What (Almost) Everyone Fails to Understand About Our Economy


Dear Reader,

Before I begin today's musings, I would like to give a musical nod to Bush, a band that seems to me to be largely overlooked. If you are unfamiliar with them (and don't mind some fairly hard rock), here are a few selections to keep you company this fine day… GlycerinEverything's Zen (live)… Comedown.

And so, with feet and fingers tapping madly, we move on…


What (Almost) Everyone Fails to Understand About Our Economy

I want to start today's missive with a couple of unusual charts. Unusual because they contain no reference points. Here's the first.

And here's the second.

We'll return to those charts momentarily. First, however, a confession.

As much as I read, and despite interacting with very smart people on a daily basis, until just recently I have missed something about our economy that, on reflection, should have been as obvious as the computer screen I spend far too many hours staring at.

Allow me to emphasize the point in somewhat stronger terms.

That I could have overlooked this particular aspect of the US economy and the overarching consequences that follow from it for all these years should, if I were a lawyer, cause me to be disbarred. If I were a doctor, the medical practice board would be entirely within their rights to revoke my license. If I were a politician, my benefactors would be entirely justified in cutting off my bribes donations. If I were a… well, you get the idea.

Interestingly, as smack-up-the-side-of-the-head obvious as this feature of the economy is, and has been for years, virtually everyone else has failed to spot it as well.

So, what is this mystery?

Succinctly, it is that, like Europe (where, during my recent trip there, the spark of awareness was lit), the economy of the United States is, and has been for decades, increasingly under the control of central planners at the expense of the free market.

As proof of that contention, we return to the two charts above. Here, again, is the first, but with the contextual reference points in place.

(Click on image to enlarge)

As you can see, the chart tracks the purchasing power of the US dollar since 1914, the year that the government, through its stooges at the Fed, took command of monetary policy. Laughably, the stated mission of these central planners was to preserve the value of the dollar. Predictably, exactly the opposite resulted.

And here's the second chart, also with the reference points in place.

(Click on image to enlarge)

As you can so clearly see, after severing the last connection with the gold standard in 1971, after which point the central planners took command of fiscal policy, we have seen an exponential growth in government debt.

(Of course, the numbers on the national debt are grossly understated as it doesn't account for the tens of trillions of dollars of unfunded and unpayable obligations tied to Social Security, Medicare and so forth.)

Now, I could go on and on, finding dozens of examples of the shift from a free market to a command economy, but in the interest of time will stop there.

The point, which I hope is now clear to all, is that the economic model that allowed the United States to rise out of abject poverty at its inception to become the most powerful economy the world has ever seen has been tossed aside in favor of a model that has proven time and again to be fundamentally flawed and always doomed to fail.

That the central-planning model, here and around the world, has been advanced by a fiat global reserve currency is undeniable. However, as the two charts clearly show, the consequences of having central planners controlling monetary and fiscal policy have created a ticking time bomb set to explode.

A few additional comments are warranted.

The first has to do with who the central planners actually are. And the best way to understand that is by considering who they are not.

Who they are not is successful entrepreneurs. Stating what should also be obvious, were they successful entrepreneurs, they would be otherwise engaged in creating jobs and building wealth for themselves and their co-workers.

Instead, the central planners almost always hail from the halls of academia, their stock and trade consisting entirely of a college degree and a façade of really knowing what they talk about. As a friend likes to say, "The biggest problems in this world are not caused by a lack of knowledge, but by people who pretend to know when they don't."

Over the years I have met and even gotten to know people who have gravitated toward jobs involved with setting government policies. And to a person, they have never held a real job outside of academia, or if they did, they failed at it. Yet they are unhesitant in telling everyone who will listen in tones most professorial how the world should work, and why enlightened government policies – not the free market – are the only answer.

These people have taken over our country, and in fact, the world. The current mess we are in should not be a surprise to anyone. All anyone has to do is look at the history of the Soviet Union, or communist China, pre-economic liberalization, to see how the story of command economies ends. How it always ends.

So, where do things go from here?

Earlier today I dropped an email to our editors, which I will quote from here as it deals with what I see as the fate of the global economy over the next six months or so.

"It's all about the debt.

