There’s an old adage in economics that the best way to cure deflation is to drop money from helicopters. Clearly, this phrase isn’t older than mid-20th century, because before that time we didn’t have helicopters… we also didn’t have manipulative central banks. Now we have both, and they are about to join forces.

The helicopter statement isn’t meant literally. It conveys how central banks approach an economy when mainstream – and even out of the mainstream – monetary policies have failed.

There’s an old adage in economics that the best way to cure deflation is to drop money from helicopters. Clearly, this phrase isn’t older than mid-20th century, because before that time we didn’t have helicopters… we also didn’t have manipulative central banks. Now we have both, and they are about to join forces.

The helicopter statement isn’t meant literally. It conveys how central banks approach an economy when mainstream – and even out of the mainstream – monetary policies have failed.

By all accounts, central banks from the euro zone to Japan fit this description, and our own Federal Reserve is getting closer every day.

When the financial crisis first hit, the central banks did what they always do. They lowered interest rates. The goal was to entice borrowers to take on more debt, which they would arguably spend on goods and services, thereby giving the economy a positive jolt.

We all know what happened next.

It didn’t work.

A main reason, which seemed just as obvious at the time as it does today, is that developed economies weren’t suffering from a business cycle recession; they were suffering from a balance sheet recession. It wasn’t that the current expansion ran out of steam. It was that borrowers simply ran out of borrowing capacity.

As consumers – mostly homebuyers – we’d taken on all the debt we could and then some.

The long list of bad actors and schemes, including shadow banks, mortgage mills, derivatives, NINJA loans, etc., were all set in motion to feed the desire of regular people to get in on the casino money that was flowing from real estate. Where else could a work-a-day, $50,000 per year Average Joe put down a little cash (or even no cash) and walk away eight months later with a $20,000 profit?

The feeding frenzy drove entire industries, like home building and furniture. However, it couldn’t, and didn’t, last. The basis for the growth wasn’t earned income; it was borrowing, which eventually reaches a limit, even when it’s extended by sub-prime lending and predatory practices.

So lower interest rates in the face of a false expansion did nothing to revive the animal spirits of the economy. When that didn’t work, the Fed turned to monetary policy number two: printing cash.

Now, to be clear, I understand the Fed doesn’t “print” anything. It agrees to take bonds from Fed member banks, and in exchange adjusts the member bank’s account to a higher number. This one-sided transaction is the magical way the Fed creates capital.

In doing so, the Fed expected newly flush banks to make gobs of loans, creating new credit that would chase goods and services. The result would be economic growth, falling unemployment, rising wages, and a return to economic utopia.

They pledged $1 trillion. It didn’t work. Therefore, they slated another $600 million. Still no deal. Therefore, they did the contortionist dance called Operation Twist, which had no effect, and eventually decided to spend “whatever it takes.”

If that sounds familiar, it’s because ECB President Mario Draghi used those words to describe his approach to the euro. Whatever it takes. Remember that, it’s important.

It wasn’t just the Fed and ECB, central banks around the world were following the same script. They had to create inflation. They had to create growth.

Yet, they couldn’t. They haven’t. The problem is that both of these massive moves – in interest rates and cash creation – were focused on new loans. However, the original problem of a balance sheet recession, which stems from too much debt, was never fully addressed.

In addition, while many people did pay off their loans or go through bankruptcy, they’d be idiots to run up the credit cards and take out mortgages at the same rate as before. The only people crazy enough to suggest such moves are good ideas are… central bankers.

With interest rates below zero in many places and umpteen trillions of new dollars, yen, euro, and other currencies sloshing around the system, it’s about time for a new approach.

Central bankers have taken on the role of chief economic manipulators, and so far, they’re failing miserably. That makes them quite cranky after such a long run of success in the 1990s and early 2000s.

Which brings us to the next phase. Helicopters. Big ones.

I’m talking hulking, tank-carrying, supply-wielding monsters that blot out the sun, or at least any light that shines from reasonable decisions on currency management.

Regardless of whether they contain euro, yen, or eventually dollars, the reason will be the same.

They’ll drop their payloads on consumers for the express purpose of being spent.

Imagine the sight. It could look like something out of the war in Iraq, where pallets of shrink-wrapped $100 bills are parachuted to the ground in supply drops for distribution to warlords.

