Recession or Collaspe

I think it is obvious to anyone following the news the past three months, the U.S. Congress, President and the Federal Reserve have thrown caution to the wind when it comes to managing the country’s credit rating, ability to pay its debts and the value of the U.S. dollar. They will do just about anything to avoid a recession. There is no longer room in politics for the business cycle.

The Congress and President are borrowing and spending beyond what anyone could have invisioned. The federal debt is $10.6 trillion. This does not include the $5 trillion in obligations the federal government has assumed from Fannie Mae and Freddie Mac. The U.S. government is also guaranteeing large amounts of obligations relating to banks (e.g., Citicorp), mutual funds, and corporations (e.g., AIG). Such guarantees are off-balance sheet and are not included in the calculation of federal debt. The annual deficit is expected to top $1 trillion this year.

At the federal reserve bank, their balance sheet has more than doubled and this increases money supply. Whenever the federal reserve buys something, it just prints the money to pay for it.

Sufice it to say, the federal government is printing and borrowing money at a record pace. Additionally, the federal government is making all sorts of loans to private companies, holding up the stock market by taking ownership in companies, guaranteeing the loans of private companies, buying all sorts of non-performing assets to clean the books of financial institutions, and buying long-term securities to lower long-term rates.

Despite all the new obligations the U.S. government has taken on, confidence in the government’s ability to pay its debts and investors’ confidence in holding dollars continues. For example, the yield on the 3-month T-Bill is 0.01%. The yield on the 10-year T-Note is a record low of 2.25%. People are eagerly lending their money to the U.S. government. The U.S. dollar, though weaker, has stabilized.

The U. S. Government has proven it is willing to back stop the economy. Thus, as long as confidence continues in the U.S. government, this will remain a recession and not turn into an economic collapse.

A recession is still bad, and this recession is worse than 2000-01 and 1990-91. I suspect it will be like the mid-1970’s recession which had 9% unemployment, but not as bad as the 1980-82 recession when unemployment reached 10.8%. Inflation will also be much lower, so the misery index (unemployment rate plus inflation rate) will be lower.

In Pickens County, the biggest employers are government institutions and they have not begun to layoff yet. Pickens now has the 9th lowest unemployment rate in the state. That is about to change, once the government layoffs begin. Then Pickens County will begin to feel the full effect of this national recession. Thus, for our county, the worst of this recession still lies ahead.

Before the our leaders in Washington threw away the notion of limited government in the 1960's, there were recessions about every 5 years. From 1983 to 2007, the U.S. had only 2 recessions. That’s not normal, and it was because the government was over-stimulating the economy, mostly by lowering interest rates too much and borrowing excessively and spending.

The consequence of too much government intervention and over-stimulating the economy is coming home now, with businesses, individuals and government in more debt than their incomes can support. As a result, government's fiscal and monetary policy tools will be less effective in the future, so we’ll have recessions as often and economic growth will be lower.

If foreign investors lose confidence in either holding U.S. dollars or the U.S. government’s ability to pay its debt, we’ll have an economic collapse. The U.S. can not fund its high level of borrowing internally. It's citizens spend most all of their income. The U.S. is dependent on foreign capital to pay its bills, like it is dependent on foreign oil to power its economy.

Watch U.S. interest rates and the U.S. dollar (and gold too). Those things will tell you how much confidence foreign investors have in the U.S. at any moment in time.

Sooner or later they'll start to lose confidence in the federal government’s ability to pay them back, and foreign investors will slow the lending of money to the U.S. government. The U.S. deficit will still have to be financed, and interest rates will have to raise significantly to attract new lenders.

This is one possible dooms day scenario: The U. S. goes into recession. As revenue to the U.S. Treasury falls, foreign investors worry about being paid back, and slow their lending. U.S. interest rates rise to attract new lenders. This makes the recession worse, U. S. revenue drops more, foreigners worry more and lend less. At some point the higher interest rates choke off economic growth and the U.S. economy collapses under staggering debt and not enough income to make the payments.

The U.S. has huge trade imbalances with countries like China, Japan and oil exporters. As a result, those countries hold huge amounts of U.S. dollars. For example, when the U.S. buys oil, it gives Saudi Arabia U.S. dollars for the oil. Those who export the most to the U.S. hold lots of dollars.

