America Has Huge Holes In Its Pockets, Part 1

The Summer Wake-up Call

Wed, Aug 24, 2011 - 11:42am

Nothing concentrates the mind of an investor like a stock market crash. At the beginning of August stocks fell by 13.3%, in only eight trading days.

During the same period, Gold prices ran up by 10.3% (based on the price of GLD) and so the SPX-to-Gold ratio plummeted by -21.4%, or an astonishing 2.67% per trading day ! - That's a huge drop of more than 20% in the "real value" of American stocks in less than two weeks.

Since then, we have seen a brief relief rally, followed by a renewed slide. Gold and bonds have continued strong, as people seek a safe haven from the uncertainties of the stock market.

Stocks have lost one-third of their value in Gold - in a few short weeks.

Click here for larger image

What caused these sharp moves was a major shift in perceptions. It was almost as if a wake-up call had finally been heard. The phony recovery, stimulated by Fed printing is losing its grip on American investors. They are recognizing the need for growth in non-governmental jobs, and a major restructuring of the sputtering US economy.

The mainstream press has focused on the obvious headline items: clumsy debt ceiling negotiations, the downgrade of America's debt rating, and rising fears that Europe's own debt problems will spill over and bring about another global debt crisis. But it is time to look deeper.

The low volume of trading in the US stock market in the last two years shows that many wealthy private investors, and even some institutions, have stayed on the sidelines. They do not believe that the Fed on its own can restore economic growth. In Shakespeare's play, Hamlet saw that something was rotten in the state of Denmark. If the Dark Prince were with us today, he would have little trouble spotting the obvious rot in the US economy. Cheap money will not fix the ills of America. A cure will require a proper diagnosis and major surgery.

Next year is an election year and the inevitable political circus has started up again in America. The clowns and snake oil salesmen are out campaigning, promising easy cures. All we need to do is launch another stimulus program, says one side of the debate - only this time it needs to be larger. The other side disagrees, and says: we should instead "cut spending" or "cut taxes to zero" and the economy will magically begin a recovery within a few short months. If only it was as easy as that.

In the darkest days of World War II Winston Churchill said, "All I can promise is blood, sweat, and tears." An honest politician would acknowledge that some painful times lie ahead. A genuine transformational leader would focus on getting the diagnosis right. The American public will only give a party and a President the strong mandate needed to bring the country through painful surgery, if they agree upon the core diagnosis. Fortunately, because the easy cures have not worked, some realism is beginning to creep into the debate.

Tough choices are usually not popular choices. But it is gradually becoming obvious to a growing number of Americans that US politicians will need to "touch the third rail", and negotiate a reform of entitlements, while reducing the size of the military budget, and changing some of the basic premises of health care. This kind of broad-based change is not going to be easy to lead. But a more narrow change, forcing only a single segment of the population to sacrifice may be even less successful.

I agree with some other observers who believe that voters can be persuaded to back a leader who isn't promising easy answers, but only if such leader is also asking everyone to share in the pain. To win wide support, the voters will need to believe that they are not the only ones being asked to sacrifice. In 2008, Main Street suffered while big Wall Street banks were handed billions of dollars of bailout funds. This proved very unpopular, offending most voters who saw the pain was uneven. In some ways, the election of tea party candidates in 2010 was a reaction to a political process that voters found imbalanced, and contrary to the interests of the average citizen.

I believe the public would back a president who is willing to voyage into the heart of darkness and deliver genuine change by taking on entrenched corporate lobbyists. The time is right for a brave leader to take back the country on behalf of the people. The average taxpayer has suffered long enough, while they see the rich getting richer, on the back of government spending and tax loopholes. If the voters are going to accept painful change in their own lives and expectations, they will need to see that the wealthy, including fat cat corporations are taking their share of pain too.

So far, the current leadership In Washington appears to be lost at sea. President Obama's stewardship is being challenged in ways that his rhetorical talents cannot mend. One particularly ineffective speech on August 10th was followed by the stock market sliding by 6.66% in a single day. The next day, the Wall Street Journal wrote: "'The Obama administration needs to stop trying to disarm the fire alarm and start putting out the fire."

Now that the debt ceiling drama is out of the way, we are seeing television interviews and newspaper columns being written about how America needs to restore growth in the private sector. After all, it is in the private sector where people pay bills and taxes from real wages. Their income is earned by providing goods and services to customers who hand over their money voluntarily. In a private sector transaction there are benefits to both sides. When a government collects taxes or just borrows money and spends it, that spending is not helping the economy in the way that Keynesian economists would have you believe. The government is simply spending someone else's money. The money has been confiscated (through taxation) or borrowed and needs repaying. On one side of the spending, the recipient may welcome the funds provided through the stimulus. But on the other side, the government is extracting higher taxes to pay for the stimulus. Or in the short term, the government may borrow and crowd out the borrowing ability of private businesses or private individuals. Taxpayers have now wised up enough to understand that a rise in government borrowing will likely be followed by higher taxes later. So government stimulus robs Peter to pay Paul. Paul likes it and may vote for more "stimulus", but Peter gets stuck with higher taxes.

