On the surface, the recent and well-publicized protests in the state of Wisconsin have been a no-holds barred struggle between public worker unions and a conservative governor, in a battle that has galvanized both the left and the right across the nation. There is truth to that viewpoint, but as is often the case, the much hyped political struggle between partisans of both sides is also a distraction that serves to mask a much more powerful and even more significant threat to the entire population, both left and right.
What we are seeing in Wisconsin and in other state budgets across the nation is not really about the states so much as it is a federal unraveling, as the government toys with allowing artificial employment levels to decline. As described in detail in previous articles, the US economy is in far worse shape then presented by the government and mainstream media. The private US economy has been in depression since late 2008, and as discussed herein, this is made indisputable by the "truth test" of actual state tax revenues that are not easily subject to federal statistical manipulation.
The depression has been hidden by funding artificial jobs with artificial money, which is an inherently unstable and dangerous process. Looming nationwide compensation and employment cuts for state, county, city and school district workers represent a public "testing the waters" with a partial reduction in artificial employment - which may then bring the true state of the economy into plain view, with unemployment, inflation and tax rates all rising simultaneously. Each of these powerful forces will devastate unprepared investors, even as they create opportunities for those who are informed and prepared.
The Budgetary Mystery
Let's step back, way back, and consider a mystery that forms the stage on which the politics play out. For our example, let's focus on Wisconsin, as it is the state with the largest (so far) and most publicized public worker protests in the United States.
Let's consider the time from 2008 until now. Like the rest of the country, Wisconsin experienced a terrible economy, the worst since the 1930s. The ailing economy led to reduced state receipts from income taxes, sales taxes and capital gains taxes. So like the other states, Wisconsin had to take drastic measures to balance its budget. Painful as it was, Wisconsin was indeed able to achieve balanced budgets during this time of extraordinary economic stress.
Now let's consider the economic projections which form the basis for Wisconsin's budgets over the next several years. Underlying those projections is a fairly rosy economic scenario which assumes the best of both worlds. That is, the economy is assumed to rebound in Wisconsin with sustained economic growth that brings increasing taxes into the state. Moreover, it is simultaneously assumed that the lowest interest rates in generations maintain indefinitely, so interest payments remain historically low on the substantial amount of debt that Wisconsin has outstanding. Starting from the base of a balanced budget, with this combination of a rosy economic scenario and low interest costs and with the hard pruning of state expenditures already done - it would seem reasonable to believe that the fiscal situation in Wisconsin would be improving rapidly, perhaps even generating significant budgetary surpluses.
But instead, the likely deficit appears to be an historically unprecedented shortfall of about $3.6 billion over the next two fiscal years. A shortfall which dwarfs the problems of the past several years and for which Wisconsin - like so many other states - doesn't yet have any viable solutions, other than a whole lot of painful austerity.
Does this combination of balancing budgets under terribly adverse economic circumstances in the past, while having the deficits be forecast to go out-of-control in the future despite the accompanying forecast of an ongoing economic recovery, seem a little bit... curious?
Does it make sense that a state would be able to balance its budget during the worst economy since the Great Depression, and yet face catastrophic shortfalls during a period of assumed rebounding economic prosperity - even with the previous cost-savings still in place?
And why are variations of this bizarre scenario playing out in the budgets of 44 out of 50 of the United States of America? The total anticipated shortfall in the states is about $112 billion for fiscal year 2012. While the protests in Wisconsin formed the leading edge of the battle, the $1.8 billion annual (FY 2012) budget deficit in Wisconsin is dwarfed by the $13 billion deficit in Texas, the $10 billion deficits in both New York and New Jersey, and the $25 billion deficit in California (note these are projected annual shortfalls rather than the 2 year budget cycle shortfalls often quoted; source is Center On Budget and Policy Priorities).
