Chapter 4. Quis Custodiet Ipsos Custodes?

The title of this chapter is a question in Latin: Who will watch the watchers? Many observers of the U.S. government during late 2008 and much of 2009 posed the same question as budget deficits, loose money, and financial rescues with taxpayer money cascaded into a waterfall of financial irresponsibility. The lighthearted corollary of this chapter title may come from Ronald Reagan’s famous quote that the nine most terrifying words in the English language are “I’m from the government, and I’m here to help.” By no means intended to alienate people along political lines, this quote is only given in reference to the unprecedented levels of government intervention that have occurred in the United States in the wake of the worst financial crisis in a century. Irrespective of political party, the stock market pays attention to spiraling private and public debt balances, runaway monetary policy, double-digit deficits as a percentage of gross domestic product (GDP), and how much of GDP is controlled by the government. If these risks are carried too far, they become everyone’s problem. This chapter introduces these developments and shows how they might contribute to risk.

To begin, let’s resume our storyline from late 2008. As October 2008 indiscriminately gored investors across the capital markets, the American people looked increasingly to their government for answers. Truth be told, in the fourth quarter of 2008, the gears of the world’s markets were grinding to a near halt. The engine was not stalling; it was failing. An entire commercial system based on trust was riddled with distrust, suspicion, and anxiety. The problems that underscored these emotions were very real—many people and banks were sliding toward bankruptcy. People felt that they could not really tell if a business or counterparty on the other side of a transaction could back their side of the deal. Still, this is the nature of the U.S. financial system. The entire economy functions on the back of one word: trust. There is no better way to describe what was occurring in the economy of late 2008 than a total meltdown in trust: “Is my bank safe?” “My sister-in-law said the bank downtown is in trouble.” “Should I remove my money?” These words were not whispered among finance-minded people; they were spoken anxiously by cleaning crews in the hallways of office buildings. The fear had become pervasive.

An Alphabet Soup of Rescue Acronyms Will Save Us

The U.S. government, and really the majority of governments around the world, recognized this on some level, at least, and mobilized their efforts to restore trust in the financial system. The situation was perhaps most dire in the United States and the other developed markets, because many of their citizens were dependent on a regular extension of credit. With the banks and credit institutions frozen, and these same lenders afraid to extend overnight loans to one another as they normally do on any given day, the velocity of money in the economy was plummeting. Money became tight and scarce. This economic environment was summoning a ghost that haunts all policy makers and officials in Washington, DC. A white whale was swimming in the Potomac, and its name was deflation. Incidentally, Federal Reserve Chairman Ben Bernanke had dedicated much of his scholarly pursuits to studying the Great Depression. He understood the blunders of the Fed during the Depression. Because he saw it as his raison d’etre, he would not repeat the mistakes of the Captain Ahabs who came generations before him, and he sought to flay this white whale in plain view for all to see. Given that Mr. Bernanke’s nickname had for years been “Helicopter Ben,” in reference to a Milton Friedman metaphor regarding a helicopter drop of money, no one questioned what was coming—only how far he might be willing to go. We can be sure that Mr. Bernanke’s strategy at a minimum was to fight off deflation with whatever requisite political will was necessary. Bernanke was not alone in this call to arms, flanked by long-time Wall Streeter Hank Paulson as the Secretary of the Treasury. Given his background as the former head of Goldman Sachs, Paulson bridged the gap between Washington and Wall Street, for better or worse. At the same time, Paulson’s proximity to Wall Street would keep him under ample scrutiny and suspicion of favoring his former firm and others.

Reviewing the record, both Bernanke and Paulson had already begun to respond to the environment prior to the credit freeze and economic meltdown in late 2008. Bernanke, in his role as Fed chief, had already been guiding the Fed Funds rate downward in the first part of 2008; he paused at 2% in April 2008. By the end of October, he had taken off another full percentage point, moving the rate down to 1%. Paulson had already been involved in all the aforementioned bailouts and interventions up until late 2008, including Bear Stearns, Fannie Mae, Freddie Mac, and AIG. Now, with the crisis increasing in severity, this dynamic duo redoubled their efforts and initiated a broader bailout plan in September 2008 for the banking system. The program Paulson devised, called the Troubled Asset Relief Program, or TARP, was met with widespread public criticism at its outset. On September 29, it failed in the House of the Representatives. However, as September rolled into October and the crisis deepened, Congress relented in a second go. It made some modifications and passed the Emergency Economic Stabilization Act, which provided the Treasury with a $700 billion kitty for its TARP. The idea behind TARP was to use funds to buy the heavily depressed collateralized debt obligations (CDOs) off the books of the investment banks and commercial banks. This would hypothetically rid the banks of their bad assets, provide them with cash to lend, and potentially make money for the taxpayer as the bad assets increased in value after the crisis settled. This simple plan quickly morphed into a complicated mess. Six weeks after the bill was passed, Paulson changed the plans. He decided to take the funds and make direct cash infusions into banks through the purchase of preferred stock. Stop the presses! The U.S. government was now wrangling for stakes in commercial banks? The Gipper’s team was getting routed before halftime. Not to mention, far from building confidence in policy makers and their ability to restore the financial system to working condition, the public and the stock market became even more anxious because of these developments. Irrespective of criticism, and the overtones of nationalization notwithstanding, this was the course chosen by policy makers. Aside from the banks, and hopefully to no one’s surprise, other beggars suddenly came out of the woodwork for these public funds. They included auto manufacturers, state governments with deteriorating fiscal conditions, and insurance companies. As long as Paulson was shifting on the fly, other leaders hopped along for the ride. President Bush decidedly wiggled into the mix and redirected a $17.4 billion slug of the TARP money to the automakers in December. This $700 billion in overall TARP money provided by the taxpayers looked like a chicken leg dropped into a fish tank of piranhas.

