We are living in unprecedented times. It’s time to question some of the most basic assumptions about your economic future, and America’s.
————–
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” — Mark Twain
That quote was immortalized in the opening of the Oscar-winning film “The Big Short”. It was very applicable to the root causes of the 2007-2008 subprime crisis, and it remains true today.
Sometimes a real crisis is what it takes to relieve us of dangerously wrong assumptions.
In 218 BC, the Romans never thought Hannibal could cross the Alps.
In 1941, the United States Navy assumed that Japan would never attack Hawaii.
Most egregiously…in 1984, the Portland Trail Blazers passed on Michael Jordan in the NBA draft because they assumed that Sam Bowie would be more valuable to the team.
And less than a month ago, everyone assumed that a barrel of oil would never sell for negative value.
Yet here we are.
Consider the paradigm shift that just took place. For the first time in history last month, anyone who owned a barrel of crude oil needed to pay someone else to take it off their hands. Storage tanks around the world have been filled, and suddenly the sheikhs in Dubai and Riyadh are wondering whether buying a Maybach for each day of the week was a prudent move. Pity.
Closer to home, many more assumptions are being tested that relate not just to the markets, but even to the stability and viability of our society. Most people never fathomed that basic consumer staples might ever one day be in short supply (toilet paper? Really?!), or that 22 million Americans might suddenly lose their jobs at the same time.
Fear and uncertainty has been on clear display in global markets. Major US equity indices lost over a third of their value in February and early March. The carnage finally stopped when the Federal Reserve, having learned some hard lessons about inadequate responses to market shocks in 2008, printed a $2 trillion tidal wave of capital that has lifted asset prices – for the moment, at least – back near pre-crisis levels.
At this point, anyone who tells you that they know which direction the market will move – in a day, a week, a year – is delusional. Fundamentals have left the building. Price and value are uncorrelated metrics. The only thing that matters now is whether the US government is back-stopping the assets that you now own. Are you long US equities? You’re probably OK for the moment. Do you own crude oil, or corn futures, or Chinese tech stocks? It would be less risky to juggle chainsaws in a dark room.
Remember what I said about dangerous assumptions at the beginning of this article? Let’s revisit three that the vast majority of people hold today.
Assumption #1: Innovation and ingenuity will save the US economy, same as before.
You’re probably – and rightly – concerned that, in the past six weeks, the Federal Reserve has printed $2.5 trillion out of thin air to restore confidence to the economy. What will be the long-term consequences of this monumental intervention?
At the same time, you’re hoping for the best. It’s in our nature as Americans. We love a comeback story, and right now we’re all rooting for a V-shaped recovery that propels the market to all-time highs.
And, you’re probably thinking, we’ve been here before. The depressed 1930s and wartime 1940s gave way to unimaginable prosperity in the 1950s and 1960s. The 2008 financial crisis soon yielded to relentless economic growth – first thanks to $500 billion of quantitative easing, and then to an historic technology boom that culminated last month – with five companies (the famous FAANG stocks) now comprising 22% of the S&P’s market capitalization.
But let’s test this assumption by taking a closer look at the amount of debt that the US economy will need to weather the current storm.
Last year (2019) the US federal budget deficit was $984 billion, or just over 7% of GDP.
At no time, even in the depths of the 2008 financial crisis, did the US deficit climb above 10% of GDP.
Yet, barely a month into the COVID-19 crisis, we have nearly doubled the federal deficit – to 18.7% of GDP. This is the second-highest level ever recorded – eclipsed only by the massive deficit that Washington ran to finance the war effort in 1943 (29.6% of GDP).
We re-built the economy after the war – surely we can do it again, right? A gigantic deficit didn’t destroy the economy in 1943.
It’s true that deficits don’t apply to countries, like they do to individuals. While you and your neighbor can’t issue your own currency to pay down your mortgage or student loans, countries can grow their way out of deficits if economic growth is significant and their debt becomes more manageable. Alternatively, they can print tons of money to pay down that debt. It destroys people’s savings (more on that in a bit), but it gets the job done.
