Government Spending and the Risk of Ruin

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A company named Freeport McMoRan Copper and Gold recently suspended its dividend and cut back its capital spending. It did this to preserve cash, so that it can service its debt in light of the fact that its business has fallen off sharply. These moves to "stop the bleeding" were prudent. The company wants to avoid ruin (bankruptcy). It is obvious that stemming the cash outflows will help it preserve its capital and provide a reserve or bulwark against hard times that may last for quite a long time. If it had not taken these steps, its risk of ruin would have been much greater.

Any person or enterprise that has cash inflows and cash outflows reaches financial ruin when the cash inflows are not enough to pay the obligated cash outflows. Clearly the risk of ruin is lower when the entity has higher cash inflows, as from income and revenues, and lower cash outflows, as from spending and debts. Just as clearly, the risk of ruin rises when spending and borrowing are increased, while income and revenues are going lower.

The risk of ruin constrains profligate actions, but it does not always stop them. There are those who direct themselves intentionally into financial ruin. While a child can understand these facts, governments act as if they can be disregarded. This leads to another fact of life: governments often destroy themselves and take their citizens down with them. They do this because, with their power to tax, they regard all the assets of everyone in their realm as theirs for the taking, albeit at some cost to them; and this induces them to multiply their obligations recklessly.

The prudence of Freeport can be contrasted with the imprudence of government. Two recent examples are Great Britain and the United States of America. Prime Minister Gordon Brown is intent on borrowing and spending more, with the hope of restoring demand. Barack Obama stands for doing "whatever it takes to get this economy moving again that we have to, we’re going to have to spend money now to stimulate the economy and that we shouldn’t worry about the deficit next year or even the year after." The $700 billion bailout bill passed earlier this year is a third example. It allows the FDIC to borrow unlimited amounts from the Treasury to cover losses on insured bank deposits. This provision relaxes the pressure on banks so that they do not have to cut back on dividends and spending.

Then we have, as a fourth instance, the Federal Reserve making loans with abandon. This is a novel way to increase the risk of ruin. If you make enough bad loans that the borrowers cannot repay, then, like any bank that makes bad loans, you risk ruin. The Fed’s risk of ruin is decidedly higher today than three months ago or twelve months ago.

Alan Greenspan mentioned a fifth example, which is likewise novel. One raises the risk of ruin when one has the seemingly unlimited ability to borrow. He mentioned this in testimony on April 6, 2005: "The government guarantee for GSE debt inferred by investors enables Fannie and Freddie to profitably expand their portfolios of assets essentially without limit." One might think that an unlimited ability to borrow is something that staves off ruin. The opposite is true. It builds up obligatory interest payments. The result of that ability to borrow without limit was the bankruptcy of Fannie and Freddie. It was like a perpetual bailout fund to them. They did not need to institute careful risk controls over their loans, the result being they made too many bad loans. Soon their cash inflows were not enough to service the payments on all that unlimited borrowing they had done.

Notice that the Fed’s ability to issue debt (currency) to any extent is equivalent to the capacity to borrow unlimited amounts. The Fed’s higher risk of ruin fits into this category too.

The risk of ruin of the U.S. government was already large before the recent financial problems occurred. The government already had made Medicare promises that it could not keep without strangling the economy or otherwise seizing wealth through high taxes and inflation. But now, as it piles program on program, and contemplates huge public works spending and the accompanying deficits, the risk of ruin is rising even more.

Our officials are not so much fearless in taking these risks as ignorant and unable to adapt to reality. They are ignorant because they do not know any better. They are both stupid and unable to adapt to reality because they are turning to the same methods that have supposedly worked in the past to stave off downturns in the economy. These are deficit spending and money-pumping. They seemed to "work," but they never did. Not understanding logic, our officials mistook their manipulations of economic activity combined with the normal forces of economic recovery for a healthy economy.