Far from sitting on his hands, Mr. Bernanke released another form of rescue plan in November that he had devised for the financial system through his Term Asset-Backed Securities Loan Facility, or TALF. TALF, as it was designed by the Fed, was established to offer one-year financing to firms from the Fed to fund the purchase of asset-backed securities. Because the total dismantling of the securitization market took much-needed liquidity out of the financing markets for consumers, the Fed reasoned that coaxing back investors with sweetheart interest rates and a guarantee on the securities might do the trick and get credit flowing again. The problem was that banks and lending institutions as we know them were in self-preservation mode. Also, the global network of investors who had been buying asset-backed securities, called the “shadow banking system,” was missing in action, if not already annihilated from credit losses. The Fed was creating a program that would hopefully resuscitate the shadow banking system. However optimistic, or perhaps naive, the TALF idea was as a facilitator to bringing the securitization market back from the dead, the Fed had already been intervening in the commercial paper markets through its Commercial Paper Funding Facility (CPFF). The CPFF was an October 2008 move by the Fed to step directly into the commercial paper market and assume the role of creditor to firms such as GE that were trying, but unable, to transact in these near-term maturity credit markets.

Problematically for the Federal Reserve and Treasury, their attempts to restore trust in the financial system actually eroded it further. The American public and the stock market recognized that their leaders did not have clear answers. These unelected officials in the Fed and Treasury who were controlling their hard-earned tax money were engaging in a very public version of throwing spaghetti against the wall to see what might stick. To worsen matters, in October 2008, about a week after the tremendous drama surrounding the bailout of AIG and the extension of $85 billion in funds from the public coffers, AIG executives took off on a retreat to a St. Regis spa in California. The event cost the company—or, shall we say, its new owners—$440,000. Americans ranging from elected members of Congress to Joe Six-pack were livid, and rightfully so. Confidence in bailout mania continued to sink, as did share prices trading on the world’s indices. By the end of 2008, Americans had a new president coming on board in 2009, as well as an estimated $8.5 trillion price tag on the assortment of bailouts that had occurred over the course of the year. To bring this $8.5 trillion into perspective, the entire dollar amount of mortgages outstanding at the time was around $12 trillion. In other words, with no end in sight to the crisis, the government basically could have bought over 70% of the loans in the market with the amount of money it was throwing at the situation. Based on polling by the Rasmussen Reports in October 2008, 63% of respondents thought Wall Street would benefit more than the taxpayer from the bailouts. Interestingly, within this 63% was an almost perfectly even dissemination across party lines. In the same poll, just 26% of American adults possessed “even a little bit of confidence that the nation’s policy makers know what they’re doing when it comes to the current problems on Wall Street.” December offered a merciful end to a year full of financial shock and awe, and Bernanke cut the Fed Funds rate again to a hail-Mary range of 0% to 0.25%. By now, the Fed was starting to resemble that frustrated man standing behind the curtain in The Wizard of Oz, vainly tugging and pulling on an assortment of economic levers. The S&P 500, after a particularly gut-wrenching run through September and October, had fallen for a total return of –37.0% in 2008. From its previous high, set on October 9, 2007, the index had declined –40.6% on a total return basis.

Strategy Number Two: Spend Our Way Out of a Spending Problem

Anyone who possessed the audacity of hope that 2009 would represent a fresh start from the runaway spending on bailouts, and the monetary policy gone wild of 2008, was quickly disappointed. The government that had rushed onto the scene as a formal cavalry brigade in September 2008 was now exposing itself as something closer to a Monty Python movie. One problem, though, was that no one was laughing.

Although it had already slipped through a $168 billion stimulus plan in February 2008, Congress had taken a backseat to the Paulson and Bernanke show up until early 2009. This would not last, though, because this group now had a legitimate excuse to unleash some real spending. The National Bureau of Economic Research, a group that officially records the dates of recessions, released its opinion in December 2008 that the United States had entered a recession in late 2007. This was hardly a keen observation. But its significance for policy makers lay in presenting a more formal opportunity to tap into public funds to pick up the slack in the economy through government spending. With both a Democrat-controlled Congress and White House, it was clear that old projects and causes that had been patiently waiting in the wings could now receive generous sums of money in the absence of any serious resistance. A quote from White House chief of staff Rahm Emmanuel sent a clear strategic message to Congress during late November 2008 about how the executive and legislative branches of government should view the current economic circumstances: “Never let a serious crisis go to waste. What I mean by that is it’s an opportunity to do things you couldn’t do before.”¹ If the things that “could not be done before” referred to taking advantage of a situation in order to spend wild sums of money in the name of aiding a crisis, Congress got the message. Unfortunately for a country with already-shaky finances, Congress took the message to heart. In February 2009, Congress passed the American Recovery and Reinvestment Act of 2009. The bill included what apparently had very little to do with the traditional reinvestment into public works and infrastructure that most Americans anticipate in a Keynesian-style stimulus package. Instead, this bill included $650 million for coupons for digital television set-top converter boxes, $30 million to protect a wharf mouse habitat, 10,000 checks mailed to deceased people, and $600 million for the federal government to buy new cars. To top it all off, the government placed $300 road signs to tout its own road construction stimulus projects. Despite the boastful road signs as evidence that infrastructure was receiving reinvestment, the Wall Street Journal estimated that only 5% of the stimulus money was actually going to bridge and road work.² Disillusioned by the flagrant political overtones, critical, satirical, or generally lucid pundits quickly redubbed the stimulus package the “spendulus” package. The stimulus package drew criticism from its early 2009 draft through its February passage in Congress. Many onlookers objected to the speed at which it was drafted and ferreted through the legislative process. The use of fear-saturated rhetoric played a substantial role in expediting the bill’s passage through Congress. Egged on by Mr. Emmanuel’s repugnant battle cry, fear had now become the sharpest rhetorical tool in Washington’s efforts to effect policy changes. President Obama, himself a gifted rhetorician, used this tool often and with precision: “If we do not move swiftly ... an economy that is already in crisis will be faced with catastrophe.”³ The stock market, acting as an on-again, off-again judge of the effective allocation of capital and resources, saw the bill and the heavy-handed political maneuvering that was swirling in its midst as unsettling. To be sure, the stock market was now pitched into a selling frenzy in the first quarter of 2009. The fevered pitch of doomsday rhetoric from Washington was accelerating the selling activity to the point where the bear market was now taking its place in history as one of the worst on record. In this respect, no bear market had ever produced such sharp losses in such a short period of time (see Table 4.1).

