Free Markets, Free People
I have to admit, I sometimes get tired of being the voice of doom. Sadly, our political class–Republicans and Democrats alike–seems determined to follow the worst policy options available. So, doom slouches closer. The proximate doom they’re fiddling with this time is the approaching debt limit. Now, I yield to no man in my hatred for ever-increasing government spending, but this debt-limit battle is pointless. We will increase the debt limit. We have no choice.
Here’s the current situation:
OMB estimates federal revenues for 2011 will hit $2.17 trillion. Granny, our servicemen, and other such untouchables — by which I take him to mean Social Security, Medicare, national defense, and debt-service payments — will add up to $2.21 trillion, meaning that even if we cut the rest of the federal budget to $0.00 — no Medicaid, no food stamps, no Air Force One — revenues still would not cover these untouchables, according to OMB estimates…
Our deficit is about 40 percent of spending this year; continued recovery, if the estimates hold, will do some of the work for the 2013 regime, but even under current forecasts that are arguably too rosy, we’ll still be running a 26 percent deficit in 2013.
Even if we eliminate every penny of spending this year except for Social Security, Medicare, and Defense, we still can’t cover this year’s spending. And next year’s spending projects an economic recovery will save us, and reduce the deficit to 26% of spending. Absent such a recovery, next year we’ll be back to another 40% deficit.
And the politicians of both parties are nowhere near to making the appropriate cuts in the budget in years farther out than that. The biggest deficit reduction package currently on the table is for $4 trillion over the next 10 years. Which sounds impressive, until you remember that the actual projected budget deficit over the next 10 years is $13 trillion. So, we’re still $9 trillion short of closing the budget deficit for the next 10 years.
But, wait! It gets better! This $13 trillion figure assumes that interest rates will remain stable where the currently are. If interest rates for treasuries go up by 1%, that wil add 1.3 trillion to the deficit over the same period. As the moment, the Office of Management and the Budget (OMB) projections are for a stable average interest rate of 2.5%. Of course, the current 20-year average is closer to 5.5%, so a return even to normal interest rates will add up to $3.9 trillion to the deficit.
But the magic doesn’t stop yet! OMB forecasts growth rates of between 4%-4.5% from 2014 to 2014. The average trend rate of growth is between 2.5%-3% however. So, if we don’t get the strong growth the OMB is predicting over the next three years, and the following years, we’ll need to add another $3 trillion or so to the deficit over the next decade. And, frankly, if you believe Goldman Sachs today, a return to trend rates of growth seems..unlikely, as they’ve lowered 2Q GDP growth to 1.5% from 2.5% and 3Q to 2.5% from 3.25%. They also forecast unemployment at end of 2012 to be 8.75%.
So, the best case scenario is that we’ll add $9 trillion to the deficit over the next decade. A return to historical growth and interest rates–even if we assume the $4 trillion of budget cuts will actually happen–means a 10-year deficit of $16 trillion. Essentially, we will more than double the National Debt, pushing the debt to GDP ratio to about 160% by 2021.
And that’s the good news.
The bad news is that, in the current debate over the debt ceiling, everyone involved seems determined to play chicken with a default–even if only a selective default–of US treasury obligations.
Tim Pawlenty even suggested that a technical default might be exactly what Washington needs to send a wake-up call to the politicians about how serious the situation is. Others, like Michelle Bachmann, and a not inconsequential number of Tea Party caucus members are steadfastly against raising the debt ceiling for any reason at all.
This is insanity.
Any sort of default, even a selective default that would suspend interest payments only to securities held by the government, while paying all private bondholders in full, will have completely unpredictable results. The least predictable result, however, would be business as usual. A technical default–i.e., delaying interest payments for a few days–or selective default, or any other kind of default is…well…a default. It is a failure to make interest payments.
The most obvious possible result of any sort of default will be to eliminate the US Treasury’s AAA rating, and push interest rates up sharply. If we’re lucky, we’d be talking about a yield of 9%-10%…and an additional $5 trillion added to the deficit (running total in 2021: $21 trillion added to the national debt).
And, again, that’s a best case scenario. Because it assumes that everyone will be willing to hold their T-Notes through all of this. If any major overseas institution or government–say, China–decides to unload their holdings, it could be the start of a flight from treasuries that will destroy the US Dollar in the FOREX, vastly increase the price of imported goods, like, say, oil, and spark uncontrollable hyperinflation in the US. The life savings of every person and institution would be wiped out.
Naturally, yields on interest-bearing instruments would then pull back on the stick and climb for the skies. Not that it’d matter much at that point, since the currency would merely be ornately engraved pieces of durable paper. Suitable for burning in the Franklin Stoves with which we will be heating our homes, in the absence of oil.
Flirting with default is extraordinarily reckless. I don’t even have the words to begin to describe how badly any sort of default might go.