Back to growth. The last time America ran huge deficits, GDP growth in the 1940s and 1950s was absolutely off the charts:
Can we grow the US economy nearly 400% between now and 2030? That would require the United States to generate year-on-year GDP growth in excess of 15% for each and every year in the next decade. For reference, economists and politicians generally consider 3% GDP growth to be a good year for the U.S. economy. Unless someone is about to invent cold fusion in a bottle, growth is unlikely to be the remedy that we need for our emerging predicament.
To make matters worse, growth wasn’t the only force required to reduce the post-war deficit. Personal taxation levels, always low before the war, went into the stratosphere. The top marginal tax rate reached 94% in 1945, and stayed there for 20 years. (And you thought Californians had it bad…)
Does anyone realistically believe that today’s US taxpayer will allow their government to extract over 90 percent of their income? We’re about to find out just how much they will tolerate.
Assumption #2: The US government will never confiscate its citizens’ assets to fund a bailout.
“History doesn’t repeat, but it often rhymes.” — Mark Twain (again)
Think this could never happen? It already has.
In 1933, amidst the depths of the Great Depression, President Franklin D. Roosevelt and his new administration knew that the US government was in dire economic straits. The Federal Reserve Bank, just twenty years old at the time, had been printing money with abandon since its inception and the American consumer had loaded up on cheap debt. (Does any of this sound familiar?)
The stock market crash of 1929 brought the party to a screeching halt. Three and a half years later, when FDR occupied the Oval Office, the US economy had sustained two years of deflation in excess of 9% per year(!)
Until that time, paper dollars had been freely exchangeable for gold at a fixed rate of roughly $20 per troy ounce. By 1933, however, credit had dried up as banks were unwilling to lend as freely as before. The free-market price of gold began to tick higher and the US government knew that a run on the Federal Reserve Bank was imminent.
So, in May 1933, Roosevelt held one of his ‘Fireside Chats’ where he published the infamous Executive Order 6102 that criminalized the private ownership of gold. Americans were given less than one month to turn in their gold bullion, for which the government paid out the “official” (i.e. government) rate of $20 per ounce. A year later, Roosevelt devalued the dollar by nearly 50% when he adjusted that gold/dollar exchange rate to $35. In doing so, he stabilized the Fed’s balance sheet, while at the same time closing the loop on the most blatant and in-your-face fleecing of the public in American history.
Morgan Housel of the Collaborative Fund recently wrote an excellent blog post about this topic, where he dug up this little chestnut that President Franklin D. Roosevelt uttered a few years later, in 1941 – presumably with a straight face:
“It is not a sacrifice for the industrialist or the wage earner, the farmer or the shopkeeper, the trainmen or the doctor, to pay more taxes, to buy more bonds, to forego extra profits, to work longer or harder at the task for which he is best fitted. Rather it is a privilege.”
Were a politician to drop that quote on present-day Twitter, the collective response would include millions of exaggerated eye rolls, followed with endless replies of ‘LOL’ and ‘OK Boomer’. I admire the politician that can repeat this quote at the 2024 Iowa State Fair and leave town with his or her limbs intact.
In FDR’s day, many Americans at the time didn’t even know that their president had polio and was wheelchair-bound. People were also more likely to believe that the government had their best interests in mind – after all, they were lurching from a Depression into a devastating war. When the Roosevelt administration banned the private ownership of gold in 1933 – in what was nothing more than an involuntary bailout of the federal government – most Americans voluntarily turned in their gold to be exchanged for U.S. dollars. I cannot imagine a scenario in which this would be the case today.
And, as it turns out, compliance with FDR’s confiscation scheme would prove to be an exceedingly poor financial decision.
Source: St. Louis Fed (FRED), US Bureau of Labor & Statistics
The price of gold (or the ‘official’ price, at least) remained relatively constant until 1974 when President Gerald Ford finally repealed Roosevelt’s Executive Order. Since that time, the price has risen nearly 4,700% in dollar terms.
Comparably, the US dollar has lost 95% of its purchasing power since 1933.
