The Economic Reformation Coming to America, Part 1

Part 3: What Crises Are Pending in the Scenario?

by Richard Brawn, CCRA, MPA, December 16, 2005Print

An assessment of what the Federal Reserve must do to meet the challenges facing America. The assessment is in three parts.

Reformation. To return to an original form. To remake in a different form. To rediscover lost truths.

Part 3 - What Crises Are Pending in the Scenario?

Because the events always unfold in chaotic ways, a precise prediction of events cannot be made. However, one can identify possible events and circumstances. In doing so, one MUST remember that predictions are underwritten by assumptions. And, an assumption is that which must be true in order for the end result (prediction) to happen. Because some event may be possible, does not mean one will be able to predict when it will occur or even if the event(s) will occur. The underlying assumptions may never become reality. So, I need to give a bunch of caveats and feed the reader some small print.

Comparing the political pressure on government during good and bad times offers some insight into possible scenarios. First, expenditures by government are not driven by the needs of the people but the needs of the office holders to please their constituencies. Government operates on a cash basis, not an accrual basis. If money is available, spend it. The powers of office last only as long as office term. So, money burns a hole in the collective government pocket.

Legislative self-discipline is all that holds back spending all of the money that can be made available each year (new debt and tax revenues). The result is not what one would really expect. In good times, the pressure is on to spend all available money because next year tax revenues can be projected to go up. Spending discipline is weak in good times. In bad times, the opposite is true. However, the needs of the people are greatest in bad economic times. In bad economic times and if no government savings are available, the projections point downward and so there is an implied need for fiscal self-discipline. But, if that period lasts too long, too many people enter the category of those hurt by the economic conditions and the conditions themselves pressure government to spend.

The economist, John Maynard Keynes was a proponent of government saving in good economic times and spending in bad economic times. The economic theory contains a highly questionable assumption. It assumes that the incumbents of political office will and can shoulder the fiscal self-discipline that is necessary to make this happen. The political will to do so is very dependent upon the political cycle of elections. Unfortunately, economic cycles and political elections do not coincide. This means the assumption is, for the most part, invalid. In short, it is a nice idea but does not work in practice.

The depth of any economic bad times to come can usually be measured by the degree to which the various sectors of the economy deviated from the mean/average in good times. The occurrence of economic bad times is different in each economic sector. For example the construction sector has a 3-5 year cycle. It progresses from project design, to project feasibility, to project governmental approval, to project financing, to project construction to project operation. Once a project is financed, it virtually cannot be stopped. The reason is that a partially completed project has significantly less value than the money put into the project. So, the depth of economic bad times in the construction sector depends upon how much over-building occurred during the good times. �Over building� is a somewhat subjective term as it depends on the rest of the economy to absorb new facilities and remove the old facilities from the inventory of usable facilities. The US economy is composed of thousands of such sectors and each has its own cyclic time span.

This all means that if, as Dr Greenspan states, the economy will be overburdened with demands that it cannot meet, then the economic disruption we will see will vary from sector of the economy to sector. This will be particularly visible as the cycles reach their economic low points. In other words, the economy will not crash. It will seem to slowly disintegrate, sector by sector. At any point in the process, fiscal and political bandages maybe sufficient to stop the disintegration and possibly even to repair it. Now that I have given all the caveats and small print, we can look at the scenario events. Below is a socio-economic-political assessment of possible scenario events. I have tried to put them in an order that maybe most meaningful to investors. But, again, I want to emphasize that I am not predicting economic collapse as if the US were to be hit by an asteroid.

If some degree of collapse were to occur, it would be the sum total of many years of mistakes and failure of governance. Each scenario event, below, can have a degree of severity from virtually zero up to 100%. Since the financial and equity markets employ leverage, they exist as fleas on the dog�s tail. So equity markets can be heavily affected by minor changes in the economy. You will see this as a divergence between media coverage of the human toll and the coverage of the toll on our pocketbook/savings/investments.

So here we go.

1. Increased essential government services will require additional money. These needs and the consequences are:

a. Welfare demands escalate due to unemployment, health needs, welfare cycle, and transfer of retirement programs the PGC (Pension Guarantee Corp. and institutions that failed to plan for bad times.)

b. Defense budget increases are needed to protect overseas US interests that come under pressure because enemies recognize a weakened US.

c. Money is diverted from long term capital improvements to immediate needs. Over time, this results in
i. An increasing effect on the economy caused by deteriorating governmental infrastructure (roads, hydro-electric, regulatory competence, police competence, etc.).
ii. Deferring maintenance and deferring capital expenditures. (These are easy short-term fixes with long term adverse effects.)
iii. Financial inability to keep people and equipment technologically up-to-date. This is done by cutbacks in training government employees and suspending acquisition of new products.

d. Social crises resulting from adverse economic conditions drive up costs to operate the Judicial, Executive and Legislative branches of government.

e. Increasing economic risks to investments cause an escalation of the funds needed to service public debt obligations.

Return of offshore dollars to the USA.

