Trade Deficits and Tariffs

 I apologize in advance for beating a dead horse, but I wanted to spout off about trade deficits and tariffs before they departed from the news cycle and went to issue heaven. The first part of this blog will deal with trade deficits incurred by the United States and if they are relevant to the functioning of our economy. After that, we will look at tariffs and whether or not they are an effective tool in addressing a nation's trade deficits. Lastly, I will tender the most expeditious and efficient cure in terms of reducing America's chronic annual trade deficits.

The United States has run a trade deficit for 50 years, since the 1970s. In other words, for half a century, the U.S. has imported more goods and services than it has exported. The trade deficit was at a small level in the 1970s, a modest level in the 1980s, and then expanded significantly over the past three decades to the point where it now exceeds $1 trillion per annum. By far our largest bilateral trade imbalance is with China. The American economy has fundamentally changed over the past 50 years. In 1970, manufacturing jobs represented 26% of employment in the U.S. These days, the percentage of manufacturing jobs has dipped below 10%. This evolution has effectively lowered wages for non-college-educated workers and has cost the U.S. somewhere between three and four million jobs. As witnessed by the emergence of Trump and his MAGA acolytes, these import-related job losses are driving a populist backlash to trade and globalization that causes political and social volatility.

There are many economists and trade experts who do not believe trade deficits hurt the economy. I embrace the position that trade deficits are neither all good, or all bad, but rather consist of trade-offs (no pun intended). The primary negatives, depressed wages and job losses for certain segments of the work force, have already been mentioned. The U.S. economy on an overall basis has benefited from lower-priced foreign goods. Consumers have realized significant savings. To remain competitive, American companies have had to increase productivity and efficiency. It also needs to be pointed out that technological innovations have played a much larger role in deindustrialization than trade trends. Look for this to continue. The robots are coming. Lastly, the exchange rate of the dollar is extremely relevant. A stronger dollar makes foreign products cheaper for American consumers while making U.S. exports more expensive for foreign buyers.

One can make the argument that on a net basis the United States has benefitted from the post-World War II monetary system agreed upon a Bretton Woods near the end of the aforesaid war. The dollar, backed by gold at the time, was formally considered the world's reserve currency. The dollar as the global reserve currency means other countries rely on holding dollar reserves, creating massive demand for U.S. financial assets. This means that the U.S. pays little for its foreign borrowing, allowing it to finance its high consumption at low cost. The singular role of the U.S. economy in providing liquidity to the global economy and driving demand around the world makes a U.S. trade deficit central to global economic stability. In exchange for foreign creditors owning about one-third of our outstanding national debt, Americans have received imported goods at a reasonable cost. This has contributed to keeping a lid on inflation.

Imposition of tariffs is seen by some as a remedy to cure trade deficits. Our current president has referred to "tariff" as the most beautiful word in the English language. He has also referred to himself as "Tariff Man." On April 2nd Trump announced wide-ranging, punitive tariffs on the entire world, friends and foes alike, even on remote islands only occupied by penguins. It was declared "Liberation Day," when in fact it should have been called "Obliteration Day." Trump's reciprocal tariff calculations were absolute, unadulterated nonsense. The White House did not properly measure tariffs imposed by various countries. Instead, it drew its estimates from bilateral trade deficits in goods. As a traditional conservative with a predisposition to look at tariffs with a negative eye, I consider tariffs nothing more than an unnecessary tax that can distort incentives in the economy. This can lead to inefficient resource allocation. History tells us that protectionist policies to close trade deficits invariably fail. Instead of promoting jobs and economic growth, tariffs can actually harm the economy by hindering innovation and reducing competitiveness. Did we learn nothing in the aftermath of the infamous Smoot-Hawley Tariff Act of 1930?

There is no shortage of misperceptions and skewed thinking surrounding trade deficits and tariffs. Although it is a complicated economic issue, the lame-stream media has treated it as a binary political issue, and not an issue with nuances and trade-offs. For example, there is the rote proclamation that tariffs automatically translate into higher rates of inflation. This is not necessarily always the case. As mentioned earlier, the strength or weakness of the dollar on the foreign currency exchange market will play an outsized role in determining if prices rise or not. Another relevant factor would be the extent the importer (payer of tariffs) of foreign-made products decides to pass on to consumers. Lastly, and most importantly, it ultimately comes down to the behavior of consumers. Consumers always have the option to modify their spending habits by seeking out sales, finding a substitute for a product, or flatly refusing to purchase a product.

