Tuesday, October 07, 2003
A cogent argument for current tax cuts.
The Double Benefit of Tax Cuts
By Gary S. Becker, Edward P. Lazear and Kevin M. Murphy
1,279 words
7 October 2003
The Wall Street Journal
A20
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)
In their debate on economic policy last month, every Democratic candidate for president called for rolling back all or part of George W. Bush's tax cuts. All politics aside, and with the economy showing signs of recovery, perhaps now is the right time to revisit the rationale behind tax reductions and what seems to be an excessive fear of budget deficits.
Proposals for tax reductions during periodsof a weak economy are inevitably followed by discussion of the stimulus effects that such cuts will have on economic activity over the next year or so. Less often is the focus on the more important issue, which is whether a tax cut helps in the long run. Tax cuts make sense for two reasons. First, government spending responds to tax revenues, so that lower revenues imply lower government spending. Second, economic growth depends on both human capital and physical capital, and investment in human capital, as well as physical capital, is responsive to tax rates. Consider each in turn.
Like any company or household, government spending is constrained by its revenue. The sum of present and future public spending, discounted by the rate of interest on government bonds, must equal the sum of present and discounted future tax revenues. This government budget equation has been recognized by economists since the pioneering work on taxation by economist David Ricardo in the early 19th century. Typically, economists take government spending as given by the needs of society, and assume that taxes, including taxes on money balances generated by inflation, adjust to this spending in order to balance the government budget equation.
Yet economic theory and empirical evidence suggest that spending often adjusts to available tax revenue rather than the other way around. Government spending responds to the ongoing political battles between taxpayers and the interest groups that benefit from government spending.
Developments in the federal budget since the early 1980s illustrate the dependence of spending on tax revenue. The Reagan tax cuts of the '80s helped promote longer-term growth, but they also increased federal deficits and subsequent interest payments on the debt. The Bush tax cuts will also help future growth, and possibly have already begun to stimulate the economy
Looking back, federal spending declined relative to GDP in the late '80s and through most of the '90s. Many observers link the moderate growth in spending over this period to the large federal budget deficits seen over most of the period and the pressure this put on lawmakers to control spending. But the primary federal budget that excludes interest had a surplus for all but three years between 1987 and 2001, while the budget including interest ran a deficit until 1998. The need to meet payments on the debt helped pressure Congress and the Clinton administration to enact welfare reform, cut defense spending, and increase efforts to rein in federal spending on Social Security and health. It is highly unlikely that any of these would have occurred without the need to adjust spending to growing interest payments on the rising debt due to continuing deficits.
Lower taxes that force cutbacks and reforms in spending programs often produce a double benefit. Besides the direct benefit from lower marginal tax rates on income, dividends, or investments, there are indirect benefits from the forced reductions in inefficient spending programs. This might be an overly generous welfare system or programs that benefit constituents of powerful members of Congress.
The looming federal deficits that many forecast today will affect the size of future federal spending. Much of the burden is likely to fall on federal entitlement programs, which take about half of all federal spending. Especially likely to be affected is the large, ever-expanding Medicare and Medicaid health systems, a Social Security system that encourages healthy workers to leave the labor force prematurely and an expanding disability system with excessively weak eligibility criteria for workers below normal retirement ages.
The same principles are applicable to state and local government spending. In fact, their spending is even more sensitive to their tax revenues since they cannot run deficits as readily as the federal government can. Booming tax revenues during the good times after 1996 not only rapidly expanded the absolute level of their spending, but also their spending relative to GDP. This ratio rose from a low of less than 12% in 1997 to a high of almost 13% in 2001. The fiscal problems facing many state and local governments, most notably California, are direct results of reckless spending while tax revenues were piling up.
The absolute effect on federal spending of shortfalls and expansions in tax revenues grew during the past 50 years because the federal budget expanded enormously over this period. This produced the sharp and seemingly inexplicable reversal of both Democratic and Republican positions on deficits. For many years, Republicans were the party of hard money, balanced budgets, and a small public debt, while Democrats wanted to prime the pump with deficits and worried little about the size of the debt. Now Republicans have become blase about deficits and the debt, whereas many Democrats are apoplectic over President Bush's tax cuts and looming federal budget deficits. Congressional Democrats also wanted to use the surpluses of the late '90s to pare down the debt.
