America's Debts and Deficit

Gold has now been in correction mode for more than a year. The fundamentals are strong...one central bank after another has embraced monetary expansion, sovereign debt continues to grow, the world economy continues to slow and enormous amounts of public and private debt need to be rolled over at very low interest rates. This back drop supports ongoing devaluation of paper currencies and a rising gold price, but the market seems hesitant to believe it and embrace the one reliable store of value that can protect against an organized assault on the value of money.  

From our perspective, it seems that financial markets have decided that they know all this, it is old news, the real problems are known as well as the solutions to them. We think otherwise: in our view, the real issues have been obscured by wishful thinking and over simplification while the solutions have been scaled down to a size that promises to be both manageable and ineffective. Perhaps due to the frequency of fiscal and monetary interventions and computer-driven trading, markets have lost the ability to discount more than a few weeks into the future.

America's Debt and Deficits

In the U.S., a debt problem of unimaginable proportions has proved to be too big to consider and the issue has morphed into a short-term obsession with the 'fiscal cliff' and another recession. The fiscal cliff is a series of automatic tax hikes and spending cuts which come into effect on January 1, 2013, many of which were agreed to during the ridiculous debt ceiling debate of August 2011.

According to an analysis by J.P. Morgan economist Michael Feroli, the fiscal cliff annually would pull about $280 billion out of the economy from sun-setting of the Bush tax cuts; $125 billion from the expiration of the Obama payroll-tax holiday; $40 billion from the expiration of emergency unemployment benefits; and $98 billion from the 2011 Budget Control Act spending cuts. In all, the tax increases and spending cuts total about 3.5% of GDP - about half the current annual deficit - with expiry of the Bush tax cuts making up about half of that.

The Congressional Budget Office calculates that the effect of the fiscal cliff could amount to a 4% reduction in GDP. The widely expected solution is seen to be a much smaller tax increase on the wealthy and much more modest spending cuts which will leave the debt and deficit largely unaddressed. Even this largely symbolic move is seen as highly contentious and possibly unattainable. What the current furor over the fiscal cliff demonstrates is how difficult any meaningful debt reduction will be. What little capacity that exists for bi-partisan agreement may be squandered on a battle that is not worth winning.

There remains an assumption among most investors that the U.S. is headed back to the 'normalcy' of 2007, slowly, to be sure, but inevitably. The enormity of the real problem appears to have been lost. Since 2007, the year before the financial crisis, a radical, fundamental shift has occurred in the U.S. (see www.theburningplatform.com):

• In 2007, the annual Federal government deficit totaled $161 billion. In 2012, the annual deficit is $1.1 trillion, about $3 billion per day. The Federal Government spends nearly 50% more than it takes in.
• In 2007, the national debt was $9 trillion. In 2012, the national debt is $16.3 trillion, an 81% increase in five years. Normalization of interest rates to 2007 levels would result in annual interest expense of $1 trillion or 40% of current government revenues.
• In 2007, Federal government spending was $2.73 trillion. In 2012, Federal government spending is $3.8 trillion, a 39% increase in five years. In 2007, GDP was $14.2 trillion. In 2012, GDP is $15.8 trillion, an 11% increase in five years. Approximately 25% of the growth in GDP is due to increased government spending.
• In 2007, Government entitlement transfers totaled $1.7 trillion. In 2012, they total $2.4 trillion, a 41% increase in five years.

Behind these depressing numbers are the underlying facts of an economy in decline:

• In 2007, the unemployment rate was 4.6%, 146 million people or 63% of the working age population were employed and 78 million Americans were not in the labor force. In 2012, the unemployment rate is 7.9%, 143 million people or 58.8% of the working age population are employed and 88 million Americans are not in the labor force.
• In 2007, real median household income was $55,039. In 2012, real median household income is $50,502, down 8.2% in five years.
• In 2007 median household net worth was $126,400. In 2010 it had fallen to $77,300, a 39% drop in three years.
• In 2007, interest income paid to senior citizens and savers totaled $1.25 trillion. In 2012, interest income totals $985 billion, a 21% decrease in five years.
• In 2007, there were 5.7 million existing homes sold at a median price of $218,900. In 2012, there are 4.3 million existing homes being sold at a median price of $183,900. Over 1 million of these home sales are foreclosures or short sales as 30% of all the homes with a mortgage owe more than their house is worth.