Price inflation is caused by the re-entry of foreign held dollars into the USA to purchase items that are globally scarce and now cheap in the US due to currency depreciation.
Fear that the FED will monetize debt works in tandem with return to the USA of foreign held dollars to devalue the dollar.
Fear by foreign holders of US private debt that the US Government will refuse to enforce credit/debt collection by foreign holders.
Fear of the imposition of capital/currency controls.
Interest rate inflation due to these heightened risks to capital/investments.

Social impact exacerbates economic problems.

Poverty/hunger caused by the use of foreign held dollars to buy food, raw materials, etc. in America (See item 2a, above.) make food increasingly expensive.
Unemployment caused by a dearth of homegrown investment capital to invest in production efficiencies needed to remain competitive.
Disposable income growth is reduced by tax increases and job losses.
As asset prices fall and interest rates rise, the combination makes it impossible for retirement funds to generate cash flows to pay benefits.
As the international balance of payments shifts toward balance, expect a loss of value for those equities whose businesses were part of the balance of payments deficit cash flows. (That balance of payments cash flow can be calculated to show that it capitalizes about $10 trillion of equity.)
FED agrees to guarantee payment of US Government debt by monetizing debt. Public outcry over reduced benefits (retirement, welfare and services) creates sufficient pressure on the Executive and Legislative branches to force FED policy changes.
FED declares its mission to include maintenance of the price/value of financial market assets.

4. Contraction of international trade

a. Unwinding of debt makes fewer Americans able to buy imports
b. Poor economic conditions within the economies of our trading partners and dollar devaluation cause them to protect their own economies from new found US competition by imposition of tariffs
c. Competitive devaluations of currencies among trading partners occurs in order to save jobs for the unemployed

5. Wars.
a. To protect overseas sources of essential raw materials (energy, metals, food, etc.)
b. Political leaders succumb to �denial� and refuse to believe that the macro-economic shift has changed international political power. Miscalculation of military strength by civilian leaders puts US forces in un-winnable wars for natural resources.
c. Military �teeth� cannot be used because the economy is unable to support the financial expense of the military lift requirement and logistical �tail�.
d. Adverse economic conditions in the US spread worldwide and provide a good justification/excuse to substitute authority for democratic processes (Impose internal controls and thus preserve order.)

6. Rise of the Apocalypse in poor countries
a. Non-competitive countries cannot sell to the rich countries and therefore cannot buy from them. The rich will buy /seize world natural resources.
b. Halt to life support technology transfers to poor countries because foreign aid has to be cut.
c. Despotism replaces the rule of law in order to maintain �order."
d. Poor countries will be unable to protect whatever resources they have. Rich countries will support whoever will deliver the poor country's resources to them.

In politics, change that is �too fast� is, change that people notice.

Nothing of this magnitude happens overnight. In fact, it is the slowness of the changes lulls people into thinking that the adverse course change is an aberration and the next course will change for the better. History is replete with examples of simply throwing away the time to prepare. In the 1930s-1940s a whole faith, the Jews in Europe, suffered from what psychologists call �denial�. With 20/20 hindsight, it is amazing that Jewish people did not respond to the clear signals being sent by the growth of Nazism in the 1930s. They were certainly not fools. But, like us, they were afflicted with disbelief that their neighbors could and would act in such a way. We must expect to succumb to the same form of denial. Right now, even though we know with absolute certainty that our political leaders put their personal political ambitions ahead of those of the country, we just cannot bring ourselves to really acknowledge this as fact.

While Nazism may not be about to rise in the USA, various elements of tyranny are never that far below the surface. Limiting highway speed to 50 mph in order to save fuel is a minor act of tyranny cloaked in the �public interest� (claiming safety and saving for the disadvantaged, etc.) Intimidation by street gangs is a form of tyranny not at all unlike Hitler and Mussolini�s street gangs. Some religious groups want to impose their beliefs on the rest of us by the undemocratic means and, others even want to use homegrown terrorism. Tyranny comes from people who see wrong and will not act against it.

Summary

Issues to be considered.

In the global economy, currencies have been separated from that which gave them intrinsic value. Fiat currencies possess only utility. What we think of as �value� is due to how we perceive the billions of individual transactions using currencies as the medium of exchange. The term �money� is anything you want it to mean that acts a medium of exchange between transactions.
Infinite quantities of any currency can be produced. Currencies can be further parsed by creating classes among the holders of the currency. (Foreign holders vs. domestic, government vs. private, etc.)
Economic re-formation or change engineered by the FED must happen in order for people to accept an economic future characterized by declining expectations. The alternative is that the government will lose its legitimacy.
Crises that result in �emergencies� are a mechanisms that allow government to usurp individual rights.
Think ahead and take small precautions so you avoid finding yourself like a deer caught out on a freeway in the midst of rush hour traffic.

Contact Information
Richard K. Brawn, CCGA, MPA
Petaluma, CA USA
Email
California Certified General Appraiser (CCGA)
Master Public Administration (MPA)