John Ing
Last year it was Wall Street's debts, this year it is sovereign debt problems. Just when everybody was told it was safe to go into the water, once again investors are told that yet another bailout is needed to stem the threat of a default. This time it is sovereign defaults. Taxpayers are again being asked to pony up as governments pile up more debt, further devaluing their purchasing power. When will it end? Investors are losing confidence in propping up heavily indebted governments, banks and corporate entities, either explicitly or implicitly. Inflation and currency depreciation is next.
To make matters worse, Mr Obama looks out of his depth. President Obama did not cause this recession, but seems locked in its past. He pledged to give us more economic freedom but instead promoted more state handouts. His government has swung to the left whilst America remains centre-right. His banking system is broke and he continues to spend. He doled out stimulus money to the banks instead of the taxpayer and now calls for bank reform. With the economy mired in recession, he opted instead for a $1 trillion healthcare plan and he is on track to become the biggest spending president since Franklin Roosevelt in the Thirties. Mr. Obama has become the Pierre Elliot Trudeau of American politics who once lifted Canada's public hopes but took the country on a Keynesian path of financial destruction leaving behind the much hated National Energy Program, big government and a legacy of debt. Canada took years to recover. American does not have the time.
Debt, Debt and More Debt
Spurred by the loss of a Senate seat, President Obama has decided to tackle his ballooning national debt, for which he bears considerable responsibility by announcing the setup of a 18 member commission - how very Canadian. To solve the debt problem, he does not need a debt commission to study a public debt of more than $14 trillion or about $40,000 per American. He does not need a debt commission to resolve a $1.4 trillion budgetary deficit that is three times the previous 2008 record. He does not need a debt commission to tell him about America's profligacy with overall debt at 85 percent of GDP and still climbing. And, the bills of Wall Street are still coming in, particularly the growing debts of Fannie and Freddie Mac which continues to drain on America's finances. Obama only has to look at what is happening in Greece today, to know what is going to happen to his country tomorrow.
Meanwhile like the wolf at the door, central banker Bernanke threatens to raise interest rates as part of his exit strategy. Yet, in light of the growing US debt load, Bernanke must print more dollars to support the huge twin deficits, fed by America's insatiable need for cheap oil and desire to live beyond its means. Another element, while he threatens to blow the house down, rates remain near zero. Still he continues to buy assets with freshly minted dollars while his bloated treasury is filled with almost $1.4 trillion of mortgage linked assets and other toxic securities. At one time, the asset side of America's balance sheet consisted largely of Treasury securities with a bit of gold. And despite the threat, he continues to support the government's spending orgy, citing the threat of a recession as the rationale to keep on spending. Fast rising debt is worrisome and unsustainable. Bernanke's exit strategy is untried and untested.
The US has been living beyond its means for some time. The government has taken a bigger role in spending and borrowing but left unsaid is that by increasing spending, it takes away from the private sector. Bernanke doesn't even seem to be concerned nor about the prospects of $800 billion interest payments on the national debt by the end of this decade up from $207 billion this year. Save for the World War II expenditures, spending on average will reach the highest levels in American history to 25.2 percent of GDP, significantly above the 20.7 percent forty year average. While President Obama prefers to blame much on George Bush, he will take the gross debt to 103 percent by 2015. Both public and private debt totals 370 percent of GDP. Also missing is a discussion of what to do with the trillions of dollars of unfunded off balance sheet liabilities related to mandated Medicare and Social Security. To be sure, previous time honoured solutions for improving the economy such as slashing spending, eliminating the mountain of regulations or lowering taxes are not part of Mr. Obama's strategy. Instead we have a Keynesian mixture of increased spending, larger deficits, higher taxes and an agenda of redistribution of whatever is left over.
