I went into 2013 with an open mind toward the economy. Since then we have seen a mixed bag kind of economy.  We have the private economy led by housing, autos, and energy, which is the good; the creeping strangulation of government regulation and control, which is the bad.  And the falling price of gold, which is the ugly.

The Good

Things have changed since January, much of it to the good. We are moving toward energy independence.  We are seeing the deficit slow, we even saw the Treasury pay some money toward the national debt for the first time in years. The deficit as a percentage of GDP is estimated to fall from 4.5% today to 3% in the next couple of years. Household wealth has increased as housing prices rose along with stock prices. Household net worth is 70 trillion dollars now, the highest since before the recession. And the banking system is stronger than in recent memory as banks have increased their capital base.

The consumer is better off also, paying down personal debt 1.3 trillion dollars, reducing credit card use, and saving more while spending less. So is corporate America better off as profits have continued upward leading to over 6 trillion dollars in cash in the coffers of businesses and individuals. This is sideline money still scared and yet to be invested.

Government spending is declining as the sequester kicked in, and while both government spending and government employment are falling the private sector has picked up the slack as employment has increased along with productivity. While the growth in the public sector is shrinking at about 2% per year, the growth in the private sector is increasing at over 3% per year.  So the 2% growth rate masks the actual progress we are making toward a transition from a growing government to a growing private economy. Housing, autos, and energy is the vanguard of the present US economy with technology as icing on the cake.

The Bad

On the negative side is a disruptive sequester process that indiscriminately cuts spending rather than eliminating the most wasteful spending by government. Then there are the higher taxes and higher fees hitting the economy and the higher costs of regulations brought on by the forthcoming implementation of Obamacare and Dodd-Frank, both of which are going to be difficult to implement. This may be an understatement since there's speculation that Obamacare cannot be implemented, and if attempted the whole system may fall of its own weight. But even given successful implementation the mere disruption and confusion this program is creating throughout the economy is incalculably damaging.

You have taxes and fees going up to pay for Obamacare, hours of employees being cut, many employees being cut to part time status by employers, and employees being pushed into exchanges and forced into new healthcare programs not of their choosing. Worse, Doctors are leaving their practices and nurses who are in short supply are getting scarcer just as millions of new retirees are enrolling into Medicare.

Harry Reid just admitted that we will need a lot more money than expected to implement Obamacare.  The CBO put a figure on it at 1.2 trillion more money, which means higher taxes, higher fees, and higher costs. Just as we have structural unemployment today, we now are creating a structural redistribution of wealth problem made necessary by the Affordable Health Care Act -- one of the most expensive programs in American history.

While it may seem that this is all political rhetoric, we must not lose sight of the fact that health care is one-fifth of the American economy, and trouble in it, is trouble for the economy as a whole. And the last thing we need is trouble in a weakening economy.

We are still in what I have been calling an "L shaped recovery" which has now lasted five years. Until and unless policies change, stagnation will continue to plague us in spite of some very bright spots like energy production and technological innovation increasing along the way. The problem being that we are not producing enough to finance what we will need to consume in later years.

Demographics and plain math dictate that in the future we will need about 50 trillion dollars more than we have. It is this wall of debt that stands in the way of prosperity and insures eventual bankruptcy if not dealt with. So while things have begun to turn around somewhat for the better, nothing has changed to push back the future need for slashed benefits and/or higher taxes to pay for what is impossible to afford.

The Ugly

Then there is the monetary problem.  The price of gold says it all: we are facing not only stagnation but a nagging deflationary/recessionary bias in the world economy that if not checked will drive us into much worse times than we are experiencing today.

If you check the money supply figures http://www.economagic.com/em-cgi/data.exe/fedstl/day-wm2ns you will see that they are falling.  In a normal economy, even under a gold standard, money supply usually rises. The Fed's open market operations which consist of buying 85 billion dollars of treasuries and mortgages have not been able to increase the money supply. Hence, inflation rates have been falling since the beginning of the year along with a stagnant growth rate.

For all the positives that have resulted in healthy profits for corporate America, the nation as a whole is slowly sinking into a Japanese style deflationary recession.  If the Fed does not change its ways the second half of 2013 will look a lot gloomier than the first half -- and the first half didn't look all that good.

The Fed is betting on improved growth and higher inflation rates in the second half. I would like to place a large bet with Mr. Bernanke that the second half will see inflation closer to 1% than 2% and GDP closer to 1.5% than 2.5%. If I'm right the Fed will have to do a 180 degree turn and increase QE rather than reduce it. The stock market investors may think that they would love such a change, but I suggest they won’t like it looking at a possible deflationary recession that will kill profits and kill jobs hurdling toward them.

In my last commentary "Inflection Point", I stated "I think we are at an important inflection point for monetary policy that will affect stocks, bonds, and commodities in the weeks and months to come." That inflection point has been triggered. Interest rates have shot up, gold has broken down, and the stock market momentum has been broken and could turn ugly if the Fed’s optimistic scenario turns out to be wrong.

In my opinion it will. The second half of 2013 will be much more about concerns about deflation and recession than any concern about monetary tightening.

Paul Nathan