Guns and Butter – Redux

Author: Dan Norcini
Source: Jim Sinclair's Mine Set

As many of you are aware, the President of the United States addressed the nation last night from historic Jackson Square in New Orleans, Louisiana. The occasion was the destruction left by hurricane Katrina and its aftermath.


Please note in advance that my comments are not meant to be political nor am I taking a partisan approach. What I am interested in as a trader/investor is the economic repercussions of the President’s agenda as laid out in his speech and how those repercussions affect us. In other words, this is meant to be cold, hard look at things unaffected by political sentiment or leanings.

I think it is safe to say that any decent human being has to feel sympathy and compassion for those who lost all that they owned because of this horrific storm and wishes to see them receive any and all help possible to quickly rebuild their lives and secure their futures. I would hope that there is no disagreement there.

In that spirit let me proceed with some brief thoughts about the President’s speech.

Listening to the President, one felt a sense of déjà vu hearkening back to the 1960’s when Lyndon Johnson was in office. It seemed as if tonight we were somehow witnessing a page from President Johnson’s playbook entitled, “The Great Society”.

Back then, it was a bold, ambitious plan to eliminate poverty from the nation and increase federal programs dealing with the poor and disadvantaged. Government would take the initiative and embark upon a course of public spending heretofore unrivaled in our nation’s history. However, what is important to realize was that all of this was not occurring in a vacuum – there was a war going on in Vietnam which was costing American lives in addition to financial resources. The name for the combination of Johnson’s war on poverty and the war in Vietnam was nicknamed, “Guns and Butter.”

Fast forward some 40 years or so to another generation. Yesterday evening, our current President laid out a bold plan to reconstruct towns and cities all across the Gulf Coast affected by the storm. He has proposed the creation of what could be considered a Gulf Coast enterprise zone which will include tax breaks for businesses willing to relocate to the area and set up shop so as to entice them into the area in hopes of spurring employment and creating stability in the region.

That is to be coupled with government assistance for retraining displaced workers which as it now stands will grant them $5,000 each to pay for education costs, child care and other associated expenditures while they are in class. From what I understand, federal initiatives will also be proposed to aid the less fortunate to secure housing of their own. Additionally, he wants to use as many local residents as possible in rebuilding the infrastructure: roads, bridges, water and sewage treatment plants etc – a type of massive federal works program that hearkens back even further than LBJ all the way to FDR.

Without getting too much further into the details, it sounds as if the plan is a type of hybrid of Johnson’s Great Society and some modern day conservative “empowerment” philosophy which teams up government and the private sector.

The plan no doubt is incredibly ambitious and represents what might very well be a second legacy of the President. If passed by Congress, it will definitely leave its mark on the American landscape.

I do think it is important, however, from the standpoint of those of us who are investors to consider that no plans were announced as to how everything would be paid for. My guess is that the President has adopted the views of those who believe that the funding will be taken care of by growing the economy. Maybe it will, maybe it won’t.

There is no doubt, however, that in the initial stages it will require massive government expenditures and huge deficit spending to finance it.

What makes this of concern to me is that it is coming on the heels of two war fronts that the US is currently engaged in: namely Afghanistan and Iraq. Both are enormous drains on American resources as was the war of the Vietnam era. Keep in mind, that I am not taking a stand here on the war either pro or con – I am merely stating that to fight such wars requires a substantial expenditure of monies. Wars are simply not cheap.

When we look at the current costs of the war on two fronts and then consider that some estimates to the costs associated with hurricane Katrina prior to the President’s announced agenda last evening were running as high as $150 billion +, it is not hard to conceive that we are seeing a virtual replay of the “Guns and Butter” policy of the Johnson Administration of the 1960’s, although this time around the costs involved are even higher after adjusting for inflation.

How this will effect the federal budget is not hard to imagine -the deficit will balloon. After reading the other day that Congressman Delay had declared “victory” in the war to eliminate unnecessary federal spending and that the Congress had managed to pare down all the fat and remove it from the budget and really could not find any other additional areas in which to cut spending, the odds of Congress showing any additional fiscal restraint in this period of Katrina reconstruction and war abroad are minimal at best.

That leaves us with the somber reality that the fiscal position of the US is going to continue to deteriorate. More debt will be issued, meaning more supply of Treasuries will hit the market. In a free market, increasing supply tends to drive prices down unless demand increases enough to compensate for that increased supply.

In the case of Treasuries, additional issues or supply should tend to drive prices of bonds and notes down, moving interest rates in the opposite direction - namely up.

Up to now the biggest buyers of our Treasuries have been the Asian Central Banks who do so for what they consider their own best interests (i.e. keeping their currencies from appreciating against the dollar and thereby keeping their exports to the US competitive). The problem comes when we know that strong undercurrents exist that concern these banks with respect to holding too large a percentage of their reserves in dollars.

Remember what happened to the bond market some time ago when the word leaked out that both China and S. Korea were considering lightening up on their dollar holdings? Bonds dropped like a lead brick and the dollar followed on that news. The reaction was so swift and so severe that officials from both nations rushed to microphones to deny the story.

The net result of all this is that the US is repeating the exact process that produced stagflation that took hold in the late 70’s, sending gold soaring to heights that at the time very few foresaw. We could very well be witnessing the foundation for an exact repeat of that scenario.

We will need to keep a close eye on both the dollar and the bond market in the months ahead to see exactly how the current scenario will play itself out. But be warned : All the ingredients are now in place.