On February 16, Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City gave a speech where he laid out, in straightforward terms, the threat posed by the U.S. deficits:
“It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well. The founders of the Federal Reserve understood this conflict. They understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster.”
He also discussed lessons from history -- specifically, German hyperinflation in 1923. Sadly, lessons of history are often forgotten or ignored. The European Union is in trouble because of Greece's irresponsible spending deficits, but will Greece adhere to the austere deficit reduction plan European Central Bank has proposed? Unlikely; at least, history indicates otherwise. Since the start of its independence in 1829, Greece has spent more than half of the subsequent years either in sovereign default, debt restructuring and/or shut out of capital markets altogether. Portugal (another PIGS member) since 1800 has had 6 defaults/restructurings, and Spain has had 13.
The ECB, to its credit, has yet to express any explicit bailout plans. But what options have we here, on this side of the Atlantic, regarding our deficits? Hoenig presented three of them, including doing nothing, or inflating our way out of at least some of the debt. Hoenig insisted, and I agree, that real fiscal discipline will only come when rising interest rates severely impact the U.S. economy. (Ed. -- EWI subscribers can read EWI president Robert Prechter's forecast for U.S. interest rates now in the FAQs section of EWI's Message Board.)
"Unfortunately, nations often must experience a profound crisis to focus the government’s attention on taking corrective action… Ironically, however, these generally are precisely the reforms that would have prevented a crisis in the first place. In time, significant and permanent fiscal reforms must occur in the United States."
When the bi-monthly offerings of tens of billions in Treasury bonds are no longer bid upon by our creditors unwilling to further invest in depreciating dollar assets, and when the Fed’s purchases can no longer keep interest rates down, the U.S. will have to face its demons and cut Medicare and Social Security entitlements; maybe other social programs, too. That was Hoenig's third option. Yes, he went there.
(Ed. -- This resonates with another one of Robert Prechter's forecasts:
"The demographic argument for a continued boom fueled by baby boomer spending and retirement savings will be transformed (somewhere near the bottom of the decline) into an argument that the same portion of the population will be responsible for a continued bust."
Prechter wrote that in his October 2003 Elliott Wave Theorist, where he gave a long list of important forecasts for the coming bear market. You can read that issue online now, in the Subscribers Library section of The Socionomist, Socionomics Institute's monthly publication. Here's what's in the new, February Socionomist.)
Bill Fox is EWI's Senior Bonds Analyst. He has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his Interest Rates Specialty Service subscribers are bond traders from around the globe.