Sponsored Links

Econolypse Now! – Three Possible Scenarios

The current economic downturn is going to get bad, really bad; but just how bad remains to be seen.  The downturn could be mild, resulting in leaner and more efficient labor and capital markets.  Or, things could get disastrous resulting in the collapse of the United States government and life as we know it.  This 3 part article will discuss 3 possible scenarios: the best, the most likely, and the worst case.  Included in the article are investing tips that will allow you survive and thrive in the post-Econolypse world.

Best Case Scenario

In the best case scenario, the stimulus package is a smashing success resulting in not only an economic recovery but steep economic growth and wealth formation. In this scenario, funds from the stimulus package miraculously make it through the federal, state, and local bureaucratic gauntlet to the Thomas Edison of cold fusion, leading to the rapid development and implementation of this game changing form of energy.  Obviously this scenario is a long shot and only possible with a monumental technological breakthrough.

The discovery of cold fusion is the best candidate to save us from economic Armageddon.  Cold fusion essentially allows for an unlimited energy supply.  This new source of cheap and abundant energy dramatically reduces the energy input cost for manufacturing, transportation, and household utilities, thereby drastically increasing productive output of the United States.  This increased output leads directly to increased incomes for all American.  The U.S. government would also be flush with funds, so the impending entitlement crisis is postponed indefinitely.

Investment Strategies

In the best of circumstances, you want to be heavily invested in U.S. Corporations and currency.  Prosperity will spread across every sector of the economy but especially in energy, utilities, transportation, and manufacturing.  Dollar cost average investing of index funds of these sectors would be a good place to park your investment dollars.

The strength of the dollar would dramatically increase relative to other currencies; therefore it would be best to avoid foreign equities especially from emerging markets.  In the best case scenario, all world stock markets would increase but just not as fast as the U.S. Stock Market.   Furthermore, the renewed confidence in the U.S. Economy and the dollar would burst the current gold bubble.  If you are heavy in gold, now is a good time to start doing some dollar cost average selling.

Living on a Prayer

The best case scenario offered here is really more of a prayer than a possibility.  The belief that President Obama’s stimulus package of extending unemployment benefits or eliminating welfare reform will somehow increase America’s productivity is magical thinking.  It’s a tribute to the Liberal Gods in the hope that they will bestow upon us mortals rising GDP and house prices.  It is really no different than primitive man’s attempt at increasing his harvest by sacrificing a virgin to the Sun God.  Our only hope is that some guy somewhere will coincidentally invent something that allows us to leap ahead in efficiency and productivity.  It is a reassuring thought to think that there is some tinkerer in his garage right now perfecting some new invention that will pull us out of our current economic peril; but it is just not going to happen.    

If the best case scenario is hopeless, then what as investors and citizens, can we expect?  The most likely and worst case scenarios paint a bleak picture of the U.S.’s economic future.  But it is this writer’s opinion that you are not responsible for everyone's prosperity.  You are only responsible for your prosperity, and having the proper foresight, you will be able to thrive in even the bleakest of economic scenarios.   (Next – Econolypse Now Part II – The Most Likely Scenario)

Econolypse Now – Part II – The Most Likely Scenario by Capitalist Hero

In our previous article, Econolypse Now Part I, we presented the best case scenario of the economic crisis.  In that article, it was assumed that President Obama’s stimulus package (American Recovery and Reinvestment Act of 2009) would work resulting in a quick recovery.   In this article, we will discuss the grim reality of our economic circumstances and provide investing tips to survive and thrive in the post-econolyptic world.

Most Likely Scenario

In the most likely scenario, the stimulus package will fail for the reasons outlined in a previous article (Keynesian Economics – A Flawed Economic Theory).  The chorus from the left will predictably call for more entitlement spending and wealth transfer payments, as if this would somehow stimulate economic growth.  The second round stimulus package will be more difficult to fund as our foreign creditors will grow increasing reluctant to sponsor our government’s boundless appetite for profligate spending.   Having no ‘bigger fools’ to buy U.S. debt, the government will have to buy its own debt vis-à-vis the Fed.  This action is the equivalent of printing money.

The U.S. will confront both double digit inflation and unemployment leading to an era of stagflation.  The painful progress of de-leveraging will commence, and with no new sources of funding to ramp up consumer spending and debt, the government will be incapable of preventing it.   Having exhausted his credit cards, home equity line of credit, and meager savings, the U.S. consumer will be forced to severely decrease his consumption.  What’s worse is that the American savers and investors (yes there are still quite a few of us) will have our life savings wiped out by the inescapable inflation.  Pensioners will see the purchasing power of their monthly stipends plummet.

Changes to our Economy

The current financial crisis is essentially a crisis of debt.  We, as Americans, have consumed much more than we have produced for more than a decade.  We have purchased tangible goods from abroad and have paid for them with intangible dollars and Treasury Bills.  We have run huge federal deficits financed by T-bills purchased by foreigners.  We have accumulated outrageous mortgage debt again financed by foreigners.  The problem is that we have nothing to show for these trillions of dollars in debt aside from a few poorly constructed McMansions in Victortiville and Barstow.  We didn’t use the debt for capital formation which we could have used to produce tangible goods.  Goods we could have exported to pay off our debt.  Servicing this debt will require significant changes to our economy and standard of living.

