the fight over unemployment benefits

My cartoon version of US politics:

A generation ago the Democrats were the party of the working people and the Republicans the party of the wealthy, especially of inherited wealth.

The Democrats’ goal was to push for strong wage gains, to improve the lot of their supporters. They were also for wealth redistribution–taxing the rich to get the money for social welfare programs like Medicare or Social Security. High wage gains would also eventually create inflation, eroding the value of the assets supporting hereditary wealth–an added plus.

The aim of the Republicans was to defend the status quo, the value of their bonds and their industrial operations, by advocating low wages, low taxes (no redistribution) and low inflation.

Even though both parties have strayed far from their roots, this old picture has some relevance in explaining economic forces at work in the US today.

The Congressional Budget Office estimates that the federal budget deficit for 2020–the amount that government spending will exceed income–will come in at $3.7 trillion.

This is where the current debate on extension of unemployment benefits comes in. Democrats are calling for another $3 trillion in aid to out-of-work Americans; Republicans are arguing for $1 trillion. In simple terms, the difference is between continuing $600 a week in extra benefits vs. reducing that to $200.

In the former case, the federal deficit would come in at about $7 trillion and total government debt would rise to just under $30 trillion. This compares with GDP of about $19 trillion this year–with real GDP growth (even before the pandemic) reduced to close to zero due to Trump’s epic incompetence. That would put us higher than perennial poor soul Italy in terms of debt/GDP and into the same bracket with Greece and Lebanon. Only Japan, with debt of 2.5x GDP would be out of our reach–for now, anyway.

(An aside: hard to believe one man could do so much damage so quickly–and that’s not considering his white racism, environmental recklessness, the secret police roaming Democratic cities…)

Anyway, the question wealthy Republican backers seem to be asking is at what point will creditors balk at continuing to fund the Federal government. Their answer can be seen in the Republican negotiating stance–we’re already there. In my view, a lot depends on whether Trump is reelected despite his devastation of US aspirations and value. I think we’re already seeing the first indications of the world’s worries in the decline of the dollar vs the euro. For wealthy holders of dollar-denominated assets–real estate, industrial plants, fixed income securities–losses could be very large.

the dollar, gold and bitcoin

the dollar

The biggest influences by far in the currency markets are the large global banks. I view them as playing a very sophisticated game that looks much farther into the future than the one the typical equity person like me is involved in. One consequence is that significant changes in the economic environment often start to play out in the currency markets before spreading elsewhere.

The currency markets aren’t infallible indicators. The dollar dropped by 20% against the euro (which is not a stellar currency, either) during the first year of Trump as president. Since then the euro has been sliding back, as Europe’s internal problems–Brexit, Italy, early, very deadly arrival of the coronavirus–came to the fore.

Despite all this European ugliness, since mid-May the US dollar has been dropping, steadily and sharply, against the euro. It’s now down by about 9% against the EU currency.

How so? mostly Trump’s incompetence, I think. Europe used US medical science to control the pandemic, while Trump’s urging his supporters to flaunt medical recommendations has it raging again domestically. I don’t think the currency markets are as much concerned about the deaths as about the second round of fiscal stimulus that his bungling has made necessary and its effect on the national budget deficit/national debt.

Trump has also compounded the risk of holding Treasuries by his suggestions that the the US may choose not to repay holders he doesn’t like.

There’s no reason to think the bad news is over, either. Trump is insisting that schools reopen on schedule without pandemic safeguards–creating the worry that a third multi-trillion dollar support payment may ultimately be needed. He’s also intensified his campaign of race hatred, drawing comparisons with Hitler’s rise in the 1930s. Then, there’s the test to detect signs of dementia that he keeps mentioning–which can be seen itself as a sign of the disease he insists he is not suffering from.

implications

Currency weakness is good for exporters and bad for importers. It’s also good for the many S&P 500 companies that have foreign subsidiaries.

gold

Gold is up about 12% since mid-May. An old, but still useful, rule about the gold price is that it remains stable in the stronger of the two currencies, US$ and DM (now the euro). In other words, most of the price rise is due to the decline of the dollar. Still, there has been a small upward movement. My interpretation–and I’m about as far away from being a gold bug as one can get–is that this is more a reflection of how pricey everything else is than a genuine desire to own gold

bitcoin

Personally, I think there’s a better case for bitcoin than for gold. There’s been a sharp spike in bitcoin this week, again more, I think, a result of how expensive other things are. Were Trump to be reelected and his fracturing of the US economy to continue, I imagine bitcoin would draw a lot more interest.