The solution to our bothersome trade deficit with the world is both magnificently simple and functionally arduous to carry out. The reason for the deficit can be boiled down to the U.S. as a whole spending more money than it makes. The personal savings rate in the United States averaged 8.45% between 1959 and 2024. This rate currently stands at 2.90%. Thus, boosting the saving rate in our country would bring down the trade deficit. Besides individuals saving more, the federal government needs to get its fiscal house in order. The combination of excessive government and insufficient revenue (tax) collections has fostered larger and larger federal budget deficits. This reduces the national savings rate and raises the trade deficit. A portion of the budget deficit is effectively financed through a rise in the total amount Americans borrow from abroad. An apt analogy would be comparing the government's insatiable addiction to spending money to that of a heroin addict craving a fix. All too often the drug addict kicks the bucket. The same can happen to a nation if the value of its currency continues on the path of debasement. We need sound money.

The Dubious Vilification of Deflation

 There is a great movie named "Usual Suspects" starring Kevin Spacey in the role of Roger "Verbal" Kint, who is thought to be simply a petty con man. Well, lo and behold, we ultimately learn that Verbal is possibly also the notorious and ruthless criminal, Keyser Soze. Either in legend or fact, Keyser Soze is described as a "spook story that criminals and bad guys tell their kids at night," a figure of fear and legend that knows no bounds. He is the consummate "Boogeyman." Deflation, prices decreasing over time, the opposite of inflation, is the economic equivalent of Keyser Soze. I picture a cluster of central bankers and other prominent Keynesian economists huddled around a campfire exchanging graphic stories about the nefarious evilness of deflation. Unfortunately, they have it all wrong.

Deflation has been on the receiving end of an undeserved bad rap for practically 100 years. This is largely based on the experience of the 1930s (Great Depression) when deflation was synonymous with economic depression. However, correlation does not imply causation. Just because two things happen together or are related, it doesn't mean one causes the other. There are often other explanations for their relationship. The most likely cause of the Great Depression would be a Perfect Storm of massive deleveraging after the 1929 stock market crash, bank failures due to lack of liquidity, the Fed's tight monetary policy, and the ill-timed Smoot-Hawley Tariff Act of 1930. Easy credit funding excessive speculation fueled a financial bubble in the stock market. The bubble burst. The Federal Reserve Bank also made a huge mistake with the banking system. Instead of flooding the system with liquidity and back-stopping banks in their capacity as the lender of last resort, the Fed did just the opposite. Many of the banks that failed were simply illiquid, and not insolvent.

Today's regulators and policymakers remain hung-up on deflation in general and ignore the fact that deflation is normally positive and can be driven by many different factors. They erroneously believe when prices are falling, consumers and businesses choose to delay purchases, hoping for even lower prices, leading to a decrease in aggregate demand. This viewpoint assumes consumers are both disciplined and patient, something I have yet to witness in my lifetime. In addition, purchases such as food, energy, auto expenses, and housing expenses cannot be deferred. Most of the time, deflation is beneficial to an economy. It gives consumers greater purchasing power. How often have you heard somebody complain about paying a lower price for a product or a service?

Besides a decrease in total demand, which can lead to problems in an economy, deflation can be driven by a decrease in the money supply. This is an extremely rare occurance - happening four times in the history of the country. Deflation is most often associated with rapid productivity growth and positive output growth. Technological advances would be considered the Great Deflator. Deflation can also promote economic growth and stability by enhancing the function of money as a store of value and encouraging real savings. The most misunderstood aspect of deflation is probably that price deflation is not a general economic problem. Falling prices merely lead to redistribution. Sellers lose and buyers win. All in all, it is not deflation, but the inflationary period that leads to debt deflation that is dangerous for a country's economy. Debt deflation occurs after too much credit is extended for unproductive purposes, in particular for speculative investment purposes. An asset bubble is created, ultimately followed by rapid deflation when the bubble bursts. The deflationary spiral ends when the bad investments are liquidated.

Who benefits from bad-mouthing deflation and continuing inflationary policies via overly aggressive money printing? The answer to that question would be politicians, large corporations, wealthy individuals, and all debtors. Deflation increases the real value of debts, meaning that borrowers have to repay the same amount of money, which has become worth more. The biggest debtor in the world is the United States government. For this reason, the government's monetary policies are biased in having a "healthy" dose of inflation. This misdirected policy and the sheer arrogance of the central planners in believing they can fine-tune and control the economy is perilous. The alleged threat of deflation is used to justify the production of new money. Rather than accept a limited amount of deflation as a new normal, central bankers attempt to cure a problem that requires no solution. They constantly proceed to trot out lower interest rates, Quantitative Easing, and an environment of lesser credit restrictions. These measures are often counterproductive, with the resulting excess credit inflating asset bubbles or creating new bubbles in the economy.