"The sovereigns owe a lot of money that they can't repay. As they try to roll over their existing debts and have to borrow more, the lenders – if any can be found – will want higher and eventually unaffordable interest rates. When the lenders dry up, the only solution will be for the central bankers to monetize, but the world will be watching closely, so this will likely trigger a death spiral in the fiat currencies.

"There are intractable problems on a fundamental, systemic basis that cannot be resolved in an orderly fashion. The day is coming when the lending locks up again, after which point everything starts to fall apart.

"So, no, I don't think it's a muddle by outcome, but a systemic crash... hopefully big enough to cause a rethink about the entire current setup with funny money and central economic planning.

"But that would take a very big crash."

Now, I know that a lot of dear subscribers, having accepted our arguments for including tangible assets as a core portfolio holding for many years now, have struggled during the latest retracement and consolidation period in the precious metals and associated stocks.

But if you step back and look at the big picture as it is constantly revealed in the headlines and regular releases of poor economic data, I think the conclusions we came to back before the crisis hit, that the Fed (and all the central bankers) are stuck between a rock and a hard place, remain the correct conclusions.

There is no simple or easy way out of this situation as the central planners are forced into a haphazard and highly destructive retreat. And the consequences won't just be economic or political… the mini-riots in Anaheim this past week are just a straw in the wind.

So, how does one cope in a command economy headed, like all its predecessors, into the trash bin of history – in this case, on a global scale?

First and foremost, diversify. Everything contains risk, so spreading it around to mitigate the chances of getting hit especially hard from any one investment sector makes a lot of sense.

Personally, I use a spread sheet program to analyze my holdings from a number of different angles, including percentage dedicated to natural resources; percentage in non-US-dollar-denominated assets; percentage outside of the United States; percentage with any one financial institution; percentage in dividend earning stocks; percentage liquid vs. illiquid; percentage in common equities; percentage in cash and so forth.

The idea is that if any one area becomes overweight or underweight, I look to make adjustments. In addition, I set certain goals – for example, the percentage of our net worth we want outside of the United States – and manage to that number.

In short, pay close attention to where your assets are allocated and don't go overboard in any one sector.

Secondly, skew toward things tangible. Over the next few years, we are going to see massive dislocations as the fiat currency system cracks apart, starting with the euro and then, after a final rush into the "safe harbor" of the US dollar, spreading to the dollar itself.

As much as possible, own things with a tangible value. Precious metals are fine, but don't go overboard as that makes you susceptible to a change in government regulations that could literally be invoked overnight. Consider property, and even income-producing property (in low-tax jurisdictions). But, again, don't go overboard because real estate is always a fixed target, which means the government can tax it or even confiscate it, and you won't be able to do much about it. Owning currencies of countries with large resources is a proxy for owning something tangible, though an imperfect proxy.

Be careful. It will only get more challenging to build net worth going forward. Whether it be higher taxes on capital gains (a certainty at some point) or the cancellation of tax breaks, or more demands on business owners from legislation such as Obamacare, generating – and more to the point, keeping – net worth will not be easy. Therefore, rule number one has to be to avoid risking big chunks of money.

Sit tight, and be right. Per my comments above, I remain convinced that our Casey Research base case – of a global economic crisis that will get much worse before it gets better, and that the central planners have few options left to them other than monetary debasement – is correct.

For those of you who already have allocations to the tangibles, and to the gold stocks (which are massively undervalued at this point), sit tight and you will come out right. If you are just now rethinking how to reposition your portfolio to get through what's next, then do yourself a favor and take a low-cost, money-back-guaranteed subscription to our BIG GOLD service and start adding positions on the inevitable pullbacks.

These are, of course, only some of the strategies you can use. The most comprehensive analysis of the situation, and how to prepare for what's next, will be at the upcoming three-day intensive Summit we are co-hosting with Sprott, Inc., Navigating the Politicized Economy, in beautiful Carlsbad, California, September 7 – 9.

The early-bird discount for the event is scheduled to come to an end on July 31, so if you are interested, follow this link to the full list of faculty, the schedule, and a secure registration form today.

Speaking of the Summit, one of the smartest people you'll rub elbows with at the event will again be Dr. Lacy Hunt, the former economist to the Dallas Fed (but a Fed fan no longer) and the nation's top-performing bond fund manager. Earlier this week, Lacy shot me over the following article that is well worth your attention.


