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Big Gov. goes into bread and circus hyper drive: T-Bond buyers beware! The perversity of well-intentioned programs that nobody can afford, Plus, Bill Bonner muses on combustible currencies and chain-smoking cavemen... The Daily Reckoning | Thursday, April 1, 2010 Mr. Market Fantasy The wacky economics of welfare politicians and how it is bankrupting America. Eric Fry Eric Fry, reporting from Laguna Beach , California… “Dear Mister Fantasy play us a tune. Something to make us all happy.” When Stevie Winwood sang these lyrics in 1967, your 7-year old California editor took them at face value. The lyrics felt soothing and magical. Today, those same lyrics feel like a grim ode to U.S. fiscal policy. Back in 1967, President Johnson was just getting the hang of raising taxes and redistributing the nation's wealth. 43 years later, President Obama has mastered the art. Obama is not unique among frees-pending politicians, of course. He merely typifies the breed. Washington’s something-for-nothing ethos has escorted our national finances so far into the extremes of fiscal lunacy that we taxpayers are left with little more than fantasies and happy tunes. The national health care initiative, for example, like so many of the initiatives that preceded it, promises to save us all money, but only by costing hundreds of billions of dollars first. We doubt this math will work. Maybe the health bill is great legislation, but it is wacky economics. And therein lies the problem. Noble ambitions cost money and no one wants to pay for them. So we end up with lots of lots of well-intentioned programs that the country cannot possibly afford. That's when things get really interesting… and perverse. When we can no longer afford to finance our own social programs, we must rely upon the kindness of strangers. And we would be foolish to expect any measurable kindness from the strangers who are buying our Treasury bonds. Our foreign creditors simply want to receive the interest and principal payments we have promised them. They couldn't care less about whether we Americans can maintain funding for food stamps or free school lunches or unemployment benefits or the National Park Service. And our creditors certainly couldn't care less about whether we Americans can continue doling out tax credits to homebuyers, subsidies to Amtrak or bailouts to General Motors. Our creditors simply want to receive full payment at maturity. In recent history, this simple fact has inspired no great consternation here in the States. That's because our largest creditors would simply take their proceeds from maturing Treasury securities and buy new ones. Lately, however, foreign creditors have modified their investment behavior. They are reducing their purchases of Treasury securities. Maybe that’s why interest rates have been edging higher along the entire Treasury curve. So far, the falloff in “indirect bids,” the category that includes foreign central banks, has been fairly modest. But remember, America’s borrowing needs are soaring, not falling. The waning foreign demand for Treasury securities is probably nothing to worry about…yet. And besides, didn’t the Treasury just book an $8 billion profit on its “investment” in Citigroup. That’s a good thing, right? “Dear Mr. Fantasy, play us a tune. Something to make us all happy…” The Daily Reckoning Presents The New Abnormal Dan Amoss You know that market sentiment has reached a euphoric extreme when nearly every presenter at a Grant’s Conference is bullish. This conference is known for attracting speakers with a more bearish slant than you would normally find in mainstream finance. Yet the mood in the ballroom at New York’s Plaza Hotel last week was much more upbeat than the last time I was there, in October 2008. At that point, equity investors were convinced that there was no way the Federal Reserve stimulus efforts could offset a seemingly unstoppable debt deflation spiral. Liquidation of every asset -- regardless of its investment merit -- was the order of the day. Eighteen months later, the investing public has moved all the way from abject fear to complacent greed. Stocks go up just about every day. What else do you need to know? Now a consensus is forming that Federal Reserve policy will support stock and bond prices in perpetuity. Several speakers at the Grant’s Conference held this view. This new consensus view goes something like this: The Federal Reserve will keep rates near zero for a long time, because inflation is only a very remote possibility; Paolo Pellegrini was the lone dissenter, implying that a loss of confidence in fiat money could force the Fed to tighten (he said, “quantitative easing is a breach of property rights”). Corporate profit margins and cash flow will remain near record levels well into the future. Asia will continue to lead the global economic recovery But economist David Rosenberg shared his non-consensus bearish economic outlook in a debate with Jim Grant. Rosenberg is bullish on U.S. Treasuries, expecting that yields will fall and prices will rise for many more years to come. In the debate, Rosenberg said