Table 4.1. The 2007 Bear Takes Its Place in History

On March 6, 2009, the S&P 500 touched an intraday low of 666 during trading, which was appropriate, since most investors probably already felt like they were in hell. Three days later, on March 9, the market hit its bottom closing price of 676. Finally, after 17 months of liquidation and deleveraging, the stock market put the finishing touches on a –57% decline from its October 2007 high. Incidentally, stocks had become heavily discounted on nearly every valuation metric imaginable (see Table 4.2). Value investors, despite being kicked around by a steady succession of even better bargains than what they had bought the day before, were finally about to be vindicated for their steadfast behavior.

Table 4.2. Fourth Quarter 2008 Stock Market Valuations

On March 10, 2009, something beautiful was born. All the pessimism that had driven the market into its depths, accelerated by margin calls among the leveraged, and fear of fresh lows among the pessimists, had finally exhausted itself. To begin with, it was becoming clear that despite the terrible economic environment, inventories across the world’s economy had been thoroughly liquidated to the point that some rebuilding would be necessary. Given the positive implications for future GDP, it at least seemed possible that the rate of contraction in the world’s economy had found a near-term nadir. It was becoming clear that the market, too caught up in its race to the bottom, had gotten carried away. During the summer months of 2009, the market was again off to the races, albeit in a completely different direction.

The Vestigial Effects of the Crisis Come into Focus

Despite the sudden and altogether inevitable reversal in stock prices during 2009, the long-term focused value investor is still left with much to ponder. The years of excesses built up in the U.S. consumer, as well as the overbearing reactions of the U.S. government to the crisis, have created vestigial effects that could linger in the fundamental landscape for years to come. The rest of this chapter explores these fundamentals. The remaining chapters highlight and discuss investment themes that offer a response or solutions to some of the problems facing investors.

As we methodically examined the financial crisis in the preceding pages, we identified several phenomena that are worth ongoing consideration from investors in the present day. First, we witnessed an unbridled attempt by the Federal Reserve to leave no stone unturned in its efforts to restimulate the extension of credit in the economy. Under conventional standards, the Fed typically sets the Fed Funds rate and then buys and sells short-term government securities in the open market to manage the money supply toward its target rate. The Fed had pushed down rates to a range of 0% to 0.25% in December, with little of the desired effect it sought in its efforts to “get credit flowing again.” In March 2009, it embarked on its most aggressive policy to date in its fight against deflation and the credit crunch—quantitative easing. Economists debate the definition of quantitative easing, as well as whether the Fed’s actions in 2009 replicated the actions of the Bank of Japan by the same definition in the 1990s following its economic meltdown. Rather than get academic, we will cut to the chase. We will denote quantitative easing in the Fed’s version as entering the longer-term markets for government debt such as Treasuries, and making purchases to inject further liquidity into the system. The Fed resorted to this measure because it had in no uncertain terms already fired every last one of its usual bullets. Quantitative easing is effectively printing money, but no presses are needed. Instead, the Fed enters a few (actually, many) 1s and 0s into a computer and credits the bond seller’s account, and, voila, we have new money. Technology is amazing; a policy maker’s ability to destroy your purchasing power has never been easier. In other words, as Mr. Bernanke and company fought off the specter of deflation, they were creating money like never before—or, actually, many times before during the course of human history, for those who study those things. Either way, Mr. Bernanke’s problem was and remains how to unwind this activity, if and when the time comes. Given the sheer volume of the preceding activity, the effects of a wrong move could prove seismic. How much money has been created? Figure 4.1 shows the growth in the monetary base of the United States.

Figure 4.1. U.S. aggregate reserves depository institutions monetary base

Source: Bloomberg, Federal Reserve

As you attempt to digest what is shown in Figure 4.1, we can offer some additional food for thought from the foremost authority on monetary policy and inflation:

Dr. Friedman’s words provide little comfort to investors whose financial goal is to accumulate and store their wealth throughout their lives in hopes of consuming at a later date. There can be little question that the U.S. government intends, at least to some degree, to inflate its way out of a good bit of this debt overhang. For anyone who thought the explicit bailouts of Wall Street were bad enough, if allowed to occur by the Fed, the government’s efforts in monetary expansion will lead to implicit bailouts of remaining entities carrying heavy balances of fixed-rate debt. This is because their fixed payments remain the same while dollars in the system multiply. No one should be confused by this phenomenon. This form of monetary expansion works, although discreetly, as a form of tax on savers and redistribution of wealth to debtors. The purchasing power of the saver’s accumulated wealth is eroded in lockstep with the debtor’s eroding balance of fixed payments relative to the multiplying dollars. Since the government is also a heavy debtor, it has an incentive to use some degree of this ploy. So in many ways, if we consider the total amount of money that has been created by the Fed during the crisis, in the name of rescuing failing financial institutions, this is a tax liability hanging over people and entities that store wealth in the U.S. dollar. If and when a likely inflation appears in the U.S. dollar, prices of goods will rise, and future dollars will buy less of those goods than 2009 dollars. This loss of purchasing power can simply be thought of as a tax bill that resulted from the financing of the 2008–2009 rescue activity through the Federal Reserve’s printing money.

