Tags: British Pound, Debt Contagion, Deflation, Gold, Great Depression, Martin Hutchinson, Private Sector, Recession, Stimulus Package, U.S. Unemployment

Dodge a Possible Debt Debacle With These Two Stimulus-Plan Safety Plays

[Editor's Note: Worried About the Looming Stimulus-Plan Debt Debacle? Market historian and former-merchant-banker Martin Hutchinson details two profit plays that will help investors dodge the fallout of any debt debacle.]

By , Money Morning •

U.S. President Barack Obama's $862 billion stimulus plan, passed in great haste after his inauguration, has now revealed its true costs and benefits. It didn't revive the U.S. economy - that bottomed about May 2009, before a dollar of it had been spent. Further, combined with the mad wave of similar "stimulus" outlays across the planet, it has destabilized global bond markets - which may end up being very expensive indeed.

The Birth of the Stimulus Plan Theory

It is well known that the theory behind stimulus plans emanates from the late economist, John Maynard Keynes. Writing during the Great Depression, Keynes theorized that economies could get trapped in "suboptimal equilibria" in which unemployment remained persistently high and economies performed well below capacity. Looking at the British economy from 1920 to 1931, you can see what Keynes meant. Unlike the United States, Britain enjoyed no great boom in the late 1920s, but instead had unemployment well above the level that had been common prior to World War I.

However, there was a non-Keynesian explanation for this: The British pound sterling had been fixed against gold in 1925 at its pre-1914 parity. And that did not take into account the inflation that Britain experienced from 1914 to 1925. What's more, Britain was at this time the only country without tariffs: The United States, Germany and other countries were thoroughly protectionist. Consequently, interest rates had to be kept artificially high to defend the pound, while the economy underwent deflation. Then the Great Depression hit, pushing unemployment up still further.

The eventual solution owed nothing to Keynes; instead of increasing public spending, Chancellor of the Exchequer Neville Chamberlain cut it, devalued the pound and instituted a modest 10% tariff with preference for Empire manufactures - more or less the opposite of Keynes' recommendations, in other words.

The Stimulus Stumbling Blocks

The Keynesian "stimulus" was more defensible during the U.S. Great Depression. The U.S. economy, aided by President Herbert Hoover's errors, fell so far that it might well, indeed, have fallen into a Keynesian trap.

In modern times, however, stimulus plans have been used as excuses for tax cuts or extra dollops of public spending - the first excuse resonating well with voters, the second with politicians.

The fallacy behind the stimulus-plan theory is this: Whether the stimulus money comes from tax cuts or public spending, it is money that has to be borrowed - so it comes out of the economy in any case. Thus, there is no obvious reason why stimulus should do any good at all - it's just moving money from one pot to another.

If, before the downturn, the government is running a surplus - as was the United States in 2001 - the stimulus will at least do little harm. The surplus is turned into a modest deficit, but not much other economic activity is choked off: Being in recession, the private sector is borrowing less than usual, and money is plentiful.

In that case, the only damage from the extra spending is the inefficiency of government. Private spending is, by definition, optimally allocated - the owner of the money spends it how he wants. In contrast, the government is spending other people's money, and is generally somewhat inefficient in getting the best value for it. (Tax cuts merely redistribute money from one consumer to another, so involve little efficiency loss.)

However, if the government starts with a substantial budget deficit, as most governments did in 2008 (the notable exception being China), then the picture is much less favorable. Not only is the spending inefficient, but the government borrowing that's required to finance the stimulus plan drains resources out of the private sector, which usually makes it tougher for small businesses to borrow.

We have seen this "crowding-out" effect here during the U.S. downturn. Commercial and industrial loans from banks have fallen by 25% during this period, and since large-company leveraged buyouts (LBOs) have remained active, lending to small business has fallen further. The result has been a big shortfall in job creation.

Small businesses generally account for around 80% of all new jobs created. However, the latest statistics, from the Intuit Inc. (Nasdaq: INTU) April 2010 Intuit Small Business Employment Index showed small business creating only 66,000 jobs, less than 30% of the 224,000 non-Census jobs created that month. Meanwhile, banks have plenty of money, but they are investing it in U.S. Treasury bonds and government-guaranteed mortgage bonds - and are picking up a large spread between short-term and medium-term interest rates.

The Greek-debt crisis has brought forth a further cost of "stimulus" spending. If the combined budget deficit and debt gets too large, bond markets get scared and make it difficult for the government and local companies to borrow. Even if the country avoids bankruptcy, that fear has a huge, depressing effect on economic activity and on living standards, while the emergency-spending cuts made necessary by the crisis may be far more painful than the original recession - as they have been in Greece's case.

The United States has not reached that point yet, but it is not very far off, and continued additions to spending through new legislation will drive it closer. This story isn't about one administration or one political party, because the problem has been building for years: The stimulus plan is just wasteful public spending piled on top of an already large deficit.

That brings us to a very clear conclusion: Given the damage done to the small-business sector, and the lack of any obvious economic benefit from the stimulus spending, President Obama's 2009 stimulus plan is a very bad tradeoff, indeed. 

How to Survive the Stimulus

Investors needn't resign themselves to the same dour outlook, however. Indeed, there's a very clear path to follow: Buy into countries that avoided last year's stimulus, and so don't have painful budget problems and possible doubts about their debt quality. Of the richer Western economies, there are two obvious examples: Germany and Canada.

Back in December 2008, then-German Finance Minister Peer Steinbruck, a Social Democrat, denounced the global stimulus wave, calling it "crass Keynesianism."

The story is even better in Canada: Not only was the stimulus avoided, but the banking system survived pretty well, also, as it was more tightly regulated. In a 2008 report, in fact, the World Economic Forum rated Canada's banking system as the safest in the world. It also certainly doesn't hurt that Canada possesses rich natural-resource reserves, making it one of the lucky "haves," in the commodities new world order.

So if you don't already have money invested in those countries, you might consider the iShares MSCI Germany Index (NYSE: EWG) and the iShares MSCI Canada Index (NYSE: EWC).

[Editor's Note: Money Morning readers are often amazed by Martin Hutchinson'sprofit-focused instincts - which are displayed in his columns by an unerring ability to paint a picture of what's to come. He's able to show us the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

So it's no surprise that Hutchinson has pulled off a string of forecasting successes in the face of the worst financial crisis since the Great Depression - a financial crisis that, not surprisingly, Hutchinson is widely credited for having predicted and warned about well ahead of time.

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Take a moment to find out more about the opportunities related to dividends, gold, "Alpha-Bulldog" stocks and The Permanent Wealth Investor, please click here. You'll likely find it time well spent.]

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