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Obama's "$5000 Gold" Compromise

How extending the Bush tax cuts makes a $5000 Gold Price more likely...

WITH A COMPROMISE agreement that extends the Bush tax cuts for two more years, the Obama administration has given investors what they wanted – but not what they needed, writes Martin Hutchinson at Money Morning.

The compromise tax deal signed into law by US President Barack Obama in December continues to draw fire from critics on both sides of the political aisle. The $858 billion tax package isn't paid for. In fact, it actually costs more than the controversial Obama stimulus plan that has been criticized for having little measurable impact – even as it caused the budget deficit and the US debt burden to explode.

And yet, investors have been cheered by the deal.

Near term, that's an acceptable perception. But in the long run, some very real problems loom. Investors who ignore those problems will take a real beating – and it will be self-inflicted. But investors who prepare for the inevitable will actually improve their positions: They'll not only protect themselves, they will profit

By extending the Bush tax cuts, President Obama and the US Congress have effectively given US taxpayers ice cream, when what they really needed was spinach.

True enough, in the near-term, there probably are some bright spots. Further out, however, some real problems loom. That means some very tough decisions will have to be made starting next year – and for years to come.

The tax deal signed into law Friday extends the entire Bush-tax-cuts package for two more years, introduces a one-year 2% payroll tax cut and prolongs the 99-week extended unemployment benefits for another year.

Due to these measures, the US budget deficit is increased over the next two years by about $900 billion over its expected figure, adding to America's debt problem and possibly "crowding out" small businesses from the bond markets even more than they already are.

In the near term, however, the tax cut is stimulative, much more so than the similarly sized "stimulus" package of 2009. Despite their similar sizes, the tax-cut and Obama-stimulus packages are very different animals.

The tax-cut package actually puts money directly into taxpayers' pockets (except for the ethanol subsidies Congress is adding to the package – an unfortunate move that's a topic of discussion for another time)

On the other hand, the Obama stimulus diverts capital resources away from taxpayers to the most inefficient bits of government (at the federal, state and local levels). Since taxpayers know what they want, that money is spent efficiently, adding to the efficiency of the economy as a whole.

To the extent the tax cuts get saved or invested, they help US capital formation, which is much too low for long-term growth. So the market is right in regarding this "stimulus" as bullish in the short term.

Indeed, economic growth in 2011 should be 0.5% to 1.0% higher than it would have been without it. So if you must expand the federal deficit to provide short-term stimulus to the economy, tax cuts are a much more effective way of doing so than government spending, because they don't sap the economy's economic efficiency.

We all know how inefficient the federal government can be, when it comes to spending. But there's now mounting evidence of a budgetary disaster blossoming at the state level, too. (Readers interested in hearing more about this should check out CBS News' excellent story "State Budgets: The Day of Reckoning" which appeared in Sunday's edition of that network's 60 Minutes TV news magazine.)

We've demonstrated how tax cuts can be better than a stimulus. But there's a "bad news" element to the tax cuts, too. And just how "bad" this bad news ends up being hinges on what Congress chooses to do in the New Year.

If Congress ignores the need to do something about the deficit, long-term interest rates will rise, damaging the housing market and crimping capital investment. What's more, the outlook for 2012 and later, when the boost from stimulus has gone, would then be for a return of 1970s style "stagflation" – with gold and other commodities prices rising to record levels.

In other words: the possibility of $5,000-an-ounce gold – which we've told reader of Money Morning about many time – is becoming very real.

If, on the other hand, Congress gets serious about making cuts in public spending in 2011 – and by "serious" I mean annual reductions of at least $150 billion (about 1% of gross domestic product, or GDP) – then the initial economic boost will be followed by a gradual restoration of the economy to full health, as purchasing power is restored to the private sector.

That's the way to navigate this portion of the financial-crisis rebound.

If US Federal Reserve Chairman Ben S. Bernanke were to increase savings by raising interest rates, the U.S, economy could over a few years return to full health.

Unfortunately, that's probably too much to ask. Without Bernanke increasing rates, inflation and inadequate savings are likely to remain problems, but the system would nevertheless be stable with no chance of a Greece-style blowout. In my estimation, the probability of either of these outcomes is more than 20%.

Most of the elements in the tax-cut-plan – like the continuation of the Bush tax cuts and the 99 weeks of unemployment insurance – represent "business as usual" as far as Washington and the US economy are concerned.

The 2% payroll tax cut is new, but I must confess that I'm stumped when it comes to thinking of a way to invest in it. So we'll have to invest instead in the likely macroeconomic effects of the entire package. You'll find the strategy in the "actions-to-take" section that follows.

Before we talk about those recommendations, however, permit one final comment. When I look back over the route that we've traveled as we made our escape from the depths of the financial crisis – and then look at the journey to come, I can offer one piece of advice with a lot of confidence.

Enjoy the tax reductions in 2011. For they will be the last ones we'll see for a long time to come.

Get the safest gold at the lowest prices – starting with this free gram vaulted securely in Zurich, Switzerland right now – using BullionVault...

Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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