Clearly, this type of monetary strategy has a shelf life. A government can betray the faith placed in its responsible management of a currency only so many times before people cease to trust the government any further. Eventually, savers see through this shallow game and seek to save in other currencies or assets that retain their purchasing power. The exit from a currency where the holders lose confidence can occur with blinding speed, particularly if the currency in question is not widely used. For countries that control the reserve currency, such as the United States, the process of its partners exiting the game can take considerably longer, because ready alternatives take time, confidence, and trust to develop. Nevertheless, if the United States allowed its monetary growth to lead to inflation, it would only be joining a rich history of countries that over time sought to finance activity through the printing of additional currency. Put another way, this leads to the debasement of their currency (if it is backed by a metal). For instance, Rome was a steady debaser of its currency throughout its history, having reduced a once-pure silver coin to mere alloys by the time the empire fell. For that matter, the United States debased its currency to finance the Civil War, as it removed the greenback from gold convertibility for over a decade. The point is that whether you are talking about England during the Napoleonic Wars or China a thousand years ago, there is ample evidence of humans issuing a currency and then sooner or later abusing their power over that currency. The temptation for government to finance activity by issuing additional currency, or by avoiding an unpopular direct taxation on its citizens, is often irresistible. This is yet another example of timeless human behavior and the search for a shortsighted, easy solution to a difficult problem. Historically, though, the consequences of this behavior have been serious. As soon as trust has been broken, or confidence is lost in a currency, it can be difficult to restore.

Despite the potential for inflationary problems at some point in time, the Federal Reserve still believes it will be able to withdraw these excess dollars from the economy before any serious emergence of inflationary pressure. Although it is possible that the Fed will safely remove this extra supply of money before it can begin to damage purchasing power, it is not probable. First and foremost, appearances and rhetoric notwithstanding, the Federal Reserve faces much political pressure to maintain a loose stance on monetary policy. The Federal Reserve Chairman is not an elected official, but instead is appointed by the president and periodically reports to Congress. So although textbooks or other official documents may say the Fed is independent, most people can view evidence to the contrary by simply turning on their television. In reality, Fed Chairman Bernanke lobbied hard for his reappointment in 2009. In a historically unprecedented but also sensible move for someone looking to garner public opinion in his favor, Bernanke appeared on the televised news-magazine 60 Minutes, where he granted a rather warm and fuzzy interview. Perhaps more than anything, he wisely struck a tone of distaste for the bailouts he had helped engineer and broker and successfully couched himself as an advocate for the little man on Main Street. He deftly executed his role of the compassionate central banker. He might have even kissed a baby during the interview had one strolled by on the streets of his hometown of Dillon, S.C. In any event, it proved a successful if not unconventional PR move, and he was reappointed by Obama. Political posturing aside, the point is that it was clear that there was political posturing of some variety from the Fed Chairman. This lays bare what most have already surmised: Central bankers like to be reappointed and will curry favor to do so. Whether they are pining for public opinion, the adoration of the president, or the steady approval of Congress, they must stay popular with the powers in Washington. Incidentally, the powers in Washington want as much as anything low interest rates and easy money. Washington certainly does not care much for recessions, since they crimp tax revenues and yield sour voters. To put it in the frankest terms, have you ever heard of a politician in Washington pounding the table for higher interest rates? With that said, the institutional framework does not support a high probability of the Fed exiting its monetary expansion soon enough to avoid a rise in inflation. What makes the situation most difficult is that the rapid acceleration in prices typically is preceded by a period of benign, feel-good economic times. Historically, when inflation first appears, it is recognized by businesses everywhere as a gentle uptick in sales, or the appearance of an economic recovery. These people running their assorted businesses respond in time by purchasing more inventory or expanding their operations, since they are examining the phenomenon mostly from their own perspective. In time, though, costs begin to rise also, and given enough time, the growth in the money supply invades all corners of the economy. Inflation in this sense produces a bit of a sucker punch to the business operator. At first conditions seemingly improve, but after time the business sees that its profits are not much better, or even deteriorating from a margin standpoint. Many businesses see their profitability decline if they cannot adequately respond to rising costs by quickly increasing their selling prices. Nevertheless, at the outset of the feel-good period, as the press, pundits, and policy makers claim victory over the crisis, does it seem likely that the Fed will abruptly step in and crash the party? Even better, would the Fed risk reentering a recession just as conditions were improving? Talk about an unpopular move, made by a group of policy makers that seem to prize popularity! 60 Minutes would run a far different piece following that policy move. It is possible that the Fed will fall on its sword for the sake of sparing the U.S. economy from these inflationary events. But it seems more likely that the Fed will wait until there is stronger evidence of an economic “recovery.” If it does so, it also runs a much higher risk that inflation is already accelerating.

