Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Bailing Out Democrats by Bailing Out StatesThe House of Representatives on Tuesday approved, and President Obama promptly signed into law, an election-year bill providing $26 billion to struggling states.  The bill will be funded by closing tax loopholes for multinational companies and cutting food aid to the poor. The bill retains some 160,000 teachers that would have otherwise been let go and 1st-response workers.

This is not the first bill providing aid to special interest groups, and it’s certainly not the largest (compared to the $300 billion small business plan). Even so, its impact could be much larger and more politically, not to mention economically, destabilizing than anything we’ve seen thus far.  At the heart of the issue lies a stunning $3.1 trillion cumulative state pension deficit (pension article below), which is crippling budgets across the country.  Average government salaries run somewhere around 60K a year (nearly 20K more than the private sector) and in most instances, when a state worker retires, he or she retains 60-80% of their pay – for life.

In a secular economic contraction such as the one we are now witnessing, where nearly 50% of the population pays no taxes (at least not directly), the ability to meet these obligations is nonexistent.  But instead of cutting pay or benefits for these employees, the states and the feds have opted for higher tax rates and increased debt, or outright money printing, to fill the gaps – all at “Joe Sixpack’s” or even at the poor’s expense.

What’s more, if the U.S. government can partially or fully guarantee these unfunded pensions, doing so will go a long way toward solidifying support, control, and the provision of another source of funding (think Social Security) for the Democratic Party.  Whether intentional or not, with every dollar pledged, the U.S. government under Obama gains more influence over the political and economic system – for now….

House passes state aid (26B)

Democrats oppose:


2. Inflation to the Fed’s Rescue? Consumer Prices in the U.S. increased 0.3% in June.  The increase was the most in a year, exceeding the 0.2 percent gain projected by the median forecast of economists.  The report showed rents, the biggest component in CPI, increased for a second month, and the cost of gas, clothing, used cars, and tobacco also climbed.  A separate report from the Commerce department showed sales at U.S. retailers rose less than forecast in July, indicating the lack of jobs is prompting Americans to rein in spending.

To summarize the above: We’re looking at higher prices and lower economic growth.  We believe we’ll be seeing more of this in the future, and to a much stronger degree.  Some would call it stagflation, but it’s really the effects of inflation.  What’s interesting is that the increase in the CPI figures occurred shortly after the Fed found itself in a quandary on Tuesday – coincidence?

We mentioned last week that the Fed wanted to stand pat on rates and further QE, which, in effect, it did.  But the boost in the CPI provided a crucial justification for the Fed to remain quantitatively neutral.  The opposite course of action – engaging in full-blown QE efforts – would admit defeat, and likely tip stocks and the economy in the wrong direction.  After all, if it gets out that the economy is still failing after a $4.5 trillion stimulus package, it would suggest that the Fed has lost control and that a depression of some kind might be in order.

Alternately, if the Fed can convince the street that inflation is growing and is the cause of all our troubles (which, in reality, it is), then it may be able to divert attention away from itself, maintain credibility and a stated purpose, and simultaneously project blame onto this ominous new inflationary enemy.  This is speculation on our part, of course, but its logic is hard to avoid because there aren’t many options left to the Fed.

Regardless of the Fed’s political maneuvering, inflation exists both here and abroad. When combined with our solvency issues, a rise in rates will emerge one way or another – forcing necessary adjustments in our markets and limiting the ability of government to socialize the system.

Have a wonderful weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO