A World of Foreign Policy Gambles

It is almost axiomatic that when a political leader faces domestic problems, he or she will turn to foreign relations as a way to divert disgruntled constituents from their daily travails.  Appeals to national pride easily tap into the often reflexive patriotism that many people have.  Folks tend to rally 'round the flag whenever there's a dustup with some bunch of dang foreigners.  Since foreign relations tend to be largely in the domain of Presidents, Prime Ministers and other national executives, legislative interference is less of a problem and credit for success can be hoarded.

With essentially all of the world's major economies unimpressive, sluggish or even tending toward torpid, it's hardly a surprise that some world leaders are indulging in cross-border shenani . . . , well, activities.  China has a slowing economy, with a real estate bubble, a debt bubble, increased competition from lower wage nations around the world, growing unemployment, a lack of high-value innovation, and a demographic demon of too many elderly and way too few young workers that's far, far worse than America's social security issues.  So what does China do?  Make noise about territorial claims in the East China Sea and South China Sea.  America responds by flying B-52s into an area claimed by the Chinese.  The Japanese, with a sludgy economy and a recently elected Prime Minister, Shinzo Abe, who appears to be of a nationalistic bent, contest the Chinese claims with their military aircraft, sabre-rattling as good as they've been rattled at.  Japan and China are quietly drifting into an arms race, while the U.S. military is expanding its presence in Asia.  And of course, there's North Korea, an economic dead zone, which engages in virtually nonstop sabre-rattling to legitimize its autocracy. 

Meanwhile, in the Middle East, a newly elected Iranian leadership faced with a sanctions-hammered economy that's circling the drain, are suddenly open-minded about a deal to slow down their nuclear program.  An American President, crippled by the virtual non-launch of his showcase domestic health insurance program, decides it's okay to let Iran continue to enrich uranium up to the 5% level, even though this isn't exactly a complete freeze of Iran's nuclear program.  (Even though Iran says it wants to have 5% uranium to develop nuclear power, since when does a country with gobs of petroleum reserves need to develop nuclear power?)  This deal could be seen as an effort by the U.S. to reduce its presence in the Middle East (so it can increase its presence in Asia).  Does that make war in the Middle East less likely?  Or will the increasingly nervous Israelis act on their own, as they have in the past?  And if they do, will America be militarily dragged into the consequences?

Over the past century and a half, foreign policy adventurism has tended to end badly.  Sometimes, very badly, with 20 million dead in World War I and 60 million dead in World War II.  This isn't to suggest that America and other nations should become isolationist.  The world is interconnected and some degree of international engagement is necessary.  But citizens should be skeptical of their leaders, who often have much to gain by stepping up their rhetoric and actions.  The recent popular outcries against American and British military action in Syria over its use of poisonous gas is an example of how the levelheadedness of the citizenry can cool the jets of a handful of very powerful people who may spend too much time talking to each other.  If a nation's leader seems to have a gambling problem in the foreign policy arena, citizens should stage an intervention.

The Great Anxiety

The Great Recession has morphed into the Great Anxiety.  Economic growth is tepid, enough so that it inspires little confidence.  Unemployment, still high, is falling, but so slowly that consumers' animal spirits remain tame.  Individual investors, confronted by three year highs in the stock market, celebrate by fleeing.  The members of Congress devote their energies to calling each other finks, rat finks, double rat finks, and triple rat finks, while the nation veers toward a fiscal vortex.  Both candidates for the Presidency, although individually quite intelligent and accomplished, swap lies about how the other is lying and inspire little more than resigned sighs from their supporters.  The Federal Reserve is operating the only show in town, and its program consists of printing money, printing money while riding a bicycle sitting backwards, printing money while juggling eight balls and printing money while doing double somersaults on a trapeze.  But the Fed can't do much to resolve the problems in Europe, which is now sliding into recession even as the sovereign debt crisis gets kicked farther down the road.

