Why the “Only Way Out” Offered Won’t Work This Time

monetary policySince the financial crisis hit in 2008, central banks around the world have enacted unprecedented expansive monetary policy that has been extreme and unusual. (In simple terms, they’ve printed money like never before.)

The hope was that by lowering interest rates to record lows and printing money, economic growth would be kick-started and get back on track to the levels seen before the crisis.

Three years later, central banks are left with the same hope. But central banks now have fewer monetary policy options, since interest rates in many countries, including the U.S., are close to zero.

Last week, China cut interest rates for the first time in three years, as economic growth in that country has fallen to the point where talks of a hard landing are gaining momentum. The People’s Bank of China is hoping this monetary policy response will stop the slide and move economic growth back to levels that recently made the country the envy of the world.


India just cut its interest rates for the first time in three years, as it used this same monetary policy (lowering interest rates) to counteract slowing economic growth. Last week, Australia also cut its interest rates.

Europe and the U.S. would attempt to follow this monetary policy of cutting interest rates, but their rates are almost zero.

As of late, the heads of two of the largest central banks in the world (the Fed and the ECB) have pointed to the fact that it is up to the politicians to enact policy to spur economic growth. The monetary policy of cutting interest rates is not working.

How have governments around the world responded? Here in the U.S., politicians just don’t get it. They bicker about raising the national debt ceiling, while not altering our economic policy to create economic growth.

But let’s face the facts. If corporate and personal taxes go up in America, businesses will not be encouraged to grow their businesses and consumer spending (which makes up 70% of the U.S. economy) will pull back. Cut government spending and, in general, more people are added to the unemployment line. It’s a no-win situation. Hence, the desperate need for an easy monetary policy.

In Europe, there are so many emergency meetings being held that I’m tempted to buy European hotel stocks. The issues center on bailouts and putting out fires. Germany is right that out-of-control spending cannot go on forever. However, its monetary policy dictated by austerity measures is killing economic growth. The plan needs to be altered.

China is being proactive. It has introduced a plan to fundamentally shift its economy from an export-based economy to a consumer-oriented one. The problem with China is that the transition is going to be painful: this is a meaningful change that takes years to enact.

In the meantime, China was hoping economic growth from around the world would help it transition. This is not meant to be, hence last week’s monetary policy response of lowering interest rates.

Central banks are right in saying that their monetary policy of lowering rates is having limited effect and so governments must do their part. With governments—outside of China possibly—not fundamentally changing their economic policies, economic growth looks like it will be difficult to achieve.

Hence, the risk of a global recession is real. If the world economy worsens, then central banks, which have already used up the monetary policy of lowering interest rates, will have no choice but to enact their only other monetary policy: money printing.

Yes, the only monetary policy option left is more money printing. Gold bullion and gold stocks will be the place to be, as governments continue to hope and print. (Also see: Another Reason to Own Gold-related Investments.)

Michael’s Personal Notes :

I’ve been detailing the plight of U.S. municipalities and states in these pages. Unfortunately, the situation can only deteriorate from here.

The main problem facing all states and municipalities is the budget deficits with their pension funds. I believe what the states and municipalities are not telling us is that they have not changed their future projection of earnings for their pension funds.

Put another way, in this low-interest-rate environment, the average pension fund in America is still projecting average annual returns of seven percent to eight percent on their investment portfolio (source: The New York Times, May 27, 2012).

This return is fantasy in this low-interest-rate environment and with an incredibly volatile stock market. If we look at the past, the National Association of State Retirement Administrators has stated that, over the last 10 years, the return for public pension funds has been 5.7%.

This 5.7% return occurred during times of higher interest rates!

So why won’t states or municipalities allow their public pension funds to take down their unrealistic rates of return? The answer: higher taxes and bigger budget deficits.

In Rhode Island, for instance, the state treasurer lowered her pension rate of return from 8.25% to 7.5%. This move increased the budget deficit by $300 million.

This $300-million budget deficit is not paid for by additional government debt, but by union members who must increase their contributions to the pension fund. If Rhode Island were to propose returns in-line with the past 10 years at 5.7%, then the budget deficit would increase by $600 million more, bringing the total to $900 million members who would have to pay to fill the pension budget deficit!

In New York, there is a proposal to lower the pension return and it is being contested by the unions. The proposal is to reduce the return of the public pension fund from eight percent to seven percent.

This one-percent change results in an additional budget deficit hole of $1.9 billion, which will not be financed through government debt. The union members would have to pay higher contribution rates to make up the difference. If returns are five percent, it would mean an additional budget deficit of $3.8 billion that members would have to pay into!

In San Jose, California, the city wanted to lower the unrealistic 7.5% return from the public pension fund there. The unions contested it, because they do not want to pay the difference in taxes to plug the budget deficit.

As if states and municipalities didn’t have enough to deal with concerning their own government debt, they will eventually have to deal with a reality that will explode their budget deficits: the low rates of return from their pension investments.

There’s no way unions will stand for these higher contributions either. Wait until these government debts and budget deficit protests make their way to the White House; then the problems will really begin.

Where the Market Stands; Where it’s Headed:

We are living in the most troubled economic times in our history. Spain asked for a $125-billion bailout this weekend, as its crisis deepens (magnifying the problems in Europe). We learned on Saturday that China’s inflation rate fell to three percent in May; that’s the lowest rate in two years. China’s big economy is slowing fast.

Worldwide, economic growth is stalling quickly. The U.S. is on the cusp of falling back into recession (see: The Inevitable U.S. Recession: Part II Starts). The bear market rally that started in March of 2009 is near the end of its rope.

What He Said:

“If the U.S. housing market continues to fall apart, as I predict it will, the stock prices of major American banks that lend money to consumers to buy homes will come under pressure—these are the bank stocks I wouldn’t own.” Michael Lombardi in PROFIT CONFIDENTIAL, May 2, 2007. From May 2007 to November 2008, the Dow Jones U.S. Bank Index of the world’s largest bank stocks was down 65%.