The Art of Mountain Climbing

I recently had a conversation with a friend who was cautiously optimistic about the US economy and its growth potential going forward. He cited statistics about corporate profits and a housing recovery and how the US was better off economically than many other countries and regions. He thought we were posed for another growth spurt that would be reflected in higher stock prices.

I agreed with his basic statistical evidence, which offered a snapshot of the distorted present rather than a sound projection into the future, leading me to a bit of a different interpretation regarding the investment risks going forward. I tried to convey my analysis by verbally explaining what lay between here and there. I think it’s easier to explain using the following illustration:


The US (and world economy) fell partly off a cliff in 2008 and 2009. One problem is that the previous peak was built on the hot air of cheap credit rather than the firm bedrock of economic productivity. Now, the US economy is still stuck at point A on the chart. The policy experts at the Fed and in Washington are desperately trying to prevent us from falling to point C by bridging the chasm between A and B with cheap liquidity, unproductive spending stimulus, and false confidence that pigs can fly.

My friend is looking backward and forward to see how the US economy has rebounded in the past and will eventually return to point B with an upward growth path. My explanation went something like this: In order to get back to gradual, step-wise positive growth (climbing the mountain one step at a time), we first need to adopt prudent mountain climbing skills. In economic terms, this means working, saving and prudently investing in productive activities. To do this we need functioning capital, labor, and product markets guided by accurate prices. Instead, in their attempts to prevent us from falling into the bottomless ravine at point C, our policymakers are inhibiting citizens from pursuing productive activities.  In other words, we can’t fly from point A to B, we have to get back to climbing fundamentals, but under the continued price distortions promoted by the wrong monetary, tax, and spending policies, many people are rationally returning to the speculative behavior that caused the crisis in the first place. Most of our private debts are being transferred to the public sector, which not only means the debts grow (see previous post on debt-driven spending over the past 30 years) but that nobody really has much incentive to watch the cash register: government borrowing and spending just keeps growing without any consideration on whether this is helping real growth and wealth creation.

We have some real world references to point to here. In the 1990s Japan had a real estate and stock market bubble that burst just like we experienced in 2008/09. They adopted the same strategy of excess liquidity and banking bailouts that prevented losses from being reset and resources from flowing back into productive activities. The Japanese have sat at point A and watched point B recede for the past 25+ years.

Another case, just the opposite, is tiny Iceland. Ten years ago Iceland embarked on a fantastic bank-leveraged financial bubble that popped with a bang in 2008. Because they could not borrow and spend their way out of bankruptcy, in a matter of weeks Icelanders went to bed at point A and woke up at point C. The phony wealth creation evaporated with an instant price reset as the Icelandic krona lost more than half its value. But Iceland is now back on a positive growth path climbing back up the mountain of growth founded on hard work and sound financial policy.

As you might have guessed, we are pursuing the same policies as Japan, not Iceland, because we can and the necessary price reset is politically unacceptable. How many of us would willingly see all prices revert to say, 2001? But we really can’t get from point A to B on the backs of flying pigs. In trying to do so we risk two possible outcomes:  one, we create another bubble and a bigger crash which will be unmanageable because the policymakers will have run out of bailout money; or we sit and watch point B recede ever into the future as economic opportunity declines, growth stagnates, and we all grow older.

Deficits, Debt and the Fate of the Dollar

If you have anything to lose, these developments should worry you. Read the following analysis carefully.

Our politicians have made it almost impossible to protect yourself from this risk. The Federal Reserve will distort financial and real asset markets with excess liquidity until the market turns around and crushes it. We see the first signs of dissent from the Midwest banking centers because they are not enthralled by Wall St.-DC financial and political interests. Historically, they have reflected more the interests of Main St., which stands to absorb the brunt of this failed policy.

From the WSJ:

The shivers that ran through the bond market after the budget deal were a signal the Fed ignores at our peril.


The year-end “fiscal cliff” tax deal sent shivers through the bond market, driving the price of 10-year Treasurys to the lowest level since April. There was a good reason. The stubborn resistance by President Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation’s No. 1 economic problem, massive federal deficits.

The bond-market decline came despite the Federal Reserve’s renewed program to gobble up yet more government debt. Presidents of some regional Federal Reserve Banks are growing nervous about this program, judging from the December minutes of the Federal Open Market Committee, which guides Fed policy. Jeffrey Lacker of the Richmond Fed, Richard Fisher of Dallas and Esther George of Kansas City have been among the most outspoken in voicing fears that continuation of the Fed’s manic buying—now running at $85 billion a month in Treasury and agency paper—will ultimately destroy the dollar. The concerns expressed in the FOMC minutes didn’t cheer the bond market either.

These are signals of dangerous times. Forget about the next Washington dog-and-pony show on the debt ceiling. The bond market will ultimately dictate the future of U.S. monetary and budgetary policy.

Bond markets only obey the law of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, the nation will be in deep trouble. The only force standing in the way of that now is the Fed’s support of bond prices. But regional Fed presidents are prudently asking how long that can be sustained.