Since we're on the subject of deflation/inflation, now would be an opportune time for me to get something off my chest. The gripe concerns a Federal Reserve Bank policy that debuted in 2012. The policy was adopted by the Federal Reserve Open Market (FOMC) during Ben Bernanke's tenure as Fed Chair. This ridiculous policy formally established an inflation target rate of 2%. In other words, the country's monetary mavens (12 individuals) unilaterally decided that it was in the country's best interest for our currency to be debased by 2% each year. Unbelievable. The origin of the "magical" 2% inflation target is even more questionable in terms of pure logic. In 1989, New Zealand wanted to codify the independence of its central bank. The applicable legislation directed the New Zealand finance minister and head of its central bank to come up with an inflation target. If this target was not met, then the head of the central bank could be sacked. In later interviews, the head of the central bank stated "The figure (2%) was plucked out of the air to influence the public's expectations." As "they" say, the rest is history. Most knowledgeable parties at the time thought it made much more sense to set a target rate for inflation in the 0 - 1% range. As mentioned earlier, the U.S. followed suit in 2012 when the 2% inflation target was established.

The Covid-19 pandemic threw a monkey wrench into the financial system in 2020 when economies worldwide shut down. It's been over five years since the rate of inflation dipped below 2%. Part of the reason for this is that the Fed waited way too long to raise the Fed Funds rate. They also adopted a policy in August 2020 that is almost comical. The strategy is called "flexible average inflation targeting." In a nutshell, this approach aims to achieve the 2% inflation target, on average, over time, allowing for periods of inflation above 2% if it has been persistently below that level. This is another example of our government's monetary bias in favor of inflation at the expense of reducing the purchasing power of Americans. Currency debasement will continue. Don't keep your head in the sand. Buy hard assets.

  

Defusing the Debt Bomb

 At the conclusion of my last blog about DOGE, I teased with the comment that some suggestions to avert the debt crisis would be forthcoming. I will now proceed to offer some ideas on how to get a handle on the problem that many knowledgeable people consider both unsustainable and existential. The U.S. federal government closed its most recent fiscal year books on September 30, 2024. With 10/1/23 - 9/30/24 government revenues at $4.92 trillion and expenditures for that same period at $6.75 trillion, the net result was a deficit of $1.83 trillion. That is a boatload of red ink. The $1.83 trillion deficit represents 6.5% of the Gross Domestic Product of the United States. That deficit level historically has only been seen during times of war or times of economic recession. With the economy growing at 3.0% per annum and the deficit at 6.5% of GDP, that scenario eventually leads to doom.

Now, let's look at a situation where government revenues (via higher taxes) increase by 10%, while simultaneously government spending is reduced by 10%. This translates to a revenue increase of $492 billion and a spending decrease of $675 billion. The new math is as follows: Annual government revenues now total $5.41 trillion with annual government spending at $6.08 trillion. The resulting deficit has been lowered to $670 billion (from $1.83 trillion). An annual deficit of $670 billion represents 2.3% of Gross Domestic Product. With sustained growth in the economy of 3.0% per annum combined with a deficit of 2.3% of GDP - eventually you grow out of the crisis and defuse the debt bomb.

Based on previous writings, I acknowledge sounding like a broken record by repeatedly harping on the risk posed by a $37 trillion national debt combined with annual deficits of $2 trillion. This is on top of the actuarily computed Present Value of the government's unfunded liabilities well in excess of $100 trillion. Before providing some additional details on how to tackle the debt bomb, there are a handful of foundational principles that need to be addressed if there is to be any success in solving the problem. First and foremost, there is going to be financial pain experienced by the vast majority of individuals to varying degrees. It is unavoidable. The pain will be widespread. It is vital to the process that everybody should share in the pain - "Misery loves company" will make the necessary sacrifices more acceptable. If possible, it should be viewed as a national challenge where all citizens share in the national goal of restoring sound money.

As mentioned earlier, my "plan" includes increasing government revenues by 10%. This will not be easy, but it is possible, and essential. Instead of promoting tax cuts, the Trump Administration should take a page from the Hippocratic Oath and "First, do no harm." It's absolutely ludicrous to cut income taxes when confronting an annual deficit approaching $2 trillion. For those supply-siders claiming lower taxes will supercharge economic growth and thus "pay for" the tax cuts, history tells us otherwise. For every $1.00 in tax cuts, there is an approximate $.40 upward bump in collected tax revenues. A prime example of this would be the vaunted 2017 Trump tax cuts. With the exception of benefits to the wealthy, that legislation was overall very costly and failed to deliver widespread economic benefits.

