The Tycoon Report

Guns, Butter and the Economy.

After complying with President Bush's generous "guns and butter" fiscal policy during the administrations first term, the Fed finally seems to have started growing a spine again.

Why deficits may finally be wearing thin at the Fed.

IT WAS A HECK OF A LOT EASIER TO PUSH PRESIDENT CLINTON AROUND.

Ever eager to please Wall Street and prove that he deserved the job, Clinton made sure to listen to what Fed Chairman Alan Greenspan had to say about deficits. Deficits are bad, Greenspan schooled him. They get us into trouble. They make us less competitive. They saddle the current generation with interest payments and future generations with payback.

More importantly, when the government borrows money to finance the deficit they have to sell bonds. And who does the government sell bonds to? Investors. And if investors are busy buying government bonds than they have less money to invest in companies. Companies that create jobs. Companies that keep us competitive. Companies that insure our future. That's called the "crowding-out" theory.

In short, it states that when the government hogs all of the money available from investors bad things happen to private enterprise. First cash becomes more scarce. Then the price of money goes higher.

Regardless of his many faults, Clinton got that message. So much so that in 1999 - almost an eternity ago - the U.S. government announced that it was no longer even needed to sell bonds (borrow money). That's right. We had a surplus. And investors were free to chase returns elsewhere. They could invest in the debt of new companies. Or help start private businessess. Private businesses that grow the economy and provide jobs.

But times changed when Bush was elected. Bush came to town knowing he deserved the job. All of the sudden it was Greenspan who learned how to dance the Potomoc two-step (the tip-toe version). Suddenly he was cool with tax cuts. Both of them. And he was cool with the spending. All of it. Even if it meant that in a shockingly liberal fashion, Bush signed EVERY SINGLE SPENDING BILL THAT THE REPUBLICANS EVER PUT IN FRONT OF HIM. It was as if years of conventional wisdom was no longer wisdom. It was as if deficits became cool again. Just like they were in the 80's, the last time the Empire so firmly held the reins of power.

But now that seems to be changing. It seems that Greenspan has given up his policy of appeasement. Maybe its because he's retiring next year. Not up for another appointment. No need to dance the two-step anymore. Listen carefully to the Fed's recent subtle warnings:

Greenspan Warning #1: "The situation suggests that investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns..."

Translation: Rising deficits come at the price of higher interest rates. Not good for equity investors (to say nothing of the economy).

Greenspan Warning #2: In the published policy minutes from its Dec. 14 meeting it was said that, "a number of participants voiced concern about domestic and global imbalances."

Translation: Fed members are worried about our fiscal and trade deficits.

But it was Warning #3 that was the most forward to date.

On January 13th president of the Federal Reserve Bank of New York Timothy Geithner (who won't sneeze without Greenspans approval) said the U.S. budget deficit was now on an "unprecedented scale."

It seemed that our leaders in Washington were finally starting to get it.

All of the sudden deficits went from being "unwelcome but manageable" to the cornerstone of their strategy for shoring up the dollar. There was even talk of the defense budget being cut by $30 billion. And then came the fine print.

The defense cuts were to take place over six years with the majority of them coming in 2008-9.

Furthermore, the White House - adding in the administrations recent $80 billion emergency funding request - projected the 2005 deficit to be the largest ever at $427 billion. That means the government will have to borrow another $427 billion this year. Which means that investors - who are already beginning to demand higher returns - will only loan the government money at higher interest rates. Which means that the stock market will likely have an anemic year.

Folks, I don't say this to play politics with you. I don't see this country in terms of Red or Blue states. But I'm an investor. So are you. And as an investor what happens in Washington - on either side of the aisle - can have profound implications on our investments.

Especially as we move into 2005 - WE MUST BE CAREFUL. U.S. stocks are already high. Real estate is even higher. And the price of bonds are as high as you will ever see them in your lifetime.

So what's an investor to do as we enter 2005? We've spent a lot of time asking ourselves the same questions. And the answers to many of these questions can be found in our last two issues of the Tycoon Report.