Our Undeniable Future

The future is fiction — not a time and place where events await us, but an infinite set of possibilities that ripple out in concentric circles from every action we take.

The mere act of predicting a trend can alter it. The simple fact that many fear a disaster can help prevent it. Nothing is truly inevitable.

Suppose, however, that we could somehow travel forward in time, witness historic decisions, and look back on what's happening today with the benefit of 20-20 hindsight. What would we see?

For an answer, we go to Camp David, Maryland ...

The time is 11 am on a Sunday morning; the occasion, an emergency gathering among the president, the Secretary of the Treasury, an economist from Council of Economic Advisors (CEA) and the Chairman of the Federal Reserve. The atmosphere is casual, and the discussion, very frank. The men sit comfortably on plush sofas, as the fireplace crackles. The Treasury Secretary is the first to speak.

Treasury Secretary: I came here today prepared to tell you about a dangerous fork in the road for our economy, and about a landmark decision we must make this week: Do we persist in our multi-year effort to stimulate the economy ... or do we turn our attention to putting out the new fires that are bursting onto the scene? Do we plow ahead with more tax cuts and more money pumping ... or do we start slamming on the brakes? Should we fight recession or do battle with inflation?

[The secretary pauses, tilting his head slightly in the direction of the president.]

President: I'm a bit perplexed by your choice of words, but go on.

Treasury: That's what I was prepared to talk about. But late last night, I realized there's something wrong with that classic metaphor, something that doesn't fit with the numbers we're seeing right now.

President: For example?

CEA economist: Let's start with autos. Sales in the automobile sector have been plunging since June.

President: Why?

CEA: No one can pinpoint exactly why, but here's what we do know: Even before interest rates started going up, the auto industry had pushed cut-rate financing deals well beyond the normal limits of diminishing returns.

First they offered zero interest. Then they offered zero interest plus zero money down. Next they added zero payments for an extended period. Meanwhile, the average term of auto loans was extended out far beyond the average life the car. And when all of these gimmicks stopped working, they even let people take cars home for a free trial.

The market for sedans, sports cars, SUVs, and light trucks was saturated, but Detroit didn't get it. So they inadvertently created their own kind of bubble. Now, with interest rates rising, that bubble is bursting.

Housing was the next to crack. At first, rising interest rates actually spurred a rush to buy. But it was a one-time spurt.

President: Please explain.

What happened was that, during the mortgage and refinancing boom, there were a lot of people who had been thinking about doing it but never did. They just kept putting it off. But as soon as they saw the Fed finally raising rates — that's when they rushed to lock in their rates, refinance their homes or take out a new mortgage to buy a home. This generated a final buying climax. But once the climax was over, the market practically died, just like autos.

Now, here's the crux of our problem: In any other cycle, whenever you see the economy turning soft, you can cross inflation off your list of nagging problems to deal with. Not this time. Despite the obvious weakness in two of the economy's largest sectors — autos and housing — inflation is still accelerating.

President: Does anyone have a rational explanation for this?

Treasury: The new numbers are forcing our team at Treasury to recognize that, maybe, what we actually have here is not an economy that's approaching a classic fork in the road.

SICK PATIENT

President: What is it then?

Treasury: A sick patient that's falling by the wayside.

Remember: For the past two to three years, we've done everything humanly possible to resuscitate the economy, to get it back on its feet. We brought on the cheap dollar to help boost exports. We packed in the biggest back-to-back tax cuts in decades. We injected enough money to bring interest rates down to the lowest level in 46 years. Never before have we fired so many big guns in such quick succession!

President: But it worked, right?

Treasury: Of course it worked. We saw factories begin to crank up. We finally saw jobs kick in. We saw the economy rise to its feet and start marching forward. But now it's stumbled again, and most people I talk to don't seem to know why.

President: Don't you?

Treasury: As I see it, there are two things happening right now.

First, the effect of the stimulants — lower interest rates and tax cuts — is waning sooner than we expected.

Second, the money we've injected into the economy in recent times is flowing through the pipeline and pumping up inflation. That's driving bonds down and interest rates up.

In other words, the side effects — inflation and rising interest rates — are now overwhelming the desired effects. Some economists are even arguing that those side effects could be worse than the original disease.

President: Who can tell me what's really happening with inflation?

