The Smoking Ruin Solution

Dear Reader,

As a quick follow-on to yesterday’s article on President Obama’s growing problem with members of his own party, it was just reported that the turnout for the Democratic primary was the lowest in 80 years. While the Republicans are clearly energized by their concerns about the direction the Democrats are taking the country in, the Democrats themselves seem to have decided to forgo the voting process, perhaps in favor of a refreshing nap.

No question about it, the president is in the hot seat.

His biggest problem, of course, is the continuing crisis – a crisis that appears to us to set up for Round Two – with more shaky news out of Greece, Ireland, Portugal, and now Belgium.

But the eurozone is far from alone in this mess – as Bud Conrad explains in detail in the current edition of The Casey Report, the export-dependent Japanese economy is at risk of rolling over and sinking under the pressure of their unusually strong currency. But if the yen actually falls – as it is likely to do – then the outlook for Japan’s economy, the world’s second largest by most measures, will become equally dire.

In other words, they need to find a policy that will allow the yen to be not too strong and not too weak – but rather, just right – or they risk an actual collapse. Given they already have the highest level of debt to GDP of any developed country in the world, and by a wide margin, finding a sustainable economic policy response is all but impossible. 

As for China, who knows? We hear of gross overcapacity in housing, but it’s hard to trust almost any data emitting from that entirely politicized economy. 

As for the U.S., while I am sure that back in 2008 Barack Obama was one happy camper about having taken the presidential prize, today one has to wonder if that victory has led him to certain bitter regrets.

His problem, the problem bedeviling the government at its highest level, is that there is actually no palatable solution to the persistent debt crisis now gripping the U.S. economy by the throat.

In fact, the only tangible solution might be best termed the “Smoking Ruin Solution.” Allow me to elucidate.

The Smoking Ruin Solution

The Keynesians would take great umbrage at the idea that the government is left with no viable options at this point. The solution is clear to them – more stimulus. And this time around, no skimping! A paltry $800 billion isn’t even going to begin to get the job done. Rather, if two trillion dollars of freshly minted money is what it takes to kick the U.S. economy out of its swoon, then so be it. Hell, make it three if that’s what it takes – we can worry about the (inflationary) consequences later.

Economists who look to someone other than Keynes for guidance, have other ideas – but not many. And, as per my comments above, none that would be even remotely palatable to the man on the street. That goes double for the politicians (of both parties), who rely on the proletariat to provide them with the votes that keep them in power and in porridge.

While I don’t have the time to scratch even a square inch of the surface of all the goofy solutions economists might trot out if asked, I will attempt to briefly address, in the broadest terms, a solution that might be considered acceptable to those who skew toward the Austrian school of economic thought. For those of you unfamiliar with the Austrian perspective, it puts a large amount of faith in the unfettered free market, and almost none at all in the ability of governments to do much more than run economies headlong into solid walls.

I have to warn you, however, that the solution I am about to propose involves no quick fix or linking hands around the fire, accompanied by happy singing. Rather, it is more akin to treating a dread disease with a very strong medicine – so strong, in fact, that should the patient survive, they would (at least for some period of time) suffer a steep degradation in the quality of life.

I say that because the only real solutions available to the country are certain to result in financial carnage and social upheaval of a most extraordinary sort. For starters…

• A dime-on-the-dollar forced renegotiation with U.S. Treasury/agency debt holders. Sorry, China, Japan, et al. – push has come to shove, and it’s over the side with you.
  
  
• Letting the banks that should fail, fail. Sorry, shareholders and bond holders, which now include taxpayers, but you made a bad bet. And sorry, anyone with more in your failed bank than is covered by the FDIC, you’re out of luck on the excess. Given that the FDIC is also broke, we’re not even sure about the money you thought was covered.
  
  
• Turning the lights out on the U.S. empire. The U.S. spends more on maintaining overseas government operations than all the rest of the world’s nations combined. While the cost of ending our involvement in perma-wars, turning off the lights at military installations, canceling aid and subsidies to foreign governments will cause widespread pain and misery – both at home for the dismissed soldiers and overseas for our allies – doing so is likely to improve our security by dramatically reducing our boot print on the face of the globe.
  
  We’ve got more than enough in the way of nukes to deal with any large-scale threats, and with a more streamlined national security apparatus, we’d be certain to get a lot better at spotting the odd terrorist threat before the malcontents make it to U.S. shores.
  