Unintended Consequences of Well-Motivated Policies

By Dr. Lacy Hunt

In the early 1960s, when JFK was in the White House and William McChesney Martin was Fed chairman, Keynesian economics was in full bloom. One of its major tenets was the Phillips Curve, which posits a stable inverse relationship between the rate of inflation and the unemployment rate. Yale professor James Tobin (1918-2002) and others argued that the social outcome could be improved by a more activist monetary and fiscal policy. Specifically, they contended that the unemployment rate could be lowered while only resulting in slightly higher inflation.

The argument posited the notion that economic-policy makers had sufficient knowledge to intervene or fine-tune the economy with tools like those of a surgeon. Presidents Johnson, Nixon and Carter (two Democrats and one Republican) followed this policy. At one point, President Nixon made the famous statement that "We are all Keynesians now." Moreover, as the White House led, the Fed chairmen of the era – Martin, Burns and Miller – generally acquiesced.

To judge the effectiveness of this policy, an objective standard is needed. Arthur M. Okun (1928-80), Yale colleague of Tobin, developed such a standard, which he called the Misery Index – the sum of the inflation and unemployment rates.

Under the activist, Phillips Curve-based policy, some reduction in unemployment was temporarily achieved. However, inflation accelerated much more than was anticipated, and the net result was higher unemployment and faster inflation, an outcome not at all contemplated by the Phillips Curve. The Misery Index surged from an average of 6.7% in the 1950s, to 7.3% in the 1960s, to 13.6% in the 1970s, with peak rates above 20% in the early 1980s.

Many US households suffered. Wages of lower-paying positions failed to keep up with inflation, and when higher unemployment resulted, many of those people lost their jobs. Those on the high end had far more resources that enabled them to protect their investments and earned income, so the income/wealth divide worsened. A half-century later, the United States has never regained the prosperity of the 1950s.

Working independently in the late 1960s, economists Milton Friedman and Edmund Phelps, who would both eventually be awarded the Nobel Prize in economics, had determined that while the Phillips Curve was observable over the short run, this was not the case over the long run. While the economics profession debated the Friedman/Phelps research, the US had to learn their findings the hard way.

Growing Evidence of the Long-term Depressants from Activist Policies

In addition to the compelling evidence that more active monetary and fiscal policy involvement did not produce beneficial results over the short run, three recent academic studies, though they differ in purpose and scope, all reach the conclusion that extremely high levels of governmental indebtedness diminish economic growth. In other words, deficit spending should not be called "stimulus" as is the overwhelming tendency by the media and many economic writers.

Whereas government spending may have been linked to the concept of economic stimulus in distant periods, these studies demonstrate that such an assertion is unwarranted, and blatantly wrong in present circumstances. While officials argue that governmental action is required for political reasons and public anxiety, governments would be better off to admit that traditional tools only serve to compound existing problems.

These three highly compelling studies are:

  • "Debt Overhangs: Past and Present," by Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff, National Bureau of Economic Research, Working Paper 18015, April 2012;
  • "Government Size and Growth:  A Survey and Interpretation of the Evidence," by Andreas Bergh and Magnus Henrekson, IFN Working Paper No. 858, April 2011;
  • "The Impact of High and Growing Government Debt on Economic Growth – An Empirical Investigation for the Euro Area," by Cristina Checherita and Philipp Rother, European Central Bank, Working Paper Series 1237, August 2010

These papers reflect serious research by world-class economists from the US, Europe and Sweden – and they all confirm the detrimental consequences of extreme governmental indebtedness.

Misery on the Rise Again

In the past year, Okun's impartial arbiter averaged 10.5%, the highest on record for the third year of an officially recognized economic recovery and almost double the average of the 1950s. The latest readings have occurred despite US gross public debt in excess of 103% of GDP and with the Federal Reserve's unprecedentedly large balance sheet that approaches nearly $3 trillion.

Other measures of well-being confirm the Misery Index. The Poverty Index in 2011 appears to have reached 15.7%, the highest reading in five decades. Not surprisingly, two unenviable records have been set: 46 million, or 14.6% of the population, are now in the food stamp program, up from 7.9% in 1970 and a record-high 41% pay zero national income tax.

In the eleven quarters of this expansion, the growth of real per-capita GDP was the lowest for all of the comparable post-WWII business cycle expansions. Real per-capita disposable personal income has risen by a scant 0.1% annual rate, remarkably weak when compared with the 2.9% post-war average. It is often said that economic conditions would have been much worse if the government had not run massive budget deficits and the Fed had not implemented extraordinary policies. This whole premise is wrong.