Beware Of Greeks Bearing Gifts
Meantime debt dependent Western governments continue to prop up the economic recovery with a dose of cheap money and government spending, but without the consumer. As a consequence of bailing out Wall Street, the US government has transferred private sector debt onto the government shifting debt repayment from shareholders to taxpayers. Indeed concerns about the level of sovereign debt prompted Moody's Investor Service to warn that even the United States and the United Kingdom were risking losing their blue chip Triple A status. First Iceland, Greece, and now Portugal. All need to put their fiscal house in order, with an exit strategy of lowering their lifestyles by raising taxes and slashing government expenditures. The dominoes have fallen.
The bigger problem is the need to finance their gargantuan liabilities at a time when there are trillions of government debt to be rolled over in the next year or so at a much higher cost and in direct competition with other deficit sovereign states. The United States alone must borrow nearly $2 trillion in 2012 to bridge its projected budget deficit and to refinance existing debt. This time, no one is too big to fail. By transferring the debt from its banking sector to the public sector, the United States only forestalls the inevitable as Greece found when it transferred its Olympian sized debt onto its own books. There is no easy way out. US debt today stands at 85 percent of GDP, compared with 115 percent for Greece, 59 percent for Spain, or 66 percent for Ireland. Yet the explosion of public debt continues as the White House projects that gross federal debt in public hands will exceed 100 percent of GDP in only two years. The US is in a much sorrier state than the other European ailing nations.
Obama's whopping $3.8 trillion budget will produce a $1.4 trillion deficit this year and trillions more over the next few years. The non partisan Congressional Budget Office (CBO) reveals that President Obama's fiscal 2011 budget would add almost $10 trillion to the national debt over the next decade. But to pay for those deficits, the US government must borrow one out every three dollars with the majority coming from foreigners. Other than a drop in the greenback, the consequence of depending on foreigners has so far been fairly benign. However as America's deficits balloon, its national security, sovereignty and even control over their currency will disappear. How long can America count on the market's tolerance? Very scary was reports that Russia almost caused the failure of mortgage giants, Fannie and Freddie last year when they dumped their positions.
China too has repeatedly expressed warnings about the sinking dollar and the growing deficits, because of concern for the safety of its vast holdings of US government debt denominated largely in dollars. China has also warned that pressing the Chinese on its currency policy amounted to a new form of protectionism last seen in the seventies in a "beggar thy neighbour" currency war that saw the US go off the gold standard. China's investments once cushioned America's finances, but China recently unloaded $34 billion of US government debt in December. Worrisome is that the Chinese have reduced their purchases of Treasuries from 40 percent of new issuances in 2006 to only 5 percent last year. Yet, the US responds with threats, selling Taiwan $6.4 billion of arms and receives the Dalai Lama, inflaming an already tenuous situation. And worse, hoping to score political points, American lawmakers threaten to slap duties on Chinese goods. Who's zooming who?
The Failure of Derivatives
Derivatives are the cornerstone of the shadow banking system and its global reach no doubt accelerated Greece's worsening financial position. Wall Street still believes that securitization is one of the greatest innovations of finance in the last quarter century. We side with former Fed Chairman Paul Volcker who said that the banking industry's greatest innovation was really the ATM. While securitization has channelled vast sums of money into housing, giving everyone the American dream without having to pay for it, the derivatives market has grown from nothing to a notational value of $600 trillion.
To some, the usage of derivatives produces no economic or social benefit. To us they are the Achilles heel of the financial system and are all about leveraged bets. Europe is calling for a ban while the Americans caution that their institutions should not discriminated against. Warren Buffett calls them weapons of mass destruction. They are worse.
Of concern is that some of those derivatives, such as interest rate and currency swaps made famous in the Lehman collapse were used to camouflage Greece's overall finances to hide its debts and mask the full extent of the problem. In Milan, four banks have been charged with fraud for devising a swap for the city. And others used derivatives to fudge their figures. A 2,200 page report into the collapse of Lehman Brothers noted the usage of the same sort of obscure derivatives that allowed Lehman similarly to over-inflate its balance sheet to hide its problem as it collapsed. Derivatives also sunk Long Term Credit Capital Management. Does anything change? The common denominator are these exotic instruments.
