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Longboat Key Wednesday, May 13, 2015 4 years ago

MARKET WATCH | Current record stock market is strong

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Although the existing stock market is not without risk, there is a string of reasons why the market has done well.

Although the existing stock market is not without risk, there is a string of reasons why the market has done well. A record-high jobs of 141 million, personal income and disposable income at record highs and 5 million job openings are some of the reasons the market is strong. Aggregate U.S. wealth of $83 trillion, up $28 trillion since 2009, is an unbelievable increase never before experienced in history; furthermore, national wealth is growing at 7.5% annually. Couldn’t be better right now!

 Historically low interest rates have forced a shift in the composition of financial assets. Debt instruments held by households aggregate $3.4 trillion, down $1.8 trillion from 2009, representing an all-time low of 4.9% of household financial assets. Investors have switched out of debt securities, which pay little interest, and into stocks, particularly the high dividend-paying growth stocks. That is one of the reasons the Dow is up substantially. Many stocks still pay higher dividend yields than bonds pay.

 

Q: Can we assume with such cheap money that businesses will continue to borrow to grow?

A: Not really. Banks are sitting on record amounts of cash. Loan demand is very low, even with interest rates so low. Everything has been done to encourage lending by the banks, but loan demand just isn’t there.

 

Q: If loan demand is weak with so much money available, and businesses aren’t borrowing, can we expect economic growth to taper off and then the market to sell off in the future?

A: The effects that this large amount of money and low rates will have on the market the next couple of years are indeterminable. Clearly one of the reasons banks are not lending is because individuals and corporations also have record amounts of cash. They choose to use their cash rather than borrow. 

Additionally, businesses are producing record amounts of cash to reinvest. Individuals and businesses have shown a preference for maintaining large cash balances because of the huge market sell-offs experienced in the last few decades. Nobody wants to get caught short of cash and be ill-liquid again.

 

Q: Is there a primary economic reason for this tremendous economic growth? 

A: There is. It has been federal government deficit spending, and the subsequent printing of additional money to pay for that spending, that has contributed to this mountain of funds available to loan. Such a reaction vindicates half of Keynesian economic theory. The hitch here, however, is Keynesian theory assumes that in bad, or slow, economic times, government deficit spending provides cash to the economy it otherwise would not have, which “stimulates” economic activity through spending. That theory also assumes that when times are good, like today, with record tax revenues, the government would use tax surpluses to pay down the debts incurred to stimulate the economy in the first place. Our government has chosen to use the stimulation, but instead of paying off debt during good times, it used our growing tax revenues for welfare and let the debt continue to accumulate. That’s why it’s called Keynesian “theory.” It doesn’t work, and never has in history. 

 

Q: Because things are going so well, isn’t continued stimulation through debt creation wise economic judgment?

A: It certainly looks that way right now; however, at some point, debt must be repaid. This cannot go on forever. After a while the country will not be able to generate the income needed from taxes to pay interest on the debt, let alone principal. This is the situation in Greece, Spain, Italy, Portugal, Russia, Brazil and Argentina, to name a few. They can’t meet the government’s debt obligations. They cannot even raise enough revenue to pay interest on the outstanding debt. They must borrow money to pay interest on the debt, a dangerous position for any economy, especially if sustained year after year. 

 

Q: Can Market Watch summarize the U.S. government’s position and point out the risk, if any?

A: Total federal borrowing approximates $18 trillion. The Federal Reserve and U.S. government statistics are misleading. They are misleading because the government does not count the debt that “we owe to ourselves,” which means money government has borrowed from the Highway Trust Fund, Medicare and Social Security, all trust funds in which the public paid taxes in cash from payroll deductions, or “at the pump.” The government borrows that money every year to cover its own deficit, and then it borrows more money on top of that. The money it borrows on top of that is what it publishes as its debt, roughly $12 trillion, as if the other debt doesn’t exist, roughly $6 trillion. In other words, if the government goes broke, Social Security, Medicare and the Highway Trust Fund are broke, too, even though government borrowings from those funds are not shown as part of government obligations.

With that preamble, let’s look at the chart. Our government is over-indebted. If the government’s financial obligations were compared to a family, it’s obvious the family would not be able to pay interest without borrowing more money, let alone pay any principal. Our government can’t pay the principal, and it must now borrow money just to pay interest on the debt.

 

Q: Smart economists and think tanks have pointed out this debt problem, and some project there is a pending currency crash. Is there anything to that thinking?

A: There is. The only thing that sustains our government’s ability to behave this way is because the dollar is the world’s reserve currency. When we need more cash, the Federal Reserve simply prints more money. It’s the biggest Ponzi scheme in history for which no one has gone to jail. There has to be a mathematical reckoning of this over-extended debt, but we do not know when it will occur.

 

Q: Is there anything that can be done to avoid such a disaster?

A: Yes. The first thing we need to do is face economic reality. To do so would require the government to behave like most families have to behave if they want to avoid financial difficulties. The government must quit spending more in revenues than it raises in taxes. The problem is that such behavior is anathema to politicians who are reluctant to cut the size of the government or the size of the government’s welfare payments. Like Greece and other countries mentioned above, if we do not cut these back, we will end up in the same shape. The magnitude of U.S. debt is the greatest in history. We are only able to pull this off because the dollar is the world’s reserve currency and we have been able to print money to cover deficits.

 

Q: Given the existing potential disasters, and our current situation, what can be done to keep the market rolling upwards?

A: First and foremost, as mentioned above, balance the budget. In the first paragraph it was mentioned that national wealth is at an all-time high and increasing at 7.5% annually. There are 5 million job openings. There are at least 5 million welfare recipients, out of the 106 million recipients of means-tested programs, who are qualified for these jobs. That would substantially reduce the dollar volume of welfare. Simultaneously, former welfare recipients would become wage-earning taxpayers. Tax income would increase at the same time government obligations are going down. Although somewhat theoretical, it is a fact that a reduction in welfare benefits, coupled with businesses’ needs for additional employees, would create a positive economic reaction. It would also be a huge step in balancing the federal budget. 

 

Conclusion

Right now things are good. The rest of the world is suffering from economic problems of various sorts, as are we, but America is in the best position to reverse its current course of excessive borrowing. If we do, the market could be good for a long time, and if we carry on as we are, we are engaging the country in greater economic risk.

Caveat emptor.

 

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.

 

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