This Is Federal, Not State
The simple explanation for the mystery is that Wisconsin's ability to balance its budgets in the recent past, and the looming fiscal catastrophe in the future, are both arguably primarily federal issues rather than state issues. Therefore, instead of looking to past and current governors, we must instead look to the President and Congress.
We'll touch on a few highlights here that are covered in more detail in other articles, most particularly in "Hiding A Depression: How The US Government Does It" (linked below). The essential point to understand is that contrary to the official government and mainstream media "spin", the US economy has not recovered, nor has it come anywhere close to recovering from the sharp depression-level downturn that hit in 2008 and 2009. As shown in the graph below, the private sector of the US economy shrank by $1.3 trillion - and it hasn't come back. This is an indisputable depression-level loss in economic output and jobs.
What has kept the national economy from looking like it is in a depression has been unprecedented, massive federal deficit spending that has caused the total government share of the economy to leap from 35% in 2007 up to 43% by 2009 (the same approximate level was maintained through the end of 2010).
The source of much of Wisconsin's "balanced budget" in recent years was in fact federal money - that the Federal government didn't have either, as it had much larger budget shortfalls than all the state governments combined. However, the Federal government has the flexibility to do two things that the states can't: it can create money out of thin air, and it isn't subject to balanced budget requirements.
Effectively, the Federal government did an end run around the constitutions of the individual states, to give them the ability to "hide" the depression that the country was (and still is) in, without having to resort to far larger job cuts or massive tax increases. Initially the US government covered the gap by borrowing extraordinary sums of money that it arguably does not have the ability to pay back - except via inflation (as I have written about extensively, including the article "Bailout Lies Threaten Your Savings" linked below). In the 4th quarter of 2010, the US government turned to outright direct monetary creation to effectively fund massive government deficits, including the Recovery Act Funds which have been subsidizing the states.
However, supporting federal spending at current levels by having the Federal Reserve simply create money out of the nothingness and purchase Treasury Bonds risks a swift collapse in the value of the dollar and a rapid plunge in the US standard of living. It is a scenario that is likely already in process when we look at global markets, and rapidly rising rates of inflation for energy and food, and some import categories. Therefore, at least for now, the federal government is purportedly swearing off this massive level of wealth transfers to the states.
This means that the individual states must finally face up to the economic reality previously hidden by federal emergency assistance and "stimulus" spending. It's a reality that says that even when we project a near-perfect scenario of economic recovery and low borrowing costs - that the states still face fantastic deficits in the years to come.
Budget Projections And Assuming Miracles
Unfortunately, Wisconsin's budget and many other state budgets have a rather major logical flaw in them: they don't connect the anticipated consequences of changes in government behavior with what happens to the economy itself.
The $3.6 billion two year shortfall is arguably a best case projection, because it assumes that going off of federal life support is in fact without cost to the economic output in Wisconsin and the other states. The total federal deficit has been running at about 10% of the total US economy. However, the budget projections assume that as the "stimulus" spending winds down and much of the state support monies are withdrawn, that the private economy seamlessly leaps forward, instantly covers the gap, and then grows some more. Remember, the budget assumptions are for net growth, and for this growth to occur, the "hole" in the state and local economies has to be filled first, and then the projected growth has to occur on top of that.
On a national basis, the salient question is where precisely will the missing real economic output come from to not only fill the hole, and instantly return the economy to its former state, but then generate further growth in 2012, 2013, and beyond? What's going on right now that substantiates the theory that on top of a purported normal recovery, there will be this surge of historic proportions in economic growth in the US private sector in the near future?
If we can't identify a credible source other than pure optimism (or political convenience) - what happens if this miraculous private sector burst of growth fails to materialize?
Tax Revenues & Feedback Loops
Even as the states have become dependent on the federal government assistance, so too the counties, cities, towns and school districts all rely on the payment of monies by the state to cover their own expenditures. These payments have already been falling fast over the last couple of years, and massive reductions in payments to local governments are one of the few places that state governments can turn to in order to cover multibillion dollar shortfalls. Basically the governors and state legislatures say to local governments: "we don't have the money, we don't know what to do, so we will make you deal with it instead." Slashing state budgets means not only slashing state jobs, but also county jobs, city jobs and school district jobs in every local government. This is why Moody's Investors Service recently warned that this would be "the toughest year for local governments since the economic downturn began." (New York Times, March 23rd.)