Hedge funds made huge speculative bets against Greek debt taking by advantage of swaps and over-exposed European banks. The centerpiece of the so-called swaps are the over-the-counter contracts that offer buyers the insurance against a default and the counterparty a premium for underwriting the contract. These contracts were written by insurance companies like AIG who originally hedged their portfolios. The seller agrees to pay the investor if the swap defaults. The swaps can be currency, credit, interest or even mortgage based. Acting as a middle man, Wall Street bastardized these instruments by underwriting these instruments to generate more fees without the need of ownership or capital of the underlying securities making "naked" bets on the direction. These instruments became increasingly complex. The more complex, the less the market understood.
And, since these instruments were really swaps without underlying assets or ownership, the credit default swaps morphed into an unregulated $50 trillion market, far exceeding the indebtedness that they were designed to protect. Furthermore, without the underlying asset, many institutions decided to syndicate or spread the risk among other dealers. When prices moved against the biggest underwriter AIG, Washington had to step in paying billions to bailout AIG and its counter-parties. AIG simply had too little capital of only $180 billion to cover a $2 trillion portfolio of derivatives. Financial markets have become so integrated that the failure of one, can cause the systemic failure of all. That is what happened two years ago. This time, having feasted on Wall Street's woes, the market is poised to feast on bigger prey, government sovereign debt.
And worse, the same big investment banks that turned themselves into commercial entities in order to be "first in line" when the Fed bailed out Wall Street are still recipients of the Fed's largesse with loans at near zero rates and their securities guaranteed by the taxpayer. The Federal Reserve was not so lucky, since today it is stuck with some $2 trillion worth of Wall Street's creations. These same banks today are lobbying the Senate to dilute President Obama's financial regulation package. Also unchanged is the mark to market accounting debacle that saw some assets inflated above their real worth. Worrisome is the apparent watering down of the Volcker Rule, which was to split proprietary trading from Wall Street's main lending businesses. There is also a need for less leverage as well as an overhaul of capital requirements and even level 3 assets. What is needed is a return to market discipline and to the basics of lending with collateral and of course proper due diligence. There is also a need for transparency, moving the liabilities and swaps to a regulated market, so regulators and investors could monitor and control risk. A simple move would be to list these liabilities on the world exchanges. Is anybody listening?
Obamanomics and Hyperinflation
Unfortunately for the Americans, there are only two realistic ways to bring the deficits down, either by increased taxes or spending cuts. How long will America's creditors continue to lend much of the money to finance America's spending? This is a lot of money. But the reality is that even with higher taxes, there is just not enough money to wrestle this and future deficits to the ground. For that, America could look for another Obama. The other alternative is for this President to inflate his way out through the monetization of deficits.
While the administration still believes that inflation is not such a bad thing since it reduces the real burden of debts, the reassurance to date about America's creditworthiness is somewhat suspect. Inflation is an increase in money and credit. Once unleashed, it is a dynamic beast, not easily contained. Amazingly Obamanomics appears to include a healthy dose of inflation to give more room to reduce rates, equating the lack of velocity with tame inflation. How wrong. However, through the next decade, his eye popping deficits (current account, budget and public deficits) will increase and not decline.
The American dollar thus faces the most serious crisis. History shows that the consequence of debt-fuelled spending, is inflation when too much money chases too few goods. Inflation is a monetary phenomena. Hyperinflation is out of control inflation. Government deficit spending is the beginning of the downward spiral. US monetary base or raw money has increased 100 percent with dollars in circulation in excess of $2.2 trillion, the greatest expansion in American history. Hyperinflation of the dollar has already occurred. As Greece found, when the music stops or an auction fails, the crisis begins.
