For nearly 75 years, Americans have relied on Social Security and other “retirement” plans to assist them financially after they stop working.  The Lamb was going to write in this post about the looming crisis in government entitlement programs like Social Security, Medicare, and Medicaid, but he will let that keep for another time.

For now, The Lamb wishes to discuss pensions.  Ahh, pensions — that little (or not so little, as the case may be) nest egg sitting quietly in the corner of our grand retirement plans.  Pension plans fall into two general categories:  defined contribution plans (IRAs and 401(k)s) and defined benefit plans.  With defined contribution plans, the participant makes investment decisions and essentially bears responsibility for the risks and returns of the plan.

However, with defined benefit plans (DBPs), the participant is promised a fixed or formulaic payout from her employer at set times in the future.  Sounds great, right?  Well, it’s great unless the employer can’t make good on its promises.  In many DBPs, the employer has made fairly optimistic and ambitious assumptions about its plan’s returns, usually 8-10%.  The employer does this for a very simple reason — it is the only way the employer can arrive at figures that will produce the requisite amount of income.

8-10%, huh?  Well, equities sometimes reach that threshold.  However, cash and bonds rarely come close to 10% annual returns.  And what about the years in which returns not only fall short of this bogey, but are actually negative?  Like, hmmm, this year.  To wit:  The Lehman Brothers Global Aggregate Corporate Bond Index is roughly down 16% in the past year; and the S&P 500 Stock Index is down over 30%, even after yesterday’s 10% rally!

Many private and public retirement plans are fully funded, some are even overfunded.  However, some of the largest plans are in dire straits.  From boston.com:

The California Public Employees’ Retirement System, the largest pension system in the United States, said it might have to require the agencies and schools that participate in the plan to increase payments after watching its investment fund shrink by 20 percent, or $50 billion, this year.

And as more and more DBPs find themselves underwater, they decide to take on more risk in a Sisyphean effort to increase returns and get their plans fully funded.  They shift a greater percentage of their portfolio away from stable cash flow instruments like bonds and into more volatile assets like stocks.  Given what has happened over the past year, it seems likely that many of these funds are in even worse shape now than what is shown here:

Given the trend and what has happened in the capital markets this year, it’s safe to assume that nearly half of state and local government pension plans (DBPs for teachers, police officers, sanitation workers, city/state employees, etc.) are significantly underfunded.

But it’s not just municipalities that are having problems.  From bloomberg.com:

The value of so-called defined benefit plans fell to $1.1 trillion by Oct. 24 from $1.3 trillion at the end of September, according to Mercer, a pension consulting unit of Marsh & McLennan Cos.

But wait!  What about the backstop of the Pension Benefit Guarantee Corporation, that bastion of government safety and security?   Well, not surprisingly, things haven’t been going exactly swimmingly for them either.  From a Wall Street Journal article last week:

PBGC reported earlier this week a $3.12 billion loss in equity investment during the 11 months ended August 2008. Those losses increased by roughly $1.7 billion in September alone, bringing the fiscal year 2008 total stock investment loss to $4.79 billion, according to documents released by the agency.

Clearly, the pension problem is exacerbated exponentially when the “insurer of last resort” is investing its reserves in the same volatile assets that it is effectively insuring!

And this from The Washington Post:

With workers retiring earlier and living longer, governments have been struggling to keep up with the promises they made. Many are taking out loans to restock their pension funds, which is akin to using a credit card to cover monthly mortgage payments. Others are passing the bill to future generations by using sunny projections of what their investments will return, claiming they do not need to dedicate more money now to their pensions.

Such “accounting nonsense” has been “pushing the envelope — or worse — in its attempt to report the highest number possible” for their investment returns, wrote billionaire investor Warren E. Buffett in a recent letter analyzing pensions for shareholders of his company. Taxpayers ultimately will pay the price when these forecasts prove wrong.

“Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed,” he wrote. “In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.”

So, what does this mean?  Well, unlike Uncle Sam, these entities can’t just turn on the printing press.  They have two choices:  raise taxes or cut benefits.  Either choice will infuriate a large group of people.  Is it fair to raise taxes for the majority of citizens to pay for benefits for a minority of the citizenry?  Is it fair to renege on promises made to government employees whose labors benefitted the aforementioned majority?