This creates a situation where the newly unemployed public workers are no longer paying income taxes, the sales taxes they pay plunge along with their standard of living, and they struggle to even come up with property taxes and mortgage payments. Because spending is going down in every community across the state (and nation) - the private businesses in each community are likely also reducing employment. This increased unemployment further reduces tax revenues, which leads to further budget cuts. This is the cycle, it is where the US would have been two years ago absent extraordinary deficit spending, and because the underlying problems have yet to be fixed - it still awaits as soon as the emergency state aid and stimulus monies are withdrawn. There have been many downturn cycles in the past, and while economies do eventually return to growth and (usually) become wealthier than ever, the long term historical norm going back to the 19th century is for the downturns to be prolonged and painful.
Back to Wisconsin - what happens to this projected $3.6 billion state government deficit when the economy is shrinking rather than growing, and future tax revenues are falling beneath current levels rather than increasing as projected, even as the federal support is cut off? Particularly when this is happening even as the funding is running out for the other stimulus projects that have been sustaining construction and other jobs across the state and across the country?
Partial Collapse Of The Third Box Of Unemployment
In the previously linked article "Hiding A Depression: How The US Government Does It", the full rate of unemployment was shown to be in excess of 25%, and the reporting of a much lower rate of unemployment is based on splitting unemployment into three boxes:
Box One: The official U3 "headline" rate of unemployment;
Box Two: The equally official but not often mentioned U6 full rate of unemployment; and
Box Three: The "artificially" employed whose jobs are being paid for by monetary creation and extraordinary levels of deficit spending.
This artificial employment is the yellow component of the graph above, and as discussed in the "Hiding A Depression" article: "If we pull away all of the massive government spending that has funded the "Third Box" of containing unemployment, then as the walls fall down and the Third Box collapses, all the newly unemployed flow over to the 1st and 2nd boxes, true comparability with the 1970s and 1930s is restored, and we have an obvious depression-era level of unemployment all around us."
What we have been exploring in this current article is one portion of the partial collapse of the walls surrounding the "Third Box", with that portion being unemployment in the public sector of one state. When the federal funding that supports the employment of all those public sector workers is withdrawn, then those state and local workers move from the yellow box to the red box of unemployment, along with all of the private sector workers whose jobs were funded by contracts under stimulus programs that are not being renewed.
Budgets & Fantasy Versus Reality
It is also most interesting to note that when we look at inflation-adjusted state sales tax revenues as of March, 2011, on a nationwide basis these tax collections still remain down almost 11% compared to 2008, representing the sharpest decline since the 1930s (source: Center On Budget and Policy Priorities). As my long time readers are well aware, I've been making the points that the real economy and real unemployment are in much worse condition than that which is presented by the US government (and what is priced into the US stock market). When we look at a tangible independent "bottom line" measure of the US economy that would be quite difficult to manipulate, which is state and local government tax dollars actually collected, the numbers are in line with an economy in deep trouble that still has not turned the corner, rather than an economy that officially emerged from recession in June of 2009, per the National Bureau of Economic Research (NBER). (While independent of the US government, the NBER bases its conclusions on government statistics.)
Where things get still more interesting is when we try to reconcile the reality and fantasy components of the state budgets over the next several years. The problem is that in the real world - state revenues are hurting badly and have not yet recovered. Yet, future budgets are based on a rosy economic scenario that is based on federal statistical reporting of a much healthier economy. There is a fundamental contradiction here, as actual state tax collections are reflecting a deeply wounded economy that has not yet recovered, while state revenue projections are based upon a rapidly recovering and growing economy that emerged from recession almost two years ago.
