“A government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the one we have today, can produce claims without limit”. Alan Greenspan, 1997
So it goes. We can always print to pay for our obligations, so goeth the Bernanke gospel, Mr. Greenspan’s successor. Yet, notwithstanding the Fed pressing the monetary accelerator to the floor, the economy is still not growing. Monetary policy has failed to engineer a strong recovery. Worse for the past four years, the White House and Congress have been locked in a political fight proving them incapable at handling economic problems. Round one, Obamacare, States are opting out. And, each time there is another round of brinkmanship. Round two, Dodd Frank, watered down. Round three, Fiscal cliff, averted. America just trades one cliff for another. Round four, the government’s debt ceiling must be raised coinciding with the March deadline (is this round five?) over the sequestered spending cuts. If no deal, then a paltry 0 billion of annual spending cuts kicks in, a drop in the bucket. Brinksmanship is repeated over and over.
Still, America’s structural problems persist. America’s debt crisis increases with each and every round of quick fixes with the public finances supported by ever more doses of money creation. In the ultimate Ponzi scheme, newly minted dollars pay out past obligations. And contrary to widespread belief, investors appear to be growing accustomed to Washington’s brinkmanship, assuming they can kick the can down the road, one more time. As long as the Fed kept the money spigots open, all was fine. But if the money printing stopped, everything would collapse. And now more and more foreign money is losing confidence and patience in America’s ability to meet their escalating obligations. America wants that free lunch, just who will pay the bills?
The United States has Become Very European
The big fear of the fiscal cliff was the belief it would usher in a period of austerity like the European experience. Indeed the US debacle looks very familiar. The US has become very European. The fiscal cliff however was just recognition of the need to get America’s finances under control and at long last tackle their crushing debt burden. The New Year’s deal did nothing. No one likes taking bitter medicine but needed in the United States was a dose of what Europe is experiencing, austerity accompanied by tax hikes. The fiscal cliff was just that, a reality check and a symptom not a cause.
In Europe, amid the optimism that the worst is behind them and after one year of umpteen summits, its 27 members are still negotiating a budget which would cover the roughly trillion in spending from 2014 to 2020. But, the gap was so wide that the only consensus was to delay. Thus the European Central Bank was left with the only policy option in its arsenal, flooding the system with cheap money. By buying unlimited short term government bonds from those needy countries, the bank is kicking the can down the road again. Greece is still in Euroland but Europe’s outlook remains grim. Debt creeps higher and economies remain in decline as currencies spiral down in a currency war.
Mr. Obama’s victory was built on a shrewd strategy created ironically by Republican strategist Karl Rove who divided constituencies to get Bush elected. This time, both parties depended on the outsized influence of narrow interest groups. Mr. Obama appealed to a coalition of African Americans, Hispanic Americans, younger Americans and of course a liberal dose of gender based policies worked to get Obama elected. The Republicans were helped by the Tea Party and superpacs. The last election was based on minutiae issues, or “small ball” politics for fear of scaring off the populace with the big stuff such as the meltdown in Europe, or even austerity vs. growth. But in this game of constituency-based politics, it is difficult to build a major consensus to tackle America’s problems among the broader-based populace. At a time when the population should be prepared to make the big choices, bipartisanship guarantees gridlock. The laws of economics state that bigger government must be financed either in higher taxes or bigger deficits. None of this however was decided when billion was spent on an election that perpetuated the status quo. Meanwhile, spending has soared as a percentage of GDP to its highest levels other than the World Wars. And looming is the threat of another US credit rating downgrade while the debt ceiling negotiations to raise the .4 trillion borrowing limit begins. The debt ceiling has been raised forty times in thirty years. Déjà vu.
Debt Forever
America has far too much debt at 100 percent of Gross Domestic Product. That debt draws down prosperity from the future. America faces a gigantic black hole between federal spending and revenues with deficits exceeding trillion for four years in a row. This year despite Washington’s machinations, the deficit will be the highest than in any year since 1946. But how to bring the trillion dollar deficits and .4 trillion public debt under control?