The explanation for these reversals is that Democrats have lost faith in Keynesian-type fiscal stimulus, and are instead worried about the effects of deficits and a growing debt on future spending programs. Republicans, on the other hand, appear to be favoring a fiscal stimulus, but they are mainly trying to limit future spending on entitlement and other programs favored by Democrats.
---
Our second point, that human as well as physical capital is key, derives from two pieces of evidence. Human capital -- the skills embodied in individuals -- accounts for about 70% of the total capital of the U.S., and a country's economic growth is closely tied to the human capital of its population. Countries that invest heavily in educating their citizens are also those that tend to experience high economic growth following such investments. For these reasons, it is important that tax policies encourage investment in human capital. Investment in human capital is responsive to take-home pay and therefore to tax rates, with the most direct effect coming from income tax.
A highly progressive income tax structure tends to discourage investment in human capital because it reduces take-home pay and the reward to highly skilled, highly paid occupations. Students work long and hard to enter occupations such as medicine and engineering that pay high salaries. The quality of labor in these occupations is lower in countries that cap the pay to professionals because reduced pay discourages individuals from investing in skills. Highly progressive tax structures decrease the gain to acquiring skills that have valuable social payoffs. The current push toward a flatter tax structure is welcome. A flatter structure will have beneficial effects, not only because of the immediate impetus to additional work, but because it will encourage investments in the skills that lead to higher standards of living over the longer run.
The evidence is clear: Cutting taxes will have beneficial effects. Tax cuts will keep government spending in check and will provide the incentives necessary to produce a highly skilled, productive work force that enables high economic growth and rising standards of living.
---
Mr. Becker, a Nobel laureate in economics, and Mr. Murphy are economics professors at the University of Chicago. Mr. Lazear is an economics professor at Stanford. All three are fellows at the Hoover Institution.
Document J000000020031007dza70002a
Saturday, October 04, 2003
US - Current Account Deficit and Fiscal Deficit and history.
US consumers are debt ridden and so is the government. The war in Iraq, the drop in the tax revenues due to the slowdown in the economy and the tax cuts in the marginal tax brackets have all pushed the government to borrow heavily to carry out its operations. The United states is also currently running a current account deficit. That means that US is importing from other countries more than it manufactures here and exports itself. Current account deficit in and of itself are not troubling. Many fast growing economies that exhibit rapidly expanding capital investment run current account deficits and they import more raw materials for thie manufacturing bases. China currently is a good example. It imports a lot of raw materials for its factories from the rest of Asia (south Korea and Taiwan on a large scale), processes them and sends to the USA to be consumed. Thus it runs large current account deficit with the rest of asia while running a large current account surplus with USA. But in sum its Balance of payments is zero or close.
What is interesting about the USA though is that the goods that are imported here are consumed here. USA is the end of the production line. Goods after entering the USA have nowhere to go except the dumpster. Thus the balance of payments for the USA are steeply negative. Consistent current account deficits like those in the USA lead to a rapid devaulation of the primary currency of the consuming nation. Unless the consuming nation happens to be the USA. USA is deemed "safe haven" given its strong property rights and a "deemed" fair judiciary system. Its central bank is also perceived to be acting in the best interest of its economy as a whole (and not just few classes) and finally the structural flexibility vis-a-vis the labor force and the growing and relatively young labor force (compared to europe) tend to emphasise the role of the USA as a strong choice to park excessive capital funds.
Indeed most of the current account deficit results in the capital account surplus for the USA which is used to fund the federal deficit. In effect the central banks of Asia (most notably china and Japan) are lending money to the US government and staking future claims on the output of the USA. The effect of such an action therefore is a transfer of massive funds from a developing (and hence a young economy) to a mature economy. This seems a gross misallocation of funds in the global economy and leads to massive structural deficiencies. These structural deficiencies need to be tackled as soon as possible. However in the short run, such allocation of funds gives a much needed liquidity boost to the still fragile consumer demand in the USA. By investing massive amounts of money, the asian central banks have helped the government finance its federal deficit at fairly low interest rates. This has also helped the asian governments to revive their own economies primarily through a export driven recovery.