  
• Goodbye, big government, and thanks for all the chicken. It’s been a wonderful run, with promises of fat chickens in every pot, affordable homes for all, safety nets under safety nets, universal healthcare, and an almost infinite number of regulations to make sure we’re safe in every conceivable circumstance. We hate to see you go, but go you must, because even though U.S. business labors under the second highest corporate tax rate in the world and the individuals who do pay taxes pay over half of their income, the shortfall between revenue and government expenses is at historic levels with no end in sight. And that’s just impossible to continue.

Under my solution, the size and scope of government will have to be seriously reduced, a process best started by severely limiting the ability of politicians to make new regulations and pass new taxes or mandates. With relatively little to do – as opposed to the situation today, when literally nothing is beyond the interest and reach of the federal government – a wholesale purge of the bureaucracy can be undertaken.

Yes, that would mean hundreds of thousands of freshly dismissed bureaucrats, many of them possessing no real marketable skills, hitting the employment market. But look at the bright side, the oversupply of labor willing to work for subsistence pay will cause “guest” workers to throw up their hands and head to greener pastures, leaving the former bureaucrats to clean the sewers, collect the garbage, and pick the tobacco.

• Farewell, Fannie and Freddie. Nationalizing the mortgage industry was a horrible idea… an idea whose time has now expired. The loans these zombie institutions hold should be pumped out into the market at whatever the free market will pay, which won’t be much, then the doors shut.
  
  
• Institute a flat tax at a level that everyone will happily pay. But that’s not fair, shout the progressives. To which I might respond, look at the facts. One of the biggest differences between America in its youth and the lands whence the citizenry came was that, in America, there were none of the entrenched classes that dog so many countries even to this day.

I can’t begin to count how many rich people I know who have lost essentially all their money due to bad investments or business decisions. Likewise, I know any number of wealthy people who started with little or nothing, but through hard work and enterprise made their mark and their money. The key to a robust economy is to make it as easy as possible for anyone to earn, and keep, the benefits of their efforts… and a reasonable flat tax goes a long way in that direction. As an added advantage, a flat tax would result in a wholesale shedding of accountants, lawyers, IRS employees, and more.

“But that will only add to unemployment,” you might fret (well, not you, but the person next to you). To which I would answer, rhetorically, by asking the question, “Is the desire to avoid such downsizing reason enough to keep the wasteful, counterproductive, and impossibly complex current tax system in place?” Hardly.

What the country needs now more than anything is transparency and the fostering of a solid foundation that allows businesses, and the entrepreneurs that start them, to do what they do best – create wealth.

• Link the money to something that limits the ability of government to print the stuff up at will. While some sort of a gold standard seems logical to me, anything that anchors the currency in such a way that the Fed – or the Treasury (in the absence of the Fed… one can only hope) – is unable to grow the money supply at a faster clip than, say, population growth, or the rate at which gold can be pulled out of the ground, would do just fine.

I could give you other examples of the sort of steps and attendant mayhem that would result from slashing government and letting the free market run its course. But I’ll stop there, if for no other reason than that by now, I suspect, many dear readers are recoiling in horror at the inanity of the ideas just presented.

No question, these solutions would leave the economy in smoking ruins – in worse shape, even, than at the height of the Great Depression.

While the devil is invariably in the details, the argument for pulling the proverbial trigger on the smoking ruin solution is understandable – at least to me – by getting back to the positive outcomes that would result.

• The overhang of unpayable government debt would be gone. Sure, the Chinese, Japanese, and Middle Eastern oil sheiks (along with anyone else who got stuck with a lot of bad debt) would be really, really unhappy with us. Again, sorry – but we’re bankrupt and pretending we’re not is just going to make things worse in the long run. Besides, in relatively short order, I suspect our trading partners would get over their losses on defaulted government bonds because…
  
  
• Business would be booming. Unshackled from high taxes and excessive regulation – and freed from the fear that at any moment some change in the regulations, or even the whim of a minor bureaucrat, can knock the pins out from under a business – the U.S. would once again become the world’s preferred place to do business.
  
  
• The debt bubble would deflate. As it now stands, we can’t even begin to tally all the outstanding bad loans, let alone who ultimately owns that debt. Each new bank that fails, each new equity and bond holder that goes bankrupt, and each new financial institution that folds reduces the toxic debt that will otherwise plague the economy and create uncertainty until it’s ultimately resolved. Under the scenario painted above, the deleveraging and destruction of debt would come fast and furious, allowing the nation to understand the true value of everything and to move forward from there.
  