And then there is the ever-present inflation risk. Stories abound about the horrors of raging inflation. There was a stark reminder of this recently in Zimbabwe and Argentina which twice experienced hyperinflation and today Argentina ousted the president of its central bank after he refused to hand over its reserves to pay off debts. Or there is the Weimar Republic experience in the early twenties, when Germany burdened with paying the debts from war reparations, inflated their debts away causing the horrible inflation in the thirties. We once reviewed the hyperinflation episodes in China, France, Argentina, Germany and Zimbabwe. In each hyperinflation, those countries were running massive annual deficits, accumulating unmanageable national debt and each had a central bank creating or printing money. The US is nowhere near hyperinflation yet. However, common with other hyperinflation periods, America has seen a large expansion of money and credit, chronic budgetary deficits, excessive debt to GDP ratios and an unprecedented currency explosion. Is it really different this time?
Today, Currency Hyperinflation, Tomorrow?
Central banks are the stewards of money by controlling the supply of money. Until the early 1970s, most global currencies were linked to gold. Currencies were readily exchangeable. However President Nixon severed the link between the dollar and gold in 1971 in the widespread inflation following the Vietnam era. The dollar soon became the world's de-facto currency and cornerstone of the international monetary system.
The three leading nations of America, Japan, and Germany accepted that their currencies would float against each other. The US dollar became the dominant and convertible currency. Most other currencies tied themselves to the dollar. So it has been ever since. Previous monetary systems were linked directly or indirectly to gold. If a government debased their currency by printing money, the currency fell in value. Today, like credit default swaps, without the discipline of convertibility, the Americans have printed dollars at an unprecedented scale. The current crisis is rooted in a combination of overly expansionary monetary policies as the Federal Reserve fed an unprecedented global supply of dollars to cover its obligations. The result is a world-wide dollar bubble that caused the subprime defaults, sovereign-debt defaults and the near collapse of Wall Street. Hyperinflation is next.
Gold is a barometer of currency fears. Gold has moved up because the purchasing power of the US dollar has moved down. Gold has moved up because investors are concerned about the mountain of debt and America's debt fuelled spending. Gold have risen 350 percent from its lows. The warning signal is clear. The US currency is no longer the dominant currency nor is it the bedrock of the world's global financial system. America's biggest creditor, the Chinese are looking for alternatives and even the beleaguered euro has replaced the US dollar in some places. To be sure, the US dollar is overvalued and the combination of economic stagnation and volatility makes gold a better store of value.
Gold is even an alternative investment to the US dollar for central banks as they have become net buyers for the first time in two decades. Gold has outperformed stock markets and been a much better investment than equities and currencies. We are moving towards a territorial world where the dollar will have less influence and a "balkan" basket of currencies will replace the dollar. Official transactions for example would expand the use of Special Drawing Rights (SDRs), the major oil countries a petro based basket, the West would float against the much diminished dollar and the Asians, a basket tied to the yuan. Like the euro, all will have a gold component - after all gold is money. The loss of a senate seat reminds investors of the political cycle in the US. The disease is set but the cure is not. Gold and the dollar are telling us that a perilous adjustment is ahead. As such, we no longer expect gold to peak at $2,000 per ounce, it will trade higher.
Today gold is the only asset class protecting investors from inflation, the loss of purchasing power and depreciating currencies. There is simply not enough supplies to meet demand and that is something that Wall Street has yet to explore due in part to its dislike of gold. We believe growing concerns about the credit-worthiness of government and the consequence of bailouts will see more and more investors look to gold as an alternative.
Conclusion
Bullion and exchange traded funds (ETFs) have been beneficiaries of gold's price rise. ETFs are now the seventh largest holder of bullion dwarfing the gold stockpiles of most central banks. On the other hand, gold mining stocks have lagged despite a pickup in profitability. This will change.
John R. Ing Maison Placements Canada 130 Adelaide St. West - Suite 906 Toronto, Ont. M5H 3P5 (416) 947-6040
26 March 2010
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
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