The large current account deficit has generally failed to devalue the dollar because of these strong capital inflows in the USA. Such inflows reached a disproportipnately high levels during the Dot-COM boom of the late 90s especially from europe resulting in the weakening of the euro vis-a-vis dollar. The large inflows were primarily because of the higher rates of returns such capital garnered in the USA as opposed to any other part of the world. The effect was that while the USA continued to run current account deficits at record numbers, the dollar continued to appreciate nevertheless. As pointed earlier this was primarily due to the massive capital investments. The large dose of liquidity provided by the federal reserve (@ the end of 1999) to stave of any catastrophe at the turn of the century resulted in a massive monetary stimulus to an already overheating and fully employed economy. Droves of immigrants came during that time and filled jobs that were hard to fill. Companies finding it difficult to hire qualified workers loosened their hiring criteria and lobbied congress to loosen the immigration requirements to the USA so that company would not have to lose workers to immgration rules. Such immigrants quickly immigrated to the USA (green card) and continued to stay in the USA long after the hiring frenzy had subsided. This may in part explain the primarily jobless recovery experienced by the USA in 2003.
However the USA had to answer to its profligate spending in 2002. That was the year that the greenback began its rapid decline with respect to most other currencies and notably the commodities. It is interesting to note that the M2 supply in USA has grown at a rapid pace. However such rapid expansion if not warranted by an expansion in GDP would have produced massive inflation. Since this has not happened it is safe to assume that the rapid supply of money growth was warranted and absent that we would have had a massive deflationary spiral. Interestingly deflation is a shortage of money supply vis-a-vis the basket of godds that it buys and not necessarily the fall in prices. Falling prices brought about by productivity gains are welcome and do not necesarily represent a defation. Such advances typically signify the process of correct allocation of funds from the least efficient producers (that will go in loss) to the most efficient low cost producers (which will make profits irrespective of falling prices). Outsourcing of work to China and India falls in this category and both have been blamed for exporting deflation to the USA. However at most that both countries can be blamed for is exporting efficiency and discipline in capital allocation to the global market place. During the DOT COM boom the low cost producers in china and the massive monetary stimulus in USA lead to bubbles being inflated in the USA stock markets (and in fact in the rest of the world too). Inflated stock markets lead to a dramatic fall in the cost of capital for public companies in the USA. Privately held companies went public at an unprecedented rate to take advantage of such low cost of capital. This resulted in massive capital misallocation as companies with faulty business plans were able to survive for much longer than they would have in normal market conditions. The low cost of capital lead to increase in the profitability of companies leading to a fall in the cost of capital further due to a rise in the stock market. Thus an upward spiral had been created wherein the dependent variables (stock prices) and the independent variable (Net income or EPS) were linked. This in words of George Soros (read his first book - about his run on Bank of England) had setup a stage for a classic and dramatically painful fall in the stock prices. The catalyst for this fall was the tightening of the loose monetary conditions as we entered the new millenium without any incident
of the Y2k bug.
Interestingly the low cost of capital lead to massive capital account surplus leading to a strong dollar even when it was running massive current account deficits. However the cost of capital has increased by the end of 2000 and into 2002 as the USA entered its mildest recession ever. Increasing cost of capital put a crimp in the profitability of the companies and hence their stock prices. Hot money flowing into the USA to chase large asset returns slowed and then reversed (especially from Europe). This was also the time of an unpopular republican president in the USA and a falling out between USA and Europe and even though money has no emotions, effects of such emotions cannot be entierly ruled out. The torch of US captial accounts was picked up from the asset return chasers by the asian central banks by the end of 2001 - 2002. Asian countries that had not missed a beat of sending low cost goods to the USA needed to park their foreign currency reserves (most predominantly US dollars). Since asian countries (most notably china and Japan) have economies that are predominantly export driven, they have tended to manage the FX markets through direct intervention (Japan) or fixed currency peg (china). Such active or passive management has resulted in large USD reserves (by some estimates almost 2/3 of all global reserves). The central banks have tended to park such reserves in the US federal bonds in order to keep their currency artifically devauled. This has resulted in these central banks having to float a large amount of their own currency in the markets. Sooner or later it bears that such large sums of money would cause inflation in the home countries (especially china that has strict capital controls on exchange between renminibi and USD and whose GDP is smaller compared to that of USA and hence cannot support the large amount of local currency as a result of the weak exchange rate)