  
• Housing prices would fall to a market clearing level. People who were forced to sell their houses would be forced to sell them at a price someone is willing to pay – and that price would likely be a lot less than the current market. Tough break, and it could lead to a bankruptcy that takes down yet another bank – but so be it. It’s time to let the chips fall where they might.
  
  
• The U.S. dollar would once again become trustworthy, and therefore in demand. It might even be able to retain its reserve status.

Such strong medicine would make the patient sick – and likely even cause reduced quality of life for some extended period of time. But I have to believe returning America to a foundation built on the principles of self-reliance and an individual’s right to the fruits of their labor would lead to a breathtaking groundswell of optimism and enterprise. Further, just as was the case in 1776, the U.S. would again provide a model for the rest of the world to follow, so the benefits would be global.

Of course, everything I just wrote would be considered almost criminally outrageous by most of the citizenry – and written off as the ravings of a madman by the politicians. 

Which is why, in time, it will be the Keynesians’ arguments that win the day, and the next leg down will be met by a wave of newly printed funny money – a veritable flood of the stuff. Certainly not before the November elections, and certainly not before the threat of a deflationary collapse provides the cover the government needs to act – but it’s coming.

Gold still seems a safe bet to this observer.

Letters from You

This first letter, and the response, was forwarded to me by our own Louis James, the hard-working editor of Casey’s International Speculator.

David,

I just got an email from a reader I'd like to share the heart of (with his permission):

Many lessons were learned yesterday. First one is, I am going to the web site you referenced to learn more about pink sheets. Second is that re-reading a couple times that which I don't totally understand is probably a good idea before I plunk my money down. 

For the better part of a generation, I wrote books and taught the subject of negotiations in industry. One of the best negotiators I ever met was a very wealthy young man in his 30s, second-generation wealth, and he was one of the nicest, coolest customers I have ever seen; particularly when it came to buying and selling. I asked him what he felt his secret to success was. He commented: "Life is full of good deals. The quickest way to turn a good deal into a bad deal is to get emotional about it." I saw him look at proposals, talk for a while, then calmly say, "No thanks, we will pass on this one," then just go on to the next and never look back. ‘Tis no wonder he multiplied his wealth so well.

Thanks again for your response, kindness, and patience. 

I think this is worth sharing because it underscores several points I return to frequently in the International Speculator. Among those are the virtue of patience (waiting for the right ball to sail over home plate and then swinging for the bleachers) and the discipline not to chase stocks (you have to be a contrarian to buy low and sell high). Those could be rephrased as not “getting emotional” about stock picks.

People get emotional, of course, when a stock goes down – but in my experience, they get even more emotional when one goes way up and we either sold earlier or never bought it at all. But as Doug likes to say, you can’t kiss all the girls. If you try, you get spread too thin and can take losses that far exceed the returns you earn from the occasional “kiss.”

At the bottom line is the question: Does our strategy make money? Well, just last month alone, our average portfolio gain was 25.7%. Over the same time period (7/26 – 8/27), gold was up 4.4%, the TSX-V was up 6.1%, and the HUI (AMEX Gold Bugs Index) was up 8.8%.

This is precisely the kind of leverage to gold our “most volatile stocks on earth” are meant to provide.

A thought to consider.

L

This second letter is from Kevin, and the response from our resident money guru, Terry Coxon.

Question for David... he writes below in the real estate piece that there is “cash on the sidelines.” John Hussman has written that this is a common fallacy.

If I understand this correctly... there is no such thing as “cash on the sidelines” in terms of a catalyst to boost the stock market... however, if one were to move his money from a source of savings and purchase a home, this could buoy real estate?

I apologize if my question is not clear... I am having trouble connecting the dots, and I always question when I see the term “cash on the sidelines.” I guess I haven't seen it outside the context of the stock market.

Thanks, Kevin.

Terry Coxon responds…

Kevin,

John Hussman is correct and is inviting his readers to use words literally when he points out that cash never “flows into” anything. Cash changes hands, as do shares of stock and pieces of real estate. But the cash doesn’t “flow into” the stock market, since the money the buyer imagines he is putting into stocks is exactly matched by the money the seller imagines he is taking out of stocks.

