The Humpty Dumpty Economy

There’s much ruin in a nation.” ~ Adam Smith

We’ve gone from a Goldilocks economy to a Humpty Dumpty economy. I see years of stagflation ahead. At best, expect a combination of slow growth and renewed inflation over the next few years.

America in 2009 will never be the same. Barack Obama is right when he said that as president he doesn’t look like any of the faces on the dollar bill. We are entering stage two of the New Deal. Obama recently spent time reading about the emergency measures Franklin Delano Roosevelt took when he became president in early 1933.

FDR started his New Deal by declaring a week-long bank holiday. The way things are going, Obama may have to do the same on January 20, only it will be an invisible bank holiday. Today the Feds rescued the nation’s largest bank by making an emergency loan of $20 billion, but more importantly, TARP (the Treasury’s Troubled Assets Relief Program) guaranteed $306 billion in Citigroup’s troubled assets.

Essentially, the Federal government was sending a message to Wall Street: “We are guaranteeing the assets of all major banks in the United States, starting with the largest.” That’s why the stock market rallied for the second day in a row. It was like Washington setting a price floor on the economy and Wall Street.

The price for this “bleeding heart do-gooder” bailout mentality will be steep. Expect deficits to exceed $1.5 trillion in 2009 and beyond. Much will depend on how many other bailouts the government will undertake. The list of handouts could be long — commercial banks, insurance companies, auto makers, credit card issuers, states and municipalities.

The new Obama administration and the Democratically-controlled Congress probably can’t say no to the "Big Three" auto makers, since a bailout is really a payback to the UAW. Expect the government to pay for the legacy costs of retiree’s pensions and medical expenses and to get back into the business of running businesses “too big to fail.” Failure to rescue Detroit could be the tipping point toward the big D (depression).

Once the economy stabilizes (notice I didn’t say grow), expect Obama to increase taxes on investors and wealthy entrepreneurs in a vain effort to reduce the growing deficit.

The Fed is doing its part by injecting billions (or is it trillions?) into the monetary system through the Discount Window and Open Market Operations.

Both fiscal and monetary policy are highly inflationary. Initially, the impact will be a stock market recovery….but the long term impact is more inflation and much higher gold prices (the ultimate inflation hedge).

FDR also took the United States off the gold standard and forced Americans to turn in their gold. Thankfully, nobody is talking about gold confiscation right now, although if “speculators” (gold bugs) double or triple the price of gold, don’t rule out this possibility.

I just returned from a trip to Bogota, Colombia, where I gave a lecture on the financial crisis. I said that America started this crisis, and America can end it. It requires the U.S. government to (a) establish a long-term stable monetary policy, with neither easy money or tight money — the Fed should adopt a Goldilocks “just right” monetary policy, a steady monetary rule that stabilizes the price of gold; (b) pass a flat tax that becomes permanent and dependable; (c) institute just and tolerable “rules of the game” so that business and financial institutions can make long-term plans for success; and (d) adopt an open and non-interventionist foreign policy.

Adam Smith said it best: “Little else is required to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, [sound money], and a tolerable sense of government.”

Tragically, America could go in the opposite direction toward a road to serfdom if we are adopt a constant policy of war, taxation, inflation, and over-regulation.

History is holding its breath to see which way we will go.