A little over one year ago, in a May article titled Our Nagging Deflationary Problem, I stated:

We will see the effects of de-leveraging; debt defaults, a search for safety, very conservative spending by individuals and governments everywhere, and less leveraged investments. As this occurs we should see lower interest rates, slowing growth, a rising dollar, and falling stocks. Commodities should fall back to lower levels and stabilize. Just as everyone begins to focus on the last couple of months of higher inflation rates, which are lagging indicators, the disinflationary/recessionary bias has already set in. I seriously doubt most people are ready for this.


Then in my Mid Year Review of 2011, also in June, I warned of the Euro Crisis:

The most likely scenario for Europe, I think, could look something like this…

Over the next few years, Greece will be forced to break from the Euro Zone and return to the Drachma as its national currency. It will then allow its currency to float and seek its true market level, which would result in a major devaluation and a de facto default on creditors.

All those with loans outstanding to Greece will be forced to write down these loans, and the losses could be huge. The world financial community would try to rally around the banking system in an effort to save it; but at a tremendous cost.

Greece would no longer be able to borrow after defaulting, and the country would be forced to live on tax receipts alone. The result would be the same kind of austerity measures they’ve been trying to avoid--only two to three times worse. Meanwhile creditors would be licking their wounds after having taken a beating on Greek bonds. Money would again become tight in Europe as creditors pulled in their risk lending and an inevitable economic contraction set in.

As governments and creditors assessed the damage, the market would likely turn to the next weakest link, and begin to attack its banking system causing fast and furious selling off of financial stocks there. That country would also be forced to part from the Euro and reestablish its own currency at substantially devalued levels. The next potential candidates to be run are Ireland, Portugal, and even perhaps Spain and Italy.

If this is the outcome, after the smoke cleared, the Euro would be represented by only the strongest, most solvent nations. Europe would be split in two, divided into a group of strong nations (the haves), and a recession torn group of financially weak nations who would then make up Europe’s have not’s.

America, I believe, would only be affected indirectly by this deconstruction. The turmoil of this experience would obviously lead to a contraction in world growth, a reduced appetite for risk, and stagnation in many areas of the world. But I would not expect to see the dollar decline in this period. In fact it should rise, except possibly against the eventual new Euro. And I do not think this kind of process would lead to a major decline in growth here in America, although we could experience a technical recession. But once the readjustment process ran its course, growth would pick up once again.


And finally, in my January 2012 Looking Forward article, I made it clear why I refused to make any specific economic projections for the year:


For the first time since I began writing these forecasts, I find it impossible to make a projection. My past forecasts have been accurate because they were all based on economic policies proposed or implemented by governments. But looking to 2012, there are no policies proposed! There are only possible political reactions to events and ongoing problems. Only when we see the resolution of the problems plaguing Europe and the US will we be able to once again make accurate projections about the economy.



What about the rest of 2012?


It’s almost July and we still have no idea what policy makers here in the US or around the world intend to do to solve the problems that face them. Yet to be resolved is the decision and political fate of tax policy, which if nothing is done, will lead to substantially higher taxes in 2013. The debt ceiling dilemma will have to be dealt with again soon. Growing debt and deficits are spiraling out of control. Medicare and social security are bankrupt with over 67 trillion dollars of outstanding unfunded liabilities. And a recessionary/deflation bias is dragging the economy down.


Internationally, policies are being drafted "on the fly.” There is no central government in the EU, no coordinated fiscal policy, and no monetary flexibility. There is no EU architecture to deal with the problems Europe faces. If it were up to me, I would kick Greece out of the EU and attempt to defend the rest of the nations in the euro-zone. The resulting meltdown in Greece would serve as an example to any nation that chooses to ignore economic reality and its fiscal condition—as Greece has done and still does today. That alone would "encourage" every other nation in the euro-zone to take the necessary measures to get its fiscal house in order -- or be next. It's tough love, but it would do more to quickly end this crisis than any other proposed policy.


While Greece has temporarily averted total collapse, and Spain has been given a credit life line, the euro-zone and its currency are not out of trouble. Alan Greenspan just referred to the euro as a "noble but failed experiment.” I agree. The euro was set up as a rigid monetary system, but without rigid fiscal requirements. For years I’ve argued against a return to a fixed exchange rate system in a fiscally irresponsible world. Without first establishing fiscal integrity, such a system would lead this nation into chaos. The euro-zone is a vivid example of such a failed attempt.


A gold standard, or any system of fixed exchange rates, helps to promote discipline. But fiscal discipline precedes true monetary stability. Those demanding a return to a Bretton Woods type of monetary system of fixed exchange rates (let alone a gold standard) do not realize that such a system coupled with today’s fiscal madness would lead us over a monetary cliff. To see such a system in action you need only look to the euro zone.


