California and its Ailing Economy

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Ireland is nearly broke. Its debt was downgraded a couple weeks ago. Unemployment is near 14%. Deflation is at 5.4% — the highest since the Great Depression of the ’30s. And it’s not over. It’s “too early” to talk about recovery, says Finance Minister Brian Lenihan.

It’s too early in England too. Financial Advisor Peter Hargreaves says that talk of ‘green shoots’ gives rise to illusions. People think they see the light of dawn when the sun is still going down. And forget about a V-shaped recovery. There won’t be any simple bounce-back. Nor even a W-shaped double decline. “There could be a quadruple dip in my opinion,” he said.

And what about California? This week’s Economist magazine gives us a new measure for California’ budget deficit — $26 billion, up from the $24 billion last reported in this space. A widely published photo shows Arnold Schwarzenegger smoking a cigar… apparently confident that the state’s problems will work themselves out somehow.

Of course they will. They always do. But not necessarily the way people hope.

California is the world’s 8th largest economy. It can print IOUs when it runs out of money. But there’s no law that says banks have to take them. They stopped taking them last week…which leaves the Golden State in a jam.

What is ailing California is ailing the entire United States of America – and much of the rest of the world, especially that part of the world that speaks English. Politicians have promised too much…without being willing to raise the money to pay for it all. Solution: spend less. Or tax more. Or a little of both.

Hey, Arnold should have asked us. It’s so simple.

But wait. California is a democracy. And the democracy is a flim-flam. As we’ve explained in these reckonings: there are two parts to it. One part is like professional wrestling – full of bullying, humbug and hollow gestures. One group wants to stop its neighbors from smoking. Another wants a flag with yellow trim. Still another wants revenge on a neighbor because it feels disrespected. There is no accounting…or predicting…what direction the mob will take.

The other part of democracy is more rational. The citizen wants to know not what he can do for his government, but what he can get out of it.

This second part is a time bomb. Once citizens realize that they have the power to vote themselves the contents of someone else’s pocket, the system is doomed. They don’t let up until they’ve bankrupted it.

A man may vote for a candidate who promises a yellow flag. No harm done. But when he votes for the candidate who promises more “benefits” at someone else’s expense, he is on the road to Hell.

“Democrats in the House propose setting a 1% extra tax on couples earning more than $350,000,” reports the Financial Times this morning. The money is to be used to pay for other peoples’ health benefits.

If you earn less than $350,000, you feel that you are getting something for nothing. But that money – had it not been confiscated – wouldn’t have disappeared. It would have been put to work in one way or another – added to the nation’s capital formation, lent to the government, used to buy a new car or take a vacation. Instead, it is to be sucked out of the benefits of the willing economy and used to give people something they couldn’t afford or didn’t want to pay for themselves.

In order to get elected, politicians have to promise more and more of these ‘benefits.’ There is no backing up…no turning around. Even when the government is clearly headed to bankruptcy. If a politician hesitates, some other clown will just take his place. He may even be overcome – in a weak moment – with a desire to level with the voters. He may imagine himself going on TV and putting it to them straight:

“Look, we’d like to continue these programs; but we don’t have the money.”

Then, he comes to his senses: ‘I might as well say I’ve fallen in love with a woman from Argentina…or a man in a public bathroom; either way, I’m dead, politically.’

Now, Dear Reader, you may object. ‘The American political system draws forth the best and the brightest from the entire nation of 300 million,” you may say. “Surely these people are capable of doing the right thing for the good of future generations.”

They are surely capable of making rational decisions. But what is rational for them – ducking serious issues…nourishing the illusion that voters can get something for nothing — is fatal to the republic.

Of course, the same thing could be said for a business…as well as a country. Why did GM go broke? It was the largest company in the world. It could pick and choose the very best managers …the smartest businessmen…the greatest investors…the most far-sighted engineers… the most wonderful of the wonderful. Surely, these fellows could add and subtract, right? Surely one of them noticed:

“Hey…if we keep adding costs, we’re not going to be competitive any more. And if we’re not competitive, we’re not going to be able to sell cars at a profit. And then, we’re going to lose money and go broke.’

How come the best talent money could buy couldn’t change course at GM? How come all those smart people in the California legislature can’t balance the budget? Well, that’s just the way it is. An institution matures…and the parasites take it over.

