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Critical Economic and Market Commentary 06/23/10

Has Humpty Dumpty Recovered?

All the king’s horses and all the kings’ men have been trying so hard to put Humpty back together again. So now that we are 18 months past the initial 911 call, how is the patient? Well, some doctors claim the patient (the economy) has fully recovered and should be back to ballroom dancing within days. On the other hand, others insist he will surely flatline at any moment so have your black veil ready. One thing is for sure: the economy is at a very dangerous crossroads.

There are two schools of thought to revive the patient

  1. The Keynesians (named after the famous economist) preach that during economic slowdowns the government should make up the difference in consumer spending with public spending. Our presidents, as well as most other world leaders, have used Keynesian economics to justify government stimulus programs for their economies.
  2. The Classicalists believe that markets are self-correcting and we should simply allow the economy the freedom to settle wherever it is necessary.

So far we have been following a Keynesian path, shoring up the economy with direct stimulus or backdrop guarantees. Unfortunately, that path is now ending and we are approaching the Crossroads. Do we veer left and keep stimulating the economy or do we tack right and allow the economy to go on its own?

Unfortunately, we need to go in both directions, which is not a good sign for the patient. The reality is that the stockpiles of medicine we have been administering are running dangerously low, and all the kings’ men are having one heck of a time delivering government money (future debt) to spend and the public will to spend it.

The problem is that even though U.S. banks have written off debt and recapitalized themselves, most governments have taken the bad debt from the private sector and transferred it to the public. When we bailed out the banks (again), the government put a floor under the economy and issued record amounts of debt to pay for it. The developed world has far too much debt, over $250 trillion of total liabilities which is the equivalent of almost 400% of global GDP, with far too high debt-servicing costs. Reducing this debt will be deflationary, regardless of the fact that banks will be forced to print money.

Positives do exist, which could keep the rally going for a while:
– Low interest rates – rates are low and will remain that way
– Liquidity – Lots of cheap money available
– Negative investor sentiment – investors remain skeptical

However, the negatives are becoming increasingly visible and will likely tip the balance:
– High unemployment – not decreasing as hoped
– Real estate prices – in decline again
– Consumer spending – not picking up as hoped
– Deflation in the future – despite governments’ printing presses in overdrive

The Big Picture:

The natural demographic cycle of our aging population points to a continuing drop in spending, and therefore demand, for years to come. Not until the next large generation comes along to pick up the demand will spending increase, unemployment decline and home prices stabilize. That generation is the echo-boomers, the kids of the baby-boomers like my son Josh who turns 16 in a few weeks, who won’t start spending in size for a few more years.

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