Susan Urahn of the Pew Center on the States perhaps says it best:

“The age of retirement was set when people did not live that long. It’s very hard to change that now,” she said. “People feel these pension obligations were a promise. And changing them feels like you are breaking a contractual promise, that you are changing the rules of the game. But the game has changed.”

The downward spiral in residential real estate has frequently been cited as a cause of the current financial contagion infecting the global economy.  But what is the source of the housing downturn and growing glut of homes weighing on the market? 

Via Standard & Poor’s:

The market giveth, the market taketh away...

Many blame those avaricious Wall Street banks whose Frankensteinian creations are now turning on them.  Still others ascribe fault to unscrupulous mortgage brokers, peddling loans to unsuspecting would-be homeowners in search of the American Dream.  Somnolent regulators are another popular scapegoat.

The Lamb would like to nominate another candidate to assume the mantle of guilt.  While there is undoubtedly enough blame to go around, The Lamb suggests that Patient Zero in this housing miasma is the (mainly American) homebuyer.  It is he who bid up prices to unsustainable levels and borrowed money that he became unable to repay, adding to the surfeit of houses and further depressing prices.

There was undoubtedly fraud involved in some mortgage loans.  However, one can not fault banks for loaning funds to people any more than one can blame the barber for suggesting that you may be in need of a haircut.  And while mortgage brokers may have contributed to higher interest rates, denouncing them is akin to faulting the retailer for not charging wholesale prices.

Some blame banks/brokers for charging steep interest rates to high-risk (i.e. — subprime or Alt-A) borrowers.  But why shouldn’t the rates be high?  If the risk of not being paid back is greater and/or the underlying collateral is riskier, banks should charge a higher premium to the borrower.  This is no different from an insurance company charging higher hurricane insurance premiums to a homeowner in Florida than to one in New York.

One can always debate when the right time is to purchase a home, or even if there is a right time.  Among things to consider is the cost of the home in relation to one’s income.  In fact, The Lamb’s favorite indicator of relative home price affordability is the ratio of median home price to median household income.  The higher this ratio, the (relatively) more expensive housing is.

Courtesy of The Joint Center for Housing Studies of Harvard University:

Up, up, and away!

For decades, home prices stayed within a fairly narrow range of 2.25 to 2.50 times median income.  However, around a decade ago, home prices soared even as income barely budged, pushing the ratio to a nose-bleed level of over 3.50.  Aspiring homeowners leveraged themselves further via lower down payments and a proliferation of easy credit, seemingly turning a blind eye to the higher prices they were paying.  It was as if the concept of home ownership had morphed from a dream into a right. 

Among steps the government is now taking to prop up house prices is recapitalizing banks and insuring their debt issuance (see the post Uncle Sam vs. Uncle Sam) in order to get them to lend more freely.  The Lamb suggests that now is NOT the time to loosen lending standards — that’s part of what got us into this dilemma.  The middle of an economic downturn, rather, is the time to tighten credit/lending terms, to strengthen banks’ balance sheets and to protect them from greater credit exposure.  The government’s plan is like Dr. Nick Riviera’s telling Homer Simpson to run a marathon every day to recover from a coronary caused by eating too many doughnuts (mmmmm….. doughhhhhnuts).

"Hi, Everybody!"

While housing might be individuals’ most valuable asset (at least for those with positive equity), it should not be viewed as a sacred cow immune from falling prices.  Investors see portions of their portfolios suffer price declines all the time.  Anyone take a peek at their equity holdings recently? 

And what about those that made socially responsible investments in the future?  For example, some invested money in alternative energy sources like natural gas.  They’ve seen their investment plummet by 50% in just the past three months — a far larger and swifter fall than the 25% two year peak-to-trough decline in housing prices.  Should they, too, be given some version of a government subsidy (read:  transfer payment)?

The Lamb is not without empathy for the homeowner who defaults on a mortgage due to a severe and unexpected illness, job loss, or other tragedy.  However, he feels that the root of this housing crisis lies in the poor economic decision-making of a large number of individuals whose actions ultimately precipitated one of the biggest financial crises in decades.

Why does it seem as though people believe they have this inalienable right to price gains on all their assets?  Good economic decisions, whether they be lucky or smart, should be rewarded while bad ones should be punished (for lack of a better word). 

