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.

debasing the currency

what debasing is

“Debasing” is goldbug-speak. In past centuries, when gold was actually used as money everywhere, when countries minted gold coins and kept reserves of the yellow metal as symbols of their ability to repay borrowings, governments in trouble would sometimes dilute their gold by blending in inexpensive base metals. So they would repay creditors substantially less than they’d borrowed. That’s debasing.

The modern equivalent of physical debasement is running a highly stimulative money policy, the idea being to create lots of inflation, which would allow a government to repay borrowings in inflation-debased currency.

A report from Goldman Sachs strategists came out this week suggesting that this process is at work in Washington right now, as a consequence, intended or not, of pandemic-fighting fiscal and monetary stimulus. Its conclusion: buy gold.

relevance for us as investors

I haven’t seen the report itself. I’ve only seen coverage in the financial press. (I’m not a Goldman client. For what it’s worth, I think the firm does top-notch factual research but struggles to find interesting investment conclusions from what it unearths. For you and me, Merrill Edge is the best I’ve found.)

I wrote about the gold issue in May. Except for China and India, where gold is still money, I don’t think holding gold achieves much of anything. The fact that a major brokerage house, typically a stronghold of Republican political sentiment, is willing to suggest–and seek publicity for–this idea, with its implied criticism of Trump’s dumpster-fire handling of the economy, is the most interesting aspect of its publication.

I think inflation is the least of our worries. Last year the federal government took in $3.5 trillion in taxes. Pre-pandemic, Washington was thought to be on course to spend about $1 trillion more than in 2020, due in large part to Trump’s failure to offset tax cuts with removal of special interest tax breaks for politically connected swamp creatures. The actual deficit will more likely be around $8 trillion. This would mean a total federal debt of, say, $28 trillion, or about 135% of GDP. That would place us up there with Italy among the most indebted nations in the world.

Yes, debt this high creates worries about devaluation as a way of not paying creditors back in full. Historically, however, such high levels of government debt are also associated with much slower GDP growth and emigration of the best and the brightest to make a life where economic opportunities are greater.

From a purely financial point of view, Trump’s threats to renege on government debt held by foreigners (basically making us look like Argentina) and his use of the banking system to attack political enemies are also giving new impetus to the search for alternatives to the dollar as the go-to currency for international trade and as a store of value.

I could go on about the other ways Trump continues to severely damage the US, while failing to provide any support for the left-behind rural citizens who support him. But I think the key question for the rest of the world is whether the US electing a white racist incompetent was a disastrous mistake or whether he really represents what the country stands for. If the latter proves true in November, the currency and securities markets reaction will likely be strongly negative.

threatening Federal Reserve independence

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

 

 

 

 

 

 

where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.