Trump underpins tech stocks …for now

The EU has a third more people than the US, has an older population and was in worse Covid shape than the US in early April. Today, however, US daily new cases are about 15x those in the EU; daily new deaths here are 7x those in the EU. The difference? The EU followed the recommendations of US medical scientists; Trump urged his supporters to ignore them.

The economic result for the US is a deeper, longer-lasting downturn than elsewhere in the OECD, huge amounts of Federal government assistance to keep the economy afloat–with a resulting budget deficit that could soon reach $6.0 trillion, vs. $0.6 trillion when he took office.

Rather than try to mitigate the suffering the US is going through, Trump appears to have decided to try to shift national attention away from his central role in creating this tragedy by creating a second, competing disaster. After the armed forces refused to help, Trump organized a gang of from other Federal agencies. Members wear identical camouflage combat gear and carry weapons. No identification on their bodies or vehicles, however. Not a thought about probable cause or excessive use of force, either. In other words, they’re shaped on the Gestapo/KGB/Stasi secret police model. Empowered by executive order and against the wishes of state and local officials, Trump envisions sending these groups into Democratic-leaning cities to instigate violence. Portland is his test case. News reports of the Navy veteran beaten in Portland (he decided to remind Trump’s minions they took an oath to defend the Constitution) show what’s going on. Kristallnacht in America is something no one would have believed possible four years ago. Talk about the banality of evil.

Relevance for the stock market? …a lot.

I’ve been writing for a while about the divergence between NASDAQ and the Russell 2000. The former is the part of the US stock market least tethered to the US by customers, revenues or physical assets; the latter represents the part most closely linked to domestic economic health. NASDAQ is up by about 55% since the beginning of 2018; the Russell 2000 is down by 4% over the same span. I read this 60 percentage point divergence as the stock market’s response to the ongoing economic damage Trump is doing to the US. The spread is very long in the tooth. It’s also so wide that it is begging for at least a temporary reversal of form. So far, however, every attempt at a counter-trend rally has been nipped in the bud.

How so? I think the pro-NASDAQ portfolio configuration has a second motivation. It is also the first step in capital flight from a country moving in the wrong direction.

Recently, coinciding with Trump’s more explicit white racist actions and the resurgence of Covid in the South and Midwest, we’ve begun to see a second aspect of capital flight–a 5%+ decline of the dollar vs. the euro over the past few weeks. The US currency has even lost ground to perennial weaklings sterling and the yen.

It’s hard to know how this all will play out. A Trump win in November is the easier case. I imagine it would create a seismic negative shift in global attitudes toward the US. That would result in a steady outflow of our most productive human and financial capital. The dollar would continue its decline. Maybe, government bonds would begin to sag, too. At some point, Washington would presumably close the border to outflows, a la Mexico 1982. NASDAQ would likely go up, led by firms announcing the relocation of intellectual property-creating operations abroad. Maybe dual listings in New York and China. China and the EU stand to be the big long-term winners.

I think a Trump loss would much more complicated. There’s the issue of repairing the enormous economic, financial and cultural damage he has done to the country. There are also the former heavy industry areas, core sources of Trump strength, which have been ignored by both parties for decades at great national cost. A counter-trend rally might finally happen–maybe even pre-election if a pro-Biden outcome were clear. Would it have legs, if so?

what might cause a dollar swoon

government saving/spending–in theory

In theory, governments spend more than they take in to ease the pain and speed recovery during bad economic times. They spend less than they take in during booms to moderate growth and repay borrowings made during recession.

what really happens

In practice, this occurs less than one might hope. Even so, the Trump administration is one for the books. Despite coming into office after seven growth years in a row, Trump endorsed an immediate new dose of government stimulus–a bill that cut personal income tax for his ultra-wealthy backers and reduced the corporate tax rate from nosebleed levels to around the world average. While the latter was necessary to prevent US companies from reincorporating elsewhere, elimination of pork barrel tax breaks for favored industries that would have balanced the books was conspicuously absent.