The international crisis will not be solved until they return to unified balanced budgets, lower debt levels, and encourage economic growth though labor and regulatory flexibility. Most nations however are still moving in exactly the other direction; and until they change direction the crisis will continue.


This should serve as a warning to the United States which is now following in Europe’s footsteps. Here in the US growth rates have fallen from 3% as of the first of the year toward 2% and less today. And as commodities have fallen, we’ve moved from 4% inflation rates to 2% inflation rates year over year with sporadic deflationary rates on a month over month basis. The recessionary/deflationary bias is taking further hold of the economy and until the policies change, we will continue to languish in my World of L for the foreseeable future, with stagnation and high unemployment for as far as the eye can see.



What can be done?


Economically the road back to health is clear. The following steps should be taken.


Tax Reform


We need a complete overhaul of our tax system. Reduce rates to something like a dual rate of 10 and 25% and eliminate all deductions. If done correctly we could end up with a revenue neutral tax that is simple and understandable for everyone. There would be greater incentives to produce and earn money resulting in increased revenue and growth. The mere act of simplifying the tax code would save billions in unnecessary preparation charges and work hours wasted. The elimination of deductions, loop holes, subsidies, and corporate welfare is estimated to increase collections in excess of a trillion dollars a year! Just this change alone would do wonders to get America back on sound fiscal footing.



Budget Cuts


Cutting government waste and duplication is imperative. There are agencies, especially regulatory agencies, which overlap and even conflict with one another. These counter-productive redundancies must be eliminated. In addition, government wages and benefits should be in line with those in the private sector. Many bureaucrats are paid 50 to100% more than what they'd get for doing the same job in the private sector. And many of those jobs can be trimmed or reduced. We don’t have to "fire policemen, teachers, and firefighters.” We simply need to streamline government. Massive budget cuts aren’t even necessary, just reasonable ones.


The best way to accomplish this is to provide block grants to the states for health, education, welfare, safety concerns, etc. These tasks should not be the province of the federal government. States have proved to be much more efficient at providing such essential services (and balancing their budgets) than the federal government has. Block grants to states would mean a smaller, less expensive federal government, with smaller deficits.



Reform Medicare, Medicaid, and Social Security


We need to means test social security and raise the retirement age. Healthcare should be returned to the private sector, where competition and individual choice rule rather than special interests and government. Low cost efficiencies have totally disappeared over the years as healthcare has moved out of the free market and into government bureaucracies. We need insurance that is individually based and determined, instead of by employers or government. Today, losing your job means losing your healthcare. That is a national disgrace, and needs to be one of the first things healthcare reform remedies.



Defense Spending


We should reduce troops overseas. End our subsidies to the rest of the world by handing them back the responsibility of defending themselves. This includes eliminating subsidies to the IMF, World Bank, and United Nations; which yield the American citizen almost nothing.



Monetary Policy


The best thing either Obama or Romney could do after winning the Presidency, is to announce the reappointment of Ben Bernanke to the Fed. This would go a long way in creating certainty and continuity which is badly needed in today’s world.  I know of no one better to bring consistency to monetary policy or to employ his exit strategy when the time comes – and it will come. No matter what you think of Mr. Bernanke, the dollar is stable and inflation is low.


A year ago, when Bernanke was being accused of creating inflation and trashing the dollar, I went on the record as saying he was not inflating; and that if inflation (which was running at 4% rates at that time) came down to 2% in the next year as predicted by the Chairman, then he would be owed an apology from those who accused him of irresponsibly causing massive inflation. Bernanke's assessment that the inflation would be "transitory" was correct. Those that predicted runaway inflation, higher interest rates, and a falling dollar were dead wrong. Instead of the inflationary inferno he was accused of creating, Bernanke has made the world a safer place. He was instrumental in preventing a depression in this country and possibly even monetary collapse.


Today the dollar is strong and inflation is under control and it worries me greatly who the next Fed Chairman will be given the poor judgment of conservatives regarding monetary policy. Had we followed their advice of tight money America would look a lot like Europe today. The EU has imposed exactly the kind of rigid monetary policies many conservatives are calling for here in the US. It is the wrong prescription.


As we move into the second half of the year, it is obvious that we are moving toward less and less growth, and continued commodity deflation. At some point I expect one more major international coordinated action to fight the recessionary/deflationary bias that is gripping the world. But the uncertainty facing the fiscal cliff ahead will continue to freeze investors and businesses in their tracks and we should continue along this long L-shaped road of anemic “recovery”.


I look forward to entering 2013, six months from now, with at least some idea of which direction this country has chosen to deal with its problems. For better or for worse the future awaits us.



Paul Nathan