Fed Chairman: Mr. President, I'm not quite ready yet to admit this in a public forum, but I can confess to you right here and now that most of the Federal Reserve governors greatly underestimated the inflationary embers and fires throughout the economy. First, we thought that we could ignore rising producer prices. Then we thought we could ignore the surge in energy and food costs, relying strictly on the core inflation numbers, which still seemed subdued. Finally, we thought we could ignore the anecdotal evidence that rising energy and food prices were beginning to stir up inflationary trends in the core prices.

By the time we recognized all the smoke for what it was, the conflagration was out of control. Consumer price inflation, which was running at an annual rate of over 5%, surged to 6%, then 7%. The inflation that was earlier confined to the core areas spread to a wider range of consumer prices. And worst of all, inflationary expectations among consumers and businesses rose to a higher plane.

President: Earlier, it was said that this is somehow different from previous cycles, that the classic metaphor of a fork in the road does not apply. Why?

CEA: In previous cycles, first you got the economic boom, then you got the inflation. Now the boom is barely beginning — even faltering — and the inflation is already hitting.

President: What do you call that?

CEA: Years ago, we called it "stagflation." But I don't think that word adequately describes the current situation.

President: Why not?

CEA: Because stagflation implies stagnation — certainly undesirable, but still relatively stable; and because this situation is anything but stable. You have major financial/industrial bubbles. You have massive overhangs of consumer debt. You have overspeculation with formerly cheap credit. And now, you have two great triggers that can puncture the bubbles — falling revenues in key industrial sectors and rising inflation.

THE LAST OPTIONS

President: I appreciate your candor, but I don't like what I'm hearing. We're in a critical phase in the recovery right now. We cannot let it fail. We must persist and persevere. What are our options?

[The others look at each other, waiting for a cue to speak that never comes, while the president answer his own question.]

President: When the economy was sailing along nicely, we started raising interest rates gradually. Now, if it's running into doldrums, we will lower them again.

Fed: Not feasible. Remember: The Fed funds is still far too low, still very close to emergency levels. These low rates were justifiable only as an extreme measure to combat deflation and bankruptcies. Now with inflation raging, there's just no way we can justify holding them down any more.

Even if the economy is not as strong as we had hoped, we must stay on course to raise interest rates over the next several months. We're committed to that course. If we back down from that course right now, we'll be the laughing stock ...

President: What's worse — damage to our pride or an abortion of the recovery?

Fed: What's worse — no recovery or no market for our Treasury securities? We can survive a recession. We cannot survive a shut-out in the market for Treasuries. Yet if you ignore inflation — just let it run amuck — that's what you'll get. Investors will shun our Treasury security auctions. Worse, they'll dump the Treasuries they currently hold in their portfolios. Ultimately, if we can't sell our bonds, we cannot raise the money we need to run the government. We can't meet payroll.

President: What about more tax cuts?

Treasury: Also not feasible — and for exactly the same reason as the Chairman just cited. It would send the signal that we are going to let the federal budget, already out of control, go to hell in a hand basket. Bond investors in the U.S. and overseas would sell in panic. We'd be unable to float new bonds to raise the money we need to run this country.

CEA: Mr. President. It's high time we recognize that the disease in the economy is deeper than previously recognized. It should have been abundantly evident in the first years of the decade, but we didn't want to believe it back then. We didn't want to face the fact that we had more than just a traditional recession. We also had a bust in technology, a fiasco in accounting, an unraveling of Wall Street scams. Plus, we had — and still have — an accumulation of debts and deficits that is unprecedented in our nation's history.

President: I cannot understand. Everything you're saying sounds bad. If that's the case, it's time to do MORE — not less. Is this a dire emergency or not?

Fed: I am convinced that this is not yet a dire emergency. We have falling auto and housing sales, but that is nothing new. We have falling stocks and bonds. That has also happened many times before. I have not talked to the board members or the members of the FOMC in a few days. However, I do have a fairly good idea of what they would be saying if they were here today.

President: What would that be?

Fed: There would probably be some disagreement with respect to your question — is this an emergency or not? However, there would be no disagreement on the best mechanism for responding to any emergency: They would sternly urge a steady, measured approach and staying on course with rising interest rates. We must never forget the other, hidden risks in our economy today.

President: What risks?

Fed: First is the budget. If the budget were robust fundamentally, maybe we could get away with lowering interest rates or lowering taxes again. Unfortunately, that is absolutely not the case. In addition to our official deficit estimates of over $500 billion, there's an off-balance-sheet deficit of a few hundred billion more.

