Green Shoots?

It's great to be optimistic, and we should all hope that it is infectious. But here are the economic realities, and problems, which might slow the growth of these "green shoots":

1. Real estate. There is a 2 year inventory of single family homes available on the market. Additionally, 5.5 million home mortgages are in trouble. A healthy percentage of them will join the "houses for sale" market in the next 24 months adding to an already bloated supply. The real estate industry is a large employer, and until these homes are absorbed, and until we get back to a "normal" pattern of foreclosures, unemployment will remain high in the real estate business.

2. Federal Government indebtedness and growth. In just 12 months the U. S. national debt has increased from $9.4 trillion to $11.3 trillion, a 20% increase in one year. In 1991 it took $2.60 of debt to produce every extra dollar of GDP growth. By 2001 it took $4.65 of debt to produce a new dollar of GDP, and by 2008 it took $6.12 of debt to produce another dollar of GDP. Most of the borrowing has been by the government. That is why there is an increasing amount of borrowed funds necessary to produce each extra dollar of GDP. Government debt is inefficiently used. It is not invested in plant and inventory that will produce more jobs and income, but rather, it is given away in the welfare system to people who, themselves, are unproductive. As long as we continue to bury ourselves in public debt, our economy will continue to struggle with growth. Government debt is never paid off, and government debt requires a constant stream of interest payments that burden the taxpayer and therefore burden the economy, because those funds would otherwise have gone into productive investments. Unbelievably, U. S. government securities are now on the watch list by the S & P Bond Rating Service. S & P is looking hard at reducing the AAA bond rating. How can the richest country in history, whose dollar is the world's reserve currency, carry on with less than an AAA bond rating?

3. "As GM goes, so goes the nation" This famous saying was coined by GM chairman Charlie Wilson, more than 50 years ago, and he was right. As General Motors grew, and grew, and grew, so grew the U S. As debt, pensions, poor management and untenable labor contracts have put GM on the verge of bankruptcy, so is the U.S. government on the verge of bankruptcy. The U. S. government is really illiquid and only sustained by taxes, and the fact that the dollar is the accepted world's currency. How much longer the dollar will be the world s accepted currency is unknown because our government is managed like GM: bloated, ridiculous pensions, overpaid and inept employees whose jobs are protected, and borrowing money without restraint. At this point the U.S. government needs to borrow $7 billion a day, just to meet its "obligations". GM and the U. S. government are really in exactly the same boat: unmanageable, intractable, and hopelessly in debt.

4. Wall Street. Wall Street encompasses the entire U. S. financial spectrum; banks, insurance companies, mutual funds, stocks and bonds, etc. Wall Street as we knew it two years ago has disappeared. A combination of Wall Street greed, and government involvement with Wall Street, has turned our monetary system upside down. Most of the funds to elect high ranking government officials, including the president, come from Wall Street. Most of the U. S. government financial organizations like the Federal Reserve System and the U. S. Treasury, are run by former Wall Street executives whose buddies are still churning out multi-million dollar bonus' at their former Wall Street firms. Under the "you scratch my back and I'll scratch yours" theory, the government allows Wall Street to package securities in an unsafe and overleveraged way because a lot of the money earned therefrom comes back to keep those politicians in office. Therefore, when the main source of funding for elections, Wall Street, gets in trouble, it is logical that government would bail them out with taxpayer dollars to keep the Merry-Go-Round going. Wall Street firms and banks get recapitalized at taxpayer expense, and the same old Democratic and Republican regimes do the same old things to confiscate our dollars and perpetuate their own power.

5. Bear Markets in the Free Economy. Bear markets exist for the purpose of correcting the faults, scams, greed and inefficiencies that grow out of the preceding bull markets. Today, however, the failures are being bailed out with massive infusions of capital contrary to free market theory that "bad businesses need to go broke, be recapitalized with new money, and invigorated with new management". To continue to keep them afloat is a politician's response to a crisis that in most cases was created, or allowed, by the politicians themselves. This "new deal" will ultimately generate more havoc as the downward spiral repeats itself because the problem has never been fixed—it's only being sustained with a band-aid.

6. Stock Markets. In bear markets, the steady liquidation of securities by those who need cash will frustrate the market's attempt to rise to new levels. With high unemployment, the economy's cash flow will not be able to increase. People will supplement their financial needs by liquidating securities, thereby keeping the stock market suppressed.

Based upon the above economic realities, it is now evident that values in America will continue to undergo reassessment. While impossible to estimate, it's reasonable to assume that values, once readjusted, will end up at 60% to 80% of where they were before the recession started. Stock markets were selling at unrealistically high values and real estate was selling at unrealistically high prices. What's interesting is that while prices may take significant drops in value over the next few years, those values will be blown out of the water by inflation sometime in the next 5 to 10 years.

What we may expect to happen

We have entered a less indulgent world which is probably more realistic than the one we enjoyed a few years ago, a world in which most people will live more frugally. Less waste, and lower expenditures, coupled with more savings, will come eventually and will help pull us out of this economic morass.

It would be helpful if our government cut back on expenditures and reduced, got rid of, or put a cap on huge welfare programs that drain the treasury. Banks have been saved with lots of cash from the Fed which the public will pay for with interest payments ad nauseam. Eventually, they will begin to lend again. The smaller banks are already lending, and the bigger banks are being encouraged to do so by the Fed and the Treasury Department. However, with everybody still shell shocked, it is not easy to reopen the loan vents. An active, and lending, banking industry is necessary to increase the velocity of money. Velocity of money is the frequency of its turnover. The greater the spending in an economy, the greater is the velocity (turnover) of money. Cash held in the bank is most useful to the economy when banks are lending and businesses are spending.

Countries in crisis need to learn to live within their means after periods of excess. Exports must be increased and imports must be cut. Our trade imbalance, which has been horrible the last several years, is getting a lot better as U. S. expenditures for frivolous items is reduced.

The job displacement that has occurred in this country over 35 years is astounding. Until 1985 the financial sector never earned more than 16% of corporate profits, and manufacturing was the big banana. In 1986 that figure ballooned to 19%. In the 90s it represented 21-30% of corporate profits and in this decade it has reached 41%. This is unrealistic and will change over the next several years, thereby reducing the influence of the financial sector in both (1) the economy, and (2) in lobbying the government for special favors that make them money with financial instruments that are very risky and lead to the mess in which we are currently mired.

Conclusion

Cicero said in 55BC: "The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work instead of living on public assistance". Amen!!!!

More than 2000 years later, many empires have come and gone of which the United States is the latest. It is unlikely that our politicians will follow Cicero's advice, or even follow our own U. S. Constitution that they solemnly swear to uphold. We will therefore stumble along until things get better, just because we are a well educated, hard working and creative people. De Tocqueville said in the early 19th century "a good government's greatest job ought to be to accustom the people, little by little, to do without their government." Expecting that government will not do the right thing, the prudent investor will be best advised to sit on the sidelines with cash, high-grade short-term bonds, and stocks that pay a high dividend, that sell at a low price earnings ratio, and that are rated "A". The conservative investor will let the market unwind itself, and the economy de-leverage itself, without making any major securities investments until times are more stable, and predictable.

Carpe Diem.
George Rauch
May 28, 2009

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