Making the Best of a Horrible Bill

“And with so much on the line, it’s time to start doing things differently. That’s why our goal must be to spend these precious dollars with unprecedented accountability, responsibility and transparency.” President Barack Obama

This Tuesday, the President is expected to sign into law a bill that was rushed into passage with about as much obfuscation as one can imagine. (Why is he waiting until Tuesday to enact this "urgent" legislation?) Normally, bills are released in the form of a PDF document that is searchable by certain keywords that normally arouse suspicion. But this time, the Spending Bill, all 1,071 pages of it was released at 1:00 in the morning in the form of a paper document (that can't be searched) with voting in the House scheduled for 10:00 am so that there would clearly not be any time for review. This was obviously done so that those who feverishly poured over the bill couldn’t be as effective in ferreting out nonsense as they normally would. Democrats freely admitted that nobody read the bill they passed.

Mr. President, where’s the “unprecedented responsibility” in that? Is that what you mean by “transparency?” Or do you just think the American people will accept whatever you have to say. By “accountability” do mean the alleged $787 Billion price tag or the real price tag of $3.37 Trillion (over 10 years) as estimated by the Congressional Budget Office?

So here we are about to force upon our children another installment of perpetual debt that will drown our nation and our children. The soap opera continues this week when Secretary Tim the Tax Cheat will ask our children to pay the cost of re-capitalizing our banks, as much as $2 Trillion. His plan includes capital injections to banks, a “bad-bank fund”, funding of consumer debt, and foreclosure mitigation that may include the government picking up the tab for part of some peoples' mortgage payment - I'm not kidding. Each one of these bullet points requires the cooperation of the banks. Yet the Federal Government has infuriated banking executives by dictating what it thinks banks should pay their top people. This is a mistake and this non-stimulus act is mandated by the Spending Bill that will be signed into law on Tuesday.

Geithner’s plan won’t work. Aside from the banks separating themselves from government assistance, Geithner actually believes that private money will come in to buy bad assets. Wouldn’t private money have come in already if there was a market for bad assets? Of course, but Geithner is all but inventing a market where none exists, or claiming one exists that clearly does not.

Geithner’s banking plan may not have a chance. Since the banks are bound by the law described in the “stimulus” bill, and considering how furious they are about this law, it wouldn’t exactly come as a complete shock to see the banks pay back the money from the first TARP funds and dissolve its relationship with the government. Besides, the goal is to “get banks lending again.” I would ask, “To whom?” Banks expect to be paid back and with job losses mounting at historic rates, the American people aren’t in a position to borrow more money whether to buy a house or car or anything else for that matter.

Inflation or deflation?

The case for inflation is obvious. $5 Trillion (or more) over 10 years is extremely inflationary. It took Obama 4 weeks, including this week to accomplish the same debt level it took George Bush 8 years to reach. Don’t forget that the possibility exists for yet another “stimulus” package that might be deemed "necessary" that some economic experts are expecting. Trillions upon trillions are either going to be printed or bonds are going to be sold. All of this is highly inflationary.

However, what most people now realize is that what we’re experiencing is a crisis of credit. We’ve built this house of cards on a mountain of debt and the brain trusts in Washington keep piling on more. They seem to think they can force banks to lend but can they force people to borrow? Lending is a two-way street and our politicians forget that.

We'd prefer to sell government debt in the form of Treasury Bonds. Unfortunately, there may not be the bond market the government thinks there is. When bond investors realize that the government has issued more debt (backed by the taxing power of the United States) than it can handle, investors will flee the bond market. In other words, investors will sell government bonds. That is deflationary. There is nothing the government can do to stop this from happening, especially in this environment where not a week goes by where you don’t hear of tens of thousands of jobs disappearing, further weakening the government’s ability to tax the people of the United States (assuming it wanted to).

In these troubled times deflationary forces trump those that are inflationary, at least for now. That will most certainly change but at least for now and for the foreseeable future, the forces that are in place are that of deflation.

It is not my intention to give investment advice, only to tell you what I’m doing. Forget gold. There are strange things happening with gold and playing gold in either direction could be problematic. In order to make the best of a horrible bill, I’m going to short long term treasury bonds by buying the ETF (Exchange Traded Funds) TBT. Short selling an instrument means to “borrow” the instrument from a broker, sell it on the open market with the expectation that prices will decline. When that decline has reached a predetermined (by the investor) level, shares are “bought back” and returned to the broker for a profit. TBT is a double-inverse instrument that shorts 20-year treasuries. They do this by selling futures each day to an amount that is twice the value of the fund and rebalancing at the end of the day. That means the investor will yield 2% (theoretically) for each 1% decline in the bond market.

With the passage of this so-called “stimulus” bill I believe the US Government has gotten itself in way over its head. I wrote last week that we can’t afford this and as you watch the prices of Treasury Bonds decline in the forthcoming months, you’ll see that the bond market will confirm this is a horrible bill Congress shoved down our collective throats.

Stop the Madness!

The Congress has already passed and the Senate has agreed to a compromise (with the 3 Republicans they need to ensure passage) on a spending bill that comprises 5% as a percentage of our GDP in one act. This precedes debate on another Federal bank bailout bill that will comprise and additional 5% of our GDP. Including the first (seemingly) failed attempt to bail out our banks from their own hubris, we added another (approximately) 5% to the total debt.

