The bottom line for 2012 is that for advanced economies who are unwilling to devalue their currency, allow high interest rates, encourage high inflation rates,  or default on their debt, the only solution is for these countries to pay down their debt. Without a financial calamity to motivate legislators to break the gridlock, this scenario sounds like a script for Mission Impossible. Does no pain translate to no gain? Sovereign debt investors would like these countries to grow and pay down their debt as part of the increased tax revenue but regardless of the economic growth or the pain, they will be paid or else that advanced economy and it’s sovereign debt degrades into “something else”. This “something else” position is assumed to be something similar to but not as bad as that experienced by Argentina in their 2002 default. It is generally assumed that a “default” should be avoided at all costs. Greece is teetering between “default” and something folks have started to call a “managed default”. “Managed default” is supposed to be a better situation than “default”. Regardless of which name you use to describe the situation, the sovereign debt investors are not getting their money back and they will unlikely make this mistake again. The primary attraction of the “managed default” plan to the European Union is that it will inflict less economic pain on Greece and as a result the Greece’s economy will fall less and recover faster than in a “default” scenario. The unanswered question is how much economic pain is required in Greece for necessary economic reforms to occur. That is probably why the European Union is asking Greece for budget veto power over the Greece budget. Considering the situations in Ireland, Portugal, Spain, and Italy are not far behind, maybe the authors will have enough material to write their next book about this never-never land for advanced economies, its pitfalls, and its benefits.

Yes, I know the authors collected a lot of valuable economic history but unless you get excited over lots of charts, it is a very dry read.

This Time Is Different: Eight Centuries of Financial Folly
by Carmen M. Reinhart & Kenneth S. Rogoff

In his January 23^rd newsletter John Mauldin used the McKinsey report, Working out of debt, to examine the probable plan that countries like the United States will use to reduce their debt level. If you follow John Mauldin and the McKinsey report’s reasoning then government deleveraging is inevitable and economic success depends on how well these countries will manage the process. The McKinsey report draws insight from history and the deleveraging examples of Finland, Sweden, and South Korea. The report goes on to describe how one the primary methods used by these countries was to grow their economies and lower their debt level was by increasing exports. For the sake of argument let us assume that using these historical examples are appropriate for the United States, then we must also assume that a 30% to 50% currency devaluation is a necessary sacrifice to stimulate exports. So here is where I am stuck. Who is going to buy our stuff and why? At the top of the list has to be China and Japan. So let’s follow this logic to its logical conclusion. We devalue the dollar by 30% and China and Japan will start buying our products! As Carmen M. Reinhart & Kenneth S. Rogoff pointed out in This Time Is Different: Eight Centuries of Financial Folly, high inflation and interest rates occur frequently with currency devaluation. It is far more likely that China and Japan will decide to dramatically reduce their dollar position in response to a deteriorating financial situation in the United States. This would likely trigger a financial panic. If China and Japan starts purchasing goods they do not normally purchase and ship them out of the United States for resale would a financial panic. In both situations currency devaluations will likely lead to a financial panic. Regardless of the reason if Chinese and Japanese treasury bond holdings go down by 30%, the Chinese and Japanese will assuredly demand changes. A likely demand will be to replace the dollar as the world’s reserve currency with a basket of currencies. This is not a new demand but it is the beginning of the end of United States deficit spending. Without the Chinese and Japanese supporting the United States treasury market and by extension the United States policy of deficit spending, legislators in the United States will be forced to deal with higher interest rates and a declining financial situation. As an advanced economy the United States is unwilling to default on its debt, allow massive currency deflation, or allow high inflation rates. This leaves only one solution. The United States must start reducing its debt level and addressing its entitlement spending. Unlike a conventional war where there is a “war dividend” when it ends, entitlement spending is a never ending war. This will require the United States to unwind its final financial bubble, the government spending bubble. Unwinding the government spending bubble will force our legislators to support an “almost” balanced budget solution involving some small tax increases, many budget cuts, and the ability to run a temporary, short term budget deficit. This is balanced budget will probably be similar to the balanced budget used by Switzerland. Unfortunately a disproportionate share of balancing our budget will fall on budget cuts including some painful and unpopular cuts to entitlement programs. In this case it is the invisible hand of the financial market enforcing same financial responsibility on the United States that it is enforcing on the rest of the world. The impaired financial stature of the United States implies that China will assume the world leadership position for world economic health sooner rather than later.

Charles Murray has a new book, Coming Apart: The State of White America, 1960-2010. The Powerline blog had a nice bit about the book and a link to the quiz. I was curious so I took the quiz. Here are my results.