While this may seem overly harsh, decisions to purchase what turned out to be unaffordable homes have had consequences for more people than just the borrower.  Think about the myriad charities, hospitals, and others who invested in mortgage-backed securities (MBSs) either outright or through bond mutual funds.  These investors were counting on homeowners to honor their obligations and pay their debts.

Because of a decline in the value of these MBSs, many of these charities are now unable to fulfill their missions or to pay their bills.  Homeowners’ delinquincies and defaults are now having dire ramifications for people dependent upon these organizations for necessities such as food and medicine.

The Lamb believes that trying to prop up home prices via easier bank lending is a poor idea for another reason.  By not allowing house prices to fall to a market equilibrium level, the government is effectively hindering potential homeowners from purchasing homes.  If the government did not target (limit) home prices during their dramatic move higher, it should not impede their decline now.  Doing so punishes those who chose to wait to buy a home and to rent instead.

In addition to renters, what about those homeowners who purchased more modest homes, planning to trade-up to more expensive ones when prices declined and/or they could better afford it?  Say a homebuyer decided to purchase a $300,000 home rather than one for $500,000 because she wanted to be more conservative and not spend the extra $200,000, waiting instead for prices to become more affordable. 

If prices fell 50% across the board, sure she would lose $150,000 on her current home, but she would also save $250,000 on the more expensive one (and gain a tax benefit).  All in all, she would save a net $100,000 (plus the tax kicker) due to her good economic decision to purchase the cheaper property originally. 

However, by forestalling home price declines, the government effectively punishes her for wise and conservative choices.  Sounds like a prescription from Dr. Nick.

When is a guarantee not a guarantee?  Well, the United States federal government would like you to believe that the answer is “never.”  When the feds say that certain debt is guaranteed, they would like the global investing public to have no fear, to suspend any fancy security analysis they might be tempted to undertake, to just close their collective eyes and “wave ‘em in.”

Unfortunately, the law of unintended consequences is a tricky thing.  Last month, Uncle Sam essentially turned what had been an implicit backing of Fannie Mae and Freddie Mac (GSEs) senior debt into an explicit one (see the post Fannie, Freddie, and Sam).  The Lamb is almost always against government interference in the operation of free markets.  However, he applauded this move in part because the feds had done almost nothing over the decades to disabuse the public of this implicit backing and because the consequences would have been catastrophic.

Following the GSE “bailout,” the feds turned to Corporate America and decided to effectively insure the continued steady issuance/financing in the commercial paper market.  Not done razing the bastion of capitalism, the government last week sought to guarantee certain senior unsecured bank debt.  Enter FDIC Chairman Sheila Bair:

The [FDIC now] guarantees new, senior unsecured debt issued by any bank, thrift or holding company, which will help banks fund their operations. Both term and overnight funding of banks has come under extreme pressure, with the costs of funding ballooning to several hundred basis points.

This guarantee will allow banks and their holding companies to roll maturing senior debt into new issues fully backed by the FDIC. However, guaranteed maturities cannot extend beyond three years. The ability to tap into this program expires at the end of June 2009.

The FDIC guarantee is not exactly like having the full faith and credit guarantee of the United States government (this is fodder for another post), but it will have the same deleterious effect on certain parts of the capital markets.  As more and more types of debt are guaranteed, the relative value of that guarantee diminishes.

Let’s venture back to the effectively “full” guarantee of the GSEs.  Prior to this event early last month, GSE asset-swap spreads (the yield differential between GSE debt and the swaps curve) were trading near their highest level ever, almost even with the swaps curve (i.e. – costing the GSEs more than ever to borrow money). 

After the GSE guarantee was announced, these spreads decreased dramatically, hitting all-time low levels of around fifty basis points lower in yield than swaps (i.e. – making it cheaper than ever to borrow money). 

However, following last week’s bank debt guarantee proclamation, these spreads rocketed higher.  By Friday, the GSEs’ funding costs had reached all-time high levels of thirty bps higher in yield than swaps, making it incredibly expensive for the GSEs to fulfill their newly assigned duties and costing taxpayers more money.

Think about how incredible this is.  These spreads usually move just one or two basis points per week, with a long run average of around 20 basis points lower than swap rates.  Yet, in the course of less than two months, the GSEs’ relative funding costs have gone from average levels to all-time low levels to all-time high levels!