I propose corporate tax rates remain the same and individual income tax rates be revised upward. This would apply to all income earners except those Americans at or below the federal poverty level, Many middle-class taxpayers believe the ultra-wealthy and wealthy should be the exclusive source of increased income tax payments. The math doesn't work with this approach. There are simply not enough wealthy individuals to move the needle. The great bulk of taxpayers fall within middle-income parameters. They will pay slightly more when the tax code is revised, with steeper increases paid by the wealthy and ultra-wealthy. The tax increases will not be at levels that greatly encumber the lives of taxpayers. For those high-income earners who will complain and claim they are being treated unfairly, I would like to remind them they have made out like bandits over the past 15 years. The top 10% has almost exclusively enjoyed the benefits of overly stimulative monetary policies and debasement of our currency since the Great Financial Crisis.

We will now direct our attention to the expense side of the federal budget. I propose mandatory, uniform 10% spending cuts across every single federal agency and department. There would be no exceptions, no sacred cows such as the Department of Defense, Medicare, Medicaid, and Social Security. Cuts in the Defense Department would be focused on the procurement process for weapons systems. For far too long, there has been an incestuous relationship between defense contractors and high-ranking military brass. U.S. taxpayers have been ripped off by the military-industrial complex. The United States defense budget is roughly the size of the next seven largest military budgets around the world, combined. Even in a dangerous world, I don't think it would be difficult to find $90 billion in cuts.

As previously noted, even the beloved entitlement programs should not escape spending reductions. In the 2024 federal budget, Medicare accounted for approximately 13% of total federal spending, with a total outlay of $839 billion. The entire U.S. healthcare system needs to be revamped, particularly Medicare. About 17% of our GDP is spent on healthcare. This is double any other developed countries that have even more challenging demographics than America. I'm not yet to the point of advocating the creation of "Death Panels," but I would be remiss if I didn't mention that 20% of Medicare costs come in a person's last year of life. A year that is normally not filled with rainbows and unicorns.

Medicaid is administered by individual states within broad federal guidelines. The programs are primarily (70%) funded by the Feds. Medicaid accounts for 8% ($560 billion) of federal spending. Consideration should be given to restricting eligibility and limiting reimbursement for certain services. Also, instead of the current matching system, it would make more sense to issue block grants to states or cap annual growth in payments to states. Lastly, further restrictions should be adopted that would limit asset transfers from individuals who subsequently apply for Medicaid benefits.

Even the most sacred of sacred bovines (Social Security) should not escape the entitlement reformers. Until it is overtaken by interest payments on the national debt in the next few years, Social Security will account for the government's largest expense item. Social Security accounts for 22% of federal spending, with a total outlay of over $1.4 trillion on an annual basis. There should be multiple changes to the program. Instead of receiving full benefits at age 67, it should be extended to age 69. Applications for Social Security Disability Insurance (SSDI) should be carefully reviewed with the more blatant abuses hopefully curbed. I would advocate getting rid of the $255 Social Security life insurance benefits. I would also endorse getting rid of surviving spouse benefits. Lastly, and most controversially, I believe Social Security benefits should be determined under a needs based formula.

A year or two after introducing across the board 10% spending cuts, I would introduce legislation to eradicate the Department of Education, as well as the Department of Energy and Department of Agriculture. It probably won't happen, but it wouldn't break my heart to privitize the United States Postal Service. I am confident that practically everybody who reads this blog will disagree with most, if not all, of the various suggestions tendered in this blog. Conservatives will vociferously object to the proposed tax increases. Liberals will vociferously object to the proposed spending cuts. Compromise is apparently a relic of the past. Unless sacrifices are made, absurd annual fiscal deficits will continue for an indefinite term and further erode the purchasing power of our currency. Don't keep your head in the sand. Buy hard assets.

DOGE

 Unless you have been living under a rock, you are now familiar with or at least heard of the acronym “DOGE.” The aforesaid acronym stands for Department of Government Efficiency. I would be remiss if I didn’t point out that “Government Efficiency” is as about as glaringly obvious an oxymoron as one will ever stumble across. Wikipedia describes DOGE as an initiative of the second Trump administration tasked with reducing federal spending. Besides carrying out spending cuts, it aims to modernize federal technology and software to maximize governmental efficiency and productivity. DOGE is scheduled to be dissolved on the nation’s 250th birthday - July 4, 2026. Some parties hope it will die a violent death before the United States Semiquincentennial.

