Debt and deficits are not inventions of ideology. They are facts of arithmetic.

~Paul Martin, Canada’s finance minister at the start of the country’s “Redemptive Decade”

Federal Reserve Bubbles

On Monday I laid out some of the reasons why most of our capital is in cash. I then went on to look at What Would Make Me Invest in the Stock Market again. I said that the current economic system is a Ponzi scheme, made more so by further quantitative easing. Markets oscillate violently according to what various Fed officials leak to the press and the resulting effects on the U.S. dollar. Good companies rise a little more when the tide is up and fall a little less when it goes down. That is as close as we seem to get to a real free market.

The Ponzi Bubble Machine & Our Collective Sammy Scheme

Once upon a time it would have been considered blasphemous to compare our mighty capitalist economy to a Ponzi scheme. These days, it seems to have become rather fashionable. Bill Gross of Pimco had this to say in his November Investment Outlook:

“Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic. . . . I ask you: Has there ever been a Ponzi scheme so brazen? There has not. This one is so unique that it requires a new name. I call it a Sammy scheme, in honor of Uncle Sam and the politicians (as well as its citizens) who have brought us to this critical moment in time.”

Gross, while basically endorsing the Fed's approach with the assumption that there's nothing else they can do, addresses the probability that their QE policy will indeed cause asset price dislocations and create more bubbles. A couple of months ago, I wrote extensively about bubbles, identifying 5 Financial Bubbles and 5 Socioeconomic Bubbles that may be ready to pop. I defined bubbles as “structurally tenuous entities with nothing of substance at their core.” I guess you could probably say the same for both Ponzi schemes and Sammy schemes.

Mr. Gross also laments the sad state of American political affairs and suggests abolishing the two party system. He further suggests that the U.S. electorate is just as responsible for the sorry state of affairs in the country, since they have elected those who are in office. In fact, the letter begins like this: “They say a country gets the politicians it deserves or perhaps it deserves the politicians it gets.” (Note that Gross also postulates that the 30 year old bond bull market is on its last legs with a really great turkey analogy.)

How Do We Make It Better?

On Monday, I mentioned that better fiscal and monetary policy might entice me to buy the markets again: “The U.S. needs to signal that it’s ready with a concrete plan to tackle its fiscal mess. There are policies that don’t involve monetary alchemy that can be used to right the ship in less time than you might think.” I promised to talk about a few of those ideas today. Incidentally, these aren't my ideas; they're just suggestions I've read about and found interesting. I hope you will too.

There are two main arguments that I'd like to highlight for you. I don't have room to go into a great deal of detail, so I invite you to read both articles in their entirety. One approach is a no-holds-barred dare aimed at Ben Bernanke's manhood and dripping with American arrogance pride. The other is a more measured suggestion that perhaps it's time for Americans to swallow their pride and borrow a solution from a country that did it right. Nice juxtaposition, eh?

Suggestion #1: Raise Rates

You read that right. Josh Brown over at The Reformed Broker sent this message to the Fed: Raise Rates, Cowards. If you set aside the testosterone-laced Homer Simpsonesque (“U.S.A.! U.S.A.!”) rhetoric of the piece, there are some really compelling arguments here for why the Fed should do a U-turn and immediately raise the Fed funds rate to 1%:

  • China shocked the market by tightening policy out of nowhere and the market flinched briefly, but then went about its business.
  • It would send a signal to the markets and the world that things aren't so bad.
  • It would act like a shot of Raid to the gold bugs and extinguish smoldering currency war fears.
  • It would kick those waiting to buy a house off the sidelines as they will want to lock in lower rates, and clear out some of the huge foreclosure inventory.

Please don't mistake my good natured chiding for disagreement or disrespect. Josh writes beautifully, and he tells it like it is. Here's my favourite section, where he describes how a rise in rates would affect the banks:

The free money game for the banks has been a holocaust for savers and the elderly.  It's also been the most despicable corporate giveaway in American History.  Allowing the banks these risk-free, automatic profits is treason.  Stop it now.  Force these banks to do their job and serve their function in society – the financing of business activity.  No more borrow-from-and-lend-to the government.

If the Fed raised rates to 1% on Monday morning, the markets would likely throw a tantrum and tank. But I have to tell you that if they did, I would be selling the rest of my inverse ETF position and fine-tuning my shopping list.

Suggestion #2: Go Canadian

Another one of my favourite writers is John Mauldin. Each Monday, he puts out an article written by someone else who thinks Outside the Box. This week's article was written by David Hay, Chief Investment Officer of Evergreen Capital Management. Today's main quote from former Prime Minister Paul Martin came from this essay.

The article is basically a review of a book called The Canadian Century: Moving Out of America's Shadow by Brian Lee Crowley, Jason Clemens and Niels Veldhuis. The book reminds us that Canada faced a horrific fiscal crisis in the 1990s and was able to turn things around within a few years.

Here are a few of the policy initiatives the Canadian government undertook under the direction of then-Finance Minister Paul Martin:

  • Martin unveiled a budget in early 1995 that shocked all the cynics accustomed to smoke-and-mirrors accounting. It reduced program spending by 8.8% over two years (and our politicos quiver over a mere hint of spending freezes).
  • As part of this radical spending rationalization, federal government employment was reduced by 14%.
  • Federal grants to the provinces were reduced by 14% as well, but the trade-off was that they were allowed to control how the money was spent. Provincial governments also needed to provide half of all funding (i.e., put skin in the game).
  • While some taxes were raised (and, according to the authors, these worked against the recovery), spending cuts were 4 ½ times tax hikes.
  • Canada’s welfare system was dramatically modified. Rather than just providing a blank check to the provinces (which administered the welfare programs), Ottawa incentivized them to put the funds to better use. Benefits were cut for single, employable individuals and aggressive efforts were made to get them back in the work force.
  • Despite accusations from the far left that the poor would suffer due to these changes, the percentage of welfare recipients fell in just a few short years from 10.7% of the population to 6.8% by 2000. From 1997 to 2007, the percentage of Canadians classified as low-income plunged by over 30%.
  • As a result of these actions, and many others I’ve left out, the federal budget was balanced within three years.

These are quoted more or less directly from the article, but there are many more interesting points, so go I would encourage you to read the essay in full. Interestingly, just as I was finishing up today's article, The Financial Post reported that a couple of economists from Wells Fargo said that Canada-style deficit reduction, ’90s-style, won’t work in the US. They point out that Canada depended a lot on exports and interest rate cuts to orchestrate their turnaround. Neither are viable options for the U.S. at the moment.

While the Wells Fargo guys make some good points, maybe there are other aspects of the great Canadian renaissance that our friends to the south might be able to use. Americans tend to be fiercely independent and that has often moved them to the head of the global class. But this just might be one of those times where it would do them some good to copy another classmate's work, for if they fail this test, they're going to take the whole class with them. Note to U.S. policymakers: Go ahead. Look at our paper – please.

What do you think of these potential solutions? Will they help or hurt? Are they better than the QE alternative?