GSEs Relative Cost of Funding

What are the GSEs’ duties and why do we care?  Good questions.  Answers:  around a week ago, federal regulators ordered Fannie and Freddie to purchase $40 billion of distressed mortgage-backed securities every month, in addition to their regular purchases.  The more expensive it becomes for Fannie/Freddie to finance these purchases, the more it ultimately costs taxpayers. 

Regardless of your opinion of the wisdom of these purchases, the devaluation of the “sacred” federal government guarantee has caused a kind of self-defeating paradox.  Guaranteeing all has become worse than guaranteeing none.  Since bank debt has always traded at higher yields than GSE debt, investors who seek out this guarantee will now eschew GSE debt in favor of bank debt.  And why not?  They’ll be buying debt with essentially the same ultimate credit (the United States Government), but be gaining incremental yield for free!

Uncle Sam is fighting himself and the American taxpayer will be the big loser.

"Which Bonds?" Indeed

Since The Lamb began this blog, many of you have contacted him regarding “Guest Posting.”  The Lamb has heard you and over the next few weeks will be accepting submissions.  This is your chance to get your views out there in print (or at least in cyberspace).

Acceding to the concerns some of you have voiced, posts can be anonymous (simply tell The Lamb what you wish your nom de plume to be).  True identities will be held in the strictest of confidence.

The Lamb values other opinions — as long as they’re similar to his own.  As George Orwell said in Animal Farm, “All animals are equal, but some animals are more equal than others.”

You can send your Guest Posting requests to The Lamb by clicking here or by clicking the Contact The Lamb button on the top left of this site.

Dear Mr. Keynes:

You must be very pleased with yourself, John.  Your ideas, rejected by many for at least a generation, appear to be making a vaunted comeback.  As part of the recently announced Bailout Bill, those of us that are still alive will be lending money to select financial institutions on very generous terms — generous for them. 

The revised bank rescue plan announced yesterday by the Treasury includes some measures that would make you grin from ear to ear (if you were still alive).  Allow The Lamb to rev up his seance machine and relay to you the plan’s highlights.

The Treasury will lend our money to select banks in the form of preferred stock that will earn us returns far lower than what was/is available in the market.  Through last week, the preferred stock of these banks was trading roughly at yields between 10% and 20%. 

But why, John, would we want to earn these 10-20% market rates when your friend Secretary Paulson is willing to put our money at risk for just a 5% return for three years? 

Oh, and what happens if these banks don’t want to pay us back in three years for whatever reason?  Well, then they can simply delay repaying us for as long as they want, giving us the same 5% for the following two years, and then 9% after that, a rate still below the prevailing market rate.

Additionally, the Treasury will guarantee for nearly four years hundreds of billions of dollars of senior unsecured debt and commercial paper that these banks issue through June 2009, regardless of its maturity.  Hmmm, what do you think that will do to our cost of financing the country’s deficit?  That’s right, it will make it that much more expensive — in essence, a double-whammy for us taxpayers.  Furthermore, this will have a “crowding out” effect on other corporations that do not enjoy the governement guarantee, making it ever more expensive for them to borrow.

And John, that gentle sobbing that you hear emanating from the next cloud over?  That’s your idealogical opposite, Milton Friedman.  This rescue plan is causing him and his ideas great discomfort.  The notion that the government would forcibly dictate such onerous terms to taxpayers would be anathema to him.

If you listen closely, John, you may hear him mournfully recounting his thoughts on the matter:  “Only government can take perfectly good paper, cover it with perfectly good ink and make the combination worthless.”

Sincerely,

The Lamb

Last Wednesday night, The Lamb had just finished his last meal for the next 25 hours and was leaving for his thrice yearly appearance at the local temple for Kol Nidre services (sorry, Mom, The Lamb was a little late).  About to turn the TV off, he heard the name of his hometown – Hollywood, Florida — in connection with a story about the ongoing financial crisis:

In the video, Mr. Prince says that he is “very frustrated and very upset” that he is losing money.  The Lamb isn’t really sure with whom he is frustrated and upset.  Investing is tough, but Mr. Prince made his investment decisions of his own volition and now seems to be looking for a scapegoat.