that today’s U.S. economy resembles the Japanese economy circa 1996. I agree that today’s U.S. economy resembles that of post-bubble Japan, but there are two key differences: The willingness to sacrifice for the “greater good” is much more ingrained in Japanese culture. This made it easy for Japanese governments to issue massive amounts of bonds to the household sector at low yields. The U.S. culture is much more diverse and independent, and those households with capital are not likely to buy Treasuries at low yields. The world is already stuffed to the gills with Treasuries. It’ll be difficult to find homes for several trillion more in Treasury securities (at low yields). Jim Grant argued in favor of this point. Chinese leaders may decide that the benefits of a higher exchange rate (cheaper commodity imports) outweigh the costs (more expensive exports). The transition away from decades of mercantilist policies and currency debasement in Asia will lead to lower demand for U.S. Treasuries. So I agree with 80% to 90% of Rosenberg’s excellent analysis on the long-term credit cycle. But I don’t agree with his view that we’ll see much lower yields for U.S. Treasuries (outside of temporary flights to safety during deflation scares). I expect yields to steadily rise -- not for pleasant reasons (faster economic growth), but for unpleasant ones (steadily growing fear among Treasury investors that they’ll get repaid in heavily debased dollars). Strangely missing from the Grant’s Conference was much discussion about the situation in the “Club Med” countries -- Greece, Portugal, Italy, and Spain. It’s clear that most of the world’s political leaders don’t have the courage to allow painful, but necessary adjustments. Talk is cheap. Thus far, all we’ve seen in the growing sovereign debt crisis is talk. However this crisis is ultimately resolved, or papered over, it will not be painless. In 2010, the European economy could easily be much weaker than the U.S. economy. French and German banks are exposed to Greek debt, so they want taxpayers to bail them out of their foolish loans. Furthermore, all developed European economies are so dependent on government spending that any plans to cut spending and raise taxes would be self-defeating. When government spending becomes woven into the fabric of an economy as completely as it is in Europe, actions taken to balance budgets can paradoxically undermine sovereign credit. GDP would shrink rapidly under fiscal austerity, which would shrink the cash flow available to service government debt. This is why, ultimately, we’ll probably see much more radical pro-inflation actions out of the European Central Bank, but probably not before another big recession scare in the big European economies. In most countries, political leaders aren’t willing to look too far ahead and take action to forestall worst-case scenarios. They want to debase their currencies to ease pain from de-leveraging and to gain an export advantage. (This tactic makes for a potentially explosive situation for gold prices. We’ve advocated a core position in gold since the inception of this letter in early 2008. The time may be approaching for another round of call options on gold mining stocks). Rather than courageously leveling with their electorates, politicians tend to promise more entitlements, more bread and more circuses. Health care is just one of these new entitlements. Governments that lose touch with reality eventually lose legitimacy. There are many examples of this fact in the history of Latin American economies in recent decades. One vivid example -- Brazil -- was mentioned at the Grant’s Conference. Bruno Rocha and Cristiano Souza manage $1.6 billion in Brazilian equities at a firm named Dynamo. Rocha and Souza are bullish on the future of the Brazilian economy, mostly because entrepreneurs are now confident that they can operate in an environment in which the government respects property rights, and in which the central bank is not eager to destroy its own currency. Rocha and Souza experienced firsthand the worst of the hyperinflation and statist policies that Brazil suffered through in recent decades. They described how engineers with advanced degrees had to drive cabs to scrape together a living. Those few individuals who possessed some capital tended to invest it in the all-cash underground economy, fearing the loss of it to corrupt or incompetent government officials. Few Brazilians paid taxes, because they didn’t have any confidence in their representative government. But tax receipts in Brazil have been rising for many years, and the government’s finances have been improving dramatically, as Eric Fry pointed out in yesterday’s edition of the Daily Reckoning. It’s very unfortunate that U.S. policymakers don’t recognize that their actions resemble those of Brazilian policymakers in the 1980s and 1990s. Trust is vital to markets and capitalism. It must be earned over time. Once it’s lost, trouble always ensues. T-bond buyers beware! Dan Amoss for The Daily Reckoning Joel’s Note: With a 44% average gain – including losers — across 36 plays, it’s no surprise that Dan’s Strategic Short Report has quickly become one of the hottest research services in the business. And, in light of the tumultuous times we see ahead, we’d like you to give it a test drive... To that end, we’re currently working on a special offer with our publishers in Baltimore that will guarantee you access to all of Dan’s research, including his next specific “short” idea...all for a special $1 trial subscription price. We’re still working out a few of the finer points on the offer but, rest assured, we’ll get the details to you as soon as it becomes available. Watch this space...  