How Thick Is Your Bubble? Guest Score » 13 out of 20  (65% )  Result  On a scale from 0 to 20 points, where 20 signifies full engagement with mainstream American culture and 0 signifies deep cultural isolation within the new upper class bubble, you scored between 13 and 16. In other words, you don’t even have a bubble. Quiz School Take this quiz & get your score

Last year my wife had a spat with our son and decided that I should be ferrying my son back to college from now on. Although it involves a lot of driving I prefer to complete the round trip in one day. With all of that time in the car I have taken advantage of the local library and their supply of audio books. For this trip I chose two audio books, The Total Money Makeover: A Proven Plan for Financial Fitness and The Original Argument: The Federalists’ Case for the Constitution, Adapted for the 21st Century.

As a fan of the Dave Ramsey show the audio books was an enjoyable review of much of the same stuff you hear over the radio.

The Original Argument audiobook is an interesting Glenn Beck project. Glenn Beck and others have translated many of the original Federalist Papers from the 18^th century English into an easier to understand 21^st century English. The objective was to make the Federalist Papers more accessible to the average person and I think he achieved that. In this book we find Alexander Hamilton and James Madison making persuasive arguments for a more powerful federal government primarily because they felt a federal effort would be more efficient and cost less than independent state efforts. From their viewpoint it was a win-win decision for the country. Although I agree with Alexander Hamilton and James Madison about the benefits of a strong federal government, I think they would be shocked to see how the balance of power has shifted from the states to the federal government. Most of the safeguards for the state that Alexander Hamilton and James Madison described have been dismantled over the years. Not only are senators directly elected by the people but the states are increasing dependent on the federal government for their revenue as shown below.  The culmination of this dismantling effort can be seen in the lawsuits over the constitutionality of the Affordable Care Act. This year lawyers will make many of same federal versus state rights arguments before the Supreme Court that was argued originally in the Federalist Papers. I doubt any of lawyers will attempt to make the argument that the Affordable Care Act is more efficient substitute or enhancement of existing state programs. The fact that the federal government can pay for the expansion via deficit spending is a bad reason to expand Medicaid. I would be more in favor of a practice that encourages responsible governing practices.

See this Cato essay on federal subsidies to the states for more on why it is critical to reverse this trend.

Last Christmas my mother-in-law said that she wanted a hand mixer. I wasn’t sure so I bought two mixers. The first mixer was the highly rated Cuisinart HM-70 Power Advantage 7-Speed Hand Mixer. She bought a cheap hand mixer recently when her old KitchenAid stopped working. It did not work out to well. The cheap mixer was tossing food out of the bowel on slow speed unless she was really careful. Although this mixer has a lot of nice features, I was not surprised that the Cuisinart SmoothStart feature was the feature she liked the most. The SmoothStart feature keeps the food in the bowel.

The second mixer I bought was the Cuisinart CSB-77 Smart Stick Hand Blender with Whisk and Chopper Attachments. I thought that this might be a better “mixer” for her considering her diminished arm strength. I think I remember seeing a cooking show extol the virtues of this blender so I kept if for myself. She didn’t want anything to do with it so I ended up taking it home. It serves me as a small, portable food processor that is convenient to clean up. I used it for pureeing tomatoes in the can.

Yesterday was cold and the ground was covered with ice. It was treacherous outside so I stayed inside and watched television. We eventually wound up watching CNN where we listened to campaign speeches by Mr. Romney and Mr. Gingrich. I was impressed with how both men appeared dramatically better in their public appearances compared to how they typically portrayed on our news programs via sound bites. Both men did an excellent job of articulating their political views and how these views connect to the shared values of the American people. As Mr. Gingrich was quoted in the Washington Times ,

“it’s not that I am a great debater,” Mr. Gingrich said Saturday. “It’s that I articulate the deepest-held values of the American people.”

As was expected the crowd response was favorable since both men were “preaching to the choir”. Their connection with their audience is no different than President Obama’s connection with his audience. This is one of the most importance characteristics of successful politicians.

If these candidates continue to have successful public appearances the presidential race will probably be determined by how people view the successes and failures of our government under Presidential Obama. The biggest problems with President Obama’s signature health care act and stimulus plan is that they have not made a difference that the average person can see. Most people have seen their health care costs go up and the expansion of Medicaid is on hold since most of the states do not have the money. The continued high unemployment rate condemns the stimulus plan. With high disapproval ratings among independents President Obama has an almost impossible task in front of him. If he is to win re-election he needs a lot of help from the Republican candidates. If the Republican candidates do not screw up, he will be a one term president.

Another thing I noticed in the campaign speeches is the repetition of some new catch phrases. It should be interesting how the phrases, “Food Stamp President”, “Crony Capitalism”, and “Anti-Job President” play in a broader political audience. The “Anti-Job President” phrase was a new phrase for me. Based on the polling numbers the Keystone Pipeline decision looks like a bad political gamble for the President in an election year. Jobs is the number one political issue and the administration does not have a lot of job creation successes to talk about on the campaign trail. Considering the present economic climate does the President really think that environmental concerns with the pipeline are more important than job growth to independent voters? There is a difference between a “Do No Harm” President and a “Do Nothing” President and I think the polling shows that independent voters can tell the difference.