As noted in David L. Smith’s Cassandra Chronicles, there are three ways to pay down this debt:  “1) Earn more and/or spend less and apply the surplus to pay down debt.  2) Voluntarily sell assets and use the proceeds to pay off debt.  3) Default.”  All three strategies will be employed but default will be the Federal Government’s major device for paying down debt.  The Government won’t actually repudiate its debt, but it will devalue the dollar so much that it will, in essence, pay back its creditors with worthless paper.

Investment Strategies

This debasement of the currency means inflation – big time inflation.  Start divesting yourself of dollars now.  Buy mutual funds of international companies like AEGPX, VTRIX, VGTSX, and VEIEX.  Buy these funds now while the dollar is relatively strong.  Commodities are the best hedge against inflation.  ETF’s DBA and DBC will give you adequate exposure to energy, agriculture, and gold.  Both funds are down 42 and 44 percent over the past year.  Foreign holders of the dollar will use EBAY a major means of repatriating the dollar as foreigners buy everything in the USA that isn’t nailed down.

 Buying a house is another great hedge against inflation.  I know this sounds counter intuitive as house prices continue to plummet, but it is a reasonable idea once you do the math.  Buying a distressed asset with a 30 year fixed at 4.75% makes sense in a climate of high inflation.  If you are in the highest tax bracket, then your effective interest rate is only 3.00%.  Assuming inflation tops out at 12% then your real interest rate is -9.00% (3.00% - 12%).  You are getting a 9.00% return on money you are borrowing from the bank.  Furthermore, in the setting of high inflation, all real assets will have a nominal appreciation.  Again assuming a 12% inflation rate and a nominal appreciation on your house of 5% (i.e. real appreciation of -7%) your rate of return is 14% (real rate of return 2% (14% -12%)).  Therefore, you are making a 2% tax free real rate of return on money borrowed from the bank.  You can make money on your house even as it depreciates in real terms with the added bonus of getting a place to live. 

Finally, having hard assets on hand is always prudent.  Get yourself a house safe and put some gold bullion in it.  Try to buy it anonymously off Ebay or with cash from a registered dealer.  No one needs to know you own precious metals, least of all the government.  Surprisingly, firearms maintain their value and they would definitely come in handy if the economic situation deteriorates more than expected leading to civil unrest and looting.  Artwork is another hard asset that maintains its value well and may even appreciate.  As with all assets just be careful not to overpay.

Hope for the Future?

The U.S. does possess many positive attributes that will allow us to rise from this economic funk.  We are the most capitalized nation in the world allowing our workers to be the most productive in the world.  It is imperative that the U. S. transforms itself from a service based economy to a manufacturing economy.  This will be made easier by the devaluation of the dollar as American goods are cheaper abroad and imports become more expensive.  Of course there will be significant real wage deflation as wages would have to come in line with the other foreign manufacturing nations.

The U.S. can be an export driven nation provided the government does not impose short sided regulations in an attempt to mitigate the pain from this transformation.  Specifically the government should:  1) Avoid interference in the currency market in an effort to support a “strong dollar.”  2)  Avoid protectionist tariffs and subsidies in an effort to protect pet industries.  3) Avoid the temptation to set a maximum or minimum wage for particular industries.  4)  Avoid placing price controls for key commodities.

Needless to say, the public clamoring to enact the above mentioned market distorting policies will be deafening.   Every congressman who has an endangered corporation in his district, every  industry lobbying group who’s profit is threatened, and every union group who’s wages are diminished will scream bloody murder.  It will take a significant amount of political fortitude to withstand this cacophony of pleas and threats.  As of late, our politicians have lacked that level of courage.  This is a serious ball check for our leaders; and if they wilt under the political pressure, we may face a Doomsday Scenario.

Econolypse Now Part III – Doomsday Scenario by Capitalist Hero

In earlier articles, Econolypse Now Part I and II, we presented the best and most likely scenario of the current economic crisis.   There is, however, a darker more ominous possibility, one where hyperinflation ensues, confiscatory taxes are imposed, property rights are rescinded, price and wage controls are enacted, and emigration is prohibited.   Although improbable, this Doomsday scenario is a real possibility.  Everyone will suffer in the post-econolyptic world, but if you follow my advice you might just survive.

Doomsday Scenario

In the Doomsday Scenario, TARP 1, TARP 2, TARP 3, etc. have failed.  Our Asian benefactors have balked at subsidizing our consumer consumption and government spending.  Desperate to service its colossal debt, the federal government will take desperate measures.  Insidiously, the government will tolerate a high rate of inflation by keeping the federal funds rate and reserve requirements for banks low.  The subsequent reduction in purchasing power will act as a regressive tax.  Individuals dependent on fixed income vehicles will face a steep reduction in their standard of living.  The conservative investor who placed his life savings in T-bills, savings accounts, and other low yielding vehicles will be wiped out.  Government dependents and pensioners whose benefits are pegged to the CPI will also feel the bite of inflation as the government measured CPI will continue to underestimate inflation.