Turning this around during a world-wide economic slow-down is likely the work of a generation. Meanwhile, another debt ceiling debate beckons early next year.

Egan-Jones is an independent debt-rating agency whose compensation does not come from the debt issuers it rates, unlike its better-known competitors. The firm has downgraded the U.S. twice in 2012 and currently has it at AA-. In an interview on November 6, 2011, Sean Egan, president of Egan-Jones, poured cold water on the notion that even an amicable and timely resolution to the fiscal cliff debate would meaningfully improve the credit worthiness of the country:

"The key measure on sovereign credit quality is debt-to-GDP. In the case of the U.S., it's risen rather dramatically, from four years ago at 75% debt-to-GDP, to currently over 104%. The problem in the U.S. is that the debt has grown whereas the GDP has not grown."

Europe Also Misses the Point

The European Union's (EU) unelected political leadership tells us that the worst is over. The Euro project is safe. The Greek Parliament has agreed to yet another 13.5 billion euros of new austerity measures which will trigger the urgently needed next tranche of some 32 billion euros of EU bail-out money within a few weeks. Meanwhile, markets believe that the European Central Bank (ECB) has successfully freed itself from Bundesbank control and with the newly-created Outright Monetary Transactions (OMT) tool, it can now intervene freely and massively in the short end of the Sovereign bond markets of countries which have agreed to fiscal discipline programs with the newly-approved European Stability Mechanism (ESM). European Sovereign bond yields have fallen dramatically.

The real facts are disturbingly different, according to Mark J. Grant, a Wall Street veteran and astute observer of the unfolding European crisis. Greece is insolvent and becomes more so every day. In a piece entitled "We Aren't In Kansas Anymore" Grant notes that the International Monetary Fund (IMF) has refused to provide any more support to Greece until the country can prove that its debt burden is sustainable. But Greece cannot pay back its debt under any scenario. It is impossible. Grant calculates Greece's debt-to-GDP ratio the common sense way, by taking into account all of its debts including bank debt and corporate debt guaranteed by the government, guaranteed derivatives and regional government debt:

"With an actual debt-to-GDP ratio now around 800% I think it can be said with certainty that the task [of repayment] is impossible even as the Troika (the EU, IMF and ECB) says the same ratio is 190%. The difference between my number and their number is just what is counted. I count in exactly the same fashion as IBM or GE tallies up their balance sheet."

Grant also dispels the popular myth that Greece could "disappear and it wouldn't matter" or, put another way, that Greece is so little no one should care. On the contrary, "with a total of $1.5 trillion in debts a default would be cataclysmic."

The Spanish banking bail-out is equally open to question. The ECB is waiting for Spain to accept an agreement with the ESM requiring Spain's guarantee of the bail-out, which in turn expands its debt-to-GDP ratio and therefore requires austerity measures imposed by the EU/ESM. The amount of the bank bail-out is variously estimated at 60 to 100 billion euros, to repair the balance sheets destroyed by the world's largest ever real estate bust. The eventual total is certain to be much higher. But real estate is only part of the problem and perhaps not the most pressing part. Spain and the other countries on the European periphery appear to be undergoing a silent but very dangerous bank run.

Suppose that you are a Spanish depositor at a Spanish bank. You are concerned that Spanish banks need a bail-out. You are also concerned that there is a small chance that Spain may be forced out of the euro. You do not want to wake up one day owning pesetas. There is no euro zone deposit insurance backed by an unlimited lender of last resort such as the U.S. has. So, you move your euros to the Spanish branch of a German bank where they are just as available for transactions, although you may get less interest...a small price to pay for a sound night's sleep.