The problems Nome has had with getting oil delivered is an interesting story, U.S. Icebreaker About to Reach Cut-Off Alaska Town. It appears that the city of Nome contracted with the Russians since they had a ice-classed tanker available. Although it was ice-classed it was not an icebreaker. So Nome had to convince the Coast Guard to send their only available icebreaker up to Nome to clear a path for the tanker. Didn’t Al Gore say the ice cap is supposed to disappear by 2014? When you look at the map, Nome is pretty far south by Artic Circle standards. The Coast Guard has another icebreaker. It is a 35-year old ship that is undergoing a $60 million renovation. They are hoping the renovation will extend its life an additional 7 to 10 years. We are setting ourselves up a major disappointment if Al Gore is wrong about the disappearing ice cap.

For those who are more scientifically inclined the Sea Ice Reference Page, http://wattsupwiththat.com/reference-pages/sea-ice-page/, is a great resource.

Since Erin Burnett had a story last night on buying guns as Christmas presents I must fess up. I bought my wife a hand gun for Christmas. I told her my Christmas present idea a few days before Thanksgiving. My wife was enthusiastic. My son just rolled his eyes.

My wife started the process by calling one of her friends who is a gun enthusiast for advice. About a week later we went to a local gun store. The store has a gun range and instructors. After about two hours of asking questions and trying various handguns she settled on the Beretta M9. Since we are novices they highly recommended they we go through a training course. As part of the deal they gave us a couple of coupons for time on the range. She was happy.

Tonight we are going to the handgun training course at the gun store. This should be fun.

If the recent up-tick in global optimism about the economy persists and Europe makes some headway toward fiscal responsibility then it is likely that the risk aversion for European financial assets will subside. The best example of this risk aversion for European financial assets is the historically low interest rate on 10 Year Treasury bonds. Currently the real interest rate on 10 Year Treasury bonds is -0.10%. Over the last five years the average real interest rate has gone from 2.29% in 2007 to 0.55% in 2011. It is reasonable to assume that the real interest rate will go back to 2011 levels regardless of the resolution of the European financial crisis. Negative real interest rates only make sense when there is high probability of massive defaults. At the minimum we are looking at an increase in the nominal interest rate on 10 Year Treasury Bond from 1.89% to somewhere around 2.54% assuming no significant change in the inflation rate. The worst case scenario is if the resolution to the European crisis results in lower risk and the real interest rates trend closer to the 2007 levels. The 10 Year Treasury Bond would increase from 1.89% to by 4.28%. Ouch! This could blow up the mortgage market.

If we follow the logic of portfolio managers the situation gets worse. To take advantage of the attractive interest rate to risk differential, portfolio managers will re-balance their portfolio quickly by selling Treasury bonds. This will put pressure on both Treasury interest rates and the Euro to dollar conversion rate. The United States could get hit with a double whammy in an election year. Here is a chart of the real interest rates from the Treasury Department.

A couple of weeks ago I decided that the muddle through economy was the most likely scenario for the United States in 2012. Having made that decision the next course of action was to investigate how the muddle through economy scenario will impact my personal finances and the place I work. Today I read a nice summary of the likely impacts of a muddle through economy in a newsletter from John Mauldin. This summary is a much better explanation of my beliefs concerning the economy than anything I have written. In the newsletter he quotes Gary Shilling who says,

Gary identifies 9 causes of slow global growth in the years ahead:

1. U.S. consumers will shift from a 25-year borrowing-and-spending binge to a saving spree. This will spread abroad as American consumers curtail the imports of the goods and services many foreign nations depend on for economic growth.

2. Financial deleveraging will reverse the trend that financed much global growth in recent years.

3. Increased government regulation and involvement in major economies will stifle innovation and reduce efficiency.

4. Low commodity prices will limit spending by commodity-producing lands.

5. Developed countries are moving toward fiscal restraint.

6. Rising protectionism will slow—even eliminate—global growth.

7. The housing market will be weak due to excess inventories and loss of investment appeal.

8. Deflation will curtail spending as buyers anticipate lower prices.

9. State and local governments will contract.

My first concern is that we may be embarking on a downward spiral in international trade. Although several people I have spoken to are in favor of protectionism for a variety of reasons, the economic impact on certain industries in the United States could be higher costs and lower sales volumes. So we may even greater economic dysfunctionality in 2012 than in 2011. What I mean is that some sectors of the economy might find themselves facing rampant inflation while other sectors are facing stagnant growth or even rampant deflation. Hmmm… maybe I should start working on the other implications of the summary.