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Volcker Issues Warning To U.S. Policymakers |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. “An Economy On Thin Ice” by Paul Volcker 2. Volcker Warns That Financial Crises Lie Ahead 3. Foreigners Will Get Their Fill Of U.S. Dollars 4. Volcker Urges Leaders To Reduce The Deficits 5. We Know The Outcome – Why Don’t We Act? 6. Thoughts On The Latest Stock Market Decline Introduction In the March 8 issue of this E-Letter, I summarized the latest long-term economic forecast from The Bank Credit Analyst, which suggested that the US economy should continue to prosper over the next 10-15 years or even longer. Our good friends at Stratfor.com have also released a similarly optimistic long-term forecast for the US. Stratfor is the highly respected geopolitical and intelligence gathering group headquartered in Austin, with offices and connections around the globe. I will summarize Stratfor’s latest “Decade Forecast,” which predicts another 10 years of solid economic growth for the US, at another time. For now, suffice it to say that Stratfor is optimistic that the US will not suffer an economic or financial crisis over the next decade. While I respect BCA and Stratfor immensely (as long-time readers know), I have to tell you that I am struggling to embrace their latest forecasts which suggest that the US will not hit any major bumps in the road over the next 10-15 years. With our unprecedented national debt, our record-large budget deficits, our record-large trade and current account deficits, our historically low savings rate and a falling dollar, I have a very hard time believing that the US is going to avoid any major problems until 2015-2020 when we reach the crest of the Baby Boomers’ retirement. Over the next few months, I intend to research and write more articles on this very topic. As we all know, if the US continues on the current financial path, bad things are going to happen. And I don’t believe that in this uncertain and dangerous world, we can continue these debt trends without an economic and financial train wreck BEFORE 2015-2020. I am not alone in my concerns. Former Federal Reserve Chairman Paul Volcker echoed my concerns in a column he wrote last week in the Washington Post. I feel that Volcker’s warning is so important that I have reprinted the article for you just below. Please take a few moments to read it carefully, along with my comments that follow at the end. [The bolding for emphasis you see below is mine, not Mr. Volcker’s.] QUOTE:
“An Economy On Thin Ice The U.S. expansion appears on track. Europe and Japan may lack exuberance, but their economies are at least on the plus side. China and India -- with close to 40 percent of the world's population -- have sustained growth at rates that not so long ago would have seemed, if not impossible, highly improbable. Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it. We sit here absorbed in a debate about how to maintain Social Security -- and, more important, Medicare -- when the baby boomers retire. But right now, those same boomers are spending like there's no tomorrow. If we can believe the numbers, personal savings in the United States have practically disappeared. To be sure, businesses have begun to rebuild their financial reserves. But in the space of a few years, the federal deficit has come to offset that source of national savings. We are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security. As a nation we are consuming and investing about 6 percent more than we are producing. What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing. There is no sense of strain. As a nation we don't consciously borrow or beg. We aren't even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar. Most of the time, it has been private capital that has freely flowed into our markets from abroad -- where better to invest in an uncertain world, the refrain has gone, than the United States? More recently, we've become more dependent on foreign central banks, particularly in China and Japan and elsewhere in East Asia. It's all quite comfortable for us. We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. It's surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth. And it's comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency. The difficulty is that this seemingly comfortable pattern can't go on indefinitely. I don't know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars. I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change. It's not that it is so difficult intellectually to set out a scenario for a "soft landing" and sustained growth. There is a wide area of agreement among establishment economists about a textbook pretty picture: China and other continental Asian economies should permit and encourage a substantial exchange rate appreciation against the dollar. Japan and Europe should work promptly and aggressively toward domestic stimulus and deal more effectively and speedily with structural obstacles to growth. And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand. But can we, with any degree of confidence today, look forward to any one of these policies being put in place any time