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Budget Deficits, Inflation, Rebalancing and Freedom - February 20th, 2011

The London Brief Budget Deficits, Inflation, Rebalancing and Freedom February 20th, 2011 At a NYU conference early in the week, Alan Greenspan supposedly told John Paulson, “Whenever I get gloomy, I think of Winston Churchill. America always does the right things … after it has tried every other viable alternative.” With last week's Obama budget, America is clearly in the trying every other alternative phase. The President's budget is not realistic about the revenue side where he assumes tax increases that he was not able to push through this year. Nor is he realistic about expenditures where there are mysterious cost savings through asterisk marks. 5% growth rates are expected when government is slashing discretionary spending and job growth is slow. There is no factoring in an increase of interest rates like the market is assuming at the end of this year or early 2012. The U.S. Budget Deficit The CBO (Congressional Budget Office) projects that GDP is supposed to increase 3.6% this year, 4.4% next year, 4.5% the year after and rise to 5.4% by 2015. Growth will then crest on through to 2021 averaging 4.5% per year. However, if interest rates go up, it is unlikely this growth is achievable. The CBO projections show that total revenues from income tax, social security, corporations and other revenue streams barely exceed mandatory budget expenditures (i.e. - Medicare, Social Security, veteran pension benefits). Under this optimistic scenario, debt to GDP rises to 76% and the budget deficit declines to 4.3% by 2013. Mandatory spending will mysteriously hold flat from now to 2013 despite the escalation in Baby Boomer retirees. The CBO also believes interest rates will average about 4% in the outer years (ie - around 2021). The scenario I see post early 2012 is that inflation will continue to rise. The Fed will be slow to increase interest rates because higher than average unemployment and low labour wage increases. Then inflation will get too significant to ignore. The Fed will be compelled to raise interest rates. It will suffer losses on the securities it bought through TARP, but it won't mark it to market because they have a wholly unique accounting system. Fannie and Freddie may require assistance as an increase in interest rates could cause a rise in delinquencies. Deficits will continue to be large and government will target discretionary spending. However, some of this spending is actually good and its removal may harm growth prospects. All the nation's resources will funnel to mandatory entitlement spending. Higher interest rates will crimp growth, raise debt borrowing costs and make the CBO's projections even more unrealistic. This in turn will create a crisis as the market prices in higher sovereign risk forcing borrowing costs upward. In the face of crisis, the U.S. government will then do what it should today: cut entitlement spending. However, Mr. Churchill and Mr. Greenspan are right when they suggest that America won't go there without experimenting with the messy alternative of default first. Although this is my ultimate outcome, I think the rest of this year to early 2012 will be more of the same. There will be an increase in growth and a rise in the equity markets. But inflation will gradually get worse, starting small as is now but then becoming too big to ignore. Speaking of Inflation The week before last, the market felt inflation trends were muted. The market reversed course this past week and it was all about the resurgence in inflation. The U.K. (at 4.4%) and U.S. (at 1.6%) reported higher than expected inflation. The European cost-of-living index flew up to a two year high (a 2.4% increase). There was a further pick-up in Chinese prices (at 4.9%) triggering a 0.5% increase in reserve requirements for banks. An interesting website called The Billion Prices Project @ MIT utilizes prices from hundreds of online retailers around the world on a daily basis. They monitor the prices of 5 million items sold by around 300 online retailers in more than 70 countries. Their study indicates that U.S. inflation is more like 2.4%, considerably higher than official CPI. Inflation causes political instability. Ben Bernanke can probably lay more claim to Hosni Mubarak's downfall than Egypt's opposition parties. The World Bank said that 44 million more people were pushed into "extreme" poverty by rising food prices. The protests in Tunisia, Algeria, Jordan, Yemen, Bahrain and Iran are as much about higher inflation and a poor economy as it is about political freedom. Bank of Canada governor Mike Carney said, "We need a system that functions better." The current monetary system "is an increasingly unstable hybrid of fixed and floating exchange-rate regimes." Yet it's unlikely central banks will act quickly to stem the recent inflation. Many talk of one-time effects like an increase in the VAT or commodity shocks. Christine Lagarde , the French finance minister, validates this thought when she said, "Clearly, if interest rates rise too quickly it can hamper growth and it would be very detrimental for the objective that we pursue. Growth is the objective we pursue". Expect central banks to continue more of the same in the near-term. Rebalancing China The Economist had an interesting article about China rebalancing its economy through inflation. The yuan has only risen 4% versus the dollar since early 2009. But according to their internal calculations, the yuan's real exchange rate (measured using unit labour costs) is up 17%. A U.S. importer is indifferent whether he has to pay higher costs for Chinese exports because of a higher yuan or higher labour prices. In this way Chinese exports decline and consumption increases. The evidence also shows that runaway inflation is usually a result of fiscal excess, financed by the printing of money or by rigid labour markets, which produce a wage price spiral that central banks cannot stop. China has neither of these problems. It could inflate internally while maintaining its peg to the dollar. This is effectively an exchange rate increase. This is a preferable course too for China's central bank. If China were to increase its exchange rate, the PBOC may need to be recapitalized as it is essentially short the yuan. Rise in Freedom Saudi credit default swaps rose this week. Next door neighbour Bahrain does not have much oil. But they do have a lot of unhappy Shiite Muslims. Shiites number 60% to 70% of the population of 740,000. After protests on Saturday resulted in violence, al-Khalifah urged a "dialogue" and will now meet with opposition groups over reform. Sunni dominated Saudi Arabia also has many Shiites, but they are a 10% to 15% minority. Most live in the Eastern Province where Saudi Aramco is based. There they constitute 75% of the population. Shiites are not allowed to build mosques, have prayer meetings, are taught only Sunni Islam in schools, are disqualified as witnesses in court, can't serve as judges in ordinary courts and are excluded from high ranking government or security posts. So far the Bahraini conflict has not moved over the border, but at least one member of the ruling family has called for an address of grievances now rather than wait for protests. Libya is having serious unrest. Human Rights Watch put the death toll on Saturday at 24 and Al Jazeera says it is as high as 50. Overnight there were further attacks on protesters pushing the death toll up to 173. Richard Lugar said, "Thus far the Libyan policy and army have stayed loyal to Muammar Qaddafi. Maybe they will continue to shoot the protesters". End Note One element that's interesting in the Middle East and North Africa protests is the youthfulness of the movement. John Fulton in an article called "The Education Bubble is Fuel for Revolt" noted that the unemployment rate for Egyptians between the ages of 15 and 29 was 87.2%. The national unemployment rate was 9.4%. Tunisian college graduates have a 45% unemployment rate versus the 15% national average. Worryingly, he noted that the U.S. unemployment rate for 16 to 24 year olds is 52%. (Note these statistics are somewhat skewed in that a large % of youths are probably getting educated and foregoing employment but the point is that it is brutally hard for younger people to get jobs even in the U.S.). Meanwhile, Russia is back to booming these days and Vladimir Putin is cashing in. Set in 74 hectares of prime land near the Black Sea coast with its own vineyard, his new palace is reported to be almost eight million square feet and has its own helipad. Other features include an indoor cinema, a summer amphitheatre, a casino, swimming pools, a gym and a clock tower. To put this in context consider that HSBC tower is 1.1 million square feet and Buckingham Palace is 800k. Mr. Putin can probably do a two day hunting tour in his own house. Omar Sayed London, February 20th, 2011 Hide message history


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