In all likelihood the governmental measures made conditions worse, and the poor results reflect the counterproductive nature of fiscal and monetary policies. None of these numerous actions produced anything more than transitory improvement in economic conditions, followed by a quick retreat to a faltering pattern while leaving the economy saddled with even greater indebtedness. The diminutive gain in this expansion is clearly consistent with the view that government actions have hurt, rather than helped, economic performance. Sadly, many of those who the government programs were supposedly designed to help the most have suffered the worst.

The Way Out

The original theoretical argument in favor of deficit spending originated in J.M. Keynes' The General Theory of Employment, Interest and Money (1936). A search of Keynes' work reveals no recognition of the "bang point," or the condition where a government engages in deficit spending for such a prolonged period of time that a massive buildup of debt leads to denial of additional credit to the government because of fear that the existing debt will not be repaid. Nor did Keynes address the situation where a large number of countries are all simultaneously getting deeper and deeper in debt and there are gradations of debt among these countries – serious shortfalls in the basic Keynesian theory.

Keynes, as opposed to some of his interpreters and predecessors, may have implicitly recognized that a bang point could occur, because he did not recommend constant budget deficits. Instead, he advocated cyclical deficits, counterbalanced by cyclical budget surpluses. Under such a system, government debt in bad times would be retired in good times. However, Keynes' original proposition was bastardized in support of perpetual deficits, something Keynes himself never advocated.

Milton Friedman, whom many consider to have been the polar opposite of Keynes, also never addressed the concept of a bang point, but he may also have understood implicitly that such a situation could occur. The reason is that Friedman advocated balanced budgets, which if followed or required constitutionally as Friedman argued, would prevent a buildup of debt. This view was largely rejected as being inhumane since in a recession, government policy would not be responsive to unemployment and other miseries of such a condition. What should have been discussed is whether some short-term misery is a better option than putting the entire country and economic system in jeopardy, as numerous examples in Europe currently illustrate.

The most sensible recognition of budget policy came not from Keynes nor Friedman, but from David Hume, one of the greatest minds of mankind, whom Adam Smith called the greatest intellect that he ever met. In his 1752 paper "Of Public Finance," Hume advocated running budget surpluses in good times so that they could be used in time of war or other emergencies. Such a recommendation would, of course, prevent policies that would send countries barreling toward the bang point. Countries would have to live inside their means most of the time, but in emergency situations would have the resources to respond.

In the context of today's world, this approach would be viewed as unacceptable because it would limit the ability of politicians to continue their excessive spending, thereby saddling future generations with obligations and promises that cannot be honored. But isn't Hume's recommendation exactly what we taught our children in preparing them to manage their own personal finances? 

Lacy Hunt is the executive vice-president of Hoisington Investment Management, a firm with over $5.8 billion under management, and one of the nation's top-performing bond managers. Lacy's work has been published in Barron's, The Wall Street Journal, The New York Times, the Journal of Finance, the Financial Analysts Journal and the Journal of Portfolio Management. Previously he was the chief economist for the HSBC Group, one of the world's largest banks, and the senior economist for the Dallas Fed.

At the Casey Research/Sprott Summit, he will be making a comprehensive presentation on the policy options the government has left to it, the consequences of those options, and how investors can position themselves. He will also be participating in an on-stage exchange of views on the Fed with G. Edward Griffin, the author of the best-selling Creature from Jekyll Island and long-term Fed critic.

One of the really great things about these Summits is that most of the faculty, including Lacy, attend the entire event, giving you a rare opportunity to meet them in person and get your specific questions answered.

Details here.


Friday Funny

I have seen a number of iterations of this particular "funny," but this one goes a couple of steps further in explaining the dynamics, so I wanted to include it here.

Suppose that every day, ten men go out for a beer and the bill for all ten comes to $100.

If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.

The fifth would pay $1.00

The sixth would pay $3.00

The seventh would pay $7.00

The eighth would pay $12.00

The ninth would pay $18.00

The tenth man (the richest) would pay $59.00

So that's what they decided to do. The men drank in the bar every day and seemed quite happy with the arrangement, until one day the owner threw them a curve.

