Fiscal Sanity Is Going to Crash the U.S. Economy

[In his latest report to clients, below, Boulder-based financial adviser Doug Behnfield sees a tough economy ahead no matter how the election turns out.  Doug is optimistic that the new Congress will finally move toward resolving a debt crisis that has held the economy in stays since the Great Financial Crash of 2007-08.  The bad news is that this will induce an economic coma from which it will be difficult and painful to emerge. RA]

Here comes the 4th Quarter! I suspect it will be action-packed. With one month to go before the election, it is a tight race and much of the investment commentary is focused on how the possible outcomes will affect the markets. Perhaps it all comes down to fate (n. 1. the power or agency supposed to determine the outcome of events before they occur; destiny). We should have a better idea whether gridlock will continue or legislative progress will be made in the effort to get the federal budget under control. The two movie scenes that come to mind are Thelma and Louise and Indiana Jones and the Last Crusade. I am pinning my hopes on Harrison Ford. The outcome will probably be more a function of how the congressional elections wind up than who wins the

presidency. I am optimistic that, through a combination of “political capital” in the Oval Office and a Congress that can legislate, the country will move forward in the battle against the fiscal crisis. However, if investors perceive the likelihood of progress, the response in the markets could be negative. That is because whatever the combination of tax increases and spending cuts, the impact on the economy is likely to be depressing.

Baby Boomer Demographics

Nobody ever said paying the piper would be easy. The sacrifices that will be required to bring down the deficit will be substantial because the natural rate of economic growth has been brought to a crawl. The combination of the credit bubble bursting and Baby Boomer demographics are mostly to blame. Because of democracy, government is a reflection of the voting households, so both balance sheets hit the wall at about the same time. The problems in Europe are similar. Fiscal stimulus seems to have reached its limit too. The outcome of this election will have an impact on where the sacrifices are inflicted, but the economic drag will be severe in any case if progress is to be made on budget deficits exceeding one trillion dollars. Research on the part of UBS, Goldman Sachs and the Congressional Budget Office suggest a range of outcomes that will reduce GDP growth between 1% and 6% in 2013. This is referred to as the Fiscal Cliff.

There is a fairly large contingent of economists who are either calling for recession or believe we have already entered one. Under normal circumstances, the vast majority of economists never use the “R” word until it is official because they are afraid of being perceived as pessimistic. Typically, recessions are declared six to nine months after they begin. Positive economic growth that is initially reported during the first quarter or two of a recession typically gets revised down into negative territory as part of that determination. The reason that this occurs is that real-time economic reporting for GDP contains an enormous amount of estimates that subsequently get replaced by actual data. This year’s 2nd Quarter growth was just revised down to 1.3% and the 3rd Quarter is expected to be below 2%. The concern among the bearish economists is that this meager rate of growth is within the margin of error and any amount of tax increases or spending cuts will be enough to push the economy over. That would most likely result in lower stock prices and higher Treasury and municipal bond prices.

O% Money Has Failed

Short-term borrowing rates have been near 0% for years without sparking a new credit cycle, and that should have been expected. The Fed and central bankers in the rest of the developed world have been “pushing on a string” for the most part and there is very little monetary stimulus left in the tool box to stave off the business cycle. Ben Bernanke has repeatedly stated that the Fed cannot create economic growth on its own and that the federal government needs to enact fiscal policy that helps. The problem is that growth ultimately is dependent on consumers, investors and businesses in a capitalistic society. Even brilliant political action and an accommodative Fed will be limited in its effectiveness by the pace of recovery dictated by the private sector.

The stock market disagrees so far, however. When it looked like a recession was beginning in 2010, the Fed implemented QEII, a $600 billion injection of liquidity, and in doing so, juiced consumer confidence enough to avoid it. Coordinated central bank easing in 2011 had a similar effect. Last month the Fed announced QEIII on the back of a bold promise by the European central bank to “do whatever it takes.” Perhaps recession will be avoided once again. But even if that proves to be the case, the stock market has priced it in by rallying 14% since the beginning of June. (The S&P500 was up 16.44% through September.) It remains below the levels reached on the day of the Fed’s announcement. Sentiment has turned extremely bullish as it usually does at tops, and earnings estimates are being cut. Time will tell.

In the meantime, the bond market continues to refuse to go along for the ride. Closed end municipal bond fund returns remain close to their highs for the year as rates have dropped. Treasury bond rates have basically treaded water so far in 2012. Sentiment there remains solidly negative, even as core inflation remains low and the Fed has extended its promise to keep rates at 0% into mid-2015.