If the Federal Reserve Board is correct in believing that public confidence is crucial to economic growth, then we are a long way from healthy, sustainable growth.  By all current indications, whichever candidate for President wins won't inspire much confidence.  Congress appears likely to remain divided between a Republican House and a Democratic Senate.  Gridlock isn't that big a problem when the economy is strong.  But it is deadly when the economy is moribund.  For better or for worse, a somnolent economy needs a decisive government, and we probably won't have one. Can kicking isn't a sound federal economic policy.  Both Japan, and more recently, the European Union, have vigorously kicked the can numerous times.  The problem, though, is that business people and consumers all know that the can is still there, and can bite them in the butt big time.  So they don't make big commitments; they don't go exuberant.  Can kicking virtually guarantees stagnation.  Yet can kicking has been the order of the day in Washington.

In a time when lukewarm coffee is all that you can hope for, invest cautiously.  It's not a bad idea to hold some risk assets.  But limit your exposure, and avoid the riskiest.  Hold a good dollop of stable assets, and don't stretch for yield.  One important way to give your net worth a boost is to save more.  Remember that the thriftiest squirrels have the best chance of surviving winter--and the coming winter could be cold indeed.

How the Federal Reserve Discourages Consumer Demand

The Fed has, for the past four years, waged a relentless war on interest rates, suppressing them to zero at the short end of the yield curve and to record lows at the long end. This was all done in the hope of encouraging lending and fostering consumer demand. With about 70% of the U.S. economy coming from consumption, there is good reason to try to encourage consumers. But the Fed's basic approach has been to tilt the playing field sharply toward borrowers and punish savers for having the temerity to be frugal, all with questionable impact on consumer demand.

The boost given to borrowers appears to be limited. Interest rates on credit cards have, if anything, been rising. This is in part due to changes in the law that have limited some of the fees with which banks previously whacked their customers. But the sharp drop in short term rates since 2008 has not been mirrored in the credit card market. With recent credit card rate increases, borrowers have the incentive to reduce balances, not boost spending.

In the mortgage markets, rates are reaching all time lows. But only a limited segment of mortgage borrowers are able to qualify for refinancing (and a lot that can refi have already done so). The people who need help the most (i.e., those underwater on their mortgages) find refinancing a tough slog, if possible at all.

In the business world, rates may or may not be dropping, depending on the creditworthiness of the borrower. Business people tend to be cautious right now, with all the headwinds from slowing economies in America and Asia, recession in Europe, the unsolvable Euro crisis, and near complete political dysfunction in Washington. Drops in interest rates aren't likely to greatly affect their view toward business borrowing, investment or hiring. That's evident from the fact that businesses are choosing to hold billions of dollars in cash for essentially no return rather than invest or hire. If you're not deploying your own cash to invest or hire, why would you borrow even at a low interest rate to invest or hire?

But the impact of low interest rates on savers is significant. Let's hypothetically take a relatively frugal American who is approaching or in retirement, and in 2006 had $750,000 in a diversified portfolio. During the financial crisis of 2007-08, this portfolio, we'll assume, was pummeled down to $500,000. Many investors victimized in this fashion have fled equities and put their reduced savings into fixed income investments. For the sake of simplicity, let's assume the Fed's war on interest rates kept the yield curve 1% below where it might have been with a somewhat more balanced approach by the Fed. (Thus, at the low end, the Fed would today be targeting a fed funds rate of 1 to 1.25% instead of today's 0 to 0.25%.) The interest lost by our hypothetical saver would be $5,000 a year. Compounded over 4 years, the saver would have lost about $20,302 before taxes. While this amount after taxes wouldn't buy a yacht, and only a modest car, consumption would probably be noticeably boosted if millions of Americans had enough additional money to buy a modest car.

Given that the Fed has promised to keep interest rates ultra low until late 2014, the lost income will reach approximately $30,760 per hypothetical saver in a couple of years. And this amount could increase if the Fed extends that promise into 2015 (a serious possibility).

It's important to keep in mind that these income losses are permanent. There is no way savers can recoup these losses. The Fed won't boost interest rates extra high later on in order to bail out the frugal. So savers' consumption will be permanently reduced.

The Fed claims to be greatly concerned with consumer expectations and their general state of mind, believing that public confidence is crucial to restoring demand and prosperity. The message sent by the Fed's long and continuing war on interest rates is that things are bad and will be bad for a long time. Any rational consumer, particularly those that are frugal to begin with, will hunker down, dig the fox hole even deeper, cover it with a sturdy layer of thick logs, camouflage it with an abundance of branches and brush, and never even dare to peek out.

