We'll Go Greek Without A Grownup Conversation

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The debt ceiling debate has evolved into one over the size and role of government. It is a debate we should have had a long time ago and we should take this opportunity to make big changes that actually address our underlying problems. Make no mistake though, solving our debt problem without killing this feeble recovery will not be easy. Doing it right requires a coordination of fiscal and monetary policy we haven't seen since the days of Ronald Reagan and Paul Volcker.

If you tighten fiscal policy without an offsetting ease of monetary policy you might get "Brother Can you Spare a Dime" and "Grapes of Wrath". If you tighten up the fiscal side while easing on the monetary side - and you get the mix right - you could get mild inflation and growth. Get it wrong and you could get disco, leisure suits and Jimmy Carter. So we want to get this right; the world does not need any more sad songs, depressing novels, Travolta movies, fashion crimes or sweater wearing Presidents.

After all the pain of this recession - unless you happen to be a farmer sucking down ethanol subsidies or a bailed out banker with a Fed guaranteed bonus - wouldn't it be nice to actually solve our problems rather than doing just enough to get to the next election? Step one should be to figure out through this debate exactly how much government we really want and then find a way to live within our means.

If the current 24% of GDP is the answer, taxes have to go up. If the historical average of about 19% of GDP is the answer we can probably get there by cutting some stupid spending and reforming entitlements. And don't tell me there is no stupid spending in DC; I'm not buying that and neither should anyone else. I guarantee you I could reduce the deficit to something sustainable over a long weekend solely by cutting out what I consider to be spending on stupid things we don't need. Hell, I could probably accomplish most of that just by cutting spending on stupid things the military doesn't need. No matter the answer to the bigness question though, big spending cuts have to be part of the solution.

Step two should be to think seriously about how we fund this government we want. Right now it is funded primarily through personal income taxes, payroll taxes and corporate income taxes. I have advocated for some time a shift to more taxes on consumption and less on income and capital. If we tax cigarettes and alcohol because we know that the extra cost will convince people to buy less of them, why do we tax income? Why do we tax capital gains? Why would we want less income or capital gains? The goal of tax reform should be to reduce taxes on things we want and raise them on things we don't.

We also need to address the long term unfunded liability problems of Social Security and Medicare. Everyone knows we can't afford to keep things the way they are but politicians are so scared of the old coots (please don't send me any emails; I'll join the old coot cohort soon myself) at AARP they have ignored the problem. Well we don't have the luxury of ignoring it any longer. The answers, again, are not that hard.

Raise the retirement age and add some means testing to Social Security. On Medicare both sides want to cap the payments but the devil is in the details. One side wants to cap payments to providers and the other side wants to cap payments to participants. Unless we plan to force doctors to accept Medicare patients, the first one won't work. We'll just end up with a shortage of Medicare doctors. That only leaves the second option so let's figure out a way to do it fairly and make sure the poorest are taken care of.

Lastly, we need to address the issue of currency stability. Most of the economic problems of the last 40 years can be traced to currency manipulation by the world's central banks. Since the last vestige of the gold standard ended in 1972 we've had one crisis after another, most of which were nothing more than currency crises in disguise. Oil price spike in the 70s? Dollar devaluation. Crash of ‘87? Falling Dollar. Japan bubble and aftermath? Yen strength. Dot com bubble? Strong dollar policy. Real estate/commodity bubble? Weak dollar policy.

One of the smartest things President Obama has said since he took office is that we need to end the boom/bust cycle. Unfortunately, it can't be done through his preferred method of regulation since that isn't the cause. Bubbles are always and everywhere a function of monetary policy. The efficient market hypothesis does not mean that all economic actors are rational. What it says is that in the aggregate you get a rational result. At any given time, you will have people who act irrationally optimistic and others who act irrationally pessimistic and others, like you and me, who act rationally. If the irrationally optimistic and pessimistic cancel each other out, you get a rational result.

The existence of bubbles would seem to suggest this isn't true. Sometimes you do get an irrational result, at least for a while. There are times when the irrationally optimistic can overwhelm the irrationally pessimistic and enough of the rational to produce an irrational result. That's what produces a bubble. When the bubble pops you get the reverse. The irrationally pessimistic overwhelm the rational and the irrationally optimistic to produce an undervalued market. So what is it that allows one irrational side or the other to win if even for a short period of time?

Manipulating the value of money distorts the perception of some previously rational or irrational actor and changes their view of the world. In a bubble they become overly optimistic; in a bear market they become overly pessimistic. The changing value of money complicates the process of valuing assets because it introduces a new variable. Where previously you only had to judge supply and demand for the asset, now you also have to judge supply and demand for the currency. Maybe something innate in humans prevents us from making a multivariable calculation of this type. I don't know but it obviously complicates the process.

We need to eliminate a variable from this calculation so we can make more rational judgments about asset values and stop the boom/bust cycle. The value of the dollar needs to be a constant or very nearly so. How that is accomplished can be debated but it needs to happen. Personally, I prefer a gold standard because it has a history and we know the pitfalls. But anything would be better than the current system of gathering a bunch of economists behind closed doors and letting them play interest rate roulette. If we don't reform the monetary system, fiscal reform won't survive the next bubble and crash.

We need to have a serious debate about how to fix our broken economy. As the President said the other day, if not now, when? What the politicians are doing now is not serious. It is a wonder anyone will still lend us money to keep up this Ponzi charade of an economy. Either we have this debate now and make some hard choices or at some point in the future, the market will force us to address them at the point of a Treasury bond. Just ask the Greeks.


Joe Calhoun is CEO of Alhambra Investment Partners in Miami, Florida. He can be reached at jyc3@alhambrapartners.com

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