For an example of an economist who believes that we have entered a recession (and who runs an equity mutual fund), I refer you to John Hussman.  Click here to access his current comments.

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  • JosephConrad October 23, 2012, 9:52 pm

    Several factors will ‘save’ h US economy from sure disaster. Eliminate the Fed and use the interest on the national debt citizens pay ($502 BILLION) to fund universal healthcare thereby removing a major business cost limiting US business success, competitiveness and profitability. Regulate Insurance Companies as they’re largely unnecessary and a ‘piggybank’ for the Wealthy.
    Include Capital Gains a part of a person’s wages and hen tax accordingly. Audit the Fed & US goal held. epublish the M3 money supply number each month in all newspapers. Abbrogate and default on all Credit Default Swap Derivatives then implement a comprehensive regulatory system for them run by major US economists.
    Reinstall the Glass-Steagall like yesterday. Indict, rmeove and imprison Wall Street Banking executives clearly committing multiple Felonies – including Prince, Bernanke, Geithner, Summers, Rubin, Greenspan Paulson, Blankfein, all major AIG execuitives and Freidman. The ‘roaches will scurry one h first one goes o jail. America’s on the brink but is citizens are too stupid, ignorant, cowardly, passive and oblivious to act. As a result, the U.S. pseudo-democracy is near death.

  • mava October 22, 2012, 3:15 am

    Very good analysis in this article. There lies the rub, correctly identified.

    To get off the needle would mean a severe withdrawal symptoms. This is precisely why nothing has been done so far to correct the situation.

    If I had to find something on which I can disagree with this author, it would be only that I am sure, whichever candidate wins the election, nothing at all will be done.

    If it was conceivable that something could possibly be done, then we would not historically see nations invariably running themselves off a cliff. The reason it is so, is that whatever abuses had been committed, had as their goal a redirection of some share (usually ever-growing) of economic output towards something (say mil.industr.complex) or someone (say friends and families of TPTB). As such, then doing something right later on would require a sacrifice of that something or someone. Such is impossible, because, as the abuses were committed by the powerful fraction of society, then it should be taken “a priori” that that fraction will be capable of resisting the change. That is why when the change was absolutely demanded, it had to be done through a revolution.

    Usually, and I believe this time will be no exception, some “other” sacrifices would be made in attempt to substitute. I.e., to deny some other parts of society their share of economic output in order to both, lighten the load and to preserve the current recipient of the largesse.
    This will probably means that we will see , say, seniors being denied healthcare or outright exterminated. This is not going to make a dent, yet, the attempt will still be made.

    Lot’s of fun times ahead.

  • BigTom October 19, 2012, 4:19 am

    LOL-Agreed – never gonna hear that, but it will arrive with a ‘nobody saw that commin from MSM!’ most political ads are best viewed with the volume turned to ‘off’ anyway……

  • Jill October 19, 2012, 3:49 am

    LOL, could you see that political ad? “Vote for me if you want to pay the piper & crash the economy.”

  • BigTom October 19, 2012, 2:06 am

    “My karma ran over my dogma”….like in a mac truck?That’s good, Jill. I think there is plenty of insanity here on both sides of this political aisle…..both parties talk the talk but neither walks the walk in helping middle america! Regardless, us street level dems or repubs pointing the finger at eachother might fix some blame in our eyes and relieve some frustration, but hasn’t yet solved any problems for a long time now. Might it just boil down to us vs. them?

    ‘Following the VonMises economic ideology seems very sane to some people, even if it crashes the economy. Easy for people to believe, if they have never experienced much deprivation in life.’ I agree. That respected financial mind I refered to above believes when they let Lehman get flushed back in ’08/’09 it was basically game over for ‘sane’ fiscal policy. One can believe that or not. The complexities of the ‘how’ or ‘why’ of that is beyond my financial understanding. But if he is correct, and he has been correct on the direction of this thing for over 10 years now, Dougs headline jives with him and they both may be right. But if we are to believe this guys text, then hoping and praying for ‘brilliant politicans’ to save this as he states in ‘Even brilliant political action….’ is perhaps going to be an OMG moment for us all!

  • Jill October 19, 2012, 1:07 am

    Oops I meant to say “what seems sane to one person seems very insane to another.