The thing is, we don’t know–we can’t know–what the results of a technical or selective default might be. It might be the judgement of worldwide investors that there are no better alternatives to US-denominated securities, so they’ll just have to ride out a technical default, and accept their interest payments coming a few days late. It might be their judgement that unloading their US-denominated securities and losing a little money is better than the risk of losing everything through a currency collapse. It might be a lot of things, and we have no way of knowing which of those things might come to pass.
As Tim Pawlenty says, a default might be a wake up call. From an exploding phone filled with napalm and plutonium.
Whatever political points might be at stake, is it worth this level of risk?
The safe path here is a simple $500 billion debt limit increase. That’ll give us 6 months to figure things out, and try to discover some way to get our fiscal picture under control, and avoid a default. Government spending is out of control, but a default is really not the best way to impose fiscal discipline.
Following yesterday’s announcement that Greek debt was downgraded to junk status, today Spain’s debt was downgraded as well. Spain is, in many ways the bellwether for Europe’s debt crisis. Spain has a much larger economy than Greece. So large, in fact, that it may be too big to bail out.
Fortunately, Spain’s debt is still less than 60% of GDP; however, the country is on a reckless fiscal path and the government shows no signs of doing anything about it.
As a result of the growing crisis, the Euro is getting hammered in the FOREX market, while the dollar is soaring. This is, in effect, an interest rate hike for US businesses that export to the Euro zone.
Naturally, this places downward pressure on US export sales at a time where the overall business climate is still weak. So, none of this is good news for the American economy, either.
I am not an investment advisor. I’m not a guru. I’m not qualified to give you any investment advice at all. I’m just looking around and seeing things, and telling you what I see. And, in this case, I’ll even tell you what I’m doing.
I do so, however, with the strong warning that you should not, under any circumstances, use me for an example, or follow my example. What I do may not be suitable for you at all. I just want to make that clear.
First let me recap some data points I’ve made in several previous posts:
The Fed has more than doubled the monetary base over the past year. The amount of money that is just sitting there in the economy is incomprehensible. But, it’s not making any trouble for us in inflationary terms, because it is just sitting there. It’s what will happen when it does stop just sitting there that is worrisome.
The Federal Budget has spiraled out of control, with the TARP, stimulus, and recession bringing additional massive amounts of debt to bear, and future deficits signifigantly larger than any in recent memory–on top of which, there is now talk of “Stimulus II”.
Despite the happy talk about the economy’s recovery, the fact is that it is still in decline–just a slower rate of decline. If a recovery doesn’t occur soon, we will run into another leg down in the economy, as households and businesses draw down their cash reserves, hit their credit limits, and slash their spending. The longer the recession continues, the more people and business that will be forced into bankruptcies, the more foreclosures will rise, etc. We call things like this “black swan” events.
On the other hand, even if there is a recovery, the Fed will be faced with the task of trying to wring the extra money back out of the economy. If they are unsuccessful, inflation will rise. If they are successful, they may spark another recession through tightening, much as they did to cause the second leg of the back-to-back recessions in 1981-1982. A second leg of a recession will undoubtedly result in greater debt and more money funneled into the economy as the government re-imposes monetary and fiscal stimulus again to re-inflate economic activity. This will both deepen the debt and increase the money supply, making the next round of interest rate tightenings more difficult, unless the economy comes back strongly.
Social Security is now estimated to begin having a negative cash flow in 2019. In other words, Social Security expenditures will exceed the payroll tax receipts. We have, until now, been running surpluses in Social Security receipts, but, of course, the government spent that money in the general fund. There is, therefore, no pot of money saved to make up for the deficit in receipts in 2016. Benefits will be cut. Taxes will be increased. Economic growth will be affected.
1. Some of these nations have no reason to risk destabilizing the USA. Esp the Saudi Princes.
2. Some of these nations have no reason to risk destabilizing the global financial system. Esp. Japan.
3. Many of these nation have leaders who are some combination of cautious, slow, reactive, and incrementalists.
4. Something of this scale would be almost impossible to keep secret 2 days after the first discussions.
5. If multiple Hong Kong banking sources knew it, their fingerprints would be all over the US dollar – as they shorted it to the max.
Having said that, while I believe this particular story is implausible, it is obvious that a number of countries, China and Russia chief among them, are urging that the dollar be replaced as the world’s reserve currency, or, at the very least, allow some other currency or basket of currencies to be used in addition to the dollar. If this happens, billions of dollars will be repatriated to the US, drastically lowering the dollar’s foriegn exchange value. China is already denominating regional trade deals in yuan, and the use of gold has been on the rise as an instrument for international settlements in Asia and Europe.
There are many more data points, but it would be both tedious and depressing to continue.