soon, much less a combination of all? The answer is no. So I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s -- a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions. The clear lesson I draw is that there is a high premium on doing what we can to minimize the risks and to ensure that there is time for orderly adjustment. I'm not suggesting anything unorthodox or arcane. What is required is a willingness to act now -- and next year, and the following year, and to act even when, on the surface, everything seems so placid and favorable. What I am talking about really boils down to the oldest lesson of economic policy: a strong sense of monetary and fiscal discipline. This is not a time for ideological intransigence and partisan posturing on the budget at the expense of the deficit rising still higher. Surely we would all be better off if other countries did their part. But their failures must not deflect us from what we can do, in our own self-interest. A wise observer of the economic scene once commented that ‘what can be left to later, usually is -- and then, alas, it's too late.’ I don't want to let that stand as the epitaph of what has been an unparalleled period of success for the American economy and of enormous potential for the world at large.” END QUOTE Why Volcker, Why Now? Paul Volcker is an international icon. He is the consummate insider. Many of us remember when he took over the Fed in 1979 and promised to end runaway inflation. And he did. Under his leadership, short-term interest rates skyrocketed to 18-19%, the prime rate soared above 20% in 1981, and we had a recession. But inflation was tamed, and Paul Volcker became one of the most widely watched people in the world. More recently, Volcker has headed the United Nations’ investigation into the Oil-For-Food scandal. Volcker’s investigation is reportedly now finished, and the actual report is due to be released later this month. And now his next act is the column reprinted above. I wonder, why Volcker and why now? I don’t know Mr. Volcker personally; I’ve never spoken with him; so I cannot know for sure why he chose to issue such a stern warning to our leaders and the public, nor why he chose to do it now. I would assume that he reads much of the same research and information that I do. I would lay odds that he reads The Bank Credit Analyst regularly as I do. I’m quite sure he has access to other publications and research organizations that I don’t. My guess is that Volcker has become very concerned with the latest round of forecasts which suggest that the US can go another 10-15 years or more without a major recession or a financial crisis. These forecasts seem to imply that the US can go on running huge budget and trade deficits for another decade or longer, and that foreigners and central banks around the world will just continue to buy and hold dollars. Let us not forget that the US dollar has already lost over 20% of its value from its peak in 2001. Most analysts believe the dollar could lose another 20% in value before the current downward trend concludes. It is also assumed that the devaluing of the US dollar can continue to be done in an orderly fashion, without a currency crisis. Maybe so, but as Mr. Volcker states, “And at some point, both central banks and private institutions will have their fill of dollars.” He is correct, no doubt about that; the only question is when? Foreigners Own A Ton Of US Debt Historically, the US financed most of its debt domestically. According to the Treasury Department, in the 1960s, foreigners owned less than 5% of our federal debt. By 1999, that number rose to 35%. And at the end of 2004, foreigners owned a whopping 44% of our outstanding debt – almost $2 trillion! It’s actually over 50% if you exclude the Treasury debt held by the Federal Reserve. When concerns are raised about this situation, the Treasury points to the fact that most of the foreign-owned debt is not among fickle private lenders, who may dump their holdings at the first sign of trouble. Rather, most of the increase in foreign ownership has been by foreign central banks, which are presumed to be long-term holders. At the end of 2004, foreign central banks owned $1.2 trillion of the $1.9 trillion of Treasury bonds, bills and notes owned by foreigners, or 60% of the total. It is probably reasonable to assume that the largest foreign holders of US debt – the central banks – are not going to start dumping US Treasuries. Yet if these institutions merely slowed down the pace of their purchases, that could send US interest rates sharply higher. Enough of this and we could have a serious recession and/or a currency crisis. Spending Like Drunken Sailors Congress and the Bush administration continue to spend with abandon. In years past, the Republicans were perceived as the party of fiscal conservatism. Yet Bush 41 and Bush 43 have proven that the Republicans can spend with the best of ‘em. President Bush’s proposed budget for fiscal 2006 is a whopping $2.5 trillion (a new record), and that does not include the costs for the wars in Afghanistan and Iraq. Federal budget deficits remain historically large. The deficit was $412 billion for fiscal 2004 (new record), and it is