The country suddenly sprouted a $1 trillion budget deficit at a time when that’s the last thing we needed.

Then came the coronavirus, Trump’s deer-in-the-headlights response and his continual exhortations to his followers to ignore healthcare protocols belatedly put in place have produced a worst-in-the-world outcome for the US. Huge economic damage and tens of thousands of unnecessary deaths. Vintage Trump. National income (and tax revenue to federal and state governments) is way down. And Washington has spent $2 trillion+ on fiscal stimulus, with doubtless more to come.

To make up a number, let’s say we end 2020 with $27 trillion in government debt (we cracked above $26 billion yesterday). That would be about 125% of GDP, up where a dubious credit like Italy has typically been. It would take 7.7 years worth of government cash flow to repay our federal debt completely. These are ugly numbers, especially in the 11th year of economic expansion.

At some point, potential buyers of government bonds will begin to question whether/when/how they’ll get their money, or their clients’ money, back. In academic theory, foreigners work this out faster than locals. In my experience with US financial markets, Wall Street is the first to head for the door. The result of buyers’ worry would be that the Treasury would need to offer higher interest rates to issue all the debt it will want. To the degree that the government has been borrowing short-term (to minimize its interest outlay) the deficit problem quickly becomes worse. Three solutions: raise taxes, cut services, find some way of not repaying borrowings.

not repaying

Historically, the path of least resistance for governments is to attempt the last of these. The standard route is to create inflation by running an excessively loose monetary policy. Gold bugs like to call this “debasing the currency.” The idea is that if prices are rising by, say, 5% annually and the stock of outstanding debt has been borrowed at 2%, holders will experience a 3% annual loss in the purchasing power of their bond principal.

The beauty of this solution in politicians’ eyes is the ability it gives them to blame someone else for what they are doing.

The downside is that international banks and professional investors will recognize this ploy and sell their holdings, creating a potentially large local currency decline.

The issue with the devaluation solution in today’s world is that sovereign debtors have been trying for at least the past decade to create local inflation–without success.

This would leave either tax increases or default as options. The slightest inkling of either would trigger large-scale flight from the country/currency, I think. Again, Wall Street would likely be the first. Holders of local currency would assume third-world-style capital controls would soon be put in place to stop this movement, adding to their flight impulse.

The most likely signal for capital flight to shift into high gear, in my view, would be Trump’s reelection.

depreciating the dollar

When a country is having economic problems–slow growth, outdated industrial base, weak educational system, balance of payments issues–there are generally speaking two ways to fix things:

–internal adjustment, meaning fixing the domestic problems through domestic government and private sector action, and

–external adjustment, meaning depreciating the currency.

The first approach is the fundamentally correct way.  But it requires skill and demands a shakeup of the status quo.  So it’s politically difficult.

Depreciating the currency, on the other hand, is a quick-fix, sugar-high kind of thing, of basically trying to shift the problem onto a country’s trading partners.  The most common result, however, is a temporary growth spurt, a big loss of national wealth, and resurfacing of the old, unresolved problems a few years down the road–often with a bout of unwanted inflation.  The main “pluses” of depreciation are that it’s politically easy, requires little skill and most people won’t understand who’s at fault for the ultimate unhappy ending.

Examples:

the Great Depression of the 1930s;

the huge depreciation of the yen under PM Abe, which has impoverished the average Japanese citizen, made Japan a big tourist destination (because it’s so cheap) and pumped a little life into the old zaibatsu industrial conglomerates.

 

It’s understandable that Donald Trump is a fan.  It’s not clear he has even a passing acquaintance with economic theory or history.  And in a very real sense depreciation would be a reprise of the disaster he created in Atlantic City, where he freed himself of personal liabilities and paid himself millions but the people who trusted and supported him lost their shirts.

Elizabeth Warren, on the other hand, is harder to fathom.  She appears to be intelligent, thoughtful and a careful planner.  It’s difficult to believe that she doesn’t know what she’s supporting.