Bill Bonner The Long and Short of The Great  Correction Bill Bonner Fire discovered! Researchers in France think they have identified the site where fire was first discovered. Carbon dating puts the discovery much earlier than previously thought. But here’s the big surprise...it was not modern humans who discovered fire. More below... Our beat here at the Daily Reckoning isn’t combustion, it’s money. We keep our eyes on the money. Trouble is, in this electronic age we can’t see the money! It passes from central bank to regional bank to local bank to local business to local household all electronically. Hardly leaves a trace. Why is this important? We can’t think of any reason it is important. We just thought it was interesting. Because now we’re getting a lot of data that purports to show that people have more money. But where is it? Consumer spending is up, they say. Housing prices are up, they add. Even employment is up. Well, no...not really. Employment is ‘stabilizing.’ Meanwhile the figures tell us that incomes are down. So, it’s hard to know what to believe. We’d like to see the cold hard cash...in peoples’ hands. One thing that is happening, say the experts, is that people are losing their houses and defaulting on their debts. This then frees up more of their incomes for spending! Then, the papers report more consumer spending; and they think the economy is improving. What is really going on? The Great Correction! In this case, the real estate market is de-leveraging. And that takes time. There will be periods when prices are going down. And periods when they are going up. But the overall trend will be down. It took nearly 20 years to deflate the bubble in Japan. It will take years to deflate the property bubble here in the US too. Same thing with stock prices. In Japan, the first crack came in 1989. Then came some years of falling prices and some years of rising prices. But the major trend was down for two decades. Let us remind readers how it works. There are little trends. And there are big trends. You can make money in a period of falling prices...but only if you’re lucky. We don’t like depending on luck. Even less do we count on brains. What we want is a market that is rising...where we can have no luck and no brains and still make good money. That was the case in the US in the 25 years from 1982 to 2007. All you had to do was to buy and hold. You would have made about 14 times your money. You could have done a little better if you were smart enough to trade out before the little downtrends and buy back in when the uptrend resumed. And you could have done better, too, if you were lucky enough to buy the stocks that rose more than others. But here at the Daily Reckoning, we’re neither particularly lucky nor particularly smart. That’s why we have to go with the trend. Make the trend our friend. And stick with it. What’s the trend in the stock market...and the real estate market...today? No one knows for sure. But our bet is that it is down. Prices peaked out in 2007. They’ve been generally going down ever since. Yesterday proved nothing. The Dow fell 50 points. Oil rose to over $83. Gold rose $8. In the stock market, investors have made nothing for the last 10 years. Most likely, this is a bear market that will last for another 5 or 10 years... If it follows the major trends of the past, we should see the Dow down below 5,000 before it’s over. Then again, who knows? And back to the discovery of fire... “This is a really important discovery,” said Marvin Schwartz, an archeologist with the University of Dundalk. “We believe we’ve located the actual site where fire was discovered. Not the place where it was first observed...for surely, primitive men observed fire following lightening strikes and forest fires. But this was where fire was first controlled and harnessed.” The site is located in Southwest France, not far from our house. It is near the region of cave paintings in the Dordogne. The cave in which the discovery was made was found by accident when a local wine planter turned over a stone to make more room for his vineyard. The stone covered the small entrance to a cave which had been used by primitive men some 50,000 years ago. “We can date the habitation from the traces of animals that had been slaughtered in the cave. The animal remains give us a way to know when the cave was inhabited and what the people who lived here ate. “What we can tell so far is that they ate a lot of meat. They were not vegetarians. We have found animal remains – which include the bones of animals that are now extinct, such as the giant elk