Debt is a Drag

Sometimes in my mind I like to compare engineering and economics. In my revelry I think about what engineering would be like if Isaac Newton had been indisposed looking at a feather and hadn’t noticed the apple fall from the tree. Gravity would be represented a little differently in our science text books. Buildings would tend to collapse under their own weight. Our engineering schools would need to produce more and more engineers because we would have to rebuild our bridges every 5 years instead of once every 100 years or so. The pay of engineers would be higher than almost any other profession because of the demand.

I guess Newton kind of blew it for the engineering field.

But the good news is that all of the people that would have become engineers are now becoming economists. This is because of the same scenario that I stated above. Just replace gravity with debt. Gravity to engineering is exactly the same concept as debt is to economics. But the boon to the field of economics is that the concept of debt has been eliminated from all of our economics textbooks. The only variable that is represented now is the debt payment.

So theoretically an economy can have an unlimited amount of debt if interest rates are at zero. This is such a compelling concept. When Ben Bernanke said that our government could prevent recessions it sounded almost magical. I kind of got a feeling of feathers and zero gravity. Or actually it was like a Care Bear on a cloud feeling. The economists will always be there to rescue us with limitless debt.

But my euphoria only lasted for a little while. I have a degree in economics but unfortunately I am also an accountant. So I did the math and sold my home in 2007 with the intention of renting for an extended period. I also shorted the stock market in 2008 when every single economist in our country was predicting blue sky forever. I jumped into the stock market as prices collapsed in late 2008 and now I am market neutral. I will short the stock market in the fourth quarter of 2010 and then buy in at good value sometime in 2012. I probably won’t buy a house again until at least 2013.

As the economists are making the economy more and more challenging, we are training more and more economists. Sometimes I think that it would be a good idea to pay them not to do anything. Kind of like farmers, only instead of a $20,000 crop subsidy it would be a $1 million bonus payment for not creating any more expensive, complicated and risky investment products that underperform the stock market. In the long run this would save our country a whole lot of money.

But this is not my beef with economists. I don’t buy any of the expensive, complicated and risky investment products that underperform the stock market. So that doesn’t affect me directly.

My gripe is that economists don’t think like engineers. They think of themselves as fluffy Care Bears. When we have economic prosperity they float on their cloud ignoring any kind of regulation or fiscal or monetary constraint. This would be the “kids are having fun don’t bother them” theory. They call it “free market theory”. But if our economy hits a slight rough patch then they down a quart of Red Bull and bolt from the Heavens to save us from absolute destruction with micro managed market manipulation. This theory doesn’t have a name so I just call it “Care Bears to the Rescue”.

There is no science to being a Care Bear. Especially when most of the Care Bears work in our financial sector and wear $5,000 suits and drive Porsches paid with government subsidies. This dynamic was never discussed by Adam Smith.

The economists may think of themselves as Care Bears but they react more like rats at a feeder bar. They only understand the need to press the liability lever faster to make the economy grow. The faster they push the lever the more they are paid by the government and the financial sector.

I admit that a little bit of leverage can increase a nation’s standard of living. But as an accountant I can tell you that there is a point where more indebtedness does not create more long run growth. We reached that point in the housing market in 2004. At the time I tried to explain this fact to anyone that would listen. I had charts and historical data to back up my claims. But accountants are party poopers. Everyone wanted to listen to the economists who guaranteed that housing would continue to skyrocket above affordable levels forever.

Today we have yet another bubble that is just as irrational. Instead of the homeowner ATM creating unlimited prosperity our economists are telling us that the taxpayer ATM will propel our nation back to the glory days of yore. Like The Rime of the Ancient Mariner the story remains the same. The albatross is destined to be carried around the neck of the taxpayer, forever.

We have tripled our nation’s debt load compared to GDP in the last 30 years as our government and financial sectors have become as obese as our populace. The goal is to starve our “productive” small business and manufacturing sectors with higher taxes while our “destructive” government and financial sectors get Super-Sized subsidies.

The economists’ plan is to continue borrowing from the taxpayer ATM for the next 10 years even though our government has not paid back a single dollar of the national debt for the last 30 years.

“Hey wait”, you say, “didn’t we pay back a little during the Clinton administration back in 1998 or something like that?”

Please do me this favor. Raise your hand and point to the stars. This has been the path of our debt for the last 30 years on a chart. Now where along that path that goes straight up did we pay back any of our government’s debt?

Yes, we have debased our currency and made a small portion of payments go away over the last 30 years. Yes there might have been an accounting error that allowed a tiny bit of fiscal surplus for a very short period of time. But the truth is that our government and the Care Bear Economists have not paid down our “real” debt load in 2 generations.

So let me rephrase this very important point. We weren’t able to muster the self-control to pay down a dollar of debt during the last 30 years of the best economic period in our country’s history as interest rates were falling sharply. But now we are planning on doubling our debt and then waiting to pay back the $60 trillion liability in “stated” and “unstated” debt during possibly the worst economic period in our country’s history as interest rates shoot to the moon.

This is all I know. There is absolutely no math in accounting that makes this policy decision tenable. Making extreme debt disappear with more debt can’t be quantified with numbers. Logically it is irresponsible and in my mind it appears irrational. Also, never in human history has a country been able to borrow itself out of extreme debt without having problems. Rising interest rates make this strategy virtually impossible without a penalty. The consequences could be stagflation or hyperinflation or a mild economic collapse. History tells us that the larger the debt to GDP ratio of a country then the bigger the consequences.