He states that the value of his investments has dropped precipitously, endangering his impending retirement.  That seems a bit odd.  If he is that close to retirement, wouldn’t it seem to make more sense to be invested in cash, or at least in bonds, with hardly any money in stocks, so that his retirement account would be very stable? 

The Lamb believes that a good general rule is to have no more than twice the number of years until you plan to retire as the percentage of your money in riskier asset classes (stocks, commodities, real estate, and foreign currencies), what The Lamb calls SCREF assets.  Keep the rest in cash and high grade bonds.  

For example, if you plan to retire in 20 years, have no more than 40% of your money in these riskier SCREFS.  Unless your time horizon is many decades, why put yourself in a position where you have so much money in SCREFS that you could lose enough principal to jeopardize your retirement?

The Lamb often hears the refrain, “Stocks always come back in the long-run,” and “if I don’t sell it, I’m not really losing money.”  Well, in the immortal words of John Maynard Keynes, “In the long run, we’re all dead.”  Looking at historical data, we can see that stocks can go decades without yielding positive returns.  

Beginning in late 1972 the market went until the early 1980’s before regaining its 1972 level.  Looking back further, following the 1929 crash, it took a quarter century for stocks to reach the breakeven level again.  And from August 1997 through last Friday, stocks have posted a grand total return of zero percent.  Kind of makes having money in boring old Treasury Bills look pretty good (and a lot less risky).

Getting back to Mr. Prince, he goes on to say that the decline in local housing prices has made it “impractical” for him to sell.  Impractical?  How practical was it to continue buying properties or not selling existing ones after South Florida housing prices nearly tripled from 1999-2006?  In fact, even after the recent downturn, South Florida real estate is still up an annualized 7.26% over the past 10 years.

Next, he bemoans the fact that his tenants are having difficulty paying the rent he’s charging.  Hmm, what are the chances Mr. Prince has lowered rents recently to reflect the declining economic fortunes of the area?  The Lamb’s guess:  very slim.  Yes, this would eat into his revenues, but it would undoubtedly be better than the revenue he’d be receiving if the units were empty.

Like a lot of us, The Lamb has gotten crushed by some of his investment decisions.  But if he’s gonna blame anyone, it’s the person he sees in the mirror.  The economy will always go through up-and-down cycles.  And while it’s true that when you pay your money, you take your choice (Rule #5), we each must take responsibility for these choices — good or bad.

It is said that capitalism without losses is like religion without hell.  According to a 2003 Harris Interactive poll, 69% of U.S. adults believe in a repository of eternal punishment and damnation.  But if Uncle Sam has his way, no one will be forced to visit or remain there.

The FDIC recently expanded its insurance for eligible bank accounts from $100,000 to as much as $500,000.  In fact, a married couple can now have up to $1 million insured at each FDIC-insured depository institution — $250,000 for each spouse’s individual account, plus $500,000 held in a joint account.

Want even more coverage?  No problem.  The FDIC now also insures trust accounts for amounts well into the millions.  And if you’re fortunate enough that you need even more coverage, all you have to do is start the process all over again at a different bank!

Why does The Lamb see this as a problem?  Isn’t more insurance good for everyone?

For everyone?  No.  The FDIC is not some amorphous entity that magically provides funds to make whole depositors at failed banks.  The FDIC is us.  We’re the insurer.  Or, to put it another way, those that don’t have funds that go bad effectively pay those that do.  

Now, you may argue that the FDIC is funded by insurance premiums that banks pay on deposits.  While that is technically true, the FDIC has only a fraction of the funds it will need to bail out depositors of the thousands of banks expected to fail in the coming year or two.  In fact, the recent “bailout bill” (The Lamb forgets what we’re officially calling it now) allows the FDIC to borrow UNLIMITED amounts of money from the U.S. Treasury (read: us) to help it maintain solvency.

All of this is IN ADDITION to Uncle Sam’s recent insuring of trillions of dollars of money market fund assets (see the post 2 + a + 7 = 50,000,000,000).  Our government is creating a system in which failure is all but impossible.  While this may look good in theory, it generates terrible moral hazards. 

The Lamb believes that investors should be free to invest wherever they please.  However, if an investment sours, those who made safer (and lower yielding) ones should not be forced to ride to the rescue.  There simply must be negative repercussions for poor investment decisions.

The preceding is exemplary of The Lamb’s Rule #2:  Know and understand what you own, and what you owe.

