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Economic Update – what happens when the government money runs out?

Posted At : May 7, 2009 10:11 AM

Economic Update – what happens when the government money runs out?
The Fed and the Obama administration are playing a dangerous game. The Fed is going to print trillions of dollars to forestall deflation and try to re-ignite the economy. What happens when the market start balking at high and unsustainable national deficits? What happens when inflation (finally) does return? Can the Fed remain independent and take back the money it is printing in the face of what will likely be a tepid recovery? And if they don’t, what happens to the dollar?

We are in a long term secular bear market. We may have bull runs, but this will take years to get through. If the bear market ended tomorrow, it would be the shortest in over 100 years. It would be very hard to believe that we were facing the Depression like scenario a month ago, and poof, it’s all gone because the government threw money at the problem. I wish life were so easy. See the chart below:DJ historical Trends

The great dilemma for the government’s stimulus plan is that the government is trying to get consumers to spend at the same time that consumers naturally are starting to save. That savings trend is being augmented by fears of a failing economy and by rapidly disappearing retirement assets. I have talked about how ridiculous it is to add debt and leverage to the government at a time when its debts already are going to rise rapidly due to huge budget deficits and the severe economic slowdown. But the same is true for consumers, with consumer debt now near $14 trillion, or 100% of GDP. Consumers are more in debt than the government is, at 60% of GDP—even though our government’s debt ratio easily could rise to 150% to 200%, as Japan’s has from trying to stimulate during a long slowdown. However, the more important insight to gain is that consumer debt declined for the first time in almost 6 decades. This is finally the beginning of the deleveraging of consumer debt, which will take years to complete.

The long-term trend should continue to be toward a deeper decline in monetary velocity, as banks tighten their loan standards and write off more loans and as consumers grow more fiscally conservative: saving more, paying down debt, and walking away from mortgage, auto, and credit card debts. That is how deflation can occur despite massive money printing and money supply expansion; declining velocity more than offsets government creation of money and declining assets and loan write-offs destroy more monetary value than the government creates. As I said last week: assets are being destroyed faster than the government can inflate.

I see lots of opportunity for disappointments and missed targets. And bear market rallies are killed by disappointments and missed expectations. However, there are more stimuli and tax cuts on the way, and they will start to have an effect, as individuals will have more disposable income, whether to pay down debt, save, or spend. That should bring enough optimism to sustain the rally a little further. However, whether it be weeks or months, as America realizes that we are not in a V-shaped recovery back to old highs, and earnings will have to be produced to drive prices, the lows will likely be tested and quite possibly be broken. Make sure you are prepared.

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