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Banana Republic Finance: Why Keynes Is Rolling in His Grave

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The bottom 50% of households will get nothing from the income tax cuts and perhaps $100 billion from the one-year extension of unemployment benefits and payroll tax relief.

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Events of the last few days show the US is on an accelerating descent into banana republic finance. First, the siren song that the cure for debt is more debt was given another stanza by the nation's chief money printer on 60 Minutes Sunday night. Then, on Monday evening, the nation's capitulator-in-chief made a deal with Congressional Republicans to light up a trillion dollar budgetary Christmas tree.

Moreover, in throwing the deficit financing spigot wide open on the back of Ben Bernanke's promise to continue monetizing all the new debt Washington might create, the tax plan negotiators booby-trapped the nation's budget with the expiration of several hundred billion of tax-cut goodies on election eve in 2012. So after the next predictable exercise in rinse and repeat, the true cost of Monday night's plan will be in the multi-trillions.

In this context, it's useful to recall the classic traits of banana republic finance. These include massive and chronic government debt issuance; reckless monetary expansion to absorb it; and pervasive economic distortions that cause an uphill flow of income and wealth to the top of the economic ladder. The Obama White House's latest act of fiscal desperation accomplishes all three.

First, this renewable feast of Chamber of Commerce Keynesianism -- there is no other term to describe it -- will prolong the current $1.3 trillion federal deficit as far as the eye can see. For the moment, the Fed's QE2 program is arguably keeping interest rates down via the purchase of $100 billion per month of existing Treasury paper to offset the $100 billion in new debt being issued by Uncle Sam to fund this perpetual monthly shortfall.

However, will Helicopter Ben allow the global Treasuries market to go "cold turkey" when the Fed's $600 billion QE2 bond-buying bucket is exhausted in a few months? That would mean permitting the old-fashioned forces of supply and demand to engage in "price discovery" -- potentially uncovering far higher interest rates to induce the People's Dollar Store of China, the Gulf oil states' spare change accounts, hedge fund punters domiciled on the Isle of Man and the like to start buying the $100 billion per month in new debt now being absorbed by the Fed.
The fact is, however, any sustained rise in Treasury yields (and drop in bond prices) would cause massive losses on the $3 trillion to $4 trillion of longer-term GSE and Treasury paper already owned by the Fed and its still-crippled wards in the commercial banking system. So it's a sure bet that to avoid this unthinkable eventuality, the Fed will implement QE3 by next spring. Stated differently, by standing ready to buy federal debt hand-over-fist (i.e. monetize it) to keep interest rates down in the face of an unending cascade of "stimulus" borrowing, the Fed has become -- like central banks in actual banana republics -- a branch office of the Treasury Department.

Most antediluvian proponents of sound money find this development alarming. They contend, correctly, that sooner or later the resulting massive leakage of unwanted dollars into the global financial system will unleash a destructive plunge into beggar-thy-neighbor monetary protectionism and trade autarky.

But even left-wingers like Congressman John Conyers, who haven't even read their Hayek, are loudly complaining that this won't end well! That's because it's not hard to see that continued money printing to fund unaffordable tax cuts will bury the nation's middle class and poor anyway.

Indeed, inner circle money printers, such as Goldman Sachs alumni William Dudley, who runs the New York Fed, have already publicly acknowledged that the transmission mechanism for monetary policy is now the global risk asset markets, not the traditional domestic banking system. Consequently, as a matter of design, the Fed is stimulating not loans to Main Street, but global commodity prices and the short-term trading values of equities, corporate credit, and all manner of derivative risks.

Not surprisingly, since mid-summer (before word of the current round of QE2 leaked out) the price of cotton is up 85%, sugar 75%, wheat 50%, copper 40%, and heating oil 20%. That's not "core inflation" as the Fed measures it, of course, but it's most assuredly swelling the cost of living on Main Street.

And that's why almost every aspect of the Obama/Republican tax giveaway plan is so perverse. The two-year extension of the 15% capital gains tax rates, for example, will shield the winnings of speculators in risk assets like copper futures and Netflix (NFLX) call options, but won't do much to incentivize real supply-side inventors and entrepreneurs. Unlike speculations in the nation's financial casinos, their creations almost always take more than 24 months to mature.

On the other side of the ledger, there are 35 million jobs in sectors like bars, restaurants, retail sales, housekeeping and the like where pay averages less than $20,000 per year. Here the 2% payroll tax abatement will amount to $400 -- a sum that won't begin to cover the cost-of-living surge fueled by the Fed's money printing campaign.

Indeed, the White House claim that the plan is mostly "progressive" and that the two-year extension of tax cuts for the rich is the price of poker is pure spin. In fact, the bottom 50% of households will get nothing from the income tax cuts and perhaps $100 billion from the one-year extension of unemployment benefits and payroll tax relief. The next 48% of middle class households will get upwards of $500 billion from the two-year extension of the Bush rate cuts, the AMT patch, tuition tax credits and the like. And the top 2% will get the rest -- perhaps $200 billion from lower rates on income, dividends, capital gains, and estates.

We have had a 30-year referendum on federal spending, starting with President Reagan's failed effort to shrink the welfare state in 1981 and culminating in the Bush-era ratification of all the spending that was there -- plus a healthy add-on for education and Medicare drug benefits. So why relieve the middle class of the obligation to pay for the government it apparently wants at the cost of showering the rich with tax cuts paid for by Uncle Sam's credit card?

Obviously, it's all about short-term fiscal stimulus, and that's the ultimate irony. The classic Keynesian cure assumed a normal business cycle had been interrupted by a sharp credit contraction and liquidation of business inventories -- conditions under which government deficit-fueled demand might restart the engines of economic expansion. But the collapse in September 2008 came at the end of a massive speculative bubble in housing, consumer credit, commercial real estate, and financial assets, not a legitimate business expansion.

Now, the artificially bloated levels of income and consumer spending that resulted from eight years of Republican deficit finance and money printing have evaporated, and can't be recreated by more of the same. In the context of a pervasive debt deflation, deficit-financed tax cuts and Federal Reserve money printing to pay the government's bills are having the perverse effect of fueling financial speculation, not economic growth. In the end, income and wealth is being driven to the top of the economic ladder, while Main Street is being punished with soaring living costs and anemic returns on bank account savings. Since Keynes despised the rich above all else, he is undoubtedly rolling in his grave in reaction to the Obama/Republican tax giveaway that is been implemented in his name.

Steve Smith's OptionSmith portfolio is +40% in 2010. Take a FREE 14 day trial to get exclusive access to the portfolio and trade alerts emailed to you before every trade. Learn more.
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