Even so, with all the superlative evidence of potential inflation built into the monetary base notwithstanding, it remains difficult, if not impossible, to forecast when (or if) it might appear. It’s possible that the newly created money could stay on the sidelines or in the system for a while. We can attribute this enigma to the peculiar nature of man and what the economist John Maynard Keynes described as “animal spirits.” The late economist coined this term to describe a sudden appearance of confidence in human behavior. Animal spirits are observed with little effort in the stock market. In stock market parlance, this phenomenon is often called risk aversion or, even more technically, the “equity risk premium.” What makes a P/E ratio suddenly rise from 7x to 10x in a few trading sessions, with only little incremental news having arrived? Confidence in future earnings or, better yet, animal spirits. So it is with the current state of the U.S. economy and the mountain of money lying dormant in banks throughout the system. Currently, spirits remain low, and banks are still largely in a state of self-preservation as they worry over further credit defaults. In other words, all that money remains in an essential lockdown, although the situation is far better than it was in late 2008 and early 2009. Fortunately, a simple equation will save us from wasted ink and fallen trees, because it explains the monetary situation in clear terms. The equation of exchange gives it to us straight: money supply × velocity of money = price level × quantity of goods and services produced (MV = PQ). The idea is that the two sides of the formula must balance. So if you increase the M for money supply and there is no corresponding increase in the P × Q side, velocity, or the number of times a dollar changes hands in the economy, must be declining. Velocity is the key here. The fact that M increased so disproportionately during late 2008 and early 2009 with no corresponding increase in the PQ (Gross Domestic Product) suggests that dollars are not circulating much. Velocity is based on confidence—the confidence to spend, the confidence to lend, the confidence to invest. As we said earlier, animal spirits. Although it’s impossible to project, we can at least turn again to the analyst’s best friend when pondering an impossible projection: What happened in the past?

For this analysis, we return to the expert on monetary matters, Milton Friedman, as described in one of his many books, Money Mischief:

If we accept Dr. Friedman’s research of history as a guide, this would mean in general terms that unless demonstrative action is taken to reverse the monetary growth, inflation might be noticeable in late 2010 through 2011. In June 2009, Alan Greenspan offered his own take on the prospects for inflation in an op-ed for the Financial Times:⁶ “If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012; earlier if markets anticipate a prolonged period of elevated money supply. Annual price inflation in the United States is significantly correlated (with a 3 1/2-year lag) with annual changes in money supply per unit of capacity.” Hopefully, neither of these scenarios will unfold, but in any event, investors should prepare for this risk and plan appropriately with the proper investments that protect their purchasing power while the market still offers opportunities on the heels of the bear market. Historically, investments in companies whose businesses can reset their prices quickly in the market stand the best chance of maintaining profitability. These types of businesses are often tied to the production or sale of a commodity, such as oil or various agricultural goods. We discuss these potential investments in later chapters. Their merits as potential long-term investments extend beyond simple inflation hedges.

In the meantime, we are not quite done with our discussion of risks being created by the U.S. government. Sadly, there is more to discuss. As we return our attention to the spendulus package of early 2009, it raises an important question: How will the government pay for all this additional spending activity? As you know, the U.S. government has substantial debt of its own and does not possess a war chest of savings that it can deploy at will on various public ventures. With that said, when the government spends sums beyond its revenues, it runs a deficit and must finance this activity, just as a consumer or business would have to finance spending beyond its means. To finance this activity, the government borrows money by selling Treasury bonds to raise the funds to support its spending. All this activity is typical and has been occurring off and on since the country gained its independence and established a federal government. In particular, it is a fact of history that governments run large deficits during wars to finance the activity. However, large peacetime deficits are a relatively newer phenomenon that emerged in the 1980s. In the present day, since policy makers use the excuse that drastic times call for drastic measures, the government ramped up its spending, and hence its deficits, to historically unprecedented levels. Figure 4.2 shows how the top-level powers in Washington, consisting of Congress and the White House, continue to steer the country’s finances into uncharted territory.

Figure 4.2. U.S. federal budget deficit as a percentage of GDP

Source: U.S. Treasury, Congressional Budget Office, Bloomberg

Figure 4.2 shows pretty well how the U.S. government has attempted, in a no-holds-barred Keynesian fashion, to pick up the spending slack in the economy left by the indebted consumer, who is missing in action. In effect, the U.S. government has picked up the baton from the fallen consumer and is trying to keep the spending race alive. As with the consumer back in 2003, the government is spending beyond its means from a revenue standpoint and is racking up too much debt in the process. All this spending behavior is being performed in the name of “getting credit flowing again” and “creating or saving much-needed jobs.” As the government tries to induce more spending among its steadfast sidekick, the consumer, it resembles the two hacks from the campy movie Weekend at Bernie’s. These characters ridiculously prop up the corpse of their wealthy boss and continue having a good time. Of course, the ploy in the movie ultimately fails. A similar outcome for the government’s efforts to foster consumerism is also probable. Unfortunately for the U.S. government and its efforts, the consumer who spent and borrowed willy-nilly during the past two decades has retreated into a state of self-preservation alongside the banking system. For all intents and purposes, the U.S. consumer is entering a phase of balance sheet repair that will be initiated by spending much less and saving much more. Two solid reasons underlie this behavior. The first is a tangible fear and recognized probability of financial failure and hardship. With their balance sheets already stretched with debt, and the value of their lynchpin real estate and equity assets still well off levels from years before, many consumers fear the consequences of a pink slip and have altered their spending habits appropriately. Second, the shadow banking system of credit securitization that funded the heavy borrowing and fueled the spending has been deeply impaired by credit losses. This change in consumer behavior is evident in the short term. It could very well establish a behavioral pattern stretching over years rather than months. This is analogous to the generation who emerged from the Depression and preached a message of saving and living within one’s means. While presenting a paradigm shift, this development would not be all that bad should it persist. First, getting the U.S. consumer on better financial footing is essential to the economy’s long-term health. Second, many exciting areas of consumerism have considerably higher growth prospects and hence offer investors better potential rewards. In fact, participating in the construction of a middle class of consumers in emerging-market countries will provide ample opportunities for investors in the years to come. Put another way, knowing what we know now about the history and economic progress of the United States, would anyone pass on an opportunity to invest in the U.S. stock market back in the early twentieth century? If you can recognize the opportunity the U.S. stock market presented at that point in time, you should recognize the present opportunities lying in China, India, and Brazil, to name a few.