  • Jill October 19, 2012, 1:06 am

    Well, what seems insane to one person seems very insane to another. Following the VonMises economic ideology seems very sane to some people, even if it crashes the economy. Easy for people to believe, if they have never experienced much deprivation in life.

    When Doug says “I am optimistic that, through a combination of political capital in the Oval Office and a Congress that can legislate, the country will move forward in the battle against the fiscal crisis.”

    LOL, which presidential candidate would that be? Romney who is promising tax cuts for the wealthiest that objective sources say he can not pay for & which will thus add trillions to the budget deficit? Oh, I forgot. Following Republican political ideology is supposed to be sane & good for the budget, even if the math does not add up.

    A case of “My karma ran over my dogma” here.

  • BigTom October 18, 2012, 10:31 pm

    I have to go back to the title of Doug Behnield’s article here….’Fiscal Sanity Is Going to Crash the U.S. Economy.’ Sounds plausable. A very well respected financial mind out there has been saying this for quite awhile….’QE to infinity,’ has been his motto thus concurring with Doug’s headline. What was once deemed fiscal sanity now has thus become fiscal insanity to survive. Once the money merry go round stops the economy vanishes. However within the article Doug states, “I am optimistic that, through a combination of political capital in the Oval Office and a Congress that can legislate, the country will move forward in the battle against the fiscal crisis.” Then he goes on explaining this concept further. I am not sure how this all then reconciles with his headline. Can someone help me out here? Or is it of any importance?….If I take this headline at face value then Doug’s solution resolving this debt crisis is going to take ‘Fiscal Insanity?’ by our leaders. And since when have any political leaders shown any willingness to ‘lead’ anything in a sane direction in this fiscal crisis? Does that mean they are going to have to be insane to solve this crisis. I have to LOL at this statement!

    Next comes the illustration. Now here is a devilish looking fellow playing the pied piper leading the citizens off to….? Not a comforting nor confident pictorial here illustrating Doug’s text, ‘confidence leaders leading the country forward in the battle against the fiscal crisis.’ This illustration seems to confirm the headline and negate the text of his article. I wouldn’t feel comfortable being one of those citizens pictured here following this guy! Something here is very confusing? RA, can you or someone help me out here?

  • mac October 18, 2012, 8:30 am

    P C Roberts:
    “As Gerald Celente says in the Autumn Issue of the Trends Journal, when confronted with the choice between two evils, you don’t vote for the lesser evil. You boycott the election and do not vote. “Lesser or greater, evil is evil.”

    If Americans had any sense, no one would vote in the November election. Whoever wins the November election, it will be a defeat for the American people.”

    Paul Craig Roberts was Assistant Secretary of the Treasury for Economic Policy and associate editor of the Wall Street Journal

  • nonplused October 18, 2012, 5:24 am

    The one concept or “meme” floating around that I find most difficult is the concept that “we have left our children (or future generations” a large debt to deal with.” Ha! They aren’t going to deal with, we are!

    The economy is always real time. Paper can no more transport assets and money through time than printing money creates wealth. Actual physical stuff is consumed as produced or turned into capital assets, but that process goes from the past to the future.

    When we get to the future, we will have what is being produced then plus what’s been built. And it’ll have to be enough for the day.

    All that happened while building the debt was a bunch of savers today lent a bunch of money to a bunch of spenders today. The idea that that process made a bunch of producers tomorrow responsible for the debt is absurd, where are they going to get the money? They’d have to produce with no incentive, which they aren’t going to do.

    Instead, today’s lenders aren’t going to be paid back, at least not in real terms. Whether its deflation or inflation, the lenders are in for a big surprise. It’s already happening in Europe.

    And as for forecasts that are extrapolated out that read something like “in the year 20XX there will be Y (some high number) of retirees for every worker”, again not going to happen. Many people have not save for their retirement. These people aren’t going to be able to retire. Welcome to freedom 75!

    So worry not for your children. You’ll still be here when the problems come to a head and you’ll be most affected.

  • BigTom October 17, 2012, 11:53 pm

    JJ – interesting facts you reveal about AAPL. I knew AAPL had a presence in China but not to this extent! Have no doubt this type of slight of hand is going on. I have dealt with government bureaucrats for years and fabrication of ‘truth’ is common place with these people, either by direct communication or by intentional omission of facts. Ignorance is not an excuse here, there is a purpose to all this madness….By now we are all familiar with the ‘bogus financial data’ the government feeds us directly or indiretly thru MSM. It makes me thoroughly convinced ‘government sponsored scientific data’ is also bogus….The same data EPA uses to regulate America out of business.This last also pounded into our brains daily by MSM. Thanks for that little bit of info. It tells a good story…..

