Investment U E-Letter: Issue # 521
Monday, March 27, 2006

Is the U.S. Economy in Crisis? Seven Trends Spell Out an Economic Medley of Woes
by Mark Skousen, Chairman, Investment U.

Last week, I gave a lecture at Columbia University on Ben Bernanke: Can the Fed Survive the Coming Monetary Crisis?”

The basis of my remarks is a warning issued by none other than Paul Volker, former Fed chairman, who wrote the following statement a year ago:

The U.S. is skating on increasingly thin ice. There are disturbing trends: huge imbalances, disequilibria, risks - call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot.

One might expect to hear such a statement from a hardcore gold bug, but from a former Fed chairman? Volker, in my judgment, is the best leader of the Federal Reserve we have ever had. His job of stopping inflation in the early 1980s was much tougher than any of the crises Greenspan faced.

What would cause Volker to issue a jeremiad?

The fact is, we do face some powerful negative forces down the road that could lead to a dollar panic, a stock market crash, or a banking crisis. And here is what’s driving a possible U.S. economy crisis scenario…

A U.S. Economic Medley Of Woes

1. An overreacting Fed, switching from “easy money” to “tight money.” The Fed has been a major source of instability in the financial system. For example, Greenspan was chairman for 19 years, and switched policies seven times! The Fed often overshot its target on both ends - raising interest rates too high in 1989, 1994, and now, and pushing them too low in 1992 and 2003.

2. Inflation and structural imbalances. The Fed’s “easy money” policy caused in part the “irrational exuberance” of the tech stock-market bubble in the late 1990s and the real estate bubble in this decade. When the bubble bursts, as it inevitably must, the effects aren’t pretty.

3. Poor consumer/investor finances. Our government policies promote overspending and undersaving on a massive scale. The saving rate has turned negative, and household debt as a percentage of personal income is at a dangerous level. (See chart below.)

4. A vulnerable financial/banking system. We live in a global laissez faire financial system that is highly leveraged with debt financing, derivatives and fractional reserve banking. Hedge funds are not really “hedged,” but highly speculative, and another collapse along the lines of Long Term Capital Management could be disastrous. (Long Term Capital required a bailout of $4 billion in 1997-98.)

5. Trade deficits and out-of-balance capital flows. The trade deficit is at record levels. To make up this imbalance, foreigners must invest $2 billion a day in the U.S.

6. Overburdened federal debt levels, unfunded liabilities and rising interest rates. The Senate just raised the national debt ceiling to $9 trillion, representing 70% of GDP. Interest expense is now the third-largest category of the federal budget, only exceeded by defense spending and domestic welfare expenditures. Imagine the impact as interest rates start climbing again

7. The rising cost of war /

The single indicator I use to monitor global instability is the price of gold. It is the numeraire of global economics. Right now, the price of gold is around $550 an ounce. This is substantially above its lows of 2001, when it was under $300 an ounce. But it’s still substantially below its all-time high of $850 in 1980, when inflation was a double digit.

If the price of gold keeps rising, and spikes upward, we’re in trouble. If it stays down, we are still on the road to prosperity.

Today’s IU Crib Sheet

• Since Americans are spending all their paychecks on current consumption, or borrowing to spend even more, almost everybody these days is cash poor. Check out Investment U # 467, Powerful Financial Planning Tools: What We Can Learn from the Monetary Shock of 2005 that No One is Talking About, and find out just how bad our savings habits have become and two steps to take now to offset the damages of this fact.
• What would be the effect on the dollar if foreigners stopped buying U.S. Treasuries? They have already dramatically cut back on buying them Learn more about this crisisand the toll it takes on the U.S. economy - Investment U # 471, Foreign Buying of National Debt: The Day Countries Stopped Purchasing Our Debtand a Seismic Shift in Investor Psychology, has all the details. And while you’re at it, revisit Investment U # 507, in which you can learn how to maximize your profits in overseas investments.

Good investing,

Mark

Related Articles:

• How to Profit From Ben Bernanke & a Volatile Federal Reserve
• U.S. Economic Outlook: The Doomsday Myth, the “Boomsday” Reality, and Forecasts and Predictions for the U.S. Economy
• Inflation’s Effect on the Stock Market: Why Good News is Bad News on Wall Street, Inflation as a Legitimate Fear on Wall Street, and the Perversity of the Stock Market Explained
• Ben Bernanke and the Economy: How Bernanke Can Keep Stocks Rallyingand Greenspan’s Final Report Card

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