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© 2009 Casey Research

Special Report

© 2009 Casey Research

Green Shoots or

Greater Depression?

By Bud Conrad/David Galland, Editors, The Casey Report

www.caseyresearch.com- 1 -

Green Shoots or Greater Depression?The Casey Report

Green Shoots or Greater Depression? By Bud Conrad/David Galland, Editors, The Casey Report

While we aren’t contrarian for the sake of being contrary, more often than not that is the position in which we find our-selves. Today, with the media falling all over itself to paint a rosy outlook for the economy while simultaneously voicing encouragement to the new administration in its remake of the nation in previously unimaginable ways, it’s hard not to ques-tion our conviction that the worst is yet to come.

Could the economy really recover this quickly from the trau-matic trifecta of a record real estate bubble, leviathan levels of debt, and a global credit collapse? We don’t see it as remote-ly possible, but yet… but yet… there for everyone to see are countless happy headlines and breathless exhortations that the worst is behind us.

So, is it Green Shoots or Greater Depression?

Getting the answer right is critical, because from it flow se-rious consequences to each of us. And not just in our invest-ment portfolios but in how we organize our lives.

Looking for an evidence trail leading to the correct conclu-sion, Casey Chief Economist Bud Conrad once again put in very long hours digging through the data. Here’s what he un-covered, about the claims of green shoots, and what may ac-tually be in store for the economy moving forward.

Rather than accepting the many commentaries that our econ-omy may be improving, let’s focus for a minute on the impor-tant forces that will play out over the decade ahead, and the minor improvements – from disastrous levels – that have giv-en commentators such hope that the worst of our problems are behind us.

What Do the “Green Shoots” Really Look Like?

While some individual measures of economic activity appear slightly less dire than previously, it’s important to understand that most improvements are largely attributable to govern-ment intervention.

For example, at the onset of this crisis, commercial paper spreads rose to the point that this important source of corpo-rate short-term funding had virtually shut down. Today, those spreads have returned to almost normal levels. But the bulk of this improvement is not due to a return of confidence in the economic system but rather to the Federal Reserve direct-ly intervening in the market with several hundred billions of dollars.

And mortgage interest rates, which briefly dropped into the 4% range, did so not because of a surge in creditworthy bor-rowers or eager lenders… but rather because the Federal Re-serve launched a program of buying $1.25 trillion of mort-gage-backed securities. Doing its part, the Treasury has poured billions into Fannie and Freddie and provides guaran-tees for their mortgages.

In these and many other instances, the “green shoots” that op-timists have spotted are really just the visible manifestations of the massive interventions by an increasingly bankrupt gov-ernment.

Indeed, the massive fiscal stimulus provided by the federal government – and by the Fed, which has slashed interest rates to near zero, purchased mountains of toxic waste, and bought up Treasury debt with billions in freshly printed money – are unprecedented in the history of the U.S.

But even a cursory review of key metrics reveals continuing declines in housing prices, rising unemployment, and slow-ing consumption as measured by falling retail sales, GDP, and the collapse of world trade. Sure, housing unit sales recov-ered a little recently, but that’s due mostly to the distress sales of foreclosed homes and houses worth far less than the out-standing mortgage. These are not signs of a strong economy.

The only rational conclusion to be drawn is that the crisis is far from over and that we are not likely to see a strong recov-ery anytime soon. In fact, things are likely to get much worse before they get better.

The massive debt expansion that played a crucial role in cre-ating the disastrously overleveraged economy is not shrink-ing. As you can see in the chart here, it’s growing ever bigger.

That debt growth was fostered by U.S. government debt growth, which is now getting out of control.



Simply stated, the government is trying to solve the debt cri-sis with yet more debt. And, as you can see from the next graphic, even the Congressional Budget Office’s (CBO) own projections show the expectation of ballooning debt well into the future. Importantly, these projections don’t take into ac-count any of the Obama administration’s big, new programs, including a new health care program that is expected to cost another trillion or two dollars.

Those graphs show that our government borrowing has grown to levels that are simply not sustainable over any

period of time – and it is anticipated to keep on growing.

Which is to say, there is no real in-tention to address one of the fun-damental structural problems confronting our economy. In-stead, it seems increasingly clear that the plan, such as it is, is to fol-low the politically popular ap-proach of trying to shift the eco-nomic problems forward into the future. Yet the sheer scale of the existing debt overhang has elevat-ed that tired old approach to the point where it is now playing a dangerous game of chicken with the dollar and, by extension, in-terest rates and the economy.

We don’t think it’s a game the government can, or will, ulti-mately win. The consequences of losing are dire and include the destruction of the dollar and a decade-long period of eco-nomic deleveraging, likely through a devastating inflation. Outright economic collapse as interest rates spike at the same time that the dollar falls, while not yet a certainty, is no longer out of the question.