A report by Yalman Onaran of Bloomberg News on Sep 19, 2012 documents how prevalent this thinking has become. Over the 12 months to the end of August, some $425 billion in deposits had been pulled from banks in Greece, Italy, Portugal and Spain. And about $390 billion in deposits had piled up in core euro countries, particularly France and Germany. Bank balance sheets in the periphery countries are evaporating. This is especially difficult for European banks which tend to fund themselves by demand deposits and other sources of short-term wholesale funding rather than equity or long-term debt. Declining liabilities mean that assets need to be sold and lending needs to be curtailed. Fewer assets mean less collateral for loans from the ECB which has already dropped its collateral requirements several times.

The European banking system is, in our view, in real danger of imploding. As the pressure builds on Greece to exit the euro, an event we consider almost inevitable, the bank runs will intensify. Who can say a Greek exit will never happen? If Greece leaves and forces its depositors to convert to drachmas, who is next? Even a small chance of such an outcome encourages deposits to flee weaker countries and banking systems especially when the costs are so minimal.  We consider this to the most pressing issue facing countries like Spain. In June $70 billion dollars left their system. In July it was $92 billion which is 4.7% of total banking deposits.  From January to July of this year, an estimated $368 billion or 17.7% of total bank deposits has fled Spanish institutions. This evidence is confirmed by the huge and growing imbalances in the ECB's Target2 settlements system.

The 'Solution': Expanding Central Bank Balance Sheets

In our view, the world's problems are bigger and more urgent than the markets seem to realize. The shape of the presumed solution is already more than clear...financial repression rather than default. Financial repression is the policy of ultra-low interest rates fixed in place by central banks, rapidly expanding central bank balance sheets and money supply, tighter controls on capital and lower exchange rates. The aim is to force savings into financial markets to maintain asset values, especially in the debt markets, and preserve liquidity. The result is necessarily a rapid decline in the purchasing power of money.

All major central banks are now involved. The Federal Reserve and the ECB have already tripled their balance sheets since 2007 and both have announced unprecedented and aggressive new initiatives, QE3 and OMT respectively. The U.K. is similarly addicted to quantitative easing. China, Japan and Switzerland are directly intervening in currency markets, printing huge amounts of their currencies to weaken them. As markets finally conclude that these policies are likely to be in place for many years, there will be, in our opinion, a rush for gold and a growing reluctance to sell it for dollars or other currencies, with explosive consequences.

The correlation between negative real interest rates and the gold price is well known. But perhaps the clearest correlations for the gold price are growing central bank balance sheets, global liquidity and public debt, as illustrated below (Source: http://goldswitzerland.com):

A surprising number of people see little or no consequence to a global liquidity boom other than price inflation, which most seem to think is a far distant event given the economy's large output gap the difference between the economy operating optimally and its current level of activity - which is supposed to have a depressing effect on the general price level according to prevailing economic theory. The fact is, we do not know.

Consider the following remarkably candid quote by Richard W. Fisher, a Governor of the Federal Reserve, delivered to the Harvard Club of New York City on September 19, 2012:

"It will come as no surprise to those who know me that I did not argue in favor of additional monetary accommodation during our meetings last week. I have repeatedly made it clear, in internal FOMC deliberations and in public speeches, that I believe that with each program we undertake to venture further in that direction, we are sailing deeper into uncharted waters. We are blessed at the Fed with sophisticated econometric models and superb analysts. We can easily conjure up plausible theories as to what we will do when it comes to our next tack or eventually reversing course. The truth, however, is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 Banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course. And nobody-in fact, no central bank anywhere on the planet-has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank-not, at least, the Federal Reserve-has ever been on this cruise before."

We believe in the wealth-protecting qualities of gold, for all the reasons we know, and those we do not know. We expect markets to come to the same conclusion.