If investors want investments with guaranteed principal repayment, great.  There are trillions of dollars of them available for purchase.  They’re called United States Treasury bills, notes, bonds, and inflation-protected securities.  Investing in them is easy (see the post Safety and Soundness) and can be done by going to the Treasury Direct website.

Are the nominal yields on Treasuries (particularly T-bills) generally lower than those of money market funds and bank deposits?  Yes.  And they should be, given the full-faith-and-credit nature of the investment. 

Put your money wherever you want.  Take whatever risks you want.  Feel free to stretch for that last basis point.  But if things go wrong, don’t take others to hell with you.  Real or not, it doesn’t seem like a very nice place to be.

While it comes in a distant second place in general popularity to The Terminator, Conan the Barbarian has always been The Lamb’s favorite Ahhhhhnold Schwarzenegger movie.  For those of us who were teenagers when Conan came out, we’ll never forget the famous scene when the Mongol general asks, “Conan, what is best in life?”  The response:

Now, what’s best in life for Governor Conan and California may be entirely different from what’s best in life for those of us that live in the other 49 states.  Governor Conan has petitioned Uncle Sam (effectively, the other 49 states) for a loan.  He says that the credit markets have made it all but impossible for California to borrow in the debt markets.  Bloomberg.com says that California will run out of money by the end of October without $7 billion in additional funding.

Next week, California will try to help itself by selling even more debt.  The state is already the largest borrower in the entire municipal market.

Clearly, there is another very basic way that Governor Conan can generate badly needed funds:  he (and the legislature) can raise taxes, specifically property taxes.  The Lamb realizes that property taxes are a live wire in California politics.  His in-laws live there and they are adamant that their property taxes should not be raised.

What you may not know, dear reader and likely property tax payer, is that California has enacted a law known as Proposition 13, now in effect for nearly three decades.  Among other things, this law restricts property tax assessments to:  1) a cap of 1% of assessed value and 2) an increase of no more than 2% annually (increases which themselves are capped by the annual cost of living increase if it is less than 2%).

What practical ramifications does this wonderful law have?  First, two homeowners with nearly identical houses can often pay radically different amounts in taxes.  Second, this law fomented one of the greatest housing bubbles in history.  This simultaneously exacerbated the risk of homeownership and made its attainment all but impossible for many in our nation’s most populous state.

Additionally, as the website wealthandwant.com points out, “California’s schools have gone from being highly respected to being well below the middle of the pack.”  It should be duly noted, however, that The Lamb’s beautiful and brilliant wife is a proud graduate of a California public school.

For years, Californians have enjoyed some of the lowest property tax rates in the nation.  In fact, as of 2007 the state was tied with Delaware for the third lowest rate (barely ahead of Alabama and Hawaii) at just 0.68%, less than half the national average of 1.38%.  Before Californians, who have been the beneficiaries of low property taxes for so long, hit the rest of us up for a loan, perhaps they should try pitching in a bit more themselves.

Although The Lamb is not part of the 10% of Rule #3 — 90% of the world doesn’t care about your problems; the other 10% is glad you have them — he can nevertheless assure Governor Conan of one thing:  if California does decide to borrow money from the rest of us and doesn’t return it, “We’ll Be Back!”

The Lamb has always been fascinated by the concept of hyperinflation — the rapid and extreme rise in the price of goods and services — (and by Michigan Football’s inability to stop a spread offense, but that’s another story).  The most fundamental causes of (hyper)inflation are an increase in the supply of money and/or a (corresponding) decrease in that money’s value.

Perhaps the most dramatic example of hyperinflation occurred in Germany during 1923-24.  Following World War I, the Allies forced Germany to sign the punitive Treaty of Versailles.  Among other things, the Treaty forced Germany to admit responsibility for the war and to pay for its damages.  The German economy, in tatters following the war, was unable to generate enough money to pay its debts.  The country embarked on a crash course of currency creation, running its printing presses non-stop.

This had the effect of quickly eviscerating the value of the German currency.  At the beginning of 1923, it took 9000 German Marks to buy one U.S. dollar.  One year later, the rate was 100 trillion marks to the dollar.  The country was futilely attempting to print its way out of debt, but only succeeded in making its currency next to worthless:

In Germany one morning in early 1924, a woman was on her way to the bakery to buy bread for her family.  Suddenly, a man accosted her, grabbing the bag she was dragging behind her which carried the trillions of marks she needed to buy bread.  As she begged him to return her money, he emptied the bills onto the street and replied, “Keep the money, I just want the bag.”