As usual politics ahead of economics. In the United States, like Europe, the government’s insatiable appetite for revenues was an opportunity to both raise revenues and for a bit of social engineering by taxing the rich in an effort to close the wealth gap. For the first time in two decades, Congress actually raised taxes. Despite the rhetoric, a sliver of taxpayers cannot pay for everything. The experience of other countries suggests that isn’t enough. Despite revenue hikes in the New Year’s deal, cuts to spending were put off to later. The most urgent priority then is to reduce the scale of spending. Easier said than done. In the New Year’s deal, the deficit would only shrink by billion or 0.06 percent.
American has an unsustainable debt problem because they have a spending problem. Not included are the big three unfunded entitlement programs such as Social Security, Medicare and Medicaid whose billowing costs have been bloated by bureaucracies, litigation and extraordinary expensive healthcare. America should start with the President’s own bipartisan Bowles-Simpson Commission that called for reduced spending through entitlement reform as well as broaden the tax base. With revenues of .4 trillion, America has little wiggle room. Federal spending has traditionally been about 19 percent of GDP but has surged to 24 percent.
Or reform the tax code where there is something like .2 trillion of tax breaks equivalent to almost half of what America gathers in taxes, which begs the question of eliminating some exemptions instead of trying to squeeze money from the one percent. Mortgage deductibility was an election sop of yesteryears ago and bigger houses are not the solution but billions are lost in deductions. Unfortunately tax reform is politically divisive but if doesn’t have to be, as Canada in the mid-90s showed that debt can be retired with tough policies.
Central Banks Have Become the Handmaidens of Government
To pay for those deficits, central banks once independent have become the handmaidens of governments, engaging in untested measures such as quantitative easing, causing balance sheets to balloon. Central banks also replaced strict inflation targeting with employment targets which is actually code for inflating debt away. Bernanke pledges trillion a year or a third of the Fed’s assets to buy as much as billion of debt a month until America’s job rate drops. “Helicopter Ben” still believes that America’s problems can be solved by printing dollars. To infinity and beyond.
We believe this experimentation has done structural damage to the world’s largest economy fueling a giant credit bubble. Aiding and abetting are the big investment banks who stepped in following the Lehman Brothers collapse but never left. Quantitative easing is more than interest rate manipulation. The mechanics saw the creation of new forms of money proxies as part of the shadow banking system that has grown to $67 trillion. In fact these derivatives are not anchored to anything concrete or physical. The shadow banking assets are sliced and diced and resold over and over. No underlying value here. It was that way in 2008 which almost broke the system and today despite Dodd Frank, the Volcker Rule and Basel III, it is the same. The volume of derivatives has swamped the world’s domestic product by twenty times or $1.200 trillion ($1.2 quadrillion). Bigger and better?
As a result, the total assets of the Federal Reserve has exploded from $869 billion in 2008 to over $3 trillion. Of concern, are the fiscal consequences since the bank resorted to the printing press to pay for those so-called assets. In the minutes of the December Fed meeting, certain members expressed concern at the open-ended nature of the central bank’s quantitative easing. Foreigners own more than a third of US debt in a pyramid arrangement where the Fed prints money out of thin air to purchase debt. Foreign purchases of US debt has slowed down leaving the Fed to buy 77 percent of all Treasuries issued last year. Of concern is the Fed’s massive expansion of its balance sheet makes an exit strategy virtually impossible, since their balance sheet has grown bigger than the entire market. A great many economists are comforted in that the liquidity sits in the Treasury or some bank’s vault. Yet history shows that money can easily leave and quickly (called velocity), leaving the Fed to close the vault door after the money has gone. Given central banks’ dismal record, gold is a haven in the event the vault door was not closed fast enough. The real danger is just ahead. Round six?