If the future economy has more to do with actual state tax collections to date, rather than rosy economic projections, even as employment is reduced at every level of state and local government along with reductions in stimulus spending, what happens to state budgets at that point, and how much worse does the feedback loop become?
2012 Elections & No Free Money
As previously mentioned, the current publicly stated plan is for the Federal government to wind down its emergency funding of the state governments, as well as other "artificial employment" programs within the stimulus packages. However, the preparations for the 2012 presidential election in the US are already well underway, and I am profoundly skeptical that either party in Washington, DC. will in practice allow the walls of the "yellow box of artificial employment" to actually come crashing most of the way down in the same year that the President, along with every member of the House of Representatives and one third of the Senate, are all running for re-election.
When unemployment shows signs of spiraling out of control even as the campaign managers are obsessively checking their polling results - my guess is that most politicians are going to (once again) say "long-term national interest be damned, my political career depends on winning this election." Meaning there will likely be more money created out of thin air on a massive scale, as the incumbents in both parties try to avoid the wrath of their constituents and keep their jobs.
An example of something analogous happening elsewhere is the Portuguese ruling party losing power on March 23rd, with politicians deciding they would rather risk national financial collapse than take personal responsibility with the voters for austerity packages. (Austerity will likely come anyway as a price of the coming EU and IMF bailout package, but this way politicians will be able to blame the painful "cure" on outside bureaucrats.)
However - voluntarily or not - the end may already be in sight for massive monetary creation in the US, as oil and food prices surge upwards. Inflation is climbing fast even as the value of the dollar is in question around the world, which can lead to rapid increases in import prices in other areas, further feeding the inflationary flames. What happens to the deficit in Wisconsin, the other states, and the federal budget deficit if interest rates begin to soar on trillions of federal, state and local borrowings as a result of this rapidly rising inflation?
What happens to the value of everything you've saved if the political calculus is to gamble what is left of the credibility of the dollar for short term attempted political survival?
While I feel deep compassion for those whose lives will be profoundly changed for the worse if the artificial employment monies are withdrawn, it needs to be clearly understood that there is no such thing as free money.
The ultimate price of creating artificial jobs with artificial money is quite possibly the destruction of the value of the life savings of tens of millions of investors, with a potential multi-decade decline in the standard of living for current retirees and retirement investors.
These are extraordinarily complex and difficult issues. For further exploration of the trade-offs between risking the value of the dollar for the short term benefit of workers, versus the potential costs for older investors, there is a much more in-depth analysis available within the article "Bullets In The Back: How Boomers & Retirees Will Become Bailout, Stimulus & Currency War Casualties", linked below.
The Long-Term Investment Implications
For the investor, it is essential to think through the likely implications of the situation described and questions posed in this article. Let me suggest that for those who are not prepared, there will be potentially catastrophic damage to the future value of investment portfolios as well as future lifestyles, with the damage falling into three distinct but interrelated categories.
1) Asset Deflation In Real Terms
An artificially propped up economy that finally finds its true level will likely devastate the inflation-adjusted value of stocks. That is, the federal government has been doing everything possible over the last several years to keep stock market valuations high. US stock market values do not reflect our current state of real depression absent government stimulus packages, nor do they reflect the rapidly changing position of the US within the world economy, in terms of losing much of the resource consumption benefits that go with global economic and military leadership.
In other words, particularly as the pace of boomer retirement picks up over the next several years, there is a very strong case to be made that the value of the stock market will be plunging in real (inflation-adjusted) terms. This would have catastrophic implications for individual investors, and, returning to our example state, is also likely to cause devastating problems for the Wisconsin state pension fund, to the extent that it has entered into legally binding inflation-adjusted promises to public retirees. This growing pension shortfall then increases the deficit, which puts further downward pressure on employment, which puts downward pressure on the economy, which in turn increases the pension shortfalls, which then feeds back to further increasing the state government deficit.
