I was reading this morning about the never ending financial problems in Spain, Greece, and Portugal. These problems along with all of the countries and states who are following down the same path have left everyone in a general state of malaise and Greece’s election of neo-Nazis to their parliament aggravated it. This is an auspicious sign for the world. Our grand experiment with socialism and big government solutions is winding down and there is not much we can do about it. Fixing it will require politicians to make hard and unpopular choices. This leaves an opening for fascism. One of Hayek’s great concerns in the Road to Serfdom was that socialism would lay the groundwork for a return to fascism. Socialism is temporary state for someone intent on accumulating political power. All of this reminded me of this old nursery rhyme.

Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again.^[1]

Humpty Dumpty – Wikipedia, the free encyclopedia

I was looking at the recent annual survey of business leaders on ChiefExecutive.net and wondered how the recently elected governors stacked up. The report had one year and five year performance but I was interested in the performance since the most recent election. So I combined the two most recent surveys and got this table. I guess it is no surprise that the leaders of the top five states that showed the most improvement over two years are Republican. The performance of Louisiana and Governor Jindal is spectacular. Those freshman Republican governors of Wisconsin and Ohio seem to have done their part of improving their state’s economies. It may not be much to brag about but it is definitely better than no improvement or a deteriorating business environment.

Business Insider is highlighting a paper just published by economists Ken Rogoff, Carmen Reinhart and Vincent Reinhart, called Debt Overhangs: Past and Present. This paper builds upon the research published in the book, This Time It’s Different, which I read and reviewed in January. In this article the authors are saying that countries debt levels above 90% of GDP correspond to lower growth rates, 2.3% versus 3.5% for low debt periods, and an average debt duration of 23 years.  Ouch! 23 years of substandard GDP growth is a very, long time and it implies a significant wealth transfer to other nations. The authors implied those results in their book but it looks like they backed it up with some more research into countries with debt levels above 90%. I guess we have to start admitting that debt does matter and big stimulus plans like those advocated by Krugman to grow out of our mess without the pain of austerity are officially dead. That leaves us with very few options. Since we cannot rely on the next generation’s income to grow fast enough to pay for our increasing Social Security and Medicare benefits, those programs have officially become a “pact between one generation and the next” systems. This should be amusing. Democrats loath to use those words while Republicans prefer to not talk about it at all. Now they both have to acknowledge that the growth in Social Security and Medicare benefits is not sustainable and that those benefits are now subservient to the taxes you can collect from the next generation. This is no surprise to the young voters. Considering the enthusiasm the young voters have for Ron Paul, we have to assume that they know how to count and they are not happy with the answer they keep coming up with. So the young voters are pissed and the elderly will be pissed shortly. I doubt anyone will be happy. The only positive thing coming out of this affair is that it should be pretty amusing to listen to our politicians spin the politically unattractive option of implementing something pretty similar to Bowles-Simpson plan, the Ryan plan, or sequestration as good for the country.

Read more: http://www.businessinsider.com/chart-reinhart-rogoff-2012-5?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+businessinsider+%28Business+Insider%29#ixzz1teHrJZYF

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.

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.