“What would Jefferson do”?

“Doubt is not a pleasant condition, but certainty is an absurd one.” - Voltaire

Never talk about sex, politics, or religion. Ordinarily this is very good advice. It is highly dangerous in polite society to venture into these subjects. If you do it is likely that people will get offended, and possibly angry, but will not change their opinion or beliefs about anything. In investment terms this is a lot of risk with limited return.

Then again there are times when it becomes unavoidable. The markets are closely tied in with economics and politics and as Paul McCulley of Pimco recently wrote ”the invisible hand of Adam Smith must frequently give way to the ‘visible fist’ of government in the real world”. Everything is connected and we are facing a period where key collective decisions will have to be made. The US is facing significant issues on pensions, Social Security, healthcare, budget and trade deficits with a record low savings rate and record debt levels.

Don’t think we have any problems? Well take a look at Paul Volcker’s April 10 article in the Washington Post – “An Economy on Thin Ice”. Paul Volcker was Federal Reserve Chairman from 1979 to 1987 and has a unique reputation for being honest and direct about economic conditions. Just to take two highlights he writes “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 that it will be financial crises rather than policy foresight.”  He also adds “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”.

Citizens as well as investors need confidence that the political system will be able to provide acceptable solutions. Most people would take this to mean that solutions will be found that will ultimately be to the benefit of the majority. This is what most people believe is delivered by Democracy. But what is the state of Democracy in the US today and how will it stand up when it is tested? It is easy to ignore problems in an environment of excessive credit, record low interest rates and profligate fiscal policy, but what happens when the credit and liquidity stops and there are no savings to fall back on? How will the bills be paid then?

Times and places change and places we love today may not be the same tomorrow. For example according to the Wall Street Journal and Heritage Foundation, in 2005 the United States is for the first time not ranked among the top 10 “free” countries of the world. In 1998, the U.S. was ranked 5th among the world’s most free countries. By last year, it had dropped to 10^th place. Now it is 13^th.

 

The U.S. seems to be resting on its past reputation as land of the free while innovative countries around the world are changing their approaches and reducing roadblocks to living free lives.

According to the 2005 Index of Economic Freedom (This is the Wall
Street Journal and Heritage Foundation speaking not me) Estonia is now
freer than the U.S.! You can see http://www.heritage.org/research/features/index/ for all the details.

Democracy?

“What would Jefferson do?” is a remarkable book written by Thom Hartmann. It provides remarkable clarity about what Democracy (too often overused and ill-defined) really is. It draws on whether we Democracy is natural, some new thinking here, and reviews the history of Democracy with a new and convincing perspective. Then it analyses the intentions of the founding fathers and the experiences they drew from when writing the US constitution.

Finally, it discusses the many changes that have taken place right up to the present, and some crucial and largely accidental changes that critically impacted the way in which the political system works today in the US. The book does all this and much more in a relatively concise and easy to read manner, and is a great contribution to the current political debate.

When it comes to democracy the acid test is whether solutions are found that benefit the many rather than the few. Of course all politicians claim this is what their policies will do, but through the mists and heat of political debate recent trends are reducing confidence in optimal democratic outcomes. What this means unfortunately is that it makes it much harder to have confidence in the ability of the political system to find adequate solutions, at a time when there are so many problems that need resolution. This then raises the long term risks involved with investing in the US.

Another consideration of equally critical importance to the financial markets is the operation of not just the political system but also its implementation through the many institutions to the markets themselves. No other institution is more important in this regard than the Federal Reserve.

The Fed’s Record

The Federal Reserve Act was passed in 1913 in the aftermath of the recession of 1907. However it was not until after WW1, let’s say 1920, that it started having any impact on the US economy. 

 

In many ways it is surprising that they decided it necessary to introduce the Federal Reserve when you consider the astonishing economic success of the previous 120 years. From 1800 to 1920 the US economy emerged from a third world country to one of the largest and most successful economies in the world. Furthermore, over this period, the price level was unchanged. Stable prices were the norm which means that about half the time the US was experiencing mild deflation. Clearly, this did not stop the incredible economic growth and success over the period.

Compare this with the period in which the Federal Reserve has been manipulating the economy. The Federal Reserve’s success can be measured by (1) the recession of 1921, the Great Depression of 1929-39, the recessions of 1957, 1970, 1975, 1980, 1981, 1990, and 2001; and (2), the decline in the value of the dollar -- approximately 95% since 1913  (Inflation Calculator: http://www.bls.gov), or average inflation above 3% per annum.

In addition to the Federal Reserve’s questionable long term record, they are now advising that the largest debt levels ever seen in the US, which they themselves have fostered through their policies, are not really a problem. They have also decided that deflation must be avoided at all costs, even though zero inflation and many periods of deflation were experienced for a period of 120 years when the US experienced remarkable economic success. They have also concluded that even if they drive the economy even further into debt that this is preferential to even mild deflation.

This preference for debt over deflation by the Federal Reserve represents an astonishing economic gamble that is very hard if not impossible to justify in the light of historical evidence. It may produce a better growth outcome in the very short term, but all historical evidence suggests longer term ruin.

Most disturbing of all is that the 4 year election cycle performance of the markets has become so pronounced. The stock market is on average flat in the first two years of an administration and then strong in the last two years prior to an election to boost re-election chances. To the extent that the Federal Reserve is a major influence on the economy and markets it therefore is strongly aligned with the White House, despite its protestation and role playing of independence.

We have to play great attention to the Federal Reserve because they have a significant impact on interest rates, the stock market and economic policy, but we do not have to believe that they are independent from politics or that there is necessarily any wisdom to what they are doing or saying.

 

 

 

Summary

So many investors have become supremely confident about the long term outlook for their investments on which so much depends, including many people’s retirement. Many profess a high level of confidence in the US system and the Federal Reserve. Unfortunately this confidence now looks increasingly misplaced.

Given the scale of the economic problems confronting the US today, anyone who believes that current growth policies are endlessly sustainable is sleepwalking through a minefield. To the extent that the Federal Reserve policy has become an inexplicable long term gamble and has become closely linked with politics, and to the extent that America’s political system has moved away from an effective democratic system, investors need to be extra vigilant and more than usually diversified. Assets need to be spread far more widely both geographically as well as by asset class, and a defensive strategy has become far more essential.

To paraphrase Voltaire, it is currently far better to be diversified and doubtful than to be absurdly confident.

 

 

 

Notice

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Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

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