Or, it might not be as dramatic. It could take the form of “social assistance,” where central banks fund payments to low-income citizens, knowing that such cash has the greatest chance of reaching a retailer in short order.

It’s unlikely that this next phase will be any more successful in establishing solid economic growth, but it will do something. It will cement the idea that central banks really will do “whatever it takes,” even when that means taking more from savers, in any form possible, just to accomplish a dubious goal over which the bankers were never given authority in the first place.

“Whatever It Takes.” The Next Level of Monetary Policy is republished with permission from Economy and Markets Daily

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Recently the bond rating company Moody’s Investor Service cut their ranking of Chicago to junk status.  The move ticked off a lot of people in the Windy City who think Moody’s overstated the case. I agree that Moody’s is wrong… not because they went too far, but because they didn’t go far enough.  Chicago is not close to bankrupt. It’s completely bankrupt. People are just afraid to say this out loud.

Recently the bond rating company Moody’s Investor Service cut their ranking of Chicago to junk status.  The move ticked off a lot of people in the Windy City who think Moody’s overstated the case. I agree that Moody’s is wrong… not because they went too far, but because they didn’t go far enough.  Chicago is not close to bankrupt. It’s completely bankrupt. People are just afraid to say this out loud.

The city’s pensions are underfunded by $20 billion. Moody’s gave a rating that reflects how the city is performing. City officials are just angry Moody’s called them out.  The bureaucrats pointed to Standard and Poor’s, which had Chicago ranked an A+. But after Moody’s released their assessment, Standard and Poor’s lowered their rating as well — just not as low as the Moody’s rating.  It really isn’t all that complicated. Unless there’s a change to how pensions are funded or benefits accrue, the pension liabilities will completely swallow the city and then some. 

Chicago has four ways it can offset this financial mess: raise taxes, lower benefits, require higher contributions from city workers, or some combination of the three. 

There has been a lot of talk about changing what workers pay into the system, as well as cutting benefits for workers that are still years from retirement… but the Illinois Supreme Court already shot this down when they ruled that similar changes by the State of Illinois violated the state’s constitution. If it won’t work at the state level, then it won’t fly at the local level, either. 

Chicago could still try raising taxes high enough to cover its costs. Though I highly doubt voters will support a tax hike big enough for public employees to enjoy their comfortable pensions, when the average private worker still must fend for himself.  That doesn’t leave the city with many options. Which means it has a liability that, at this point, it can’t pay. That sounds like bankruptcy to me.   

Still, city officials claim that Chicago won’t grind to a halt, and it won’t. It’s a vibrant hub of commerce.  It’s not Detroit, where residents fled the city and homes sold for $100. It’s not Puerto Rico, which racked up massive debts to fund its unbalanced budget. 

But the fact remains that Chicago is unable to pay what it owes. Something has to give, and soon.

As we’ve seen in other cases — Stockton, Vallejo, and Detroit — when there’s not enough money to go around, it’s the bondholders that get the shaft, no matter what their claim on assets.  That’s why Moody’s was right to give Chicago the rating that it did. It’s their business to rate the city such that potential bond buyers can make informed investment decisions. Their business is not to salvage a city’s reputation.  If Moody’s analysts forecast Chicago won’t be able to pay all of its bills, with the result that bondholders likely will take a hit, then the company has an obligation to publish that outlook. 

Of course, city officials see things a bit differently. They’ve literally cut the company out of current deals, and are now only using credit agencies that see Chicago in a better light.  It’s hard to feel any sympathy for Moody’s since this firm, as well as Standard & Poor’s, made a fortune during the housing boom by slapping their highest ratings on shady sub-prime deals. 

It’s investors who purchase Chicago bonds that deserve some level of protection, or at least quality information, which they get with the junk rating Moody’s assigned to Chicago.  At the end of the day, all of this highlights the same issue — there’s no such thing as risk-free investing. 

Chicago bonds are backed by the “full faith and credit” of the city. Given everything we know about their finances and how bondholders have been treated in the past, the words “caveat emptor” come to mind, no matter what the rating of any bond.  Municipal bond buyers and muni bond fund investors should closely inspect their portfolios to see if they have any exposure to the Second City.  Better to find out now, before things get worse.

The Gathering Bond Storm in Chicago was republished with permission from Economies & Markets

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As I read the news and watch the markets, I am struck by the yawning difference between what is going on with the economy and what is happening with equities.