Before further opining on the subject matter, I believe it is requisite to issue a couple of disclaimers. First and foremost, I have been a long-term proponent of small and limited government. In that light, I am generally supportive of anything that reduces spending and removes government intrusions from the lives of Americans. The second disclaimer concerns my biases accrued over the past half century when comparing the public sector workforce to the private sector workforce. Opinions tend to be a product of our cumulative experiences. Granted, my public sector employment was extremely limited, while my private sector employment in the world of commerce was both lengthy and extensive. I am thus predisposed to support DOGE and pro-business policies in general. I consider the private sector to be the productive portion of the economy with the public sector for the most part being the unproductive portion.

Supporters of DOGE point out that besides seeking a reduction in spending - fraud, waste, and gross incompetence are all being targeted. With annual government expenditures now over $7 trillion, there is no doubt waste and abuse that can be mitigated to a certain extent. While shocking headlines may be generated by DOGE’s findings, there will not be enough overall savings to move the needle. When the dust eventually settles, there could be $250 - $300 billion in savings in discretionary spending. This represents a measly 3.5% of total spending. I’ve said it before and I’ll say it again: the only way to cure the spending problem is to go after the Big Boys: Defense, Social Security, Medicare, and Medicaid. Another point I would like to make is that government employees are inherently inefficient. Without a bottom line and the necessity to be profitable to retain employment, there is not an incentive for government employees to be efficient.

Practically every president since Teddy Roosevelt has campaigned with the promise of rooting out government waste and keeping a lid on federal expenditures. There is  always a surplus of proclamations and bold talk before the issue quietly slinks away after the election. Even the renowned  conservative, Ronald Reagan, tried and failed miserably in his endeavors to shrink the government. Although I fully expect Trump to similarly fail in his efforts to stop or slow down the expansion of the federal government, I give him credit for at least talking about dramatic changes and at least initially doing something to curtail Big Government. Unfortunately, I feel an economic crisis will derail real fiscal reform and the runaway train will start gathering steam again.

One can make the argument that fiscal motives were not the only reason to unleash DOGE. The ruthlessness and expediency of the job cuts tells me something else is at play. Trump and his policy wonks see government employees, especially those in certain agencies, as being diametrically opposed to his free-market orientation and capitalistic roots. He also thinks, and probably rightfully so, they opposed him during his first term as President. One aspect that MAGA Republicans and traditional conservatives share in common is their disdain for the federal bureaucracy. They mutually view it as a sprawling, unaccountable monolith with multiple tentacles choking out the lifeblood of American businesses and citizens. A heavyweight brawl will soon be front and center. In one corner will be Donald J. Trump representing the Executive Branch of our federal government. The opposite corner will be the  professional managers and their  unions  representing the federal bureaucracy. I anticipate the Supreme Court having an extra-busy  docket over the next few years as they adjudicate various cases coming out of this epic conflict. It was only a matter of time before a chief executive aggressively pushed the boundaries. I look forward to the Court determining the parameters of the extent of power wielded by the Executive Branch.

I’ve made it to the near end of this spiel without even mentioning the country’s $36 trillion debt and annual deficits representing 6% - 7% of our Gross Domestic Product. Anybody with half a brain knows these numbers are unsustainable and a direct threat to the continued prosperity of the United States. Tick, Tick, Tick….the debt bomb is ticking. Americans want this issue addressed, but greatly prefer somebody elses ox be gored. The next blog I churn out will offer some suggestions to avoid a crisis. It will be universally reviled because  everybody’s ox will be gored.

Wealth and Income Inequality

 There is generally a high degree of correlation between wealth and income. The reason is obvious - for the most part, financial assets generate income in the form of interest, dividends, and capital appreciation. The more assets owned by an individual, the higher the level of income generation. There are of course some exceptions to this close relationship between wealth and income. An investor sitting on a pile of gold receives zero income from his precious metal holdings, but could have a significant net worth. Another classic example would be the occasional NBA superstar who earns tens of millions of dollars per year for a finite number of years. However, due to a profligate lifestyle, income tax obligations, and incompetent, if not outright unscrupulous, agents and managers, finds himself in bankruptcy court when his playing career comes to an end. For the purposes of this blog, I'll be making the assumption that high wealth and high income are interchangeable. My goal is to outline a thesis detailing how economic disparity is viewed by Americans and then explain why the discrepancy has widened so much since the Great Financial Crisis (2008-2009).