These foreign countries can either continue to hold or save those dollars, sell them in the foreign exchange market to get back (buy) their own currency, or use those dollars to buy U. S. real estate, companies and even politicians.

All this is going on now, but if those foreign countries decide they have all the dollars they want or they own enough U.S. real estate, companies or politicians, they’ll start to sell the dollar. As the dollar falls, foreign investors will slow their lending to the U.S. Why would a man in Germany exchange his Euros for dollars, then lend them to the U.S. Treasury at 5%, when the dollar is falling 6% per year? Net, he’ll lose 1% a year.

No matter what, the U.S. will still have to finance its government deficit, so it’ll have to raise interest rates to attract needed lenders. The U.S. economy then collapses under the weight of rising interest rates. This is another dooms day scenario.

By the way, gold goes up in both scenarios, and this is why I like gold in the long run. My target is still $1,500 per ounce, despite the recent setback. The chances of these scenarios is risingin the minds of investors and that is why gold is trading at $850, even though inflation is only 1%. People are buying gold, because they are worrying about world wide credit mess, which has the U.S right in the middle.

With all this U.S. borrowing and printing of dollars, why are U.S. interest rates so low? Why aren’t foreign investors bailing out on the U.S. dollar?

I suspect foreign investors and countries are willing to hold U.S. dollars because they realize there are many valuable U.S. assets that can still be bought -- U.S. real estate, companies, politicians, etc.

Everyone knows someone who is spending more than they earn. Think about that person's situation. As long as he has a house, car or other assets he can sell to get money to fund his deficit, he can avoid bankruptcy.

The U.S. accumulated a ton of assets its first 200 years. Slowly it has been selling off its real estate and companies to foreign creditors. Sooner or later the U. S. will have sold off its most valuable real estate, companies and politicians to its creditors and those foreign investors and countries will see few reasons to hold on to so many dollars.

As bad as the U. S. fiscal and trade situations are, there is still confidence in the U.S., with the dollar stable and interest rates low. As long as the U.S. government is willing to back stop the financial economy and confidence continues in the U.S. government, this will remain a recession and not turn into an economic collapse. With all this economic stimulus, beit 0% interest rates, low oil prices, and government stimulus packages, I believe we’ll see positive economic growth in Q3 of 2009.

In the long run, if the U.S. government as well as state and local governments do not curb their spending, borrowing and taxing ways, I believe within the next 20 years there will be a financial/ economic collapse. There is also third scenario that could lead to collapse (see below).

As we saw with the near miss on September 17, the spark for a collapse could happen at any time. Foreign investors could stop lending the U.S. money tomorrow, next month or next year. Could the U.S. deal with that? More likely now, then 20 years from now.

While the fiscal strains on the U.S. Treasury are high and growing now, the biggest challenges are ahead. Social Security, Medicare, and Medicaid are growing considerably faster than national income. Around 2030 these programs will all be in deficit, significantly worsening the U.S. fiscal situation.

Removing the law that prohibited banks from operating in more than one state and allowing banks to get into the risky business of securities trading and investment banking was a mistake that could very well bring the U.S. to its knees. U.S. banks have become too big to allow them to fail. Put that together with the very risky transactions they now engage in, likely, the banking system could end up in the same mess a few years from now. The next time, however, the U. S. government’s credit rating (or ability to borrow) may not be strong enough to withstand the strains of trying to save the banking system.

On September 17 our country was within inches of a financial collapse, that would have resulted in an economic depression like the 1930’s. The U. S. government stepping in to make everyone whole saved the day. As its obligations mount, they will be less and less likely to do that again and again in the future.

If you didn't believe what I have been saying the past few years, that mini-crisis should have been enough to convince you the U.S. has major financial problems and they are getting worse and worse.

Unfortunately, most in government, from the federal level down to the county level do not understand the situation or are just so liberal they will be taxing, borrowing and spending right up to the collapse.

It is unlikely our government leaders will take the necessary steps to avert the collapse that is heading our way sometime within the next 20 years. Use this time wisely to get your fiscal situation in order. Live within your means, pay down your debt and put money aside for the storm that is coming.