Conundrums Conundrums Conundrums

We have always known about Greenspan's Interest rate conundrum but now we are becoming aware that he has a few more conundrums. In his latest speech he mentioned the "Currency Trade deficit" conundrum. Which is actually two conundrums in one; the first is the fact that currently as our trade deficits get larger our currency is been getting stronger, which is functioning contrary to popular belief and the other one; although closely related, is during periods of currency weakness there does not seam to be any appreciable increase in our exports or decrease in our imports.

There is another conundrum which he has not yet labeled as such, and that is the relationship between Tax cuts Revenue Increases and Budget Deficits.

And yet with all these conundrums they all still consider Greenspan to be our greatest economist and best FED chairman ever. The Brokers the Media, the politicians and the rest of us common folk wait with bated breath to hear his pearls of wisdom and then argue about what it was he actually said or meant as each word or phrase is extensively examined for hidden meanings and the world's financial markets react .accordingly. Who are the fools in this scenario?

But it's not just Greenspan that has these conundrums. The rest of the world's talking heads politicians and economists seem to have them as well. Does that mean that economics is useless when it comes to solving our biggest economic problems? How can we entrust the three most important functions of the FED; stabilizing our currency and promoting full employment, while controlling inflation at the same time, to someone who admits he doesn't know what's going on?

The BIG Question that nobody seems to be asking is, are these three objectives mutually exclusive? Is it possible to promote stability and job growth at the same time?

When it comes to Ben Bernanke, the only logical assumption is, a lot more of the same. Since he was a FED Governor under Greenspan, as well as a friend and confident and is currently head of the Presidents council of Economic Advisors and would certainly have enlightened Mr. Greenspan, if he had any of the answers, then he must be suffering from the same conundrums.

After listening to Bernanke's testimony, more of the same is the best that we can hope for. But then again, is that not what everybody wants. He mentions that he intends to target inflation and keep it in 2%-3% range. Should he be successful and he can keep inflation at an average of 3% then that means that the purchasing power of our Dollar will be cut in half over the next 25 years. Yup that's about the same as what's happened over the last 25 years. The BIG danger is that Mr. Bernanke is a product of the Princeton, Ivey league click of economists that have basically been controlling the world's economic theory at least since the 30's.

That means that he is a disciple of Keynes and believes in the socialist philosophy, that recessions and depressions are caused by a sudden drop in aggregate Demand that must be made for up by more government spending. Bigger government, more government and more government intrusion and involvement in business has been the mantra in Washington since the 30's.

In spite of the fact that only a FREE MARKET system as ever been able to create wealth, we as a country continue, regardless of the party in power, to push relentlessly toward a more and more socialist economy, the lessons of Europe not withstanding.

However, his put down of the foolish theories of the socialist senator Sarbanes gives me at least some hope that Mr. Bernanke just might be the right man at the right time. For all our sakes lets keep our fingers crossed and wish him well.

THE INTEREST RATE CONUNDRUM

Let us examine the problem and see if it really is that much of a conundrum. You may recall from either your old economic text books or your latest reading of any explanation of economic thought; from the simplest supply/demand example to the most complex econometric model, economists are wont to use the same exact simplification phrase "all other things remaining equal" and therein lies one of the main problems, "all other things never remain equal". That phrase is only supposed to be used when explaining economics to first year students. The other elementary first semester problem in Basic economics, is confusing "cause and effect" Raising the Discount Rate is only one of many factors influencing rates but does not and never did have an exclusive direct one to one relationship to interest rates, especially long term rates.

However, like Greenspan you may believe that there is this one to one relationship, and then the first time it doesn't work, like now, you have yourself a conundrum where none really exists.

INTEREST RATES

Interest rate is just another word for the "Price " for money and the price of money is determined like the price of any other commodity in a free market economy, by the interaction of supply and demand for money. The Discount rate is just one of many factors affecting both the supply and the demand for money to various and ever changing degrees. In our present situation; while raising the Discount rate is meant to reduce the supply of money. However if at the same time increasing the reserves of the banking system, lowering the lending requirements and encouraging the making of sub-standard loans, increases the supply of loanable funds (money), more than compensating for the higher discount rate and send confusing signals to the free market. So in actual fact there is no conundrum. Interest rates are behaving exactly as they should be once you examine all the facts that go into the determination of the free market rate of interest.