In the meantime however this has resulted in financing the US deficit and consumption at attractive low rates resulting in giving the nascent consumer/capital recovery a leg up. Since all the world either directly or indirectly depends on the US to consume its goods and services, such low cost financing is absolutely welcome. However since the USA GDP is large it bears to mind that expansion in GDP (people forecast 4% for fourth quarter 2003) would result in large # of USD to float around. These large # of USD would likely cause a larger # of other currencies too. What in effect will happen is that commodities (if assumed to be at the same supply level) would be in relatively shorter supply than the other currencies. This would imply an appreciation in the value of commodities for the foreseeable future. Case in point the rapid appreciation in prices of gold and other metals and the commodity based currencies (namely CAD, AUD, NZD, and SAR). To be fair it is to be noted that Natural Gas has been going up in value in recent years due to a shortage in exploration and storage. Case in point nolder and newer LNG terminals are being grought online only after a sustained gas NG crunch. Oil has been moving higher due to concerted efforts by OPEC countries to maintain a supply at low levels and problems in non-OPEC countries such as venezuela and Russia. Gold has been going higher due to un-hedging of the gold contracts by the gold miners (newmont mining is biggest) it they are unwinding the future gold that they had sold and doubling on their gold price exposure. This is incredibly bullish if very risky.
So given that the limited supply of the commodity and the ever increasing quantity of the money that relates to it (whether justified to stave of deflation or unjustified to increase short-term prosperity at the expense of long term inflation) it is almost certain that the commodities should increase in value. The few reasons that the commodities as individual will fail to rise are :
1) Increase in the future supply of the commodity vis-a-vis its current supply. The primary reason of the gold standard in the economy of yesteryears was that new gold supply per year was at most 2% of available reserves. This meant that there would never be a dramatic increase in the available gold reserves any year (and causing catastrophic deflation if money supply wasnt increased proportionately or massive inflation if it was). Therefore the primary argument for rise in commodity price in face of commodity crunch is that newer reserves are not found and extracted economically at current prices. Of course a rise in prices might mean that newer and hereto uneconomical resources can be tapped economically and at a profit. Case in point the recent growing interest in LNG terminals as the NG price firms up. The very fact that big oil companies are clamoring to reopen these termianls indicates that they expect NG prices to remain high for the foreseeable future. Commodity assets like NG then are a good hedge against inflation as well as falling dollar.
2) Subsitute to a commodity will result in the price of the commodity to be under pressure for an extended period of time. A large number of coal fired plants in the USA that generate elctricity are being converted to NG fired plants as a result of environmental reasons (less sulphur pollution and acid rain). This will keep any increase in coal prices in check and NG prices high.
3) Finally and most importantly the perceptions of people about the returns expected in paper currency denominatd assets. The primary reason of the explosive growth in the stock market in the late 90s was the perception among people that internet had irrevocably changed the paradigm and made people more productive ie "this time its different". This was the reasoning and cheap money was the means behind the explosive growth in the stock markets. If people's perception change again in the coming years then paper denominated assets will return higher and hence will be demed more attractive. Commodity in that case might languish. Of course in hindsight we call the late 90s as the dotm com *mania* and that should give us a clue.
Thus if a case can be made that we are entering into a period of time where the dollar has to fall with respect to stable supply of commodities or with respect to other strongly defended currencies then the following things need to be kept in mind :
1) Dollar cycles are large. If a fair exchange rate is determined based on purchase parity then dollar has a tendency to overshoot or undershoot this "fair" excange rate by at least 20%. Most of the curenices have reached their purchase parity based exchange rate with respect to the dollar. And any gains henceforth will rely on the overshoot of the dollar to the downside.
2) Dollar cycles are long. If history is any indication dollar cycles typically last about 4 -5 years. The current cycle that we are in started in Jan/2002, indicating that it still has a few years of life left.
Of course these are based on heuristics and history and as they while future results are not guranteed, history is a powerful guide.