  • Anthony F October 17, 2012, 10:57 pm

    I believe Rick’s strategy of watching the tape, while
    keeping one leg ready on the window’s fire escape, is all
    one can do at the moment…
    Here are some arguments pro-fiscal stimulus..
    8 Facts That Prove Our Govt. Is Not Going Broke
    http://www.garynull.com/home/8-facts-that-prove-our-govt-is-not-going-broke.html

    And these are some arguments for the EU fiscal implosion…
    http://www.garynull.com/home/the-largest-economy-in-the-world-is-imploding-right-in-front.html

    In addition the Liberal party in Italy is making the case for the April elections to possibly exit the EURO.

  • bc October 17, 2012, 9:21 pm

    The question remains: “What is the shape of the stock and bond index price function connecting today with an eventually fully cratered number?” My guess is there will be a very sudden, very large gap down in equities and bonds both at the same time. I say this because there is no way all the boomer guppies along with the insurance companies and retirement funds can ever get out of the market with their shirts even half on. Any reasonable decline rate would allow time for some to escape whole. I just don’t see this as possible. They don’t call it the 1929 stock and bond crash for nothing.

  • roger erickson October 17, 2012, 9:06 pm

    “ECCLES: We [the Federal Reserve] created it.
    PATMAN: Out of what?
    ECCLES: Out of the right to issue credit money.
    PATMAN: And there is nothing behind it, is there, except our government’s credit?
    ECCLES: That is what our money system is.”

    – Federal Reserve Board Governor Marriner Eccles in testimony before the House Committee on Banking and Currency in 1941, during questioning by Congressman Wright Patman about how the Fed got the money to purchase two billion dollars worth of government bonds in 1933.

    Can someone ask Doug Behnfield if he’s ever heard of Marriner Eccles? Or learned how our currency operations have worked since 1933? Hint, we can’t default on fiat.

  • buck novak October 17, 2012, 8:22 pm

    I reject the idea the U.S. has a capitalist economy. It is exactly the same as the old USSR in a different uniform. The U.S. is a command welfare economy. The government federal reserve controls the monetary function. What is pushing on a string except a command economy. Each Presidential candidate is claiming he has a job creation plan. A Federal Reserve note is just a piece of paper backed by debt and credit that politicians and in conjunction with the Federal Reserve aka Central Planners plot to continually to debase Federal Reserves to create a small amount of inflation to rob savers and create constantly rising prices. Rising prices trick businesses into producing more. It is really an incentive trap. What is QE 3 but a command economy central planner racket using taxpayers wealth to create the illusion of growth. It is really doing the opposite as the taxpayer is on the hook for these credit debt instruments aka treasury bonds. The command economy of the USSR collapsed because it was an inefficient racket. The U.S. and the Western World is exactly the same. It subsidizes inefficiency to create jobs through debt. It ended badly in the USSR. It will be no different here.

  • John Jay October 17, 2012, 6:49 pm

    Thanks everyone.
    Here is some more serious food for thought about our bogus Government Statistics which I find shocking.

    “The fault might lie in the way statistical information is collected and presented. Apple, for example, is a US corporation. It reports its worldwide earnings to the IRS. Its manufacturing is counted as US manufacturing as it is a US corporation. However, Apple doesn’t produce a single computer in the US. They are produced in China. The employment that Apple reports is in China. ”
    Link:http://www.paulcraigroberts.org/2012/10/16/america-r-i-p/

    So, the manufacturing AAPL does in China get lumped into the US GDP figures?
    That link is down right now, but perhaps someone out there more familiar with US GDP accounting can confirm or deny this?
    And does that mean that any manufacturing in the USA by a foreign company does not get counted in the US GDP ?
    Can anyone clarify this situation?

    • mario cavolo October 18, 2012, 2:50 am

      interesting point JJ, as I’ve noted 50% of S&P earnings are international, so as you are asking, which parts of their revenue is coming from where in the global world. I bought a Chinese brand car, made by SAIC conglomerate with a Citroen chassis and a Toyota drive train, etc. Parts of American cars made in America are made with foreign parts, so what’s what? The global way of business is getting more and more complicated and certainly they are going to learn how to play with their books to look better…confusing stuff, Cheers, Mario

  • fallingman October 17, 2012, 4:44 pm

    Couple of quick thoughts. John Jay is spot on target, as always.