NOTE: For the last twenty years or so the money supply has been growing at an average of 10% above the economies growth rate. That my friends is the definition of inflation. Most of the excess cash has found its way into an overvalued Stock Market, Bond Market and Real Estate. The world is awash in cash and most of it is concentrated in the hands of the super wealthy and the worlds Central Banks. Unlike us common folk, they are more interested in preserving their wealth than in making a few extra percentage points profit. And they all know that when, not if, the S--- Hits the Fan Treasuries and Gold are the safest places to be. They must inevitably be in treasuries because there is just not enough Gold to absorb all the cash that is floating around out there.

THE CURRENCY TRADE DEFICIT CONUNDRUM

Understanding this conundrum is a lot easier than the previous one because it is not really a conundrum at all. It is simply a error in "causal" relationships due to the fact that for many years and for all other countries there seemed to have been a direct relationship between large trade deficits and weak currency. When the deficits became too large their currency eventually collapsed. But a falling or weak currency is an affect of large trade deficits not the cause.

The USA is deferent from all other countries. it has the worlds only reserve currency and each country, for their own reasons, is interested in maintaining a strong Dollar. For the time being all of their various reasons seam to coincide and until their objectives, fears and goals change we will have a strong dollar regardless of the fact that our trade deficit as surpassed 7% of GDP.

A lack of personal savings (USA saving rate is now close to zero) in conjunction with huge government budget deficits, means we as a country are living beyond our means and is definitely a cause for alarm; "trees can't grow to the sky" and "all good things must come to an end" but not to worry at least for the immediate future. However a category 7 hurricane is definitely forming on the horizon.

TAX CUTS AND BUDGET DEFICITS

Before one can solve a problem one has to cut through the "BS" and political propaganda and get to the facts.

A recession had started in October of 2000, Greenspan was then he FED Chairman. Bush came into office in Jan 2001 and 8 months later the Twin Towers went down. Greenspan did his utmost to reverse the recession as he rapidly slashed interest rates down to 1%, the lowest rates in 45 years.

The drastic cuts in rates did manage to halt the slide in the stock markets but it did not do much to revitalize the economy. Between a sharply fallen stock market, which eliminated any all capital gains and the taxes there on, a recession and a looming depression as well as the coming wars in Afghanistan and Iraq the projected illusionary budgetary surpluses turned to huge deficits. What the economy needed to turn itself around were tax cuts which it got in 2002 and in 2003. The economy turned on a dime. It took a while for job creation to resume but it did and we have now had 10 quarters of over 3,5% growth and an unemployment rate of 4.8%, the best since the 50's and better than the Clinton years. But there is always a caveat Huge Budget Deficits.

Now we are facing a hue and cry, especially from Democrats but also from more than a few Republicans, to rescind at least some of the Tax cuts. Doesn't anyone study history? Tax cuts always bring a robust economy and sharply rising tax revenue along with reduced demand for emergency assistance. Although both Bush I and Clinton raised taxes but they were minor and were concentrated mostly on the poor and elderly. A 5 cent a gallon tax on fuel and a 50% tax on social security benefits on people who earned more that $14,000 are taxes on the poor and did not hurt the economy very much, no matter what the rhetoric. A 3% increase in the top rate, on people that can manipulate their income and that cam take advantage of every form of tax shelter doesn't mean very much.

It's the SPENDING stupid. We all like to talk about graft, corruption and fraud in other countries but they all pale in comparison to the graft and corruption imbedded in our $1.5 plus Trillion government budget. No matter what the conditions are, government spending always increases even though they talk about cutting out some programs and reducing others, they never do, as each politician does his utmost to get his share of the pork, pay off his supporters and buy votes with government largess to all the various special interest groups.

Warning: Increasing taxes at this particular stage of the economic cycle could trigger the biggest depression since the 30's.

Does History Repeat? Will Hillary be come president in 2008? Will she then, as promised, increase taxes on the wealthy as she increases government programs and becomes the FDR of the 21st century? Will she then preside over the biggest depression in American history? We only have 21/2 more years to wait and see.

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767

17 November 2005