The situation in Japan is illuminating. The Japanese central bank has, since its own financial crisis in 1989-90, banished positive interest rates from the land (encouraging the so-called carry trade, where Japanese citizens deploy their savings or borrowed yen into investments in foreign currencies that offer positive returns; thus Japan's capital is productively used in other nations). Japanese consumers have gone from being luxury hounds to penny pinchers and bargain hunters. Japan has been stagnant for more than two decades, and its most recent economic statistics show that the stagnation has become a seemingly permanent and undesired house guest. America appears to be headed down the same path. Although the headlines generated by politicians and candidates for political office promise solutions, hard evidence to be optimistic remains scarce. Even the tech sector, America's economic sweetheart, has offered a lot of disappointment lately, with Facebook's stock losing almost half its IPO valuation and other familiar tech companies serving up results akin to the financial equivalent of Spam quiche. Will America become Japan? This is no longer the question. The question now is how will America stop being like Japan.

Losers and Winners on the Ides of March

They weren't kidding about the Ides of March.

LOSERS. This is a day for losers.

Japan. With the 9.0 earthquake (about as big as they come) and the 30-foot tsunami that followed, Japan got walloped. Now, the rising risk of reactor fuel meltdown has the Japanese nation turning to its nuclear industry and asking, "Et tu?"

Industrialized World. Japan is deeply integrated into the world economy, as an exporter and importer. The ramifications of the soon-to-come earthquake-driven recession there affect crucial industries around the globe, including electronics, automotive, insurance (obviously), petroleum, and banking. With China slowing its economy to rein in inflation, Europe turning to austerity as it struggles with its currency crisis, and America getting by on the methadone of Federal Reserve easy, easy money, there's not a whole lot of horsepower in the international economy to pick up the slack left by Japan. The stock markets are starting to figure this out.

Nuclear Power Industry. While some Japanese nuclear power plant workers may, in effect, be committing hara kiri trying to contain meltdown risk, nuclear power projects worldwide are being curtailed and cut. When you play around with stuff that has real potential for destruction, no amount of engineering can guarantee safety. That's true of nuclear energy, and it's also true of financial derivatives.

Libyan Rebels. With the world's attention diverted to East Asia, the Libyan rebels' chances for resupply and a no-fly zone from other nations are fading rapidly. The U.S. buys little or no Libyan oil, and has no vital national interest there. Britain and France were quick to advocate a no-fly zone, but they know that only the U.S. Navy has the resources and power to actually impose one. That means America would have to bear the burdens and take the casualties. The U.S. government is clearly stalling for time--its demand for UN authorization is a transparent pretext for delay. Maybe the Obama administration knows something it can't really share with the rest of us, yet. Things in the Persian Gulf may be worse than the news services have reported. Saudi Arabian troops have rolled (in unmarked vehicles) into Bahrain, in order to help the Bahraini government stay in control. Things in the Persian Gulf could be deteriorating, and the U.S. military may have to keep its powder dry in order to retain the option to play a role there, where the U.S. has a large vested interest.

Barack Obama. The President hesitated to join up with the Libyan rebels, and they now think he has a secret pact with Gaddafi. Obama has called on Gaddafi to cede power and leave Libya, so Gaddafi knows that Obama isn't on his side. No matter who wins in Libya, America and Obama lose. The Japanese nuclear crisis has blown up Obama's nuclear power policies, and a recession in Japan could put pressure on the administration to apply more fiscal stimulus (i.e., engage in more deficit spending, which isn't exactly politically trendy these days). The perhaps not well publicized unrest in Bahrain and Saudi Arabia, along with a deteriorating situation in Yemen, put the Obama administration in the position of wanting to side with oppressive monarchs in order to protect U.S. interests. Even if these monarchs survive, America's already compromised image in the Arab world will suffer.

Republicans. International events are taking front page news coverage away from Republicans and their domestically-focused agenda. They can't easily criticize President Obama's foreign policy, which is strikingly similar to George W. Bush's. They may have to settle for appearances on Dancing With the Stars.



WINNERS. Even in ugly situations, there are winners. That's why you find the most cynical of stock market speculators swarming into select parts of the market when a crisis hits.