The bottom line is that the trends outlined above will, in all probability, necessitate dealing with our foreign creditors. Such dealings may require us to reschedule our debt payments, which will devastate the bond market, make future borrowing far more difficult, and end the notion that treasury notes are “risk-free” investments. If so, we will have become a financial banana republic in which future investment will be given the gimlet eye. We may also be required to those foreign debts off in some currency or basket of currencies other than dollars, in order to prevent the government from inflating the debt away.
These trends will also probably require devaluing the US dollar by a substantial amount, so that our imports become expensive, while our exports become cheap. This will allow us to earn the money to pay off our foreign debts, although it will, of course, result in a lower standard of living in the USA.
This the inevitable result of allowing the government–and the voters–to loot the system for 70 years.
So here is what I have done–and this is purely for informational purposes. I do not recommend it for you, and I urge you to consider that I may be entirely wrong.
Several months ago, I completely pulled all of my investments out of equities, and into some select bond funds with a mix of government and private bonds. As of today, I have ceased placing any more money in to either equities or bonds.
For the forseeable future, I will be buying gold bullion. Not gold stocks. Not Krugerrands. Not gold depository accounts. I mean direct bullion purchases of gold bars or rounds. My personal preference is for APMEX or Pamp Suisse 10g bars, or Scotia Bank 1/4 oz. rounds, since they have the lowest premiums over the spot price, and are small enough to conveniently convert at local jewelry stores, pawn shops, or gold dealers at need.
Trying to convert a 1kg bar on short notice would be…inconvenient. Even 1oz. Krugerrands might be hard to convert as the value of each single coin is now over $1000.
I have no interest in paying a premium for “collectible” coins. I have no interest in purchasing a depository account, where my gold holdings have to be reported to the government. In fact, prior to this month, I had no real interest in gold either. Indeed, if you bought gold at any time from 1979 to 2001, by march of 2001, you would have lost money–perhaps quite a lot of money, depending on when you bought it. However, in the current circumstances, let’s just say that my interest is now…heightened substantially.
Whether your interest should be heightened…well, I couldn’t say.
A week or so ago, I mentioned the fact that Russia was lobbying for a new international currency to replace the dollar and opined that it most likely wouldn’t have any legs. By itself, Russia just didn’t have enough clout to bring about such a change. But apparently Russia was only the beginning. Later that same week, the UN came out in favor of a new currency option:
A U.N. panel will next week recommend that the world ditch the dollar as its reserve currency in favor of a shared basket of currencies, a member of the panel said on Wednesday, adding to pressure on the dollar.
Currency specialist Avinash Persaud, a member of the panel of experts, told a Reuters Funds Summit in Luxembourg that the proposal was to create something like the old Ecu, or European currency unit, that was a hard-traded, weighted basket.
Persaud, chairman of consultants Intelligence Capital and a former currency chief at JPMorgan, said the recommendation would be one of a number delivered to the United Nations on March 25 by the U.N. Commission of Experts on International Financial Reform.
“It is a good moment to move to a shared reserve currency,” he said.
But does the UN have enough leverage to push something like this through? Probably not without some fairly powerful backers of the idea. And speaking strictly of the UN, any such proposal would have to pass through the Security Council, and it’s unlikely the US would sanction such a change.
Today, though, China came out in favor of doing exactly what Russia and the UN recommend:
China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.
In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.
As was noted last week, China has some concerns about the US economy:
“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.
And that’s a valid concern. With the Fed pumping out trillions of freshly printed dollars, inflation is almost assured.
In case you haven’t noticed, Russia and China are two of the four countries known as BRIC (Brazil, Russia, India, China). These emerging economies feel they deserve more clout than they now enjoy. And they’re meeting in advance of the upcoming G20 meeting in April of this year:
Finance ministers and central bankers from Brazil, Russia, India and China will convene ahead of the Group of 20 finance chiefs’ meeting in London on Friday, a Russian delegation source told Reuters on Thursday.
The source said the four will discuss the reform of international financial organizations such as the International Monetary Fund and the Financial Stability Forum, anti-crisis policies and preparations for the G20 summit in April.
Take a look again at China’s proposal for basing the international reserve currency in the IMF and the topic of their upcoming meeting in advance of the G20. Suddenly Russia’s proposal has some legs.
What clout does BRIC bring to the proposal? Well they are the holders of vast portions of the currency reserves around the world:
China runs the world’s biggest reserves, Russia comes 3rd, India 4th and Brazil 7th, as of last autumn.
Keep an eye out for Brazil and India weighing in on this. Should they come out in favor of such a change, as has China, it could portend some fireworks at the G20.
In the meantime, read this by Mikkel Fishman. It will explain some of the deeper and less evident problems we face. Then take a moment to look around and reflect. In my estimation, this truly is the calm before the storm.