Manning the Pumps

Much of the economic pain now being felt is due to a dramatic decrease in borrow-ing by households and businesses. Rather than leave it to market forces to resolve the recent excesses of borrowing, as painful as that might be, the government is jumping in with both feet in an attempt to keep the bubble economy inflated.

This stunning jump in government debt is largely a result of it buying up toxic as-sets and putting them on its own books. The rationale for the unprecedented inter-vention is that if the financial institutions no longer have these bad debts on their



books, they’ll be free to start making new loans to restore the economy.

But ultimately the government will still have to deal with all these bad debts. How? The current plan is to leave them on their books as if they had value and to let the very institutions that conjured up the worthless paper in the first place pro-ceed with business as usual. In time, it is hoped, the paper will be revalued upward – problem solved.

Unfortunately, there is no such thing as a free lunch. Paper shuffling won’t make the problem go away, if for no other rea-son than much of the toxic paper represents claims on mort-gage holders who can’t, or won’t, pay the debt owed on their greatly depreciated properties. Simply moving bad debts from the financial sector to the government sector won’t make them good debts.

Which means, of course, that while the financial institutions get a free pass, taxpayers get stuck with truly ugly levels of yet more government debt. How much? It’s almost impossible to get our arms around the size of these programs, but the tally so far includes on the order of $12 trillion in a combination of guarantees, outright purchases, and loans.

You won’t see a number anywhere near that amount on the books of the federal government, however. Thanks to a pen-

chant for accounting fiction, while the total budget for the U.S. government for fiscal year 2009 has grown dramatically, it reflects only about $4 trillion of increased spending, and that in-cludes the big stimulus package. The rest is largely ignored, leav-ing huge and eventually desta-bilizing amounts of loans to be dealt with “down the road.”

Yet transferring bad debts from the balance sheet of the private sector to the balance sheet of the government doesn’t make those debts vanish. Rather, it assures these problems will still be with us for many years, costing taxpay-ers fantastic amounts, instead of

forcing the original lenders and debt holders to recognize the losses and deal with them so that a true recovery can begin.

At the core, the actions being taken by the federal govern-ment are intended to keep the credit bubble inflated. But there is too much debt outstanding, and the level of debt needs to decrease markedly in order to restart the economy. Despite the big bailouts from government, the private sector is not borrowing, meaning a continuing slow economy.

Even so, the biggest problem looming for the monetary sys-tem is the ballooning debt of the federal government. While deficits of $400 billion under the Bush administration – the result of cutting taxes, initiating two wars, and a generally slow-growth economy – were considered fiscally irresponsi-ble at the time, the projected 2009 deficit of almost $2 trillion is so far outside the realm of “normal” that it is difficult to pre-dict how bad its effects will become.

Exacerbating the situation, over just a few short months, the Federal Reserve doubled its balance sheet, largely by trading good assets for toxic waste and printing up the balance. Then there is the overhang of debt owed to foreigners, which at $6 trillion is so big that we have no way of paying it off.

All told, the federal government debt held by the public is now approaching 50% of GDP but is likely to grow to 80% in



the next few years as we add $1-$2 trillion to the deficit each year.

The nearby annual budget deficit projection from the CBO is shown below as improving greatly from the 2009 level. But this is before a new, second Obama bailout that is being ru-mored, and before a new trillion-dollar health care reform. It seems likely that the annual deficits will be worse than this projection – but even this projection brings us to dangerous levels.

Any Way Out?

There are three ways a government can attempt to fix a prob-lematic deficit; tax increases, a reduction of government ser-vices, or outright debt default. While an administration may eventually appear that is willing to take serious action on those fronts, based on its actions to date, it won’t be this ad-ministration.

Yes, there will be a plethora of new and escalated taxes on the “wealthy” in America, but those taxes will soon be-come counterproductive. As Laffer’s curve showed, you can only squeeze a taxpayer so hard, even a rich one, before tax revenues level off. And we don’t see a politician as skilled as Obama backing a broad-based tax increase that direct-

ly breaks his much repeated campaign pledge not to tax the middle class.

Cutting back government services? So far, the measures pro-posed are the exact opposite of that.

To be fair, this is not a Democrat vs. Republican thing. Rea-gan and both Bushes let the deficits expand, while Clinton (with some encouragement from Gingrich and the Repub-licans in Congress) contained runaway spending and raised

taxes, returning some sense of fis-cal responsibility, albeit briefly.

The retirement of baby boomers, a $50 trillion liability when taking Social Security and Medicare obligations into account, is not a government tax policy problem but a demographic one. With only two workers supplying all the funding needed for one retiree, the taxes required approach half the income of each worker. That is patently unsustainable.