One Trillion Marks -- Almost Enough For Bread in 1924

Segue back to this side of the pond.  Congress has passed and the President has signed the now (in)famous $700 billion bailout/stimulus/rescue plan.  Now, $700 billion (the final tab could be less) may not be huge when compared to our roughly $14 trillion economy.  Yet, this spending/printing of dollars is all too typical of America’s solution to economic problems (see 1980’s Chrysler loan guarantee, 1989’s Savings & Loan bailout, and this year’s massive Bear Stearns backstop and AIG rescue, just to name a few).  Uncle Sam has even committed money to protecting over $2 trillion in money market fund assets — see the post 2 + a + 7 = 50,000,000,000.

One may argue that the Feds undertook a similar strategy in the 1930’s to counteract the consequences of the Great Depression, with relatively few ill effects from runaway inflation.  While we can debate the wisdom of New Deal programs, the fact is that the United States was a creditor nation then (an idea that is a distant memory now) and, more importantly, was on the gold standard.  Our current system of fiat money leaves us far more susceptible to a rapid decrease in the value of the dollar.

The Fed, under its last two Chairmen, has been more concerned with deflation than inflation.  They have targeted a low federal funds rate, or as The Lamb calls it, “growth at any cost.”  In fact, Fed Chairman Bernanke has given speeches bemoaning the dangers of deflation. Unfortunately, by the time inflation rears it ugly head the next time, it may already be too great to contain.

The deadweight loss created by the Troubled Asset Relief Program (TARP) is just the latest in a tragedy of financial errors — see the post Brother, Can You Spare 7 Trillion Dimes? And when considered alongside our roughly $800 billion current account debt (cumulative trade deficits) and our $10.1 trillion national debt (not to mention future expenditures for entitlement programs like Medicare and Social Security), you get total debt of nearly 80% of the U.S. gross domestic product (GDP) and rising…

Now, not even The Lamb, as long-term bearish as he is on the U.S. Dollar, believes that we are on the cusp of hyperinflation.  Though the Dollar has been on a terrible slide this decade (see chart below of the U.S. Dollar Index, courtesy of fxstreet.com), it has shown signs of life the past few months.

Look Out Below.....

However, the recent strengthening of the greenback is due largely to the ubiquitous need of corporations and banks to make outright purchases of needed dollars that they are unable to borrow in the credit markets for their ongoing financing activities.  The dollar may very well continue to rise until lending in the money markets returns to equilibrium.

But if/when the dollar restarts its slide, it may be swift. That may be a good time to put The Lamb’s Rule #7 into action — If you’re gonna panic, make sure you’re the first.

Severe inflation would have a few tertiary advantages for some.  Homeowners’ existing fixed-rate mortgages would effectively be wiped out as the dollar’s value plummeted, essentially producing mortgage-free homes.  Other hard assets, from cotton to coffee and from silver to soybeans, would also rise in value on a dollar-basis.  Those that owned these “real” assets would enjoy a modicum of protection from the ravages of breakneck inflation.

However, there would be a catastrophic downside.  Interest rates would soar and those lenders that hadn’t already been forced into bankruptcy would be wary of lending at all but the most punitive of terms.  Furthermore, the price of goods and services would soar as sellers sought to stay one step ahead of our crashing currency.  Commerce would screech to a halt.

Let’s remember, a slowing economy, even a recession, is not the end of the world.  It’s called the business cycle.  This country, actually most countries, go through periods of economic contraction.  This is a natural way for the economy to build a stronger and more stable base from which to maintain long-term growth.  As painful as economic slowdowns might be, they are far less deleterious than the flip side — runaway price increases.  See Zimbabwe’s current 531 billion percent inflation as a savage example.

Call The Lamb Chicken Little, but he’ll take a weak economy every now and then if it means he’ll never be emptying out a bag packed with cash just to make it easier to carry.

Disclosure: The Lamb owns UDN and CYB, two exchange-traded funds expressing bearish views on the U.S. Dollar.  The Lamb also owns GLD, a trust that buys and holds gold bullion.