and the dwarf mastodon. “But most important, we have found soot on the roof of the cave. This shows the use of fire began much earlier than previous researchers had believed, around 50,000 BC. Either these primitive people discovered fire...or they were chain smokers. Either way, it’s an extraordinary find. “I should tell you something else that is extraordinary. They weren’t people like us. The remains in this cave are not those of Homo Sapiens Sapiens. They were a different branch of the hominid family. Actually, we’re not sure what they were. DNA samples do not match any of the other known biped groups – neither the Neanderthals, nor the diminutive group found on the Isla de Flores in Southeast Asia, nor even the recent human-like remains discoveries in Siberia. “What we’re looking at here is a previously unknown group of proto-humans. Surprisingly, the study so far has been unable to identify this particular branch of the human tree. All I know is that they must have been incredibly stupid. They had fire long before our ancestors. But we’re alive. They’re not.” But the intriguing inference comes from a colleague, Dr. Yin Yang of the University of Taipei: “It incorrect to say they stupid. More likely, fire stupid innovation, like TV. Or video games. Bad invention. Made them weak. They got too hot. Overcooked their food. Then, they couldn’t compete with our honorable ancestors.” U.S. Decline, Sloth Look a Lot Like End of Rome: Mark Fisher March 30 (Bloomberg) — Historians cite the late second century as the turning point of the Roman Empire, when the once- proud, feared society began its descent into infamy. As the ruling class was undermined by civil wars and attacks by outsiders, the Romans’ respect for law and social institutions began to erode. In the end, a combination of political and economic mistakes led to the empire’s downfall. The U.S. today is a mirror image of the Roman Empire as it tipped into chaos. Whether we blame our bloated government, a greedy elite or a lethargic population, the similarities between the two foreshadow a gruesome future. The Roman economy grew fat from the plunder of conquered territories and the added productivity offered by new lands. The waning of expansionism didn’t bode well for the empire. While the U.S. ascended quite differently, it also used its position as a superpower to fuel economic expansion. Because the country had the strongest military and economy in the post-World War II era, the U.S. dollar became the de facto global reserve currency, ensuring endless competitive advantages -- which have vanished in the last decade. Americans have become less productive while relying more on social safety-net programs such as Medicare, Medicaid and Social Security -- and now expanded health-care insurance. Worse, like the ancient Romans, a sense of entitlement has replaced the drive and motivation we once championed. With easy access to abundant government handouts, it’s no wonder so many jobless people have stopped looking for work. Bread and Circuses In the fifth century, the Roman political elite began searching for ways to distract its population from the hopelessness at hand. Bread and circuses postponed the ultimate fall. The tactic stopped working when people realized their bread tasted stale and sensed the true scope of the impending disaster. The U.S. government’s version of bread offerings proliferated throughout the fiscal crisis, in which collapse was averted only by a massive financial bailout and an endless supply of paper money, along with the rest of the seemingly endless sustenance being shoved down America’s throat. Meanwhile, the administration hasn’t yet tackled the most pressing issue: job creation. Given the current state of the labor market, American workers can’t possibly provide enough tax revenue to support the government’s swelling debt. Even more unsettling is the government’s inability to fix the financial crisis. After a stream of stimulus programs and bailouts, the Federal Reserve continues to print enormous quantities of dollars and buy the nation’s debt. California Like Greece Many state governments are in even worse shape. With California’s 10-year debt currently yielding about 4.5 percent (municipal debt typically yields less than 10-year Treasuries, which now yield about 3.9 percent), the state poses the same sort of danger to the U.S. that Greece does to the European Union. If the federal government decides to bail out California, what happens when Michigan and New York start demanding the same treatment? The burden of underfunded pension liabilities will cause states’ budget deficits to further balloon. Since defined state benefit plans assume an unrealistic 8 percent rate of return -- zero percent, at best, is more likely -- we can only imagine the catastrophe to come once states have to make good on their obligations. As our society becomes increasingly immobile and sits on the couch doing nothing but surfing the Internet, using iPhones and watching “Jersey Shore,” the hopelessness of the situation becomes clear. Regards, Bill Bonner, for The Daily Reckoning Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com