THE RISK OF A DOLLAR DECLINE

President: Is that correct?

Secretary: I'm afraid it is.

Fed: The second risk is the dollar. The dollar went up for years, so it was often assumed the dollar was strong, that it was not a risk. Not so. Foreign investors hold close to $5 trillion in U.S. stocks and bonds. They are the single largest owner of most of our asset categories — larger than our domestic banks, insurers, or any other single domestic sector. If you do anything to shatter their confidence, if you frighten them in any way, look out below.

President: Can't we afford to let it fall for a while? Won't that help America become more competitive? Won't it help stop American jobs from being lost to cheap-wage countries like China and India?

CEA: Perhaps. But that's assuming you can control the dollar decline. Suppose it starts falling beyond your control. Then what are you going to do?

Fed: Plus, as you've seen in recent months, there's a third risk — real estate. In recent years, a lot of people have been saying money was leaving the stock market and going into real estate. That was only partially true. The primary source of money for real estate has always been mortgage debt, and we now have outstanding mortgage debt approaching $7 trillion. But it is not growing any more. Now, that sector is weakening, and if it continues, you can kiss the recovery goodbye.

Plus, there is also a fourth hidden risk — derivatives. We can't tell you much about them, and therein lies the heart of the problem. It's largely an unknown risk. All we know is that in terms of their total face value, which admittedly exaggerates the problem, there are over $70 trillion in the U.S. and perhaps another $50 trillion overseas — more than all interest-bearing debt in the world. Plus, we also know that certain large U.S. banks — Morgan Chase, Bank of America, and Citibank, for example — are at the center of the derivatives markets. The key concern is that each of these banks is risking 100 percent or more of its capital on derivatives, according to the OCC.

President: Gentlemen, you've knocked down every single suggestion I have made today. I have no problem with that. But you gentlemen are the brains, the experts here. If my suggestions are no good, give me an alternative. And don't give me a wimpy, pea-gun solution that may have some trickle-down effect someday. The economic recovery is failing now. All these frightening risks we've heard about are in existence now. So I want a cannonball solution that has big-bang impact potential — also now.

Fed: We all understand the urgency. But here's the dilemma in a nutshell: You have two fundamental choices — you can try to save the economy or you can try to save the government bond market. You can't do both.

Assume choice number one — you try to save economy. Result: You shatter worldwide confidence in the U.S. government and you torpedo the entire government bond market.

Assume choice number two — you try to save the bond market by fighting inflation. Result: You torpedo the entire economy.

Those are your choices: Kill the bond market or kill the economy.

President: I've had enough of this "damned if we do, damned if we don't" talk. What do you suggest we do?

CEA: Nothing.

President: You mean you don't know?

CEA: No, sir, I know exactly what we should do in this situation: Nothing. Stand pat. Go back in history and look at the experience of the past. Every aggressive action produced an unexpected market reaction. And every action-reaction cycle has come with shorter and shorter intervals. Nixon's wage-and-price freeze bombed and led to runaway inflation and the Arab oil embargo. President Ford's budget deficits and easy money were a prelude to the first dollar collapse. Carter's bond market rescue package of 1980 resulted in a sudden recession. The 1984-86 money — pumping binge produced still another dollar collapse and the worst stock market crash in history. Clinton deregulated, and it helped open the spigots for the greatest tech stock speculation in the history of mankind.

Now, all these crises are coming to a head. We have an automobile industry crisis, a housing industry crisis, an accounting crisis, a budget crisis, a recession crisis, a stock market crisis, a bond crisis, a dollar crisis — all at the same time. Regardless of the consequences, you have only one choice, and that is to keep your hands off — not because of some invisible hand that will magically cure everything, but because, at this particular juncture, the no-action choice is the wisest decision a true leader can make.

President: Do you want a do-nothing president?

CEA: No. But right now, we need a market-neutral government. Let the market make the decisions. We have no other choice.

BACK TO TODAY

The meeting ends, and we return to today's reality of complacency and relative quiet. But don't let it deceive you.

Also, don't let election-year politics distract you from what you have to do to prepare.

Remember: This is not about Democrats vs. Republicans. Nor can we blame the current administration for present and future economic predicaments. The situation we face today represents the accumulated consequences of multiple administrations, and many congressional sessions.

My advice: Prepare for both a weaker economy AND higher inflation at the same time.

Martin Weiss