The U.S. consumer aside, the current spending deficits from the U.S. Congress are complicating matters on a number of fronts, including the ability of the Federal Reserve to unwind its wildly stimulative policy of quantitative easing. The Federal Reserve took the unprecedented step of purchasing long-term Treasuries in an effort to directly impact the level of mortgage rates (to keep them low by putting buying pressure on Treasuries to help mortgage rates). It also injected staggering amounts of liquidity into the U.S. economy. Therefore, at some point, the Fed has to sell these same Treasuries to unwind its loose policy. In other words, selling these Treasuries withdraws the cash the Fed created earlier from the economy. However, with the U.S. Congress running deficits well over $1 trillion for the next ten years according to CBO projections, the Fed will have to tread carefully so as not to add to the selling pressure of U.S. Treasuries in the market. This creates a delicate situation. With the Treasury already selling more bonds than normal to finance its outsized deficits, this added selling action by the Fed could create additional market pressure for lower prices on these Treasuries. As you know, lower bond prices spell higher interest rates, and rising rates on Treasuries affect everybody. Higher interest rates would potentially crush all those poor souls still stuck in ARMs as their rates continued to reset at higher levels. The irony of the situation is that the government’s actions to rescue these borrowers with aggressive policy created a potential risk that could undermine the same people in a foreseeable chain of events. Likewise, higher interest rates in the bond market get the final say and would act to override anything the Fed or politicians could devise. Ultimately, the bond market creates the interest rates that proliferates all other financial contracts denominated in that currency. So whether we are discussing the potential deluge of Treasury sales or the arrival of inflation, it appears that a discernible risk exists for potentially higher interest rates. Either way, we can say with relative certainty that one of the two parties must change its current behavior to lower the risk of future inflation and higher interest rates. For instance, since the Fed is primarily concerned with keeping interest rates low in key financial contracts such as mortgages, it does not want to see its policies unraveled by a deluge of Treasury sales. With that said, the Fed would benefit if Congress and the White House would back off of their spending also. Based on all available information at the moment, this is unlikely. Applying the Congressional Budget Office’s deficit projections for the coming ten years (see Figure 4.3), we can find little hope for a sharp reversal in current spending levels.

Figure 4.3. U.S. federal budget deficits

Source: Congressional Budget Office

We have already discussed the complications that this spending creates for the Fed, but there are further long-term considerations also. First, this deficit activity also represents a large change in the structure of the government’s balance sheet. Under the current projections, the nation’s debt-to-GDP ratio would rise from 41% in 2008 to around 70% of GDP in 2019. If these numbers taken as a percentage of GDP seem abstract, let’s add another perspective. Figure 4.4 shows the CBO’s debt projections resulting from proposed deficits out of White House estimates. Because a deficit translates into debt, we can see that the projected debt will more than double. Put another way, beginning when George Washington took office in 1789 through George W. Bush’s presidency in 2008, it took the U.S. government 219 years to accumulate $5.8 trillion in debt. Based on the current president’s spending plans, it will take only about six years to run up a comparable amount of debt. This spending path is untenable, because under these current projections, close to 90% of the budget deficits in 2017 through 2019 will be comprised of interest payments on the debt itself.

Figure 4.4. U.S. government debt held by the public

Source: Congressional Budget Office

Unfortunately for the roughed-up U.S. consumer, if this deficit plan comes to pass, well over 3% of GDP will already be spoken for through interest payments on government debt. Assuming that U.S. consumers did repair their balance sheet in the coming years, they must do so knowing that taxes may rise as these deficits persist. We can only hope that sometime during the coming years, this deficit path will be reversed, and these levels of spending are never recognized. Otherwise, the purchasers of U.S. debt—which back around World War II were entirely American citizens but now are almost half comprised of foreign governments such as China and Japan—may start demanding higher interest rates. They would want to be compensated for a weaker balance sheet and rising inflation expectations, just as any lender would in that circumstance. Although it is true that a U.S. Treasury obligation carries no default risk, there is substantial risk of a loss of purchasing power, and these bondholders recognize this risk. Likewise, there is a much smaller but still identifiable risk that the largest holder, China, could threaten to sell its Treasury holdings faster than the market could absorb them to avoid falling prices and rising rates. This act, although a very unlikely scenario, would effectively send Treasury rates much higher and the value of the U.S. dollar lower, forcing a significant standard of living adjustment on Americans (for the worse). As mentioned, this scenario is unlikely, but its possibility should be respected by policy makers and not ignored. The United States successfully threatened this same strategy on Great Britain in 1956 during a dispute over whether to engage in military action over the Suez Canal. Although the United States did not sell its substantial pound holdings, the threat alone was enough to send the pound’s value plummeting. Many observers cite this event as a defining moment in Great Britain’s loss of its status as an empire. Fortunately for the United States, China still needs the U.S. as a trade partner and does not have much incentive to undermine a key customer for its economy. However, this economic position will change over time as China continues to develop and builds a larger domestic economy. It is important that the United States get its financial house in order during that time span. When taken in sum, the potential consequences of all these behaviors by the U.S. government present a basket of unique risk factors to Americans who seek to protect their purchasing power. At the same time, investors can potentially lessen these burdens by seeking long-term investments in countries that manage their finances in a far more responsible manner. As ironic as it may be following the Asian Financial Crisis, many emerging-market countries currently are in better fiscal shape, and are more responsible stewards of public finances, than the developed-market countries that rescued them from financial turmoil in the late 1990s.