Could the US government confiscate gold – or Bitcoin – or another asset class again?
According to the International Emergency Economic Powers Act (50 U.S.C. §§1701–1707), the U.S. President has the unilateral authority “to declare the existence of an unusual and extraordinary threat… to the national security, foreign policy, or economy of the United States”. This is the same law that President Trump invoked in 2019 when he claimed the right to force US companies to stop doing business with China. It is generally believed that the IEEPA could also, in an emergency, be applied to ban US citizens from owning gold or any other asset that is deemed ‘a threat’ to the US government. (Bitcoin HODLers take note…?)
Is this scenario unlikely as of the current day? Of course it is.
Should you assume that it is improbable, given America’s history? No, you should not.
Assumption #3: America will always be able to print more money.
This is perhaps the most dangerous assumption of all.
Since World War II, the United States has enjoyed what former French finance minister Valery Giscard d’Estaing complained was an “exorbitant privilege” – the ability to print money at will in order to finance deficits and ensure unchecked economic growth.
The dollar’s status as undisputed global reserve currency has not been in doubt for nearly a century – and, indeed, is not in doubt today. All of the world’s largest markets – commodities, repurchase agreements (repos), and foreign exchange – are priced in dollars. If you live anywhere in the world and you want to buy something from China, your money most likely flows through a US intermediary bank where it is exchanged to dollars before being converted into renminbi. The world cannot function without dollars.
But look around, and you see telltale signs that the dollar system is under stress. Money market funds collapsed in 2008. In 2019, the Fed had to bail out the global repo market with a $400 billion cash injection. And last month, producers of crude oil – the literal lifeblood of the global economy – had to pay someone to take it off their hands.
Are these signs of an impending disaster? It is impossible to predict the outcome, but the emerging pattern is troubling at the very least. Something is amiss. The first priority of a financial system is to provide stability, and the current system is failing to provide that.
The ‘exorbitant privilege’ exists only for lack of a better option. The dollar has acted as the world’s reserve currency for the past century because its issuer, the United States government, is perceived to be the ‘lender of last resort’ and the most stable institution on the planet. What happens when that perception is no longer intact? The privilege disappears, along with the ability to print one’s way out of a crisis.
Do not assume that the status quo will remain in effect forever. It will remain intact until a better option becomes available, and no longer.
Conclusion
This missive is not intended to be a ‘gloom and doom’ rant that exhorts the reader to buy gold, or Bitcoin, and run for the hills. This is simply a wake-up call. When one is in extraordinary times, one needs to consider the possibility of extraordinary outcomes.
Let’s question our assumptions one more time:
Assumption #1: Innovation and ingenuity will save the US economy, same as before.
Question #1: Can America grow as rapidly, and tax its citizens as punitively, as it did after WWII?
Assumption #2: The US government will never confiscate its citizens’ assets to fund a bailout.
Question #2: Are the incentives of our elected leaders aligned with those of the electorate?
Assumption #3: America will always be able to print more money.
Question #3: Are the emerging signs of systemic failure (mortgages, repos, crude oil) uncorrelated and solvable, or is a larger and more ominous trend beginning to emerge?
No one can answer these questions for you, least of all me; the reader must consider each of these assumptions in turn, and then decide whether his or her conclusions match with the narrative that ‘authoritative’ sources are currently espousing. If these assumptions are no longer a certainty for you, then plan accordingly.
The US government is fully committed to the current financial system, and the Federal Reserve will continue to print money to bail out asset classes. More risks and crises are sure to emerge as the world navigates the COVID-19 emergency. In fact, current budget forecasts – which assume that the Fed will not need to print more money beyond the $2.5 trillion already created – are in my opinion wildly optimistic. As we noted earlier, it is quite possible that we may surpass WWII-levels of indebtedness within 12 months.
In the coming months and years, the strength and continued stability of the US dollar will be tested as never before. While our three core assumptions may hold true in the end, the prudent investor and thoughtful citizen needs to consider how to prepare, and act, in the event that they do not.
