Why Is Everyone Panicking In Washington?

I’ve abandoned free-market principles to save the free-market system. ~ George W. Bush, 2008

Stop the presses: Keynes has dethroned Adam Smith on top of the Totem Pole of Economics.

To commemorate my book The Big Three in Economics, I commissioned a Florida woodcarver to make the Totem Pole of Economics. Being a free-market economist, I put Adam Smith on top (representing laissez-faire capitalism), followed by John Maynard Keynes (symbolizing big government and the welfare state), and left Karl Marx (advocating totalitarian central planning) as low man on the totem pole.

But now I’m afraid Keynes has moved up to the top, judging from the response of Washington policy makers to the panic of 2008. (Let’s hope Marx stays at the bottom.)

This week the B & B Brothers (George Bush in the White House and Ben Bernanke the Fed chairman) panicked.  On Tuesday, Ben Bernanke and the Fed announced that it was cutting the Fed Fund Target Rate to practically zero (0.25%) and the Discount Rate to 0.50%. Even more reckless, the Fed announced it would start buying mortgaged securities, long-term Treasury bonds (to keep long-term rates down), and lend credit to households and small businesses.  

Startling, shocking, reckless. There’s no other way to describe the Fed’s statement this week.  

Then Friday morning, President Bush announced a $17 billion "bridge loan" to the Big 3 auto makers that will keep them afloat until March (they hope).  Unfortunately, Bush rejected the Senate Republicans’ proposal that the U.S. automakers go into Chapter 13 bankruptcy.  It’s another example of government intervention into private enterprise, which can only make matters worse down the road.  

Clearly the B&B Brothers have learned their Keynes all too well.

It seems that every action by the Bush administration and the Fed has been based on a thoroughly Keynesian “prime the pump” philosophy: Recession is bad, deflation is bad, and we must do everything we can to stop it.

Bail out every major bank, run huge deficits, guarantee all mortgages, cut short-term interest rates to zero, inject massive amounts of new money into the system, buy toxic assets, rescue the Big 3 auto makers.  Damn the consequences — huge national debt and a potential run on the dollar — full steam ahead!

Washington’s new slogan of big government might be (apologies to Ben Franklin): “Early to bed, early to rise, inflate like hell, and supersize!”

Bill Clinton was a false prophet when he predicted in 1996: “The era of big government is over.” Expect more government, much more, when Barack Obama takes office next month: He’s already talking about spending $1 trillion on public works projects (shades of FDR). The U.S. budget deficit hit a record $455 billion in the year ending Sept. 30. Expect it to double by next year.

He will also inherit a big mess at the Big Three automakers, who are racing against time to avoid bankruptcy.  The $17 billion bailout is nothing more than window dressing.  Until the U.S. automakers make European style cars in the U.S., no amount of federal loans and guarantees will be sufficient to make up for lackluster sales.  

What would we followers of Adam Smith do? Cut taxes on corporate and personal incomes and make them permanent to encourage investments and genuine recovery. Eliminate bad accounting rules like “mark to market.” Downsize Sarbanes-Oxley. Minimize deficits.  Let the Big Three automakers go through Chapter 11 bankruptcy.  The Fed should maintain a stable “natural” rate of interest, and be a prudent “lender of last resort.”

As individuals and as a nation, we could learn a lot from Ben Franklin, who emphasize a trinity of virtues: “industry, thrift, prudence.”

But Adam Smith and Ben Franklin aren’t popular these days in Washington.

What to expect in 2009? The Fed can’t cut short-term rates anymore, so it will resort in more “quantitative easing,” a fancy word for depreciating the dollar by inflating the money supply. (M2 is growing at an unprecedented 12% a year.)

The Fed’s plan is working to reduce interest rates.  The yield on 30-year Treasuries is down to 2.5%.  Expect mortgage rates to drop, too, which will encourage refinancing and new buyers.  

Washington thinks it can get away with its reckless stimulus package as long as consumer prices and interest rates stay low.  Gas prices are now below $2 a gallon.  At almost zero short-term interest rates, and low long-term rates, Americans are starting to refinance and buy more houses.  The government will be able to finance its bigger debt, and pay for it through monetary inflation and currency depreciation.  But how long can it last?  

An Obama administration will run huge deficits and spend billions of roads, bridges, ports and other infrastructure (plus "green" technology). While infrastructure investment is probably a good thing (heaven knows, we’ve been under investing on a massive scale for the past 30 years), it can be subject to waste and fraud (e.g., building pet projects such as theme parks).  

The only good thing to come out of this mess is that Obama will probably postpone his proposal to “soak the rich” investors and wealthy entrepreneurs. That’s one side of Keynesian economics that fits with the Adam Smith supply-side model: In a recession, never raise taxes. (Unfortunately, the 50 states ignore this lesson and are always finding ways to raise taxes during a recession. The governor of New York just proposed 88 new taxes in fiscal year 2009.)

If Washington succeeds somehow in stabilizing the economy in 2009, expect a stock market rally, and maybe even a stabilization of housing prices. As they say on Wall Street, “Don’t fight the Fed.” But I believe the big money will be made in gold, commodities, and infrastructure-related assets, which is already experiencing a Santa Claus rally. Expect gold to go back over $1,000 an ounce.

The greatest danger is a run on the dollar, as Paul Volcker, the former Fed chairman, has predicted. The U.S. might face a debt crisis and a currency crisis next year. A dollar crisis could wreak havoc with Washington’s stimulus plans.

In addition, there could be further fallout from the “Mad Dog” Madoff scandal (see my column on Tuesday). Expect more hedge fund liquidations and financial bankruptcies.

All this leads to uncertainty and fear. The best strategy is to maintain a well-diversified portfolio of quality stocks and bonds, keep a position in cash, and buy a “prudent” amount of gold. Gold is the ultimate hedge, a surrogate currency, against a raft of new debt and inflation.

Interestingly, the world’s largest gold-backed exchange traded fund, the SPDR Gold Trust, now holds a near record 765 tons of gold.