Casey on Government as Gorilla

Casey Research provided the following in an email. Doug Casey is a savvy guy as is David Einhorn who is quoted below. For investors, this might be a good read. At least it should cause you to examine your own investment assumptions.

The Gorilla Trade

Dear Reader,

It has become common for governments to levy large fines against successful companies. For instance, when the EU poked Intel in the eye in 2009 for $1.45 billion for being a tough competitor, an action the U.S. is now looking to get in on itself. Likewise, Microsoft has been forced to pay up over $2 billion and to unbundle much of its own software from its Windows operating system.

For the sake of discussion, let’s assume that, as a regular computer user, I were one of those fully disadvantaged by these miscreants. Let’s further assume that the extent of my lifetime losses – because I personally buy a new computer approximately every couple of years, and Microsoft’s software and Intel’s memory chips were components of those computers – might total the entire $8,000 I estimate I may have spent on their products.

In exchange for my dollars, I’ve received an extraordinarily useful set of tools, starting with the Word processing software I’m using to write you at this very moment. And the amazingly powerful laptop that I’m working on. To achieve the same computational power packed into its two pounds would have required a computer that filled a good-sized building thirty years ago.

No one has forced me to pay for my computing power or threatened me if I did not. And I didn’t need to pay up front for the billions these companies spent researching the improvements that have taken us from buildings to laptops. They took all the risk, confident they could build better technology than the competition, and that they would be able to charge a market price that allowed a tidy profit.

All we had to do, dear reader, was to sit back and benefit from their progress, periodically dipping into our savings to upgrade or buy the hot new computer resultant from their efforts.

Now, I don’t know how much time and money these organizations have saved me over the last thirty years, but I suspect the savings were far more than the $266 a year I estimate having spent.

By contrast, there is the government that is now bedeviling these, and all, companies. Even though I do not live in a particularly fancy or expensive house, this year alone I’ll pay the state government over $14,000 in property taxes. If I fail to pay these property taxes, my house will be sold out from under me. And that’s the least of what the government now costs each of us. Suffice to say it is exponentially more than I spend on computation, or even what my family spends on the necessities of life itself: shelter, food, power, clothing, etc. combined.

What does this have to do with investing? Everything, these days.

In our quest to extract important knowledge from the ocean of information, we use a number of analytical approaches. Yet no line of analysis has become more important than understanding the government’s actions as they relate to the economy.

That’s because the growth in the scope of government and the operations it has taken on have made it dominant in the economy. Today these operations have expanded well beyond the irksome nanny state activities of blessing all the food we eat, deciding the curriculum our children must learn at school, and how many warning stickers a ladder must carry, etc., ad nauseam and involve spending trillions of dollars the government doesn’t have to promote and propagate all manner of politically motivated ends.

Speaking as an individual and as a citizen of this former hotbed of economic freedom, the bloated role of the government is deeply concerning. Speaking as investors, however, accepting the irrefutable truth that the government is now in control of the commanding heights allows us a unique opportunity to profit. That’s because rather than having to anticipate how tens of millions of independent entities might act, we’re able to position ourselves in a  productive trend – or step out of the way of an unproductive one – by understanding what actions the 300-pound gorilla in the room is most likely to take next.

Calculating the gorilla’s next move is as easy as identifying what will most enhance the ruling party’s fortunes in the next election. While some poor, deluded fools may still believe that officialdom acts with the “public good” in mind, history has shown us time and again that the political path is not the hard path – for instance, addressing the unsupportable burden of Social Security and Medicare. Instead, the political path is the shortcut, the easiest possible route to delivering pabulum to the squalling majority ahead of the next election.

Since the latest experiment in pure fiat money began in 1971, the handiest form of nourishment has come from ginning up as many dollars as is deemed necessary to paper over whatever ails.