The fall in the dollar value with respect to other currency will have a damning effect on the economy. A strong dollar and the pre disposition of many central banks of using USD as the reserve currency has meant that american people have enjoyed a good standard of living at the expense of other people of the world. Any perception then that dollar is weakening and hence dollar denominated assets will not return a good investment return will curb the appetite of foreign banks to hold US governemnt debt and will also increase the risk premium to hold such debt. The end result would be an increase in interest rates in the USA and a general disability of the US Govt to finance its debt (which in of itself is not bad, since this might curb excessive govt spending). The rising interest rates would lead to snubbing out of the nascent economic recovery. Large fiscal deficits lead to what is known as the crowding out effect, wherein the government and the private businesses compete for the same dollars. And since the government holds the money spigot, private businesses end up hurting as they cannot raise adequate capital at attractive rates.
Irrespective of how the government finances its deficit : externally or internally it will try to reduce its future real payments either by devaluing its primary currency or creating inflation respectively. What this would portend then is that anybody holding dollar assets is at grave risk of seeing their purchasing power being eroded. Now then is probably a good time to hedge against such risk.
4) Inflaton hedges
5) What if this is all wrong.
6) Fed credibility
US consumers are debt ridden and so is the government. The war in Iraq, the drop in the tax revenues due to the slowdown in the economy and the tax cuts in the marginal tax brackets have all pushed the government to borrow heavily to carry out its operations. The United states is also currently running a current account deficit. That means that US is importing from other countries more than it manufactures here and exports itself. Current account deficit in and of itself are not troubling. Many fast growing economies that exhibit rapidly expanding capital investment run current account deficits and they import more raw materials for thie manufacturing bases. China currently is a good example. It imports a lot of raw materials for its factories from the rest of Asia (south Korea and Taiwan on a large scale), processes them and sends to the USA to be consumed. Thus it runs large current account deficit with the rest of asia while running a large current account surplus with USA. But in sum its Balance of payments is zero or close.
What is interesting about the USA though is that the goods that are imported here are consumed here. USA is the end of the production line. Goods after entering the USA have nowhere to go except the dumpster. Thus the balance of payments for the USA are steeply negative. Consistent current account deficits like those in the USA lead to a rapid devaulation of the primary currency of the consuming nation. Unless the consuming nation happens to be the USA. USA is deemed "safe haven" given its strong property rights and a "deemed" fair judiciary system. Its central bank is also perceived to be acting in the best interest of its economy as a whole (and not just few classes) and finally the structural flexibility vis-a-vis the labor force and the growing and relatively young labor force (compared to europe) tend to emphasise the role of the USA as a strong choice to park excessive capital funds.
Indeed most of the current account deficit results in the capital account surplus for the USA which is used to fund the federal deficit. In effect the central banks of Asia (most notably china and Japan) are lending money to the US government and staking future claims on the output of the USA. The effect of such an action therefore is a transfer of massive funds from a developing (and hence a young economy) to a mature economy. This seems a gross misallocation of funds in the global economy and leads to massive structural deficiencies. These structural deficiencies need to be tackled as soon as possible. However in the short run, such allocation of funds gives a much needed liquidity boost to the still fragile consumer demand in the USA. By investing massive amounts of money, the asian central banks have helped the government finance its federal deficit at fairly low interest rates. This has also helped the asian governments to revive their own economies primarily through a export driven recovery.
The large current account deficit has generally failed to devalue the dollar because of these strong capital inflows in the USA. Such inflows reached a disproportipnately high levels during the Dot-COM boom of the late 90s especially from europe resulting in the weakening of the euro vis-a-vis dollar. The large inflows were primarily because of the higher rates of returns such capital garnered in the USA as opposed to any other part of the world. The effect was that while the USA continued to run current account deficits at record numbers, the dollar continued to appreciate nevertheless. As pointed earlier this was primarily due to the massive capital investments. The large dose of liquidity provided by the federal reserve (@ the end of 1999) to stave of any catastrophe at the turn of the century resulted in a massive monetary stimulus to an already overheating and fully employed economy. Droves of immigrants came during that time and filled jobs that were hard to fill. Companies finding it difficult to hire qualified workers loosened their hiring criteria and lobbied congress to loosen the immigration requirements to the USA so that company would not have to lose workers to immgration rules. Such immigrants quickly immigrated to the USA (green card) and continued to stay in the USA long after the hiring frenzy had subsided. This may in part explain the primarily jobless recovery experienced by the USA in 2003.