I know the worn out arguments.

People are buying stocks because they do not have many choices. That’s fair, to some extent. The return on stocks (dividends, expected earnings growth) is higher than the interest paid on bonds.

As I read the news and watch the markets, I am struck by the yawning difference between what is going on with the economy and what is happening with equities.

I know the worn out arguments.

People are buying stocks because they do not have many choices. That’s fair, to some extent. The return on stocks (dividends, expected earnings growth) is higher than the interest paid on bonds.

Then there is this one: Foreign investors moving to U.S. dollar-denominated holdings are driving up prices.  And my favorite: Stocks will keep going up because… they have been going up. I am not sure how that makes sense, but I guess it follows some thread of logic.  There is some truth in each of these, but we need to keep one overriding factor in mind.

For years, the silver lining has been growth in the equity markets. Every time we have discussed weakness in other parts of the economy, someone has always yelled, “But look at the markets!”  Clearly, it is true. Many people have made tidy sums over the past six years through investments… even if their paychecks have remained modest.  However, the silver lining is always in contrast to the cloud, and in recent years, it seems as if people have forgotten the cloud exists. Not only is it still with us, but it is growing more ominous by the day.

First quarter gross domestic product (GDP) was just released. For the first three months of the year, the U.S. economy grew at an annual rate of 0.2%. Note that this is the annual rate. The actual rate for just the quarter (one fourth of the year) was 0.05%, which is about as close to zero as you can get and still be positive.

This level of growth comes on the heels of our Fed printing almost $4 trillion, our mortgage agencies allowing home loans with a mere 3% down while conforming mortgage rates sit below 4%, and new car loans charging less than 3% interest.

With so many forces propelling the economy forward, we should be growing at 3% to 4% per year, not struggling to understand why we are sitting close to zero. Yet, here we are, looking forward to another year of subpar growth — and it is nothing new.

The Federal Reserve estimates GDP growth at every regular meeting, and they have been woefully wrong in their assessment for half a decade.  In late 2010, just as they launched the second round of quantitative easing (QE), the Fed projected 2011 growth at 3.3%, 2012 at 4%, and 2013 at 4% as well.

It did not work out that way.

GDP grew 1.6% in 2011, just a smidge below the Fed’s 3.3% expectation.  Still, the group was undeterred. In January 2012, they estimated growth at 2.5% for the year (lowering their previous estimate by almost half), thought 2013 would grow by 3.0% (a point less than previously thought), and pegged 2014 at 3.7% (just under the prior estimate).  Their 2012 figure of 2.5% was close. The economy grew by 2.3% that year. However, subsequent years failed to live up to the lowered expectations. GDP grew 2.2% in 2013, and 2.4% last year.

Notice a pattern?

No matter what we have done to encourage lending and borrowing, economic growth remains anemic. This cloud is starting to blot out the bright light of the equity markets, which appear to have recently noticed that, not everything’s sunshine and roses in the economy.  On a recent portfolio investment call at Dent Research, as usual we polled everyone for their opinion on the markets. The group includes Harry Dent, myself, Charles Sizemore, Lance Gaitan, Ben Benoy, John Del Vecchio, and usually Adam O’Dell, but he was on vacation that day.

As the rest of us went through our notes, I was struck by a common theme. We all noted that the markets continued to advance, but none of us could tell why.  At one point, I asked everyone for a single answer on what could propel the markets higher. The only response was that the Fed could keep holding interest rates near zero a bit longer in the face of bad economic news.

That is probably the best commentary of all on this cloud — the only positive is that the economy is so weak, even with all the stimulus and booster initiatives, that the Fed might not move short-term rates off zero for another four to six months.

Pardon me if I do not break out the champagne.

With six years of strong equity growth on the books without a significant correction, and the U.S. still suffering with weak growth, the chance of a break in the markets seems to grow with each passing day.  We have reiterated this point many times, but it bears repeating — be cautious. Now is not the time for added risk or speculation.  If you employ an investment process, pay close attention to your stops and sell signals.

If you do not use a system, take the time to review your holdings to see if any pruning of gains is in order. When the current cloud starts to rain, it could quickly turn into a flood.

Hey, Fed – Where’s Our Silver Lining? is republished with permission from Harry Dent Jr.

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