Like practically every other political issue these days, conservatives and liberals typically hold dramatically different viewpoints on income inequality. Progressives tend to claim that Americans with high incomes don't pay their "fair share" of taxes and promote extensive redistribution (income) efforts. I've never heard or read what redistribution advocates define as "fair share." Many conservatives, including myself, offer a counter-argument pointing out in no other country do the rich bear a greater share of the income tax burden than they do in the United States. In terms of federal income taxes, the top 1% of taxpayers in the U.S. pay 40% of taxes paid, the bottom 20% have negative tax rates. Over 40% of households pay no federal income tax. When the data are adjusted to account for all government programs that transfer income, the U.S. is shown to have an income distribution that aligns closely with its peers. It seems both unfair and illogical to demonize and target the taxpayers who tend to be the smartest, hardest working, and most productive participants in the economy. All that said, I take the position it may be wise to tweak the tax code and various government programs at the expense of the wealthy and to the benefit of low and middle income Americans. History tells us that a society needs a release valve when a significant portion of the population is falling further and further behind the well-to-do. Otherwise, social unrest and violence is all but inevitable.

As with many of my previous financial blogs, I intend to place the blame for growing wealth/income inequality squarely on the monetary policies of the Federal Reserve Bank and the fiscal negligence of the United States Congress. Zero or near-zero interest rates in the wake of the 2008 financial crisis (2008-2015) and the Covid-19 pandemic (2020-2022) are coming home to roost in a most distressing manner. ZIRP (zero interest rate policy) that was aimed at stimulating economic activity ended up serving the needs of big government, big business, and owners of financial assets, while ordinary savers received almost no return on their savings for more than a decade. The largest borrower in the world is the U.S. government. The Treasury reaps the benefit of borrowing at a reduced cost when interest rates are held down. Large corporations are beneficiaries of Fed largesse when they can borrow money cheaply to buy back their own shares in the equity markets. By artificially increasing the earnings-per-share, they raise the price of their stock. Because many top executives have compensation packages linked to their companies' share price, this maneuver rewards these executives. Wealthy individual investors are especially well positioned to benefit from "accommodative" monetary policy. They borrow funds at extremely low interest rates and proceed to arbitrage high returns from pumped-up equity markets against a low cost of borrowing.

It's abundantly clear that monetary policy can channel financial benefits to some members of the population at the expense of others. While interest rate manipulations by monetary policymakers offer up a speculator's paradise for those who can grab quick profits by trading derivatives and currencies, these manipulations make life considerably more challenging for people who must function in the real economy. In her 2021 book, "The Engine of Inequality: The Fed and the Future of Wealth in America," financial consultant Karen Petrou explains: "Ultra-low rates fundamentally eviscerate the ability of all but the wealthy to a gain an economic toehold; instead, they lead investors to drive up equity and other prices to achieve return-on-investment objectives, but average Americans hold little if any, stock or investment instruments. Instead, they save what they can in bank accounts. The rates on these have been so low for so long that these thrifty, prudent households have in fact set themselves back with every dollar they save."

The main impetus for the aggressive post-GFC expansion of the country's money supply was to spur faster economic growth. In addition to keeping rates at effectively zero, the Fed utilized QE to purchase government debt securities. To the surprise of many economists and policy wonks, the economy remained sluggish. Even more surprising, inflation all but disappeared for the second decade of the 21st century. Normally inflation results when the money supply dramatically increases. Where did inflation go? The answer is that inflation from 2010 - 2020 was concentrated in asset values, primarily equities and real estate. Inflation in goods and services did not appear until the government mailed stimulus checks to Americans during the Covid-19 pandemic. To finance this massive outlay along with all the other Covid-19 relief programs for businesses, Uncle Sam had to issue a boatload of debt securities. A good portion of this new debt was purchased by the Federal Reserve Bank. The burden of paying this debt will fall on future generations. Government debt securities are claims on future tax revenues derived from wealth yet to be created and incomes yet to be earned.

The structure of our economy has fundamentally changed over the second half of the 20th century and first quarter of the 21st century. We are no longer a productive economy that makes products of substance. The United States is now a financialized economy, where the financial sector and its priorities have become increasingly dominant in all aspects of the economy. The U.S. financial sector grew from 10% of GDP in 1950 to 22% by 2020. In 1950, manufacturing had 40% of all profits and 29% of the nation's jobs; today, financial enterprises have 40% of the nation's profits with 5% of the jobs. The real economy and financial markets have reached the point where they are practically totally detached and fundamentally at odds. While Main Street has lagged or even retreated, Wall Street has thrived. Growth rates of the economy since 2008 do not in any way support the valuations of the stock market.