Retirees, executives with their golden parachutes, the halt, the lame, employees, managers, hangers on, lawyers, accountants, businessmen… everyone has an interest in keeping the hustle going. The executive wants his bonus…the retiree wants his pension…the lawyer wants his retainer… All can see that the old place ain’t what it used to be. They all know that the gravy train won’t go on forever…but that just makes them more eager to get it while the getting’s good. So they jiggle the numbers so each quarter doesn’t look so bad…jive the news so it sounds almost as if the institution had a future…and they juke up the whole system so that no one even mentions that they’re going broke.

GM “sets out on a fresh start,” says the Financial Times. “From this point on,” says its top man, “our efforts are dedicated to customers, cars…” and repaying the feds.

What were they dedicated to before they had to turn to the feds for money? Answer: to looking out for number one.

What are they dedicated to now: refer to the question above.

This from our old friend, Adrian Day:

“I’ve been called a cynic-and worse-but, as Winston Churchill told us, if you don’t know the future, look to the past. So if we want an idea how long the government might be subsidizing GM and Chrysler, let’s look to the experience with railroads. In 1970, Penn Central, America’s largest rail company, filed for bankruptcy, and Congress created Amtrak. The government passenger rail monopoly was confidently expected to be paying its own way by 1974. Well, 38 years and $33 billion later, it has still to turn a profit. So this year, congress has voted another $14 billion for the next five years.”

From our perspective – because we hate taxes and we like trains – it would have been better if the railroads had gone broke…and been bought up by whomever could make a go of them.

And from our perspective – because we hate taxes and we like cars – it would be better if GM had been allowed a death with dignity. Then, other automakers could have salvaged the wreck for spare parts.

Of course, this formula applies to all the crippled banks, bankrupt households, reckless insurance companies, greedy Wall Street…and all the rest of the flotsam and jetsam of the Bubble Epoque.

As Yu Faz, who anticipated the ‘laissez-faire’ economists by 500 years, said: “A man lives under the roof of his own making. If it falls on his head, so be it…”

********************

The Financial Times interviewed our friend Hugh Hendry, of Eclectica Asset Management. Excerpts:

“I’ve never known a moment where a trade has become so crowded. And that trade would be this absolute certainty that the future is going to result in inflation. And not just any old inflation. People are using quite severe language. And there are notable contrarians and commentators who are comparing America’s monetary policy with Zimbabwe. And they’re not just saying inflation, they’re saying hyperinflation.

“Prices today…are falling, in America and in the British economy, and indeed across Europe. That never happened in the 1960s, 1970s, 1980s. 1990s. That’s a new phenomena. It’s almost as if we have this flood and yet people are buying fire insurance, and that’s quite – you couldn’t make this stuff up.

“When Japan hit the turbulence which we’re experiencing now – when they hit it twenty years ago, their public finances were very similar to the public finances we had in the UK going back a year or so, and the US, where gross public debt was no more than 40% of GDP. Now over the last 20 years, the Japanese have fought crisis after crisis by expanding the public sector debt. They’ve issued trillions, literally trillions of yen, and debt is now approaching two hundred percent of GDP. What’s happened to government bond yields? They’ve gone down.

“Here we are with the most profound collapse in industrial production, world trade, since the 1930s. That is not an exaggeration, that is reality. Okay? And yet today …they only proposed to grow the money supply at the rate at which it’s expanding just now – it’s expanding at like nine percent just now…history will determine that their steps were modest, and they were massively overwhelmed by this hysteria, which raised interest rates.”

We can’t find the passage…but one thing in what Hugh said stuck in our brain. He said the inflation narrative was “too easy to articulate” and too persuasive.

That’s what’s been bothering us too. It’s too obvious. The feds print money. Prices go up. People who own gold get rich.

Well, the fed is printing money, but as Hugh points out…probably not enough to offset the economic collapse. Are prices going up? No, they’re going down.

Should you be long or short bonds? The dollar?

We suspect Hugh is right. In the short run, you should probably be long both. The correction has been underestimated. It will be worse than most people realize. Since a correction is fundamentally deflationary, the dollar should rise.

But here at the Daily Reckoning, we’re not smart enough to invest in the short- run. We never know how short short is. And we fear having our short positions when the long run finally arrives. So, we’d prefer to take the long-run position from the get-go. In the long run, we have faith in the feds. They may not be very good at causing inflation. They may have underestimated the downward tug of the correction. But give them time. They’ll keep emitting their I.O.Us…and keep propping up their dead institutions with make-believe money…and keep handing out their bonuses and benefits…

…until the country goes broke.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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