Dr. Hussman is also correct that looking at cash levels in particular parts of the market may not reveal as much as it seems to. Low levels of cash held by mutual funds, for example, seem to indicate a lack of potential buying power for stocks. But the cash that mutual funds don’t have is held by others, and in their hands it is potential buying power for stocks.

Nonetheless, the total amount of cash held by everyone is significant. When it is large in comparison with total wealth, as it is now, it only takes a modest shift in sentiment to generate strong bidding for the asset classes the public has come to view more favorably. Real estate could be the beneficiary of such a shift when, as we expect, today’s fear of deflation is replaced by a fear of inflation.

This next letter comes from a fellow David… and also deals with real estate.

Greetings,

My general motto is, "While I might be over-opinionated, at least I am under-informed." That said, my “worth what you paid for it” comment on housing is this: Interest rates are not high enough for this to be (even close) to the bottom.

I know that locking in a low rate can be a home run (I have a jumbo 30 at 6% that will likely be one of my best "assets" in the future), but generally real estate is at its low when rates are high.

All the best,
David

David is, of course, correct. The higher the interest rates, the fewer the number of people who want to borrow to buy the stuff. Which is yet another reason why the inevitable increase in U.S. interest rates from today’s historically anomalous lows will be so devastating to the economy. Do I think we’ve seen the real estate lows put in? Not hardly.

But as interest rates start to ratchet up, casting doubt on the ability of the world’s largest debtor (the U.S.) to meet its many obligations, there is very real potential – some would say a certainty – of a currency crisis. Which is to say, a wholesale dumping of dollars with devastating results for anyone caught holding the proverbial bag. In that environment, a lot of people will remember real estate as the tangible asset it is.

For the time being, patience should be well rewarded. And if you feel compelled to buy, buy only for personal use and base your offer on a price you’ll be really happy to own the property at – even if it subsequently falls in value by another 20%.

The End of Cash

The end of cash, folding money as it used to be called, is but one of the almost certain longer-term consequences of global governments growing desperate for new sources of revenue. The technology to eliminate cash already exists and is well proven. Credit and debit cards are ubiquitous, and in many markets you can now use your cell phone to buy things. Step up to a soft-drink machine, dial the right number, and the desired refreshing beverage falls into the slot with the price added to your monthly bill.

The advantages to governments of eliminating cash are as substantial as they are obvious. In the absence of money that can be used in private transactions, out of sight of anyone but the seller and buyer, most transactions would become visible to powerful government programs that match spending to income, available credit, and net worth. When a mismatch is spotted, up goes the red flag and down comes the heavy hand of the IRS.

Of course, being as adaptive as rats to new threats, humans will quickly look for, and find, alternative methods of hiding wealth and transacting – but it will be no easy thing. Imagine, for example, that you were an ardent drug user and no cash were available to keep your transactions private. You could use what income you have to buy things such as, say, a small television, then trade the television to the dealer for your favorite recreational drug – but the complexity involved in such a barter system, and the problems it would cause the dealer who then has to get rid of the television in exchange for something other than cash, would cripple that business. Ditto any other that requires privacy and discretion to continue.

And forget hiring illegal aliens, paid off the books with cash at the end of the day. In fact, forget hiding any wealth from the multi-faceted fly-eyes of revenue-seeking governments.

The list of advantages to the government of doing away with cash are so powerful that I have to believe that in our lifetimes, and maybe quite soon, it will happen. 

“But wait,” you say cunningly. “I could buy gold and use that in my transactions.” Sorry, but once cash is gone, it’s just a matter of time before gold and precious metals are also outlawed – in the interest of national security, of course. 

It’s really just a matter of time. Fortunately, you’ll be able to hear the klaxon horn well before the government moves to ban precious metals – just watch for the news that high government officials are discussing programs designed to reduce or even eliminate cash, in favor of money transfers using more modern technologies.  That will be your sign that we’re about to step onto a very slippery slope.

Not to alarm you, but here’s one article forwarded to us by a reader on just that topic, titled, The Death of Cash?

That’s It for Today

And with that, I will say sayonara for the day, wishing you only the best, even in the worst of times. Together, we’ll come out of this just fine. But it’s sure going to be an interesting ride.

Until tomorrow, thanks for reading and for subscribing to a Casey Research service.

David Galland
Managing Director
Casey Research