The Visible Hand Is Coming into View, and It’s All Thumbs

It might be reasonable to assume that after covering so many potential risk factors introduced by the U.S. government, we have exhausted the topic. Not exactly. We have yet to tackle the replacement of Adam Smith’s invisible hand with the big clumsy hand of the U.S. government. Actually, to say that the United States was guided by an invisible hand in its financial markets is unjust. To be frank, having a Federal Reserve that actively controls the money supply and sets interest rate policy is not laissez faire. For that matter, neither is having a Congress that forces banks through policy to lend money to less-than-creditworthy borrowers. Although it is true that Alan Greenspan gained street credibility by hanging out with Ayn Rand, the U.S. system has been a mix of free markets and interventionism from the outset. The two forces have worked alongside each other since the beginning. Over the course of the twentieth century, regulation and deregulation have waged bitter turf wars. During late 2008 and early 2009, Americans saw these forces remanifest their ongoing clash as the financial system nearly collapsed under the weight of too much borrowing and unbridled risk taking. On one hand, the excesses of Wall Street and risk taking that spilled over into the main economy were credited to the ills of deregulation. But regulators incentivized this behavior by creating public-private market devices such as Fannie and Freddie. Rather than laying the blame wholly on an inanimate idea such as deregulation, one could argue just as easily that regulators are simply ineffective. We all know that Bernie Madoff was a crook, and onlookers tried to tell regulators the same, years before the collapse of his Ponzi scheme. The facts show that the SEC was warned by more than a few observers that the firm smelled fishy. The SEC was even provided arithmetic evidence that Madoff’s strategy was incompatible with his assets under management. It is not a novel idea that regulators fall short of expectations. Although most people recognize this reality, human behavior is to still consistently seek more regulation in the wake of a crisis. This pattern is too well established in the history of the United States. Policy makers can be counted on to increase their dominion over the public when given the least opportunity, much less a glaring one such as 2008.

Most people are familiar with the correlation between crises and the impending introduction of further government regulation. No less than 16 government agencies were created in response to the Great Depression. Likewise, many more people have come to recognize that regulation grows of its own volition if left unchecked, because government bureaucracies generally expand over time. One simple way to examine this phenomenon in growing regulation is to measure the number of pages printed in the Federal Register over time. The Federal Register is a lengthy book dedicated to printing the rules, proposed rules, and notices of Federal agencies, organizations, and executive orders. In one rough brushstroke it can be used as a proxy for the growth in United States regulation over time. Figure 4.5 shows the annual page count for the Federal Register since its first printing in 1936. It is often cited by Milton Friedman and regularly scrutinized by a publication produced by the Competitive Enterprise Institute called the “Ten Thousand Commandments.” The Federal Register has ascended from its humble beginnings of 2,620 pages in 1936 to a staggering 79,435 pages in 2008.

Figure 4.5. Annual page count in the Federal Register

Source: Competitive Enterprise Institute, “Ten Thousand Commandments”

As you can see in Figure 4.5, the Federal Register has displayed fits and starts over time in its growth rate. Although not a perfect measure, these growth rates have corresponded quite well to different regulatory regimes and their accompanying economic growth rates. Most noticeable is the tremendous rise in the annual page count during the 1970s. To bring these growth rates into better focus, Figure 4.6 shows the same data as in Figure 4.5 on a ten-year compound annual growth basis by decade.

Figure 4.6. Ten-year compound annual growth in the page count of the Federal Register

Source: Competitive Enterprise Institute, “Ten Thousand Commandments”

The assorted growth rates in regulation demonstrate the runaway regulatory behavior of the 1970s. As you might have guessed, economic growth faltered in the U.S. economy as it became overly burdened by the substantial growth in regulations, and their associated costs that were ultimately passed along to the consumer. In Milton Friedman’s 1980 book, Free to Choose, he offers an assessment of the 1970s regulatory environment and its deleterious effects on economic growth:

Dr. Friedman’s comments on the growth of regulatory agencies in the 1970s are illuminating, but this phenomenon is far from a historic relic. The collective budgets of federal regulators have increased at a steady compounded growth of 9.8% in nominal terms during the past 49 years. Put another way, the whole of regulators’ budgets, and their drag on economic resources, have been doubling nearly every seven years for the past 49 years, as shown in Figure 4.7.

Figure 4.7. Regulators’ budgets, in billions of dollars

Source: fiscalaccountability.org

The conundrum is that everyone can agree that some amount of regulation is necessary. In its simplest form, the United States requires some authoritative enforcement of the right to own property, if it is to function as it was originally designed. Problematically, when regulation tries to do too much, adverse effects set in. Businesses waste their precious resources filling out paperwork, attempting to understand legalese, and spending money to comply with certifications, tax preparation, or purchasing new equipment that meets specific guidelines, to name just a few distractions. In some industries businesses must hire employees whose only purpose is addressing and complying with regulations. This has two effects: It makes the cost of running a business higher, and it distracts businesses from their core objectives. Even worse, it pulls businesses away from their most beneficial societal externality—innovation. This wasted activity, although difficult to measure, is estimated to range from $1.2 to $1.5 trillion in the United States. Put another way, businesses waste a sum equivalent to approximately 9% of GDP (or the economy’s total output) on regulatory costs. Since this money flows toward the government and its myriad agencies, we can fairly call this another form of taxation. Likewise, since businesses pass along these costs through higher product prices, consumers ultimately bear these regulatory costs. So although regulations are often constructed with good intentions, it is nothing short of ironic that their negative consequences of higher prices and forgone productivity create a perverse by-product that works against a society when taken too far. When regulation gets taken to an extreme, people seek to circumvent it and operate in the informal economy. In these instances everyone loses, because governments receive less revenue, and people’s rights are not protected.