When the working poor and government dependents feel the sting of their decreased purchasing power, the rancor from their advocates will be deafening.  Hysterical pleadings for increased benefits and concomitant solicitations of increased taxation of the “rich” will dominant the political landscape.  Of course inflation and bracket creep (Warning! Bracket Creep Ahead!) will make the definition of “rich” much more inclusive.  The millionaire janitor may be surprised to find himself in the top bracket.  Of course the government will be surprised to find fewer and fewer “rich” to tax as more and more workers voluntarily drop out of the workforce and into government dependency.

Once social security starts to go unfunded, the elderly electorate will demand action.  The U.S. government might decide that your 401k is public property, besides it’s not fair that some people had the forethought to save for retirement and others did not.  Your 401k will be liquidated and distributed amongst the spendthrift baby boomer masses.  If the government gets really desperate, stock portfolios, trust funds, insurance policy, will be taxed at confiscatory rates with the proceeds going into the public treasury to be distributed to those unfortunates who failed to save and invest.  Needless to say the estate tax will remain intact and strengthened.  After all, it’s not fair that certain individuals will receive a windfall just because they are “loved one” of parents and grandparents who worked and saved in order to leave them a nest egg.

Medicare and Medicaid will be the first to go bankrupt.  They will be replaced by universal health care which will set controls on supply.  Supply will be restricted by price controls as prices will be set at artificially low levels.  The Laws of economics dictate that when a good’s price is set at an artificially low level it will be over consumed and under produced.  What this mean is that doctors will reduce the supply of care they provide. 

Why would a doctor take call over a holiday weekend if he’s not are not going to be reimbursed at a reasonable level.  Furthermore as physicians’ incomes drop, talented young people who would have become doctors will self select for more profitable industries.  Medicine will be awash with C- students as the field goes the way of public education, where mediocrity is championed and innovation is stifled.  In the doomsday scenario, the government will prohibit patients and doctors from opting out of the system; so even if you are rich it will be illegal for you to obtain private care.  We will all be relegated to Medicaid-like insurance and government run hospitals where care will be rationed and doctors won’t care.  Things like dialysis and chemotherapy will anachronisms- something for rich people who can afford to get private care in Mexico or Costa Rica.

Hyperinflation, of course, means that prices of everything will skyrocket.  Commodities like gasoline, milk, etc. will be deemed too essential for market pricing and price controls will be established.  As stated before, when a good’s price is set artificially low, it is over consumed and under produced.  In the Doomsday scenario, we will drive to the gas station with our trunk full of hundred dollar bills only to find the pump is dry; or we will take our wheelbarrow of cash to Wal-Mart, hoping to buy milk and eggs, only to find bare shelves.

I know what you’re thinking.  You’re thinking that you will avoid all of this mess by physically holding precious metals.  Well, you better hurry, because once hyperinflation sets in the government will prohibit private citizens from owning precious metals.   Also, the government will demand that all transactions are executed in dollars and bartering and in-kind exchanges will be illegal.

Capital goes where it is treated best and many wealthy and productive people will seek to emigrate to more hospitable nations.  The federal government will prohibit certain individuals that they deem essential from emigrating.    Physician, engineers, computer scientists, etc. will be deemed too important to the economy to be allowed to leave.  Wealthy people will face prohibitive taxes if they chose to leave.  If you are rich you can leave; but they are going to leave your wealth here.

Survival Strategies

In times of hyperinflation, owning material goods, that you can barter, is essential for your survival.  Precious metals and foreign currencies are the obvious choice.  If things get really bad, then even gold will be worthless.  You can’t eat gold.  Nonperishable food items, gasoline, firearms, and ammunition will be the new currency.  Tradesmen with real skills will be at a premium.  Carpenters, mechanics, electricians, and appliance repair men will be the new elite.  Therefore learning a skilled trade may in the future, be more valuable than an Ivy League education.

Conclusion

The best, most likely, and doomsday scenarios, discussed in this and previous articles illustrate investment and survival strategies for each of these situations.  In the best case scenario, the US economy leads the rest of the world into recovery.  In this scenario, purchasing domestic stocks at their current low prices will be the buying opportunity of a lifetime.  In the most likely scenario, double digit inflation will ensue but the infrastructure of the economy remains intact and property rights are respected.  Hedging inflation is the best strategy in this scenario.  Owning funds indexed to commodities and foreign markets will be sufficient.  In the doomsday scenario property rights are rescinded, confiscatory taxes are enacted, and emigration is limited.  Survival strategies in this scenario include physically holding hard assets and learning a trade in which in-kind exchanges may be negotiated.  Time will tell which scenario plays out, but my advice to you: hope for the best and prepare for the worst.