And that is before layering on all the new programs now anticipated, not to mention the rising costs of servicing the debt, made worse by the certainty that

interest rates will ratchet higher over time.

Not a Typical Business Cycle

After digging through an enormous amount of data, I can only conclude that this is very definitely not a typical four-year business cycle from which a few green shoots are sup-posed to herald a normal recovery. Rather, it is a systematic, endemic crisis that could only be addressed by starting with a 180-degree turnaround of government intervention in the economy.

Given that is extremely unlikely, what we expect instead is that the government will continue to avoid the hard choic-es by remaining firmly on its well-worn path of debasing the dollar. Unfortunately, the scale of the unaddressed structural



problems will almost certainly lead to a dramatic acceleration in the pace of that debasement.

That will leave the global financial system in disarray, for the simple reason that the U.S. dollar now provides an underpin-ning value for most of the world’s paper currencies. With that anchor cut loose, the world will have to scramble to find an al-ternative method of valuing their unbacked currencies, lead-ing to a hugely disruptive transition period.

One potential consequence is that the U.S. – and maybe even the world – could experience a hy-perinflation in our lifetimes. Even if nothing so dire occurs, it is a near certainty that we’ll see a new monetary regime arise, one that will not be linked to the currency of a single nation. Of course, the impact of the dollar losing its glob-al reserve status will have an extreme effect on the U.S. economy, incalculable at this point. Our grandchildren will not thank us for blowing the greatest economic gift ever bestowed on a single nation.

What about timing?

While we see this crisis as protracted, the odds now favor the emergence of a relatively high in-flation in 2010, triggered by an escalating deteri-oration in the confidence of foreigners in the dol-lar. This falling confidence has already been seen in a general reduction in overall purchases of U.S. Treasuries by foreign central banks and a notice-able shift from long- to short-duration paper for the purchases that are made.

As their own economies continue to come under pressure, and their falling trade surpluses reduce their stock of available cash, we expect to see fur-ther reductions in the foreign reinvestment that has been so critical to supporting the U.S. dollar over the past decade.

In the top chart – from Brad Setzer at the Council on Foreign Relations – you can already see the sharp drop in trade in the first quarter of 2009. This is a far more rapid contraction in trade than we have seen at any time since the Great Depres-sion.

But the chart also shows that the fall in private financial flows – outflows as well as inflows – has been even sharper than the fall in trade. While U.S. private investment in the rest of the world (shown as “private outflows” in the chart) rebounded a bit in the first quarter, private demand for U.S. financial as-sets remained weak, with foreign investors continuing to pull funds out of the U.S. This is not an encouraging trend, and it is likely to get worse.

Soon, we expect to see more foreigners moving out of Trea-suries, either by outright sales or simply by failing to roll ex-isting Treasuries into new ones – of any duration. Given there is no way the United States can pay off the $6 trillion of accu-mulated trade deficits, a rush for the exits could lead to devas-tating consequences.



Regardless, as U.S. deficits spiral upwards, it’s a safe bet – and a bet we are making – that what remaining buyers there are for U.S. debt won’t be satisfied with the almost non-existent yields now on offer.

At that point, with the Fed increasingly forced to step in as the buyer of last resort, a negative feedback loop sets in, with higher and higher rates required to entice buyers and stave off runaway inflation. We are not optimistic that eventuality can be avoided.

It’s Not Over

No one likes to be the bearer of bad news, but absent an im-mediate about-face by the wildly interventionist government, you can ignore all reports of green shoots.

Instead, things are likely to get progressively worse as the year drags on, with hundreds of small to mid-sized U.S. banks be-ing closed over the next year due to commercial real estate troubles. U.S. municipal defaults are also not out of the ques-

tion, though in that event we would expect the federal gov-ernment to again step into the breach with more bailouts.

But make no mistake, the patience of U.S. taxpayers and for-eign investors for bailout upon bailout, coupled with expen-sive new programs in healthcare, energy, and general stimulus spending is not without limits. The government is playing a dangerous game with the dollar – a game that, if it continues, risks a devastating devaluation.

Simply, this crisis is far from over. Caution in all things finan-cial remains the watchword. Tell your friends.

“Make the trend your friend” is the motto of The Casey Re-port… and that goes for any trend, even a severe economic downturn. One of our favorite investments for 2009, for ex-ample, is betting on rising interest rates – simply because they have nowhere else to go but up. Read how to best play this unique opportunity by clicking here.

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Green Shoots or Greater Depression? - Homepage - … · The only rational conclusion to be drawn is that the crisis is ... but the tally so far includes on ... The Casey Report Green