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Longboat Key Wednesday, May. 12, 2010 7 years ago

Market Watch: Market senses unsustainable deficits, debt

by: George Rauch

The first rumor floating around about last week’s market sell-off of 1,000 points was that an order was placed requesting the sale of 1 billion shares of a stock, rather than 1 million shares. That was baloney.

Nothing like that happened. Last week was an example of the continuing uncertainty that will exist in the markets until the U.S. government gets its spending and taxing policies under control. (See table.)

To put this in perspective, let’s say that U.S. deficit expenditures of 11.1% of GDP last year was based on an economy with a GDP of $100. State, local and federal government would spend $35, more or less, from taxes, leaving $65 in the economy. However, the $35 was not enough for our federal government, so it borrowed another $11 to meet its operating expenses in 2009.

If the government were a family, the family would be broke, because the family does not have the power to print money. But our government simply goes to the Federal Reserve System and says, “I need another $11 to meet operating expenses,” and the Fed acquiesces.

The reason the Fed acquiesces is because the Fed is totally dependent upon two things to stay in business: (1) big central government and (2) a handful of private banking institutions that are “too big to fail.” This accommodation to the government’s excess spending requests, shown in the chart, is encouraged by the central banks, because that is how they make money. 

Deficit spending is, furthermore, encouraged by the banks that are “too big to fail” because they are the ones that sell government securities. They make a market in government securities, and they hold hundreds and hundreds of billions of dollars in government notes and bonds every hour of every day of the year. 

As long as we have spending like this, the markets will remain jittery. The markets’ questions really mirror our own:

1. How will the government get the budget balanced?

2. At whose expense will this budget correction be, and how much will it cost in additional taxes?

3. Is the government merely going to lie to us and go about its merry way as it has over the past 40 years?

4. Can we find enough leaders in the House and in the Senate whose egos are not so bloated by their power that they will be able to vote to get America under control again?

5. Will interest rates continue to go up for many years as the bond market is now indicating?

The answer to the above questions will give us an idea of which way the market can be expected to move over the next several years. So far, there are no proposals to curb any of this spending except for the
European Economic Community “legislating” to Greece that it must reduce its deficit from 13.6% of its GDP
to 3% of its GDP. That’s how socialistic governments solve their problems, and that is probably the best the U.S. government will do. Legislation like that means people have accepted the right of the government to spend money in excess of existing tax revenue. 

Breeding more government
The solution guarantees a continuation of big government in all countries that accept solutions like the above. And, as usual, the government is not the solution to the problem; the government caused the problem. Continued government solutions to problems only breed more government and additional future problems.

During the last month it has become increasingly difficult to sell government bonds without higher interest rates being offered. The bond market clearly sees that all of this deficit spending is going to cause inflation over the long term, seemingly forever. Investors are, therefore, not willing to buy any kind of long-term government paper (15 to 30 years) without an adjustment for inflation in the interest rates of the bonds purchased, which means higher interest rates!

We have had a 30-year bull market (bonds going up in price and interest rates going down), and it looks like the bull market in bonds is over. The amount of financing and refinancing of government debt is so great that it continues to compete with the private sector for investment capital, thereby pushing up interest rates.

Unemployment will remain high, and profits will be squeezed, which puts further pressure on the tax receipts of the federal government. The greatest growth industry in the last 40 years has been government.
Over 40 years we have accumulated a phenomenal $11.4 trillion of debt in a $14.3 trillion economy. None of this money went into bricks and mortar or anything of substance that produces profits. It has all been used to buy votes, and it has all been used for welfare of one form or another.

The present

On May 7, the Dow closed at 10,380 points, 48 points below its 2009 close of 10,428 points. We have lost all stock-market gains this year in one week of market activity. Debt is the current consumption of future earnings. We are complicating our children’s and our grandchildren’s financial futures by allowing our government to behave in this irresponsible manner — and it’s crippling the stock market.

The dollar is likely to lose its reserve status (the dollar represents 65% of the world’s monetary reserves). Sovereign countries, with their own problems, do not want to fund our deficits any longer.

During 2000-2009 we had the worst stock-market degeneration in our history, greater even than the 1930s. During the 2000-2009 decade, we lost our manufacturing base. We built up a $54 trillion mountain of unfunded liabilities: Medicare, Medicaid and Social Security. And that was before this new health-care legislation that nobody knows how to fund.

There is literally no money out there. During those years the United States maintained its standard of living through credit and borrowing from other countries, and although that is still the case, it is a process that is no longer sustainable. 

And guess what? Recently, behind closed doors, President Obama signed a bill increasing the U.S. debt ceiling to $14.29 trillion from $11.53 trillion.

The future
An investor with a good cash position is always able to cover his current needs, plus make good investments when they become available. The stock market is currently a highly risky investment. Better to stay in cash, or cash equivalents, than risk much money in this already dangerously overpriced and volatile market.

Caveat Emptor!

George Rauch is chief executive officer of Bradenton-based General Propeller Corp. and lives on Longboat Key.

At a Glance

                                    2009 deficit
Country                       as a % of GDP
Ireland                         14%
Greece                        13.6
Spain                           11.2
United States               11.1
Italy                              10.4
Portugal                        9.4

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