"Since you are all such good customers," he said, "I'm going to reduce the cost of your daily beer by $20.00."

Drinks for the ten men now cost just $80.00.

The group still wanted to pay their bill the way we pay our taxes, so the first four men were unaffected. They would still drink for free. But what about the other six men – the paying customers? How could they divide the $20 windfall so that everyone would get their "fair share?"

They realized that $20.00 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:

The fifth man, like the first four, now paid nothing (100% savings).

The sixth now paid $2 instead of $3 (33% savings).

The seventh now paid $5 instead of $7 (28% savings).

The eighth now paid $9 instead of 12 (25% savings).

The ninth now paid $14 instead of $18 (22% savings).

The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before! And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

"I only got a dollar out of the $20" declared the sixth man. He pointed to the tenth man, "But he got $10!"

"Yeah, that's right," shouted the seventh man. "Why should he get $10 back when I got only two? The wealthy get all the breaks!"

"Wait a minute," yelled the first four men in unison. "We didn't I get anything at all. The system exploits the poor!"

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

For those who understand, no explanation is needed.

For those who do not understand, no explanation is possible.


Casey Report Editors in the News

In the way of weekend reading/watching, following are links to some media coverage senior Casey Report editors Bud Conrad  and Doug Casey received this week.

The first is an interview with Bud Conrad by the always competent Jim Puplava of the Financial Sense Newshour. In it, Bud discusses his analysis of how the new abundance of natural gas is a game changer for the US. He lays out how the new technology has provided the US with a huge new source of energy that is growing in production and use. Here's a link to the interview.

Better still, you can get the whole story with the details in charts and graphs showing a new method for predicting the price of natural gas, and Bud's investment prediction, by signing up for a no-risk trial to The Casey Report.

Doug Casey ripping things up at the Agora Financial Conference. My dear business partner of some years is many things, but a shrinking violet is not one of them. Regular correspondent Brett of the Contrary Investing Report is in the audience at the Agora Financial Conference now going on in Vancouver, and filed the following recap of Doug's remarks. Here's the link.


Weekend Reads

Much of these fall into the category of yet more examples of central planning and the consequences that inevitably follow. Some are quite eye-opening, starting with…

Fire Ice – We have all seen the news about the deadly wildfires now sweeping the western United States. Would you believe that there is a proven technology that could have snuffed those fires out long ago? That could snuff them out right away? Yet the company that possesses the technology – which other states have used very successfully – remains sidelined. Perhaps, as one observer put it, by whichever politically well-connected company now has the contract to fight the fires. Here's the link to the eye-opening story of Fire Ice.

Bloomberg on Cops Going on Strike – You probably heard that Mayor Bloomberg of NYC proposed that the nation's police go on strike until gun control laws are enacted. If not, here's the story – and a fact-based response to his contention that police are increasingly at risk from being shot by members of the public. The truth, however, is just the opposite – with police shootings, such as set off the Anaheim riot, on the increase. Here's the story from the always excellent Reason.com.

Also from Reason, a Mind-Numbing Story About the IRS – Imagine a family being asked to pay millions in taxes for a piece of worthless art. Worthless not because it's not fine art (though not to my taste), but because the government's own rules make it illegal to sell. Here's the story.

Airports and Border Crossings in Canada Wired with Listening Equipment – from Our Friends at the  International Man. One of the participants in the forum at InternationalMan.com tipped us off to this story, that the Canadians are wiring their airports and border crossings so that they can listen in and record your conversations as you wait to go through. What has happened to the world? Oh, that's right, I remember – the central planners, in this case those charged with protecting our "security," have been at it again. Next time you are in a Canadian airport, any airport, remember, mum's the word. Here's the story.


And Finally…

Ending on a positive note, the following just came across the wires. Though the story comes from Cuba, it points to a better, freer future for us all.

That's because while a centrally planned, command economy can last a long time, it can't last forever. And when the house of (poorly arranged) cards comes crashing down, the free market will reemerge.

Here's the headline of the story, and a link to read it.

Cuba to end Soviet-style economy and will implement market-friendly policies

Here's the link

And with that, I will sign off for the week by thanking you for reading and for being a Casey Research subscriber.

Remember, the early-bird pricing for our upcoming Summit ends July 31 – don't miss it.

See you there!

David Galland
Managing Director
Casey Research

Jul 27, 2012