To illustrate the inherent wastefulness of most government spending, it is useful to think about the old "broken window fallacy", and how it represents the economic ideas of Maynard Keynes, and his modern disciples like Paul Krugman. These misguided economic thinkers seem to think that growth can be initiated by the government spending with little regard to how the money is actually spent. In his General Theory, Keynes wrote, “To dig holes in the ground, paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.” The digging of holes may not be productive on its own, but Keynes seems to be betting that the diggers would spend the money they receive in wages in a way that will help the economy. If the diggers merely put their wages into savings accounts there is no gain anywhere for the economy, just money being confiscated from the original saver.

In another example, Keynes claimed he could create jobs by soiling towels in his hotel room. Whilst someone might be paid to retrieve the towel, launder it, and fold it - a job like that is not going to grow the productive part of the economy in any meaningful way. Conveying the money to the same person through charity would have been better, since it would not have required an unnecessary human effort, and it would not have wasted soap, water, and energy to run the washers and driers. But once again, if the recipient does not spend their towel-cleaning wages, no one else in the economy will benefit. The Keynesian system therefore ignores the need for productive investment by assuming that someone further down in the chain will spend the money well, even though the first level of spending by government may look wasteful. The unfortunate truth is that an economy loaded with unproductive jobs may fail to generate any productive growth at all, if it is leaking wealth from many pockets. Such is the US economy - a rotten mess of an economy, with multiple "huge holes in its pockets" as we shall see later.

I am not against all types of governmental spending. Some types of governmental spending are better than others, and some are worse. Spending on War, which destroys the standing works and wealth of others, is probably the worst of all. (I still find it odd that some doctrinaire Keynesians, like Paul Krugman, may be incapable of seeing that war is merely wasteful. He seems to believe that a job, any sort of job at all is good for the economy, even the "real work" of warriors and armaments makers is to mete out destruction. A wartime economy may bring full employment, even while it can barely feed the population. How can any thinking person welcome spending like that? Unless they own an armaments factory or happen to be a military contractor.)

Where some public sector spending may be justified is in the area of infrastructure. Better than charity or no-strings-attached unemployment payments, would be when a job-hungry person is employed in repairing America's crumbling infrastructure. Another area we need to think about employing people, is in rebuilding our cities so that people can live closer to work, and will therefore waste less energy in their daily commuting. A job which reduces the everyday cost of living and curtails energy waste, through enhanced infrastructure will help to improve the overall efficiency of the economy and thereby contribute to sustainable growth. Paying people for productive efforts like that is far better than wasting money and effort on digging holes, washing soiled towels, or going to war. And also tops mere charity.

Obama had the benefit of much misguided economic advice in the early days of his administration. The economy was in free fall, and his advisers saw that there was strong public support for government spending to support a faltering economy. As Rahm Emanuel, Obama's Chief of Staff, put it: "It would be a shame to waste a good crisis." The result was the Democratic controlled congress put forward a massive "stimulus" program that included 50 years of dream programs, and then the new President used his then-exalted approval rating to jam the program through Congress. Emboldened by that success, he moved onto introducing a hugely expensive new health care program. President Obama then used up much of his remaining political capital in getting that passed too. The result is massive budget deficits as far as the eye can see, and the average person is now worried that they will pay away huge amounts of future income in taxes, and never get the secure health care they have been promised.


White House economic advisers like Christina Romer spoke of the economic multiplier effect of those 2009 programs, and how of government governmental spending would bring .57 of economic growth. So programs like "Cash from Clunkers" were piled onto of the pet pork-barrel programs from Pelosi's people. The US government's budget deficit shot up from 3 billion in 2007 to 7 Billion in 2008, and .4 Trillion in 2009 - and fell only slightly in 2010, a year of growth. With so much new spending, and reduced tax revenue in a weak economy, taxes covered only about 60% of the recent year's spending so government borrowing became massive. The US debt grew from .6 Trillion in 2000 to over Trillion in mid-2011. If all the extra spending had actually grown the economy by a factor of 1.57 times, then the extra debt would not have mattered so much. But the multiplier effect did not work. The economy leaked wealth through its many holes, and has remained stalled creating few jobs in the private sector. With so little productive growth, tax collections were anemic too. American workers with stagnate or falling incomes, were being asked to shoulder their share of the rising Federal debt through higher taxes. Looking back, few saw any compensating benefit from the stimulus.

Instead of facing up to the out-of-control spending, Obama now says he wants to raise taxes on "the Rich". There is some justification for this, since taxes as a percentage of GDP has fallen, and many (including Warren Buffet in a recent newspaper article) say that America's rich are "under-taxed" compared to what they pay in other countries. But Obama's definition of whom is rich will shock many middle class people. And even if taxes on the rich were doubled, they would not bring in enough revenues to balance an out of control federal budget.

Spending needs to be cut. But where? I will discuss the four big holes in American pockets in future posts. A careful diagnosis can help to identify where changes in government programs can plug the holes where wealth is draining out, and improve the health of the US economy.

Coming: Where are the four big holes in America's pockets?

The largest single component of the Federal budget is health care. And the explosive growth of this spending is virtually guaranteed by Obamacare.

The US spends twice the share of its GDP on military spending, as its major allies.

The Banking sector has become bloated, and lives off over-lending and speculation.

The US addiction to foreign oil, is a major vulnerability, particularly if the US dollar falls.

About the Author

DrBubb [at] GlobalPropertyCycles [dot] com ()