Natural Gas and Shale Oil. The NIMBY style controversies over fracking may seem manageable in light of massive radiation releases from Japanese nuclear power plants. Natural gas and shale oil might have to be repriced to cover the costs of reimbursing people damaged by fracking. But the stuff is found in plenitude in these United States, and will surely be a growing source of energy in the future.

Coal. It's not beloved by environmentalists and mining it leaves ugly scars on the land. But America has massive coal reserves and will surely turn more and more to them in the future. Long term, alternative/renewable energy sources may begin to play a major role in America, but for the short and medium term, coal will be definitely be a part of our lives.

Oil Producers. Oil producers, like Venezuela, Russia, Nigeria and Canada, see their fortunes rise. Too bad not all of them are friendly to America.

Iran. Iran gets a win-win here: increased revenues from rising oil prices and more opportunity from the Arab uprising to stir up Shiite co-religionists on the Arabian peninsula.

China and Taiwan. As Japan's economy struggles, Chinese and Taiwanese companies will get a chance to get into high value-added product lines the Japanese have dominated. Semiconductors and high tech automotive components are obvious targets. Look for Chinese automobile companies to try to move up their deadlines for introducing their products to America.

Stop Worrying About Deflation

The Federal Reserve is running its monetary printing press day and night, desperately seeking to inflate the U.S. dollar. It may have accomplished its goal, at least outside the U.S. Oil, which is traded in dollars, has risen sharply in the past few months (starting well before the Arab unrest). Food prices worldwide have also risen. Global supply of food hasn't fallen. But increased demand for meat, poultry and other higher status foods, especially in China and the rest of the developing world, has strained supplies of grain, and pushed up the price of bread. It's probably no accident that the unrest in the Arab world was preceded by rising bread prices. It's tough to be complacent if you and your family are having trouble getting enough to eat.

In America, there seems to be little inflation. The Fed worries that deflation, even though it's not actually occurring, would lead consumers, hoping for lower prices later, to hold back on spending and retard the economic recovery. It asserts that Japan's meandering price levels are a cause for its economic stagnation. So the Fed keeps shoving bales of dollars off its loading dock. But this is a misadventure in misjudgment.

First, deflation today would help consumers. Household incomes have hardly risen for decades, and consumers react to higher prices by cutting back, not spending more. Rising gasoline and food prices discourage discretionary expenditures. Some people may swap a fuel hog for a gas sipper. But most can't afford to do that, so they just spend less on other things. Price deflation would increase their spending power and lift demand.

The last period of sustained deflation was in the 1930s. But that deflation was the result of the economic downturn, not the cause. Speculative financial and real estate bubbles, aggravated by misguided monetary policies, caused the Great Depression. Did deflation retard recovery from the Great Depression? There's not a lot of evidence of that. Joblessness, by all indications, was the primary factor holding the economy back. When employment rose as America geared up for World War II, consumer spending rose. (It was partially delayed by rationing during World War II, but there was a surge of consumer spending as the war ended which led to the postwar prosperity.)

Sustained deflation also took place during the Gilded Age (1865-1900), when prices dropped by roughly one third. This was a period of great economic growth. Although punctuated by financial bubbles and sharp recessions, the Gilded Age saw dazzling technological innovation (construction of municipal electrical energy systems, the telephone, improved steel manufacturing and oil refining, etc.), legal innovation (evolution of the general business corporation), and financial innovation (nationwide capital markets that featured vibrant secondary markets in common stock and corporate bonds). All this innovation spurred enormous growth. Income distribution was problematic, as business elites accumulated vast fortunes, often by forming cartels and monopolies, while workers struggled to get living wages and farmers combated monopolistic railroad freight rates. Price deflation was a gift to ordinary Americans trying to survive. The growth of mass market mail order retailers, like Sears Roebuck and Montgomery Wards, signaled that Americans of this era had little aversion to consumption in spite of falling prices.

