“My Two Cents”
By Andy Sutton

7/26/2006

The rhetoric surrounding the upcoming Fed meeting is beginning to reach fever pitch. Will they go again? Will they pause? Maybe a 50 basis point hike, then a pause? Speculation is running like wildfire in the financial community. Truth told, the Fed is in an unenviable position. In one corner, they have the dollar; the world's reserve currency and safe haven when things go wrong. In the other corner, they have 70% of GDP in the form of consumer spending, in essence, the lion's share of the US economy. Lets lay some groundwork and hopefully the reason the Fed is in such a bind will become crystal clear. The following are just some of the issues facing the Fed as it sits on the precipice in the upcoming weeks.

Issue #1 - Zero Savings
Americans for the first time since the Great Depression stopped saving in 2005. That savings rate has remained negative. Some blame high energy prices, some blame profligate spending. It really doesn't matter. Americans as a whole are now dipping into the savings they do have to pay their bills. Those who have no savings are accumulating debt, much like the US Government. Even a modest slowdown in the economy will mean the loss of jobs. Since savings have dwindled, many households will become insolvent. A frightening number of households live paycheck to paycheck as it is. We can't endure a recession without major fallout.

Issue #2 - Current Account / Trade Deficits
These two issues by and large are not understood by most Americans, but they become critical when you look at how we deal with the world in a financial sense. In simple terms, they are an indication of the cash flows of the country. In both cases, the cash flows are negative, which means we're sending money out faster than we're bringing it in. In the case of the trade deficit, the imbalance is over $60 billion per MONTH. Every so often a politician or economist will be heard uttering the words 'so what?' The reality is that, as a nation, we are now dependent on others for our continued survival. Americans pay for foreign goods with dollars. Those foreign governments take those dollars and give them back to the US Government by purchasing our Treasury Notes. Now the Government has to make periodic interest payments on those Notes, then eventually return the principle to the holder of the Note. In essence, our dollars leave the country as an asset, and return as a liability. If foreign investors stop buying Treasuries and sell their dollars en masse on the open market, the value of the dollar will fall overnight. Right now, they keep buying, mainly because there is an illusion that they need us to buy their goods. This is not the case. Those countries could very easily consume their own goods and improve their own standard of living as opposed to sending their savings here for us to gobble on an unending stream of frivolities.

Issue #3 - Unfunded Future Liabilities
When you add up Social Security payments, Medicare, Medicaid, Welfare and all the entitlement programs, plus the very real potential of war on at least 2 continents, the numbers range anywhere from $50 trillion to $120 trillion. Its hard to get an accurate number, but even at $50 trillion, it is well in excess of the aggregate worth of every property, asset and bank account in the United States (roughly $42 trillion give or take). This money will be owed in the next 10-20 years. The government, like most households, has no savings to pay for any of this. There are going to be two choices: Cut benefits or print the money (inflate).

That leads us back to the Fed. Central Banks around the world are beginning to raise their interest rates. This is going to put pressure on the Fed to do the same or risk other currencies, particularly the Euro, becoming a more attractive safe haven. However, if they raise rates, the housing market, which provides the catalyst for much of the spending that's been driving the economy, will suffer. Many say the Fed has already gone too far in terms of the health of the housing market. So do they go again or not? I am quite certain at this point that the hand of the Almighty isn't going to descend from the heavens laden with gold, wisdom and production capacity to bail us out of this mess. There isn't going to be any great intervention. We made this mess, now we're going to have to deal with it. We're going to either lose our currency, or our economy. I am going to bet the Fed chooses the currency and pauses; if not in August, then shortly thereafter. Pull a dollar out of your wallet. George isn't smiling is he? He knows his days are numbered.

Andy Sutton holds an MBA in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics.

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