Importantly, regulations tend to unduly punish the small business—in particular, the entrepreneur. First and foremost, a large organization is far better equipped to absorb the monetary costs that result from meeting regulatory burdens. Second, as regulations increase, government effectively increases its oversight of and direct involvement in business practices. In this sense, large firms have the financial resources to lobby policy makers and protect their interests. In this paradigm, however, the small firm has no say and can be subjected to various forms of de facto protectionism as larger firms seek to influence policies and steer government initiatives that protect their interests above all else. These policies typically evolve into serving two interests: the incumbency of the firm doling out the money, and the politician receiving the money. In the end, new entrants into the given industry become disadvantaged or discouraged from entering by these self-protective measures. Politicians are amenable to these lobbying efforts for several reasons. These include financial rewards, reciprocation by the company to enact government industrial policies, the small number of large companies (easier for politicians to deal with) versus many entrepreneurs, and the higher number of jobs (employed voters) controlled by the company.

One striking example of this behavior at work can be found in the U.S. government’s rescue of General Motors. For starters, GM was a large employer in a heavily regulated industry. Much worse, but not by accident, once the company received its billions of dollars of taxpayer money to retool, it announced that it would start producing more “green cars.” Not coincidentally, this production plan matched a core industrial policy that the Obama administration has peddled in its efforts to create “green jobs.” Never mind that GM could not profitably produce run-of-the-mill gasoline-powered vehicles, much less these fuel-efficient vehicles with their higher breakeven costs. Unfortunately, these relationships between regulators and large corporations have been shown to breed corruption in countries where regulation overreaches.

Another related and worrisome development in the United States that stemmed from the financial crisis was the government’s intervention in the banking industry through the conditions imposed on the TARP funds that were used to rescue ailing institutions. At the time the government initiated its investments, there was widespread concern in the American public that the government would nationalize the banks. What most observers missed were nuances derived from accounting rule APB 18 under U.S. GAAP. It states that in instances of less than 20% ownership, an entity should be consolidated into the acquirer’s balance sheet where control is exercised. Any observers focused on who was exercising control over the country’s largest banks would have unmistakably concluded that Uncle Sam was calling the shots, irrespective of the absence of common equity ownership. During a February 11, 2009 Congressional hearing, the heads of the large commercial banks, including Citi, J.P. Morgan, and Bank of America, were called to Capitol Hill and publicly browbeaten like miscreant kids yanked off the playground. No one should have—or did, for that matter—shed a tear for the bankers. However, there should have been some sorrow for private businesses around the country, given that banks subordinate to politicians soon become allocators of capital to politically-driven objectives. Fortunately, several banks have repaid their TARP money, but many have yet to do so. Those that have not repaid their loans, including Citigroup currently, have seen a large increase in telephone calls from their new bosses in Washington, DC. According to reports on the Bloomberg newswire in July 2009,⁸ Senator Charles Schumer of New York telephoned Citigroup’s CEO, Vikram Pandit, to protest the withdrawal of a mall developer’s credit. After Mr. Pandit had executives review the credit line for a mall in Syracuse, N.Y., Citi stuck with its prior decision. Bank of America reported that calls from lawmakers in Washington increased fivefold from a year earlier. If the banks have resisted calls from politicians to direct their business, sadly, GM has not. In June 2009, Congressman Barney Frank of Massachusetts asked with success to delay the closure of a plant in Norton, Mass. for 14 months. Translation: The U.S. taxpayer should subsidize a loss-making activity on behalf of a lawmaker’s constituents. Taking all this into consideration, the evidence of the government’s attempted involvement in capital allocation for political objectives has already been shown, even if the bankers have resisted it.

We cannot be sure what the future holds. But based on available information, including the tremendous growth in federal spending and deficits, as well as the introduction of legislation attempting to cap and trade carbon emissions, and even possibly provide universal healthcare, intentions are known. We can be sure that the U.S. government is posturing toward a dose of bigger government and interventionism. What is most odd about these policies that are being pursued is that they are often promoted in the name of progress. However, if the U.S. government pursues its budget deficits on the current course it has suggested, it will introduce the risk of a rise in long-term interest rates and an effect of crowding out private firms’ access to capital. Among all the adverse regulations and policies that could impact small businesses and entrepreneurs, an inability to access capital due to punitive interest rates would be particularly damaging. In turn, the withdrawal of the small business or entrepreneur due to these factors would truly halt progress. The free-market system of commerce’s success relies on many factors. But for a society to truly progress, it needs to foster the creative destruction that is borne on the back of highly competitive small business. Societies that promote the freedom of individuals to pursue these goals will continue to progress faster than their counterparts over time.

We have discussed many potential risks to consider over the coming years, ranging from inflation in the U.S. dollar, to runaway spending deficits, to a sharp rise in regulation and government intervention. Again, no one knows the future. We may be weighing risks whose importance will fade in time. However, wise investors will always watch the watchers and prepare for potential risks they introduce accordingly. The following chapters discuss investing alternatives that seek to avoid many of the risks discussed in this chapter. They target areas with strong long-term opportunities and the ability to help protect purchasing power over time.

Endnotes

¹ Review & Outlook. “40-Year Wish List.” WSJ.com, January 28, 2009.

² Ibid.

³ Susan Davis. “Obama Praises Democrats for Quick Work on Stimulus.” WSJ.com, February 5, 2009.

⁴ Milton Friedman. Money Mischief. Orlando: Harcourt Brace, 1994.

⁵ Ibid.

⁶ Alan Greenspan. “Inflation — the real threat to sustained recovery.” Financial Times, June 25, 2009.

⁷ Milton Friedman and Rose Friedman. Free to Choose. Orlando: Harcourt, 1980.

⁸ Alison Fitzgerald. “Pandit Defies Schumer as Lawmakers Flex Muscles.” Bloomberg, July 22, 2009.