    In the article, Doug uses the phrase…”brilliant political action.” I’d like to nominate that gem for oxymoron of the year

  • Andrew Gutterman October 17, 2012, 2:39 pm

    Somehow this reminds me of 1972- 1973. Roaring bull market, optimism everywhere, earnings going up, everyone very happy. Different foundation today which means a much different result when the s**t hits the fan, but very similar otherwise. An election just finished, the incumbent got back in, and the market saw an all-time high in January 1973. The ensuing decline was brutal, to say the least, especially since earnings were going up for most of the time the market was going down.

    We won’t get the earnings push this time around. I think corporations have squeezed out all the savings they can in the face of falling demand. All that’s left is the credit the FED is issuing, and we ALL know what can happen to credit when the tide has turned. Not money printing as many would put it, but credit. A huge difference.

    As long as the credit spigot is turned on its hard not to buy into a rising market. But its a bubble. And bubbles always come to an end.

    I remember being caught up in the housing bubble 10 years ago. Bought a house for $81K in a bad neighborhood in Charlottesville, VA in 2002 (lots of gunshots and more than a few dead bodies just a couple of blocks away). Needed to refinance after the first year to cut the 9% rate. Wow! Talk about appreciation. No problem. Within six years of my purchase the appraisal companies had the value of my house up to as high as $225,000. I got so caught up in what was going on that I extrapolated the gain going forward into infinity, even though deep down I knew this could not be right. It wasn’t.

    We sold for $165K in 2008. Even after several refinancings to pay for living and medical expenses and two cars we came out with a tidy profit, which then evaporated in more medical expenses for my wife, before she qualified for Medicare. (I’m living what Romney cannot even begin understand.)

    The stock market today is very similar. Just keeps going up, and I hear forecasts of a doubling or even higher within a few years. Ditto for gold. All that money being printed…(not)

    What I watch are interest rates. In normal times there is a strong connection between a rising stock market and a growing economy, and interest rates going up when there is demand for money, no matter what the FED is doing at any given moment. Not much demand for money today, outside of outright speculation.

    Rates are flat to falling, and the history of such rates strongly suggests even lower rates in the future for a very long time, which implies that the economy is going to struggle to get any kind of growth, which means the stock market is way overpriced.

    I wanted to ask Candy Crowley to ask the question I never see asked of any candidate: In the face of record debt, a shrinking labor force and the demographic cycle working against growth just how do you propose to create jobs? Especially 12 million of them?

    I’m not expecting an answer……

    Andy

    • mario cavolo October 18, 2012, 2:53 am

      One thing I do know, because it is the #1 initiate / push of the American Chamber Shanghai, the largest most influential chamber, is being on Washington’s ass to increase exports, particularly to China. The numbers they represent are that every one billion in increased exports creates 60,000 American jobs. Further, exports are rising, record levels and climbing, to China. Its something….

      Cheers, Mario

  • JasonS October 17, 2012, 12:59 pm

    JJ, a good piece. love the ‘pick up sticks’, a great analogy!

  • John Jay October 17, 2012, 4:03 am

    I think the size of Federal, State, Municipal debt and unfunded liabilities are TBTP.
    To Big To Pay.
    ZIRP and fraud is all that is holding our economic system together.
    I have seen estimates that claim the Fed is buying up to 70% of US Treasury paper to make ZIRP possible. ZIRP and ignoring homeowners who have not made a mortgage payment for three years and counting have managed to stabilize the housing market.
    Combined with the Fed buying bogus MBS paper at par on an ongoing basis.
    If the US Domino becomes the last one standing, we have some time.
    If not, the question is can we rebuild enough essential manufacturing capacity here before our trading partners refuse to accept the Dollar?
    By essential I mean factories that produce tires, computer chips, shoes etc. that we no longer seem to make here.
    I think we can get by with the crude oil, NG, and coal we have here, thank God.
    To say a return to Fiscal Sanity will depress the US Economy is an understatement to say the least.
    But I think that is now true for the entire planet.
    If no one wants the US Dollar to pay for our imported goods, a big market for the worlds factories disappears.
    The world economy is now an interlocking pile of “Pick Up Sticks” built of fraud, debt, fiat currency, and Trade Agreements.
    Hard to say which stick will collapse the pile when it is removed.
    Great fun!

    • redwilldanaher October 17, 2012, 5:55 pm

      What is written above is true!