By Professor Ricardo Ulivi, Ph.D.
Yesterday, the Fed decided to continue injecting heroin into the blood stream of America. The stock market, like any junkie, became euphoric. No wonder–it’s enjoying the same high an addict experiences with every new dose.
The Fed explained that it needs more evidence that progress will be sustained before it can reduce its massive bond buying program. What they fail to realize is that an addict is an addict. More drugs aren’t the cure. What we need is not easy money; that will only lead to more problems down the line. We need to change some structural imbalances in our economy. We run a massive trade deficit, which means the world sells to us, but few buy from us. Wealth cannot be created this way. Income for the middle and lower classes is not increasing; when 70% of economic growth is fueled by consumer spending, and most people’s income is stagnant, you cannot expect sustainable growth.
We continue to run huge federal deficits. In other words, the government keeps borrowing like there’s no tomorrow. Yet, poverty affects 15% of the US population, and the average Joe has not seen his income rise in years, because income distribution is skewing more and more towards the wealthy. For example, statistics are telling us that 95% of the income gains over the last few years have gone to the top 1% of the earning population. So, unless you are in that group, your financial life is tough.
In sum, the economy continues to grow slowly and interest rates, while having increased over two months ago, are still remarkably low in historical terms. In my opinion, the main reason the economy continues to sputter along is due to the easy monetary policy being followed by the Federal Reserve. This, however, cannot continue forever. What is likely to happen in the near future when they discontinue or reduce this program?
Will we experience a prolonged period of deflation?
Imagine a decade where real estate prices stay where they are today, your salary barely grows at all, inflation continues to be very low—way below the historical 3%–and stock and commodity prices stagnate. In other words, everything is worth what it is today, but 10 years have passed. Does a chill run down your spine? This type of deflation, while not as devastating as what occurred during the Depression of the 30s, is possible. Here are some scenarios that might lead us there.
Scenario 1: The economy begins growing at a faster rate–say 3% annually–and unemployment starts dropping. The Fed, as promised, curtails their easy money policy, and so interest rates rise moderately, to say 6% for the 10 year Treasury, as opposed to the 2.8% of today. This rise in rates most likely will shut down the engine that is driving the current expansion: real estate and car sales. This flattens the faster growth rate, and we go back to a period of no growth or a mild deflation
Scenario 2: Because of the Fed’s current easy money policy, inflation takes off. Interest rates rise quickly, and workers’ take home pay is reduced because of inflation. The result? Lower consumer spending, and the economy sinks into a period of slow or no growth. Mild deflation hits us.
Scenario 3: The Fed continues with their easy money policy, but the economy stays stuck and does not grow. This means that the average American’s income is stagnant, so consumer spending cannot support economic growth. We are back to a deflationary period.
What will happen in the near future?
The Fed yesterday said, in other words, that the economy is so fragile it can’t sustain itself without the Fed’s massive monetary infusion. But if this is the case, why is the stock market setting new records? It is unabashed financial speculation, and we know the dire consequences that type of activity can result in.
I don’t have a crystal ball, but I strongly believe we are currently stuck in a fantasy world created by the Federal Reserve’s easy money policy. This cannot continue forever, or it will create incredible imbalances in the economy, with grave financial consequences. The bottom line is this: the Federal government is still running a massive deficit, and the world sells us all sorts of goodies, while few buy any of what we are selling. As a result, we have a terrible trade deficit, which means we are not competitive in trade around the world. Eventually, this will lead to a decline in the standard of living of most Americans. A prolonged period of deflation may be upon us.
Some of you may be thinking I am a pessimist. OK, but how can you be optimistic when we have serious structural imbalances in our economy? Federal deficits and trade deficits combined indicate fever. And the medicine the government is using–easy money–reminds me of the doctors 200 years ago who believed that bleeding a sick person would cure them. I am a fiscally conservative adviser, not a pessimist. I believe in living below your means, saving and investing wisely. I also believe values should be determined by facts, not speculation. And I leave the extremely risky investing to others.
I have given you my opinion. What is your scenario? Let me have your thoughts about what is likely to happen in the near future. Just reply to this email with your comments.
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