Sanity Zone 8-28-2014 Looking down the Barrel

A lot has happened in the last 6 months that seem to be going under the radar. Depending which side of the issue you're on, you could be looking down the trigger side or the exit side of the barrel.

First up, the exchange rate is really favorable for the US. That's excellent for anyone who likes a job. Demand for Manufacturing jobs are increasing, service jobs are increasing, wages are rising, inflation is creeping up (a good thing, for now) and asset prices are recovering. All because the dollar is weak, and $ based purchases are cheap compared to the Euro and Asian currencies. One reason behind the favorable rates is because of quantitative easing. (See one of my earlier posts as to what that is.) Another is fear-driven, as capital flight from various countries is bidding up scarce currencies like the Euro and Swiss Franc. And some of it is the realization internally that the US, though it infuriates Fox News, did not slide into the Pacific in a smoldering lump of Obama-crusted fecal matter, and that we can resume our regularly scheduled lives.

On the flip side, the presence of inflation is making the markets hungry for higher interest rates. This will be a mixed blessing. Those who save will get a higher rate of return, even one that exceeds inflation (woo hoo!). This will also serve to put a brake to quantitative easing, which is putting downward pressure on the dollar, which is to some extent fueling the inflation to begin with. It will also make it harder to borrow, which, unfortunately for some businesses, make growth opportunities more expensive to fund. But, higher rates will attract new capital, which will help to mitigate the interest rate rise.

This inflation prospect is troubling. We've needed inflation for so long that we may not be really ready when it gets here. Wages almost always lag, which means that purchasing power of the vast majority of Americans will get eroded more quickly than they can negotiate for wage increases to compensate. Without corresponding wage growth, we could see a phenomenon known as Stagflation, where inflation rises with a fall in output (usually a rise in output accompanies a rise in inflation, a fall in prices accompanies a fall in output.) This will result in higher prices and higher unemployment, something that we experienced in 1977-82, which for most Americans was a much worse economic experience than the 2008 crisis. The only way out of Stagflation is to strangle the money supply, lowering the available funds and raising interest rates to Tony Soprano levels.

We could be yoyo-ing from one extreme monetary policy to the other, destroying wealth, crippling industries, and sagging our infrastructure. It may not be popular, it may be against your religion, however, the only tool we haven't really used in the last 5 years is Federal Infrastructure Stimulus. We have nearly 20 years of infrastructure projects just for remediation and we have another 30 years of infrastructure projects for new infrastructure. When we talk infrastructure, it means roads, bridges, rail, public use buildings, electrical grids, alternative power, sewage and water and communications. China and Western Europe have already outpaced our core investment in societal infrastructure and are reaping the benefits of a more stable set of economic conditions. Implicit in the policy remains a commitment to building a healthy middle class, where wages and wealth are more equitably distributed than they are in the US. A solid middle class with a functioning infrastructure tempers an economy's potential for extremes.

History has a graveyard of countries who religiously adhere to an intellectually bankrupt dogma. We have to recognize that we have a choice as to which side of the barrel we look down. We had better get our priorities right today or we may lose the choice of ends.