I recently came across the text of an interesting speech by David Einhorn, the highly respected investor and head of Greenlight Capital. It was interesting, not because his views were new to us, but rather because they echoed our own. A relevant quote:

Four years ago I spoke at this conference and said that I favored my Grandma Cookie’s investment style of investing in stocks like Nike, IBM, McDonald’s and Walgreens over my Grandpa Ben’s style of buying gold bullion and gold stocks. He feared the economic ruin of our country through a paper money and deficit-driven hyperinflation. I explained how Grandma Cookie had been right for the last thirty years and would probably be right for the next thirty as well. I subscribed to Warren Buffett’s old criticism that gold just sits there with no yield and viewed gold’s long-term value as difficult to assess. However, the recent crisis has changed my view.

The question can be flipped: how does one know what the dollar is worth given that dollars can be created out of thin air or dropped from helicopters? Just because something hasn’t happened, doesn’t mean it won’t. Yes, we should continue to buy stocks in great companies, but there is room for Grandpa Ben’s view as well. I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money-printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with. When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one of these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

The Gorilla Trade

As we embark upon a new year, other than Einhorn and some of his more intelligent colleagues, most of the mainstream analysts are now circled around the view that the dollar must rally and that that will be bad for tangible assets such as gold and silver. As Bud Conrad points out in his 2010 Forecast article in this month’s edition of The Casey Report, this view also expects a steady improvement in GDP and in unemployment.

While we can’t know for sure, and no one can, we are far less sanguine about what’s coming next. Given that the reins of the U.S. economy are now firmly in the hands of politicians, and will remain so (the color of their boutonnieres means little), we must look to them – to the gorilla – to see what’s coming next. And what’s coming next is a very important mid-term election that the ruling party knows it will lose if it doesn’t “fix” unemployment, and fast. While there are many tools the gorilla might apply to the task, the ones that can actually have a lasting effect – e.g., cutting spending to free up capital for the real economy, reducing taxes and regulation – will be left in the drawer in favor of using the fiat monetary system in an attempt to reflate the economy on a sea of new money.

Why not push for a lasting effect? Simply because reducing taxes on businesses and productive individuals, or reducing regulation while simultaneously reducing government programs, would anger large swaths of the loyal supporters of the current administration. They expect socialism, and so socialism they will get, good and hard.

Trading on this entrenched trend has seemed to us for some time, as it now does to Einhorn, the most logical approach to take in the new year. And that doesn’t mean simply buying and holding precious metals and stocks – though those should do very well. Rather, it means trying to anticipate the effects on business and housing prices, and other corners of the economy, particularly bond markets, as the increasingly worthless money washes in.

In the coming year, there will be opportunities galore, but also risks aplenty. And no risk more potentially serious than that the dollar will crack, triggering the currency crisis we expect to see before the last page on this crisis can be closed.

Is our view too contrarian? Paradoxically, we believe our thinking is conventional when viewed in the context of monetary history. To expect that the latest 39-year experiment in fiat money will end differently than the abject failure that has been the hallmark of all the other experiments in fiat money that have preceded it, would be to expect the exceptional.

While we have written frequently on the topic of the impending currency crisis, we’ll let Einhorn weigh in again, if for no other reason than the import of his views as indicative of a growing number of other large fund managers…

When the government calculates its debt and deficit, it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to shadowstats.com, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis. Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger.

Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action. In the nearer term, the deficit on a cash basis is about $1.6 trillion or 11% of GDP. President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade.

The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

The year ahead is going to bring many surprises, with the serious potential that we’ll see one or more black swans land. But it should come as no surprise to anyone – though it will – if the fiat currencies continue to weaken against tangible assets.

Nor will we be surprised to see the gorilla acting in increasingly desperate ways as it tries to avoid being gutted in the next election. No small task, given the size of the problems now confronting it.

I started these musings by referencing the computer industry and the clear cost versus benefits that have received from it. There was a time long ago when the gorilla, just a little feller at the time, provided good value. But not today. Today the gorilla is the problem. You will either learn to make it your friend, by essentially front-trading it or to get out of its way by getting out of the country, or you risk being crushed.

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