What logically and actually worked was that entrepreneurs in the business sector were able to create new jobs and whole new industries. That covered up the drag and distortions placed upon the economy by government policies. That drag is now being magnified even more. Even Tiger Woods won’t be able to drive a golf ball 100 yards if we load him down with all sorts of weights, braces, and contraptions.

This business cycle is worse, much worse, and it will stay much worse than prior recessions. The problems of the economy will not be resolved by anything that the government and the Fed are now doing or contemplating doing. These problems are too deep and structural. The financial system has failed, but the problems are far more profound. They arise from a long-term set of government and monetary policies, and they go to the production structure of American business. They reach overseas into trade issues. They reach into our poor educational system. They reach into ethical failings. They reach into misguided war policies. When a social and economic system has been misled for decades, the results go deep. They can’t be altered by public works spending and money-pumping.

The crisis has firmly-set and long-established roots. Americans do not have a stable medium of account that underlies their currency. The result of that is to misdirect effort into speculation against both deflationary and inflationary episodes. The lack of currency stability affects investment. At times, it has shortened investment horizons unduly. At other times, when interest rates have been too low, it has lengthened them unduly. At times, the government has acted to mitigate the speculative errors of business and financial interests, and this has induced inordinate risk-taking behavior. The government has attempted to provide a safety net for individuals as well. This has induced anti-social, anti-family, and profligate behavior. People have become less responsible and less oriented to planning and carrying out long-term plans. Government policies put in place supposedly to help people have, in the long run, undermined and distorted the normal functioning of society and business.

America’s problems run very deep. They will not be overcome by electing a candidate of change who does the same old things, only more so. Universal health care simply extends the problems besetting the health-care system. Transferring the army from Iraq to Afghanistan simply extends expensive and devastating war-making. Money-pumping simply repeats the error that has helped bring us to where we now are. Public works programs do not differ significantly from any other wasteful government program.

Since this crisis is bringing home to roost all of the errors of the past, only very large government counter-measures can possibly induce and manipulate the economy into a state of simulated recovery. The government is trying to make the zombie go through the motions one more time, with big doses of drugs and stimulants. This hastens the demise of the system. America’s fall will be more rapid than the fall of other nations who have faced ruin because of the enhanced scale of America’s attempted recovery efforts.

These efforts won’t succeed because they logically cannot succeed; they can only further distort and deflect the economy from a healthy and progressive course. The crisis will stretch out endlessly under these policies. They will lead to worse policies, such as exchange controls and controls over domestic investments. The Senate by the chances of politics actually did something right by rejecting the auto manufacturers’ initial bailout. The White House will try to do it anyway. This is what we are coming to, an economy that is more and more manipulated by the government. Such an economy is a stagnant economy.

Under these circumstances, unless the government changes its policies, capital will more and more flee the country. People will flee. Domestic conflict will rise. The dictatorship we already have will heighten.

This all will have investment implications. Gold will rise in price. As the current conditions take hold, I expect a gold price of $1500—$1700. That is, I expect the dollar to depreciate significantly. Don’t ask me when.

We do not need disaster scenarios for this to occur. All we need is what we are now getting, which is the existing political policies. The commitments for Medicare and the big deficits will cause the dollar to depreciate. Battles in foreign lands add to the deficits. Public works add to the deficits. There are nothing but large deficits as far as the eye can see.

I think interest rates will rise and bonds fall. The risk of ruin will affect government bond pricing. Government bonds are short sales. They’ve had a tremendous rally that looks irrational to me in view of the big deficits that lie ahead.

I expect stocks to be volatile or "messy." They will eventually go lower.

It was right to get out of stocks in 2007 and 2008. It is right at this time to get out of both bonds and dollars.

The old saying is to never sell America short. Rules like that eventually are broken. Buy and hold in the stock market is a broken rule. Even diversification is a broken investing rule. Buy and hold has failed because it amounted to a bet too. If one bets on the wrong market, buying and holding it is useless. Diversification fails when it can’t foresee the states of the world and how the assets will perform in those states. And it usually fails to see those critical details, so it does not know how to diversify. Not selling America short is the next rule to be broken.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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