We currently have record setting total debt compared to GDP in our public and private sectors. Anyone that tells you differently is an economist or is getting information from an economist. They are trained to ignore the accounting balance sheet. This ignorance has allowed our nation’s economists to help the government and the financial sector balance their books by hiding tens of trillions of dollars of future liabilities. It is illegal for accountants to misstate their balance sheets but in economics it is rewarded. Economists get paid high salaries to suggest ways to hide debt so our government and our financial sector can borrow ever more money:

· Before the financial crisis our nation’s largest banks that are subsidized by taxpayer dollars were leveraged 30 to 1. An impossible number in accounting but for economists it was definitely no problem.

· The fact that our nation has not paid back a dime of it’s debt in 30 years is also not a problem. Economists are sure that more red ink will make this government lard melt away quicker than the fat from a chicken fried steak in a George Foreman Grill.

· And as for the future government deficits created by reckless spending for at least the next 10 years. Whataya kidding? There is no problem here, please move along.

Money is usurped and the bill is sent directly to the taxpayer. Rationalization is not required. And in the case of The Federal Reserve, documentation is not even required. The largess that is passed by savers to the government and the financial sector by currency debasement and artificially manipulated interest rates is all under the table, so to speak. The public sector is an economist’s dream and an accountant’s nightmare.

Sometimes I ponder the fate of Andrew Fastow, the CFO of Enron. If he was an economist, instead of sporting an orange jumpsuit he could be wearing Armani and raking in a huge salary working for some heavily subsidized quasi government organization while giving highly paid speeches espousing free markets. Who knows, he might have at least one Nobel Prize under his belt by now.

At this point, I really need to know something from our next Nobel Prize winner. Mr. Bernanke, could I actually see the chapter in the economics text book that says borrowing more money eliminates carrying an extreme amount of debt? Is it like two negatives make a positive? Are you sure that you’re not quoting Adam Sandler instead of Adam Smith? It’s a joke … right?

But alas it’s not a joke. We are in uncharted waters living in an economic fantasy world as 300 years of economic thought has been cavalierly tossed overboard. The knowledge of the financial geniuses of the past has been replaced by an Orwellian world where producers will be brutalized with high taxes in the future so speculators who make idiotic bets can be made whole today. The government is manipulating every aspect of our economy to keep our markets free. Savers are demonized and forced into the purgatory of zero interest rates as indebtedness is held up as our savior.

The Care Bear Economists keep hitting the liability lever as money pellets rain down from the financial sector and the government.

Can things get any worse? You better believe that they can. Just keep listening to the economists.

The fact of the matter is that our nation’s future economic problems will be 100% debt related. Unfortunately our economists are functionally illiterate in this area. As our nation’s debt becomes more of a drag their analysis will become even more useless.

Honestly, hasn’t their analysis been useless for the last ten years? Nobel Laureate Paul Krugman wrote an article about this fact called “How did economists get it so wrong?” But ironically he didn’t mention our country’s extreme debt load or even the idea of debt. So in essence he has it wrong also.

Bigger government and a bloated financial system make absolute sense to the Care Bear Economists. This is who pays their salaries. And in the future they will float to the taxpayer’s rescue once again with suggestions of even meatier pork for the government and ever larger bailouts for our financial sector. This will create even more jobs for the economists. The rest of us that don’t pay their salaries won’t be so lucky. Our fate will be to drag our country’s ever growing burden step by onerous step up the next interest rate mountain.

Now let us take a moment to predict the growth path of our economy. What are the chances that a future 10 years of reckless spending by our government will eliminate our nation’s extreme indebtedness? Does it make sense to strip future resources from our productive sectors and use them to increase the size of our nonproductive government and financial sectors today? But more importantly, will the weight of the burden that we are creating to increase the size of our nonproductive sectors today become a drag on the economy as interest rates rise in the future?

In my mind, the controversy between accounting reality and our nation’s present economic fantasy comes down to one simple question.

Do you believe in gravity?

Value Investing in this Dysfunctional Market

I just listened to an interview by Rick Sutmeyer at the Value Engine website. I normally tend to agree with his thinking on the stock market. He says that the DOW has more of a chance of reaching 8500 before it reaches 11500. I would tend to agree with this analysis with a caveat.

Rick is presently short in the stock market and I am not. I will not hold a significant short position until at least the fourth quarter of this year. The current stock market is a freight train running down the mountain on greased rails created by unrealistic expectations and unlimited government debt. These unrealistic elements have been fermented by the extreme market manipulation by the Federal Reserve and our government. I refuse to stand in front of this rolling bomb.

But I am playing the volatility in the stock market. I sold most of my position in VXX(volatility ETF) at a tidy 30% profit for the week in this investment. I just bought a significant short position in long term bonds(TBT). Anyone that is presently long in this market has guts. I am a value investor and the only value in the stock market today is playing on the incompetence of The Herd of momentum investors. Considering our country's economic future, being long on this overpriced market is pure speculation. And given that the market manipulation of our government has created a herd of incompetent speculators then I can see short investors getting trampled.

Until the fourth quarter of 2010 I will trade the volatility of the market. If the S & P index is at least 20% overvalued by September then I will start to dollar cost average into a significant short position and then wait for the mild recession of 2011-2012. I have hopes that this will be the beginning of the change in our nation's outlook from growth created by debt, speculation and government bailouts. To a future of saving, prudent investing with less government bailouts and market manipulation.

But as always, my timing depends on the investment decisions of The Herd.