We can’t afford this. As of November, 2008 our debt crossed the $10.8 Trillion mark. This debt comprises 71% as a percentage of GDP and does not include the federal guarantees made since last June nor does it include the estimated $2 Trillion in debt between the recently agreed to spending bill and the proposed bank bailout to be debated next week. The following chart shows that we’ve been here before but what is different this time makes this increasing percentage of debt unsustainable.

The Root Cause. On August 15, 1971 Richard Nixon decoupled the US dollar from the gold standard. This began a period where the dollar no longer held an intrinsic value but became worth what the issuer said it was worth, hence a “fiat” currency. This decoupling allowed the US, freed from the fiscal restraints of gold-based currency to issue debt as it pleased, based on the creditworthiness of the issuer. In the ‘70s, ‘80s and ‘90s this wasn’t a problem since the US enjoyed a Triple-A credit rating and each dollar or Treasury Bond was backed by the “full faith and credit of the United States,” and debt to GDP hovered around 30-40%.

Things have changed. Compared to a post-war expansionary period that produced unprecedented growth, we no longer have the means to expect the kind of growth in GDP that we previously enjoyed. In post-war America there was the absence of a looming crisis in entitlement programs we now have. These entitlements make up an additional 400% of current GDP which will certainly affect our ability to sell more debt through US Treasuries. In fact, just last week the NY Times reported that China is “losing its taste for US debt” and the Federal Reserve is assuring us that it is prepared to buy US Treasuries if it needed to, which could be problematic in much the same way as writing youself a check to cover your credit card payment. Japan, the second largest holder of US debt is also pondering a reduction in the purchase of US debt.

With foreign investors rightly shying away from even more purchasing of US debt, the only way we can finance both the spending bill and next week’s bank bailout, part II is to issue dubious treasury notes. If no buyers are found and the Federal Reserve has to buy these notes, interest rates are sure to rise and the value of the dollar is almost certain to halve from today’s value once the current deflationary environment ends.

Non-stimulus Contrary to congressional opinion, this economy does not need to be “jump-started” by expanding the social programs offerings that we can’t afford, that will be “paid for” the same way that helped to bring about the current mess we are in – by selling US debt, assuming that buyers of nearly $2 Trillion in US debt exist.

Two things: 1. The deflationary environment we’re experiencing is psychologically based, or at least it began that way. Currently, those of us who still have jobs are worried we might not keep them much longer. That’s why we’re not spending and that is what is leading to more and more job cuts each month. This deflationary spiral will not end until the social mood improves. 2. 70% of our economy is based on the consumer so the way to stimulate the economy is to get people to spend. To get the folks to spend we need to get them back to work. To get them back to work we need to encourage employers to hire back the millions that have been laid off. Employers can’t hire back people that they can’t pay and they can’t pay these people with the credit markets the way they are. So it stands to reason that if the government truly wants to help with the crisis, they need to unfreeze the credit markets first and foremost.

After the credit markets have thawed we need to promote economic growth. At the risk of starting a political fight here, economists across the country agree that permanent tax cuts, not temporary tax rebates are the best avenue for promoting economic growth. Specifically, a permanent reduction in the corporate income tax to reduce the cost of doing business and a cut in the capital gains tax to encourage capital investment would be all that we need to do.

Bringing domestic growth back to a respectable level of around 2-3% should be primary, not building tennis courts in Bryan, FL ($1.4 Million), providing light bulbs in Hollywood FL ($8 Million), resuscitating Amtrak ($10 Million), or buying digital TV converters ($600 Million), among many, many other trivial items and pork projects that have no stimulus effect whatsoever. When we’re back to where we should be, then we can look into providing the means for American television sets to tune into digital television signals. But let’s not delude ourselves into thinking this spending program will “stimulate” anything regarding the economy. We cannot spend out way out of this!

“We have tried spending money. We are spending more than we have ever spent before and it does not work.” – FDR’s Treasury Sec. Henry Morgenthau Jr., architect of the New Deal.

Tracking Government Failure

The NASDAQ has created an index that allows anyone to track the success/failure of companies who have received $1 Billion or more from the government in the form of a bailout or "rescue", symbol Nasdaq:QGRI. This new index consists of 24 companies, including recognizable names like AIG, Citigroup, Capital One, Wells Fargo, GM, Bank of America, and J.P. Morgan Chase. It is called the Nasdaq OMX Government Relief Index and all concerns are weighted equally.

So far in the first two weeks, performance has been shall we say, "Less than stellar." The index began its calculation on January 5th with a valuation of $1000. Friday, QGRI closed at $724.17 or a loss of 27.5%. Some of us in our personal 401k accounts managed to take all of last year to lose this much but the index that tracks government bailout programs accomplished this astounding feat in two short weeks.

You can't buy this index yet since the folks at Nasdaq haven't made it available for 3rd parties to form options in order to build products on top of the index, but they plan to. When it becomes available, you will be able to buy the index for its current market value if you believe the government is on the right footing with TARP and other bailout oriented concerns. A better bet would be to find a broker who offers shares of the index for shorting opportunities (or put options) since government bailouts have traditionally never produced the intended outcome.

The good news is that QGRI is the first index of the Government Relief Index Series that the Nasdaq plans on launching in the coming weeks. There will soon be many ways to officially track the failure of the US Government.