2) Monetary Inflation Rising Rapidly
Government inflation index manipulation notwithstanding, the average person is experiencing soaring costs for food, rapidly rising gasoline prices, and health insurance premiums climbing at a punishing rate. The official stance that the US has effectively zero inflation is becoming a joke that is harder to laugh at with each passing week. If rampant monetary creation continues to be used to fund the short term artificial semblance of a prosperous economy, the long term results are likely to be devastating, including a plunge in the value of money, a plunge in the value of all of our savings, and a collapse in the value of bonds. And it will be accompanied by the artificial component of the economy imploding anyway, giving us the worst of both worlds.
Let's go back to the feedback loop with our example state of Wisconsin. If soaring inflation leads to soaring interest rates that devastate the value of the bonds in Wisconsin's retirement fund portfolio, even as the interest that Wisconsin pays on its debt climbs rapidly - what does that do to the fiscal health of the state of Wisconsin? What does that do to the deficit and then the economy itself?
3) Rising Taxes
Increasing deficits and a likely decreasing ability to manufacture money by the federal government, along with extraordinary political pressures from many people who believe they have an absolute right to maintain their current lifestyles, is likely to lead to simultaneous asset deflation and monetary inflation even as the pressure rises to increase tax rates. Now so long as the value of money falls fast enough, even assets that are worth less in real terms every day will grow higher and higher in their nominal dollar value, meaning they generate taxable income, of which revenue hungry states and the federal government then take a big share in the form of taxes.
As an example, Minnesota - Wisconsin's next door neighbor - has more than twice the deficit problem, with an estimated $3.8 billion shortfall in fiscal year 2012 alone. The recently elected governor of Minnesota has a simple solution - just raise the state income tax rates until they are the highest in the United States. While he is highly likely to be blocked by the Minnesota legislature, this proposed solution of simply raising the tax rates as high as needed is the most popular solution among many politically powerful special interest groups whose jobs and / or power bases will be affected by budget cuts and austerity measures.
This political pressure leads to the situation that I believe is likely to be the central danger facing long-term investors, retirement investors and retirees over the coming decade, which is this three-way combination of losing the value of your assets, losing the value of your money, and being taxed on the whole thing in the form of inflation taxes. If you're not familiar with how this 1-2-3 combination threatens future older investors' standards of living, I suggest watching the two minute video "Deadly Danger Of Dow 50,000" within the article linked below:
In the years that I have spent developing solutions for these issues, I have come to believe that the best answers all come down to a matter of financial positioning. Ultimately, inflation is not a destruction of real wealth, rather it is a redistribution of real wealth. Similarly, asset deflation destroys paper wealth (that often never was real in the first place), but it doesn't directly destroy the real wealth of goods and services that were there the whole time. Asset deflation does, however, redistribute the rights to that real wealth, with some people growing wealthier than ever in real terms as a result of asset deflation, even as most people are hurt.
Inflation taxes themselves are a redistribution of wealth from citizens to the government in the form of hidden taxes. However, astute individuals who recognize what is truly going on can find ways to not only thwart these unfair hidden taxes, but actually reverse them to their personal benefit.
For someone who follows the (currently) respectable conventional wisdom when it comes to retirement and long term investing, what is currently playing out in Wisconsin and other states risks savaging their long term standard of living. Major monetary inflation, plunging real values for assets, and rising tax rates may work in a three part combination to destroy the fruits of decades of hard work and responsible savings for tens of millions of people.
However, when we step outside of the conventional investment box and seek innovative solutions - each one of these wealth destroyers is also a wealth re-distributor. And if we can change our fundamental financial profile such that each one of these terribly adverse events redistributes wealth to us rather than taking it away, then we can take perhaps one of the worst decades of our lifetimes for investors, and turn it to our powerful financial benefit. The difference between being a victim and growing wealthier than ever will be one of gaining the understanding for how to change our financial positioning.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com.