However the USA had to answer to its profligate spending in 2002. That was the year that the greenback began its rapid decline with respect to most other currencies and notably the commodities. It is interesting to note that the M2 supply in USA has grown at a rapid pace. However such rapid expansion if not warranted by an expansion in GDP would have produced massive inflation. Since this has not happened it is safe to assume that the rapid supply of money growth was warranted and absent that we would have had a massive deflationary spiral. Interestingly deflation is a shortage of money supply vis-a-vis the basket of godds that it buys and not necessarily the fall in prices. Falling prices brought about by productivity gains are welcome and do not necesarily represent a defation. Such advances typically signify the process of correct allocation of funds from the least efficient producers (that will go in loss) to the most efficient low cost producers (which will make profits irrespective of falling prices). Outsourcing of work to China and India falls in this category and both have been blamed for exporting deflation to the USA. However at most that both countries can be blamed for is exporting efficiency and discipline in capital allocation to the global market place. During the DOT COM boom the low cost producers in china and the massive monetary stimulus in USA lead to bubbles being inflated in the USA stock markets (and in fact in the rest of the world too). Inflated stock markets lead to a dramatic fall in the cost of capital for public companies in the USA. Privately held companies went public at an unprecedented rate to take advantage of such low cost of capital. This resulted in massive capital misallocation as companies with faulty business plans were able to survive for much longer than they would have in normal market conditions. The low cost of capital lead to increase in the profitability of companies leading to a fall in the cost of capital further due to a rise in the stock market. Thus an upward spiral had been created wherein the dependent variables (stock prices) and the independent variable (Net income or EPS) were linked. This in words of George Soros (read his first book - about his run on Bank of England) had setup a stage for a classic and dramatically painful fall in the stock prices. The catalyst for this fall was the tightening of the loose monetary conditions as we entered the new millenium without any incident
of the Y2k bug.
Interestingly the low cost of capital lead to massive capital account surplus leading to a strong dollar even when it was running massive current account deficits. However the cost of capital has increased by the end of 2000 and into 2002 as the USA entered its mildest recession ever. Increasing cost of capital put a crimp in the profitability of the companies and hence their stock prices. Hot money flowing into the USA to chase large asset returns slowed and then reversed (especially from Europe). This was also the time of an unpopular republican president in the USA and a falling out between USA and Europe and even though money has no emotions, effects of such emotions cannot be entierly ruled out. The torch of US captial accounts was picked up from the asset return chasers by the asian central banks by the end of 2001 - 2002. Asian countries that had not missed a beat of sending low cost goods to the USA needed to park their foreign currency reserves (most predominantly US dollars). Since asian countries (most notably china and Japan) have economies that are predominantly export driven, they have tended to manage the FX markets through direct intervention (Japan) or fixed currency peg (china). Such active or passive management has resulted in large USD reserves (by some estimates almost 2/3 of all global reserves). The central banks have tended to park such reserves in the US federal bonds in order to keep their currency artifically devauled. This has resulted in these central banks having to float a large amount of their own currency in the markets. Sooner or later it bears that such large sums of money would cause inflation in the home countries (especially china that has strict capital controls on exchange between renminibi and USD and whose GDP is smaller compared to that of USA and hence cannot support the large amount of local currency as a result of the weak exchange rate)
In the meantime however this has resulted in financing the US deficit and consumption at attractive low rates resulting in giving the nascent consumer/capital recovery a leg up. Since all the world either directly or indirectly depends on the US to consume its goods and services, such low cost financing is absolutely welcome. However since the USA GDP is large it bears to mind that expansion in GDP (people forecast 4% for fourth quarter 2003) would result in large # of USD to float around. These large # of USD would likely cause a larger # of other currencies too. What in effect will happen is that commodities (if assumed to be at the same supply level) would be in relatively shorter supply than the other currencies. This would imply an appreciation in the value of commodities for the foreseeable future. Case in point the rapid appreciation in prices of gold and other metals and the commodity based currencies (namely CAD, AUD, NZD, and SAR). To be fair it is to be noted that Natural Gas has been going up in value in recent years due to a shortage in exploration and storage. Case in point nolder and newer LNG terminals are being grought online only after a sustained gas NG crunch. Oil has been moving higher due to concerted efforts by OPEC countries to maintain a supply at low levels and problems in non-OPEC countries such as venezuela and Russia. Gold has been going higher due to un-hedging of the gold contracts by the gold miners (newmont mining is biggest) it they are unwinding the future gold that they had sold and doubling on their gold price exposure. This is incredibly bullish if very risky.
