by Mike Patton
One of the most critical financial issues facing us today is understanding what could happen when the world’s central bankers discontinue their quantitative easing and return to normal monetary policy. Since the current monetary expansion has cultivated only minimal GDP, how will the economy react when the liquidity onslaught ends? Today, we are faced with a tremendous debt, record deficits, and a Fed with a hypodermic needle filled with a seemingly unlimited supply of cash. In this article, we’ll tackle these important issues and discuss some possible scenarios. Let’s begin with GDP.
GDP
GDP measures the extent an economy grows or contracts and consists of four parts: consumer spending; business & industry spending; government spending; and net exports. Consumer spending is the largest component of GDP, accounting for nearly 70% of the total. Hence, ours is a consumption-based economy, unlike China, for example, which has an export-based economy. It’s equally important to understand that if consumers were to cease borrowing, economic growth would come to a grinding halt. Therefore, debt is essential to economic growth. In 2008, banks tightened their lending standards and although they are much more relaxed today, the economy continues to grow at a very slow rate. This is largely due to the tremendous amount of debt incurred by consumers and businesses in the decades prior to 2008. These factors provided the rationale for government to step in and borrow as much as it did to help stimulate the economy. However, when government engages in deficit spending, it’s effect on economic growth is much more muted than when the private sector borrows. This economic benefit from spending is referred to as the “multiplier effect”, which again is much greater in the private sector.
Deficit Spending and Debt: Public and Private
From 1901 through mid 1974, the federal government balanced its budget the majority of the time. However, beginning in the mid 1970′s, the deficit began to expand. With the exception of fiscal years 1998 to 2002, the federal government has spent more than it has received. Moreover, the deficits have increased substantially since 2002. To some extent, politicians use government revenue as a means to repay political donors. But that’s a subject for another time.
Businesses and individuals also engage in deficit spending, but only so far as they can afford to service their debt. At some point they must restrain themselves. Though individuals and businesses have limits, the federal government has a tremendous amount of latitude. However, limits still exist on the amount government may borrow. It is, however, much harder to determine just where those limits are. The reason is that government can raise taxes to pay for its spending. Typically, new taxes begin with the rich, but when it appears the level of taxation is hitting a ceiling, government sets its sights on the middle class. Then, when the middle class feels it’s being over taxed, the pitch forks and torches emerge. Where is the limit on the amount of debt a government can acquire? It’s very hard to say, because we have yet to see the type of demonstrations which would indicate we have reached it. Yes, we did see the 99% protest a while back, but it was a demonstration against the rich not against higher taxes. Moreover, it was precisely the type of deflection technique and result many politicians were hoping to achieve. In other words, anger was directed toward the rich, not toward the politicians who are responsible for managing the tax revenue we pay. Remember, it is government who makes the rules, the rich just learn how to successfully maneuver them. Today, we have $16.8 trillion in federal debt and the expectation is that it will increase by as much as $15-20 trillion over the next decade.
Fed Tools
The Fed is charged with the dual mandates of maintaining full employment and stable prices. To accomplish this, they have several tools in its box, including: expanding and reducing the money supply; raising and lowering interest rates and bank reserves; and a few additional strategies at the margin. In 2008, when the crisis hit, the Fed introduced the T.A.R.P. program, an $800 billion monetary infusion. Next, we had QEII, a $600 billion expansion over an eight month period. Today, we have QEIII, where the Fed is adding $85 billion per month to the system. Normally, lowering interest rates, expanding the money supply by a reasonable amount and reducing bank reserves were sufficient to stimulate economic growth. However, today, it’s clear this is not enough. Part of the Fed’s current expansion is to buy longer term government securities (i.e.; 7-10 year maturities). This will help push bond prices higher and interest rates lower. Hence, it will also, by design, keep mortgage rates low which will increase refinance activity which will then free up cash flow which can be spent in the economy. This technique was nicknamed operation twist.
A Quick Global Economic Overview
The U.S. economy is the largest in the world and GDP remains weak. Europe, as a whole, is the second largest economy and is in recession. China, the world’s third largest economy, is not exporting as much due to the weak economies of the U.S. and Europe, and its GDP is falling which hurts Japan, the fourth largest economy. Japan has been in a deflationary funk for over two decades now. In fact, deflation fears in the U.S. seem to be central to the Fed.
Possible Scenarios
It’s possible that the U.S. economy could recover and pull the rest of the world out of the doldrums. However, this would be a tall order as Europe has such a tremendous amount of debt to manage and possibly little time until it unwinds. Therefore, here’s my best guess. America will continue to expand its money supply, amass debt, and raise taxes. After the “rich” have had enough and taxes are near a peak, the middle class will be next. That’s when, as I mentioned, we’ll see the pitchforks and torches. Europe will likely face a depression-deflation-default scenario as they may have found and exceeded this ‘limit’ on government debt I alluded to earlier. America could get serious with austerity or as they say back home, budget cuts. Will Americans put up with cuts in its entitlement programs? Entitlements are the largest items in the federal budget, but it would be a tough sale for politicians, that is, until such time as it becomes evident that there no other options exist.
Whatever the case, here at home, we probably have some time until it unravels. How long? That’s anyone’s guess. But unless Washington begins to make the tough choices, everyone will pay the price and there will be a lot of finger pointing. Of course, it is possible that consumers could begin to borrow heavily and our economy would expand, thereby helping the rest of the world. But it was excess borrowing that brought us to where we are today. To summarize, it’s not a foregone conclusion that the U.S. economy will collapse. However, I do see rough times ahead as I find no evidence that Washington understands what’s at stake. In essence, it seems to be politics as usual.
Stay tuned for more!
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