Policies introduced by the Fed and other central planners have enriched elites at the expense of poor and middle-class Americans. No where in the Constitution does it say that money shall be regulated in such a way that some groups benefit more than others in accordance with decisions made by the nation's central bank. It is blatantly inconsistent with founding principles to allow monetary authorities to deliberately debase the dollar in order to achieve what they construe to be "price stability." Perhaps the Fed should simply serve as the lender of last resort and allow the free market to determine levels of interest rates and the country's money supply. As evidenced by multiple surveys over the past 15 years, faith in our institutions and capitalism is waning. When citizens believe the system is "rigged" to reward those who are already at the top in terms of wealth and income, this belief feeds an attitude of resentment and cynicism. As we have recently evidenced, an environment of this nature is a rich breeding ground for political populism.

Is Buy and Hold Dead?

For the context of this blog posting, the term "buy-and-hold" specifically refers to an investment strategy whereby an investor buys equity securities with the intent to hold them long-term with the goal of realizing price appreciation. This is strategy endorsed and often utilized by historical investment icons such as Jack Bogle, John Templeton, Peter Lynch, and of course, the legendary Warren Buffett. Although, in the past few years, it appears Mr. Buffett has liquidated and converted to cash many of his holdings in various companies. The majority of professional participants in the investment world now believe buy-and-hold is basically dead and gone. I don't believe buy-and-hold is dead and gone, but it's definitely on life support.

One reason buy-and-hold has fallen out of favor is that the strategy implies the risk of assets is always justified by the reward. The idea that every year is a good year to own equities is patently false. The risk of buying and holding securities is not justified by the reward under certain conditions. Another problem with buy-and-hold is the implication that prices don't matter because the strategy requires you to buy-and-hold at all times regardless of price or valuation. Is there any other buying decision in your life where price doesn't matter? The answer to that question is glaringly obvious. Besides completely ignoring the essential investment concept of managing risk, buy-and-hold requires little intelligence, skill, or serious effort. Combined with the ongoing trend of passive investing, this is a recipe for disaster.

There are additional reasons why a buy-and-hold strategy, while not complete nonsense and outdated, is a risky endeavor these days. It totally misses the dynamic evolution of the world - everything changes throughout time and the speed of change is ever-increasing. The number of variables at play also is increasing at a geometric rate. Another risk is the reduced lifespan of a business, even originally successful businesses. The lifespan of large, publicly traded companies has significantly decreased over time, with some studies indicating a current average lifespan of around 15 years or less. More stocks have vanished or gone to zero than have survived to this day. One of the chief reasons buy-and-hold isn't king anymore is due to the new, more extreme conditions in the market. Although currently in hibernation, volatility and the Bear have not gone extinct. Through greed and lack of attention, our markets are sometimes built on inflated bubbles. I can make the argument that is presently the case. Furthermore, while timing the market to perfection is improbable, if not impossible, wise investors tend to reduce their exposure to stocks when the market is expensive relative to the fundamentals, and keep their exposure down - if need be, for years - until the market becomes much cheaper. It then involves increasing exposure, and keeping it high, again for years, if necessary.

As mentioned, the market is more dynamic than ever. Investors will miss out on gains from shorter term movements if they rely exclusively on buy-and-hold and do not hold capital for shorter term investments. Buy-and-hold is a purely offensive investment strategy that ignores the defensive half of the investment equation. At times it makes sense to take a short position in a stock. Warren Buffett was mentioned earlier. Probably no other investor has been more closely associated with buy-and-hold than Mr. Buffett. His baby, Berkshire Hathaway, has recently sold a substantial amount of stocks and is presently sitting on a record $325 billion cash pile as a result. Old Warren believes equities are severely overvalued and a market crash is possible. He is wisely waiting for bargain basement opportunities. This is not the behavior of a true blue buy-and-holder.

  

Optimum Asset Allocation Model?

 If not an outright trick question, the title of this blog is misleading. The optimum asset allocation can only be determined in retrospect, for nobody can read the future. At least not accurately. When establishing an asset allocation model for an investor, one size does not fit all. Multiple variables come into play when establishing an investor's customized asset allocation parameters. Besides personal preference and financial goals, the next most important component would be somebody's level of risk tolerance. A person who can't psychologically deal with a stock market correction (down 10%) or a Bear Market (down 20%) should have minimal portfolio exposure to equities. Other important factors to take into consideration would be an investor's age, health, and level of current and expected interest rates.