Mr. Obama currently is riding high, pumped up by his success in resisting Republican budget-cutting demands during the “cliff” talks. But the deal he muscled through Congress is a hollow victory. His so-called tax on the wealthy will produce scant revenues. The money sucked out of American pocketbooks by higher payroll taxes will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which the president refuses to consider, can shrink the deficit enough to reduce the danger it poses.

The Fed’s worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates. That’s why the early-January upward blip in bond yields was a yellow warning light. If Treasury bond prices decline significantly from the artificial levels that massive Fed purchases have supported, several things will happen, none of them good.

First of all, government borrowing costs will rise, making it even more difficult to control the deficit. Second, the value of the Fed’s gargantuan and growing $2.6 trillion portfolio of Treasury and government-agency mortgage bonds will decline. It won’t take much of a portfolio loss to wipe out the Fed’s capital base. Without capital of its own, it would become a ward of the Treasury, costing the Fed what little independence it has left to defend the dollar.

Even now, the Fed faces a cruel dilemma. It can let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation.

Over the past four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump.

Brendan Brown, London-based economist for Mitsubishi UFJ Securities, reminds us that asset inflation is usually followed by asset deflation, and that’s no fun, as the events of 2007 and 2008 testified. More seriously, a rise in the price of assets often presages a general rise in the prices of goods and services.

Inflation can ultimately destroy the bond market, as it did in 1960s Britain during the government of the socialist Labour Party. No one wants to commit to an investment that might be worthless in 10 years, never mind 30 years.

Throughout history, governments have inflated away their debts by cheapening the currency. That process is well under way through the Fed’s abdication to irresponsible government. If Fed policies continue, another huge tax—inflation—will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on “price gouging” by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.

The Fed’s dilemma is in fact everyone’s dilemma, given the universal stake in the value of the dollar. And all because an American president and a substantial number of senators and representatives don’t understand one simple fact: In the end, the bond market rules.

Politics Without Romance

It’s a shame that the nonsense Mr. Buchanan had detected has taken root in our politics.

From the WSJ:

In Appreciation of James M. Buchanan

The Nobel-winning economist who understood how politics really works.


James M. Buchanan, who died Wednesday at age 93, was one of history’s greatest economists. Though he won the Nobel Prize in 1986, Jim at heart was always a farm boy from Tennessee—an old-fashioned, hardworking American who disdained unearned privileges as well as deeply distrusting the promises of politicians and the passions of collectives.

The theme of his life’s work is best summarized in the title of his 1997 article “Politics Without Romance.” With longtime colleague Gordon Tullock, Jim launched a research program—public-choice economics—that challenged the widespread notion that politicians in democratic societies are more nobly motivated and trustworthy than are business people and other private-sector actors. In a wide river of books and papers, Jim warned against the foolishness of romanticizing government.

Jim regarded his work as simply extending and applying the insights of America’s founding generation, especially those of James Madison. Unlike too many pundits and professors over the past century—but like America’s founders—Jim understood that politicians’ lovely proclamations of their desires to improve society too often camouflage unlovely venal motives that prompt politicians to disregard the general welfare in order to transfer wealth and privilege to powerful interest groups.

Auto-company bailouts, Solyndra subsidies, farm programs, tariffs—the real and ugly reasons for these and many other government activities become clear after absorbing Jim Buchanan’s lessons.

His deep skepticism of government, combined with his expert understanding of free markets, led Jim to describe himself as a “classical liberal.” But it wasn’t always so. Like many of his generation, the young Jim Buchanan was a socialist. His socialism was cured, though, by his studies in economics at the University of Chicago. While there, Jim polished his keen instincts for detecting nonsense.

Jim’s nonsense-detection instincts are on full display in his 1958 book “Public Principles of Public Debt.” By the 1950s most economists were trumpeting the Keynesian myth that government debt is no burden on future taxpayers as long as it is held internally—that is, as long as “we owe it to ourselves.”

Wrong, said Jim. It is unfortunate that he is no longer here to speak out against the again-rampant Keynesians who advocate massive deficit financing. Misled by their own unjustified lumping together of taxpayers and domestic bondholders, Keynesians mistakenly conclude that government is exempt from the reality that counsels households and firms to follow prudent rules of finance. This Keynesian error is one that Jim never tired of challenging.

Not that Jim held much hope that his speaking out against unwise government policy would do much good. He sought to prevent harmful policies by tying politicians’ hands rather than by pleading with politicians to be more public-spirited. And to tie politicians’ hands Jim championed constitutional reform. He believed that only binding, enforceable constitutional rules can prevent Leviathan from eventually suffocating private markets and stamping out human freedom.

Ironically, the constitutional reform that Jim advocated practically requires the cooperation of the politicians whom he so distrusted. Yet it is a mark of greatness in Jim Buchanan that he held out hope, until his dying day, that clear-eyed scholarship would eventually persuade people of the dangers of unconstrained government and of the need to somehow rein it in.