophecy as anxious drivers blitz their local filling stations and run them dry. The long lines of the ’70s have returned, and a few illiterate politicians from Hawaii and Florida have even called for the reinstatement of price controls. (Hopefully, they will be muzzled or ignored.)

Things were already looking precarious before Katrina, with the consumer savings rate in negative territory, discretionary income dwindling and energy prices high enough to cause fresh concern. The disruption of Gulf Coast production did not create a new problem. It merely kicked an existing one into overdrive.

While gasoline prices will ease a bit as initial panic dies down and excess driving is curtailed, there is another psychological bogeyman waiting in the closet: natural gas.

Natural gas futures were already challenging all-time highs before the disaster struck. They have since gone into orbit on concerns that commercial storage inventories may not be enough for a cold winter ahead.

From a psychological perspective, the unknown often generates more anxiety than the known. Consumers are already dealing with shock and awe as they fill up their gas tanks. Now they have to endure a more frightening question: How high will the heating bills be this winter? It’s impossible to know, and there are many months to dwell on the question...before we find out just how cold the coming winter will be.

As consumers adjust to these new realities, the instinct to cut back may finally kick in. We are likely to see the savings rate tick up over the next few months, as anxious consumers brace themselves for a further body blow this winter. This shift in sentiment could put further pressure on the retail sector as discretionary income erodes, and a slowdown in import consumption may put economic pressure on Asia, as well. Of course, if China starts to feel the pain due to consumer slowdown, the complimentary Treasury purchases that have kept interest rates low and home values high may grind to a halt.

“At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb the markets, with damaging volatility in both exchange markets and interest rates.”
                      - Paul Volcker, “An Economy on Thin Ice”

“What we are looking at... is one of the biggest U.S. public finance projects of all time.”
                      - Joe Mysak, Bloomberg columnist

As a result of Katrina, the pace of government spending will increase rapidly. At the same time, the Federal Reserve is facing increased political pressure to pause in its campaign of interest rate hikes. This combination is likely to weigh heavily on an already weakening dollar, as foreign creditors look on with growing concern. (All this with a vulnerable Asia in the background, no longer so anxious to provide vendor financing.)

This is not a criticism of the coming rebuilding efforts, or a denial of the need for federal assistance in time of disaster. It is simply an observation that the bill is coming due at a time when U.S. finances are decidedly shaky. Government officials have promised whatever it takes in terms of federal funds, and estimates have consistently estimated, with some suggesting Katrina could ultimately cost more than the wars in Iraq and Afghanistan combined. This comes on top of more than $100 billion in estimated economic damage, with long run energy costs still unclear. Not to mention federal assistance for a million displaced individuals. Meanwhile, fiscal conservatives are disgusted with the lack of political will to cut back pork in other areas as we are hit with these massive expenditures.

It is hard to play the role of fiscal hawk in the face of human suffering. The natural moral instinct is to give with compassion and expect the government to spare no expense in restoring order. The problem is not the financial realities of disaster relief, but rather the fiscal excesses that came beforehand, putting the country in such an untenable financial position in the first place. Nothing has been put aside for a rainy day. The credit card of last resort is already loaded with charges. Nature’s misfortune has compounded the ill winds of poor financial planning.

At the end of the day, America has essentially borrowed $2 trillion from the rest of the world and spent it in mostly nonproductive ways. The Fed fueled this binge and facilitated a gold rush in paper assets (what else do you call $400,000 condos that don’t yet exist?). To the degree that real estate appreciation is fueled by borrowed dollars, the appreciation is not real wealth, but rather a temporary loan from overseas creditors. Consumers are not using these generous loans to start productive businesses with an aim for future return on investment. They have been swapping houses, monetizing their mortgages and living it up on the proceeds. When that money has to be paid back, America will have little to show for it. The only way out will then be to manage the dollar downward, which in turn triggers a deliberate erosion of purchasing power for all those holding dollars and dollar-linked assets. The consequences of fiscal profligacy may be long delayed, but ultimately cannot be denied.

The inevitability of a managed dollar descent is not in question. In fact, it is a key piece of the “optimistic” scenario for a soft landing. America has all but admitted that its fiscal rehabilitation plan hinges on inflating its way out of trouble, a “burn the bag holder” scenario. Only an issuer of the world’s reserve currency could get away with such a brazen plan - and probably not more than once.

Reserve currency or not, no credit line reaches to the sky.

It is a foregone conclusion that America’s net borrowings from foreigners will eventually cease, and then head into reverse as fiscal imbalances sort themselves out. When this happens, the dollar will begin its slide in earnest, and moneymen the world over will pray that the descent is an orderly one.

No central bank stands to gain from a free-fall scenario in which the world reserve currency plummets. But if things start getting precarious, it could easily become every financier for himself. As Jesse Livermore dryly noted, in times of crisis, the bankers do not stand around saying, “After you, my dear Alphonse.”

Hopefully, the destabilizing event that former-Fed Chairman Volcker hypothesized was not a natural disaster. Hopefully, we are not already making our way down the slippery slope.

Regards,

Justice Litle
for The Daily Reckoning

P.S. Still, if the final-straw event (or combination of events) has not yet arrived, the hour is surely coming, and Katrina may have hastened it.

But you can protect yourself - and even profit - from this scenario. Find out how here: Energy = Wealth
http://www.agora-inc.com/reports/OST/WOSTF420

© 2005 Justice Litle, Outstanding Investments
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Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas - among other things. This monthly gathering includes the cream of the crop of financial minds - and for a limited time, the Agora Financial Reserve is open to the public at a 98% discount. Get your invitation here: The Birth of an Elite Club http://www.agora-inc.com/reports/AFR/WAFRF972 

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