Before looking at different allocation models, let's delineate the major asset classes. These asset classes would be as follows: 1.) Cash and Cash Equivalents (includes Treasury bills); 2.) Equities (stocks); 3.) Fixed Income (bonds); 4.) Real Estate; 5.) Precious Metals (gold and silver); 6.) Commodities; 7.) Foreign Currencies; 8.) Cryptocurrencies; 9.) Collectibles. It goes without saying many of these categories could be further divided into sub-classes. For example, Fixed Income could be broken down into U.S. Treasuries, corporate bonds, and municipal bonds. Real Estate could be further divided into residential, commercial, and agricultural real estate. For our purposes, we'll stick with the general classes in order to avoid getting stuck in the mire of excessive details.

Historically, 60% equities and 40% bonds has been the most common allocation recommended by financial advisors. This has been considered a balanced portfolio and has been the standard for decades. Quoting songwriter and crooner, Bob Dylan - "And you better start swimmin', Or you'll sink like a stone, For the times they are a-changin'." There has been an evolution away from 60/40 and toward other investment allocation options. The primary reasons away from 60/40 would be high equity valuations, Federal Reserve Bank monetary policies, increased risks in bond funds, and low prices in the commodities' markets. Many experts are now saying that a well-diversified portfolio must include more asset classes than just stocks and bonds. Besides those asset classes itemized in the previous paragraph - private equity, venture capital, and private credit are now often incorporated in the modern investment portfolio.

There once was an old rule of thumb that utilized the investor's age to determine the stock/bond allocation in a portfolio. For a thirty-year-old, the recommendation was to hold 30% in bonds and 70% in equities. For a fifty-year-old, the recommendation was to hold 50% in both stocks and bonds. Thus, for a seventy-year-old, the recommended allocation was 70% in bonds and 30% in equities. In our topsy-turvy world, older investors these days often turn this approach on its head and flip-flop to 70% equities and 30% bonds. The percentage Baby Boomers are allocating to stocks is at an all-time high. These folks are ill-prepared to weather a 30%-50% down market.

I've always been partial to the 30/30/30/10 allocation model allocated as follows: 1.) 30% - stocks; 2.) 30% - bonds; 3.) 30% - real estate; 4.) 10% cash. The double-digit percentage in cash would be applicable when short-term interest rates are depressed as they were during the Covid-19 pandemic. Otherwise, I would take cash to 5% and increase equities to 35%. In an environment where the continued debasement of our currency is a distinct possibility, I would be comfortable with the following allocation: 1.) Equities - 40%; 2.) Fixed Income - 20%; 3.) Real Estate - 25%; 4.) Gold and Silver - 8%; 5.) Bitcoin - 2%; 6.) Cash - 5%. Equities, real estate, and precious metals total 75% in this scenario and offer some protection against inflation. If major inflation and loss of purchasing power are a strong possibility, the 12/20/80 asset allocation rule may appeal to some. In this scenario, an individual holds 12 month's worth of expenses in safe, liquid funds. Then, the remainder of his assets are divided between equities (80%) and gold (20%).

For those investors with a contrarian bent and a morbid fascination of market crashes, I suggest extending consideration to what I'll refer to as a "Black Swan Portfolio." In the context of finance, a black swan event is used to describe a rare, random event that nobody sees coming that poses a significant risk to the stock market and economy. Some historical examples would include 9/11, Great Financial Crisis (2008), and the Covid-19 pandemic (2020). The term is closely associated with the trader and author, Nassim Taleb, and founder of the hedge fund Universa, Mark Spitznagel. The "Black Swan Portfolio" is quite basic in its application and has been widely successful in the rare times it has been implemented. The first component of the strategy is to go long the S&P 500 Index for 97% of your investment portfolio. Using the SPDR S&P 500 ETF Trust (ticker symbol SPY) is an instrument that can be used. Next, with the remaining 3% of your portfolio, buy deep out-of-the-money put options on SPY (60-90 day expirations), and do this on a regular basis. By doing this you are effectively shorting the market, tail-risk hedging, and possibly realizing a windfall if a Black Swan event materializes. Be prepared  to suffer small losses for literally years before the money spent on the constant purchase of put options pays off. As mentioned, the Covid-19 pandemic was a Black Swan event and the market tanked in March 2020. The aforementioned Mark Spitznagel's hedge fund (Universa) made a return of 3,612% for that month alone, and over 4,000% for the year 2020. I have to assume Universa's investors were elated to benefit from a 40 bagger in 2020.