So given that the limited supply of the commodity and the ever increasing quantity of the money that relates to it (whether justified to stave of deflation or unjustified to increase short-term prosperity at the expense of long term inflation) it is almost certain that the commodities should increase in value. The few reasons that the commodities as individual will fail to rise are :
1) Increase in the future supply of the commodity vis-a-vis its current supply. The primary reason of the gold standard in the economy of yesteryears was that new gold supply per year was at most 2% of available reserves. This meant that there would never be a dramatic increase in the available gold reserves any year (and causing catastrophic deflation if money supply wasnt increased proportionately or massive inflation if it was). Therefore the primary argument for rise in commodity price in face of commodity crunch is that newer reserves are not found and extracted economically at current prices. Of course a rise in prices might mean that newer and hereto uneconomical resources can be tapped economically and at a profit. Case in point the recent growing interest in LNG terminals as the NG price firms up. The very fact that big oil companies are clamoring to reopen these termianls indicates that they expect NG prices to remain high for the foreseeable future. Commodity assets like NG then are a good hedge against inflation as well as falling dollar.
2) Subsitute to a commodity will result in the price of the commodity to be under pressure for an extended period of time. A large number of coal fired plants in the USA that generate elctricity are being converted to NG fired plants as a result of environmental reasons (less sulphur pollution and acid rain). This will keep any increase in coal prices in check and NG prices high.
3) Finally and most importantly the perceptions of people about the returns expected in paper currency denominatd assets. The primary reason of the explosive growth in the stock market in the late 90s was the perception among people that internet had irrevocably changed the paradigm and made people more productive ie "this time its different". This was the reasoning and cheap money was the means behind the explosive growth in the stock markets. If people's perception change again in the coming years then paper denominated assets will return higher and hence will be demed more attractive. Commodity in that case might languish. Of course in hindsight we call the late 90s as the dotm com *mania* and that should give us a clue.
Thus if a case can be made that we are entering into a period of time where the dollar has to fall with respect to stable supply of commodities or with respect to other strongly defended currencies then the following things need to be kept in mind :
1) Dollar cycles are large. If a fair exchange rate is determined based on purchase parity then dollar has a tendency to overshoot or undershoot this "fair" excange rate by at least 20%. Most of the curenices have reached their purchase parity based exchange rate with respect to the dollar. And any gains henceforth will rely on the overshoot of the dollar to the downside.
2) Dollar cycles are long. If history is any indication dollar cycles typically last about 4 -5 years. The current cycle that we are in started in Jan/2002, indicating that it still has a few years of life left.
Of course these are based on heuristics and history and as they while future results are not guranteed, history is a powerful guide.
The fall in the dollar value with respect to other currency will have a damning effect on the economy. A strong dollar and the pre disposition of many central banks of using USD as the reserve currency has meant that american people have enjoyed a good standard of living at the expense of other people of the world. Any perception then that dollar is weakening and hence dollar denominated assets will not return a good investment return will curb the appetite of foreign banks to hold US governemnt debt and will also increase the risk premium to hold such debt. The end result would be an increase in interest rates in the USA and a general disability of the US Govt to finance its debt (which in of itself is not bad, since this might curb excessive govt spending). The rising interest rates would lead to snubbing out of the nascent economic recovery. Large fiscal deficits lead to what is known as the crowding out effect, wherein the government and the private businesses compete for the same dollars. And since the government holds the money spigot, private businesses end up hurting as they cannot raise adequate capital at attractive rates.
Irrespective of how the government finances its deficit : externally or internally it will try to reduce its future real payments either by devaluing its primary currency or creating inflation respectively. What this would portend then is that anybody holding dollar assets is at grave risk of seeing their purchasing power being eroded. Now then is probably a good time to hedge against such risk.
4) Inflaton hedges
5) What if this is all wrong.
6) Fed credibility