The way the Fed measures inflation tints the lenses through which it sees a threat of deflation. The Fed's preferred benchmark is the Personal Consumption Expenditures Price Index (PCE). The better known Consumer Price Index measures changes in price of certain selected consumer items. For example, the CPI measures inflation or deflation in the price of name brand coffee by comparing the current price of that coffee against its past price. By contrast, the PCE incorporates substitution of products by consumers. If the price of name brand coffee rises, and consumers switch to less expensive supermarket house brand coffee, the PCE records lower inflation than the CPI because consumers avoided paying the price increase in name brand coffee by switching to lower cost house brand. The fact that drinking house brand coffee can sometimes be a near death experience isn't counted as inflation.

The PCE typically records about one-third less inflation than the CPI. So by focusing on the PCE, the Fed sees a greater potential for deflation. But the Fed's use of the PCE means that a reduction in living standards in response to rising prices doesn't count in the measurement of inflation. That notion would be a hard sell to shoppers facing the daily realities revealed on grocery store shelves. It also means that the harder the Fed tries to instill inflation, the lower it might push living standards as consumers substitute cheaper and cheaper goods when their preferred choices become costlier as a result of Fed inflating. Perhaps the Fed should consider that forcing people to substitute sawdust for bread might snatch defeat from the jaws of victory.

The primary reason why people consume or don't is confidence in the future. Moribund consumption in Japan is due to Japan's uncertain future. Younger Japanese adults face dismal employment prospects, often limited to temporary jobs instead of the lifetime employment contracts given their parents. Since younger adults tend to consume with vigor, their lousy employment picture dampens economic growth. (Older Japanese are actually spending more as they tap into their savings for retirement, but this hasn't made up for the reticence of the young.)

No matter how much the Fed inflates prices in America, people won't consume deliriously if they fear layoffs. Using your old washer and dryer for a while longer makes sense of you're trying to reduce debt and build up an emergency cash fund. Spending like the maniacal days of 2005 doesn't make sense if your house looks like it's headed for a double dip in value. The Fed thinks that rising prices will scare people into spending. Rising prices do scare people. But, in these uncertain times, they scare people into pulling back. A little deflation would come as a relief.

Euro Zone on a Slippery Slope

After taking a break for the holidays, the Euro zone's debt crisis is back in full swing. Portugal is now under pressure to take a bailout. As previously choreographed for Greece and Ireland, the Portuguese government is strenuously resisting the idea, proclaiming that it has more than met its goal this year for deficit reduction. If things go according to script, the bond markets will smack Portugal around, and European leaders will pressure Lisbon to bite the bullet before other dominoes--think Spain and Belgium--being to teeter.

This time, China and Japan have joined the fun. Both nations committed to buy bonds to help shaky Euro bloc nations, Spanish debt in the case of China and special bailout bonds jointly issued by the Euro bloc nations in the case of Japan. This isn't altruism. Both Asian nations are export-driven, and already hold significant amounts of Euro-denominated investments. They have plenty to gain if the Euro zone stabilizes and much to lose if it doesn't.

Europeans may welcome the Asian infusion. But it changes the landscape. The more China and Japan help Europe, the more they would want the EU to remain intact. Germany and other wealthy EU members may find themselves increasingly constrained to support their profligate neighbors, even as their citizens become more restive over the costs. The political dialogue in Europe could deteriorate, particularly if EU leaders appear to pay heed to China and Japan while their citizens pay more taxes.

The Euro zone is on a slippery slope. That China and Japan would openly acknowledge their support for Euro zone debt highlights Europe's inability to finance itself. The more Europe needs outside help, the fewer options the Euro zone will have. Unity will be its only rational option. The need to pay back Revolutionary War debt was one of the major reasons why the 13 rebellious British colonies in North America remained united after attaining independence--ultimately, the United States assumed responsibility for this debt as part of the price of ratification of the Constitution. Europe will have to move toward greater political union in order to establish greater fiscal control and restraint.

But people aren't always rational. In the preceding century, Europe was the principal battleground for two world wars that killed tens of millions. Why? Historians still debate that question, but there's no rational explanation. Although the Euro's problems won't lead to war (the Europeans learned from WWII not to be trigger happy), precipitous secessions by wealthier Euro bloc members can't be excluded. Electorates have a limited tolerance for bailouts, as the American mid-term elections last year illustrate.

There's no to know for certain how things in Europe will end up. But the continent cannot maintain the status quo. It's on a slippery slope, and time will tell which way it slips.