projected to be at least $427 billion for fiscal 2005, again not including the cost of the war in Iraq, etc. The President’s 2006 budget projects a deficit of $390 billion, but it will probably be more like $450 billion when we add in the cost of the war, etc. Keep in mind that all of these numbers are also understated by the amount of the Social Security surplus in each of these years. When Congress or the Office of Management & Budget (OMB) calculate the deficits, they reduce the total by whatever the Social Security surplus is each year. If this were done in a public corporation, the officers would go to jail! Conclusions: We Know The Outcome, So Why Not Act Now? We all know that Social Security is going to go bust; the only disagreement is when. We all know that Medicare will be an even greater financial nightmare than Social Security; again, the only question is when. And we all know that the US cannot continue to run $400+ billion deficits every year. President Bush knows it, Congress knows it and the American people know it, for the most part. Yet year after year, nothing is done about it. We just continue to spend more and borrow more. Almost no one in Washington advocates cutting the budget. There is rarely even a mention about freezing the budget in order to eliminate the deficits in a few years. Freezing or cutting the budget is considered barbaric in Washington circles, even though everyone knows where we are eventually headed. President Bush may be a conservative on social issues, but he’s a liberal when it comes to balancing the budget. In his article, “An Economy On Thin Ice,” Paul Volcker does not include a timeframe and frankly, no one knows. But Volcker does say, “I don't know of any country that has managed to consume and invest 6 percent more than it produces for long.” Forecasters can make predictions – BCA and Stratfor seem to think we have a decade or more before we hit the debt wall – yet nobody knows for sure. Here is one thing for sure, though: the longer we wait, and the longer we run these huge budget and trade deficits, the harder we will hit the debt wall and the bigger the crisis will be. Everyone knows it, yet our politicians in Washington do nothing about it. Actually, they just make it worse year after year. I believe it is very significant that Paul Volcker has sounded the alarm. Volcker is not a gloom-and-doomer. Yet let’s read his words again: “I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.” It may be true that we have a decade or longer before we hit the debt wall. But it could well come sooner. We live in a dangerous world. We all saw how the terror attacks of 9/11 disrupted the world’s financial markets. It could happen again. I would not have the bulk of my assets invested in a strategy that is dependent on another decade or more of economic growth and no serious recessions or financial crises. Thoughts On The Latest Stock Market Decline The Dow Jones has plunged from near 11,000 to near 10,000 as this is written, a drop of over 8% in just over a month. The other major equity indices are down sharply as well. The equity markets are reacting to what I have been telling you for the last several weeks – that the economy is slowing down, inflation is creeping higher and the Fed is likely to have several more interest rate hikes in store for us. Just this morning, we learned that housing starts plunged 17.6% in March, the largest monthly decline in 14 years. We also got the latest Producer Price Index which showed that wholesale prices jumped 0.7% in March. The market decline has occurred despite the fact that crude oil prices have retreated from above $58 a barrel to near $51 as this is written. This is a perfect example of why it is a good idea to have some of your money with Advisors who can get out of the market (or hedge their positions) during market declines. On January 18, I introduced you to Third Day Advisors, LLC. On April 5, I introduced you to Scott Daly’s Asset Enhancement Program. I am happy to report that both of these Advisors went to cash and side-stepped most of the recent decline in the stock markets. If you have not done so already, I highly recommend that you check out these Advisors as well as the others I use to manage money for my clients all over the country. As I have emphasized in recent weeks, the stock markets face some stiff headwinds now. The slowing economy, high oil prices and rising interest rates and inflation make the equity markets vulnerable to sharp selloffs whenever there is any bad news. The kind of volatility we’ve seen over the last couple of months could become commonplace. The good news is that the economy is still going to have a good year; it probably won’t be a 4% year, but it should be at least a 3% year. No one knows how far stocks may fall in the current decline, but there should be an excellent buying opportunity before long. Of course, many investors have been spooked out of the market in the last few weeks, and they will probably have no idea when to get back in. That is precisely why I use professional Advisors to manage my equity portfolio. Wishing you better days in the markets,
Gary D. Halbert
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