China’s Fifth Generation
At a time when the US and China chose their new leaders, it is remarkable that the two opposite countries should have in common the disparities of wealth among their population. It appears that there never has been a wider gulf between the haves and have-nots, or the 1 percent versus the 99 percent. Both countries approached their problem differently. Rather than tax and spend, China has grown at warp speed, due in part to the migration of workers into the cities. Growth is the key. Urbanization has been good for China and it is estimated that over half of the population lives in the cities and towns, much less than average developed economies where 80 percent live in the cities. All of which means that China’s new leaders’ task is to continue the movement of the population into the towns and cities. Urbanization will mean the need for new buildings, infrastructure and construction, which are good for the consumption of resources and extension of the commodity supercycle.
There was much attention on the election of the fifth generation party leaders in China. To be sure, freshly installed Xi Jinping will embark on a brand new five year plan. The new leadership must not only govern more than 1.3 billion people but also cope with demonstrations and riots that number about 500 a day. China is evolving with their companies once branches of respective ministries to commercial entities, all in less than 20 years. We expect the first few years to be cautious while Mr. Xi and his colleagues consolidate their leadership. Importantly though, five leaders of the seven member politburo retire at the end of five years, so Messers Xi and Li will be able to appoint individuals much more closely aligned with them. While much attention is spent on the fight against corruption, we believe that the economy will be “Job One”.
Cheap Money
Every central banker has become pro-growth, repeating the same mantra, more money. Money has never been so cheap and so easy. The price of credit is too low, forcing investors to take bigger risks in the quest for yield. Interest rates are near zero and real rates remain negative with no signs of inflation. However, those central bankers were not around in the seventies, which was the last time monetary policy was so liberal that inflation eventually took off to hyperinflation levels. We are told it is different this time. So far the liquidity that the central bankers have unleashed has spilled into hard assets such as oil, gold, and financial assets just like the seventies. Ironically with the Fed’s new emphasis on growth instead of inflation, there is evidence of creeping inflation everywhere. Subway fares will go up yet again as well as property taxes. Postage rates up, haircuts up, taxes up, as are energy prices. Rising prices are symptoms of inflation. For the early part of the seventies, prices were illusory and it took a while for the prices of goods and services to go up. Cheap money has encouraged leverage with another bond market bubble ready to burst.
The Fed has backed itself into a corner. America has attempted to inflate its way out of the debt problem since that debt is denominated in its own currency. We believe the rise in debt will be a burden for decades. The near collapse of the financial system in 2008 caused the recapitalization of the financial system and the burden of servicing that debt shifted from the private sector to the public sector. This is our problem. In this new age of austerity, with a monetary system based on the dollar, the world has tied themselves to a high cost and highly indebted country that still believes they can always print more dollars or recently, issue a one trillion dollar platinum coin to pay for their debts. The Fed has tripled the monetary base. Currency circulation has also increased, due largely to the monetization of the US fiscal deficits and increases in commercial bank reserves have been converted into faster money growth.
We believe the Fed’s policy of directly monetizing newly created debt to service their debt will prove inflationary. Once a pickup in growth, either in China or elsewhere, that excess liquidity will find its way into an inflationary explosion of demand for labour, goods and services. Like the seventies, the Fed won’t be able to reduce the excessive stock of money it has created. Were rates suddenly to rise because the Chinese demanded more, the value of the Fed’s $3 trillion portfolio would collapse since most of its assets are of long term duration. In fact a paltry one percentage increase could wipe out the Fed’s entire capital base. Ironically, the Fed’s near zero interest rate policy aimed at stimulating housing, ignores demographics. As baby boomers become empty nesters, they downsize and most retire. The demand for bigger houses is not there so slashing interest rates penalizes the same group, punishing the retiring savers and rewarding the spendthrifts. Margin debt in November is at $326 million, higher than the pre-collapse levels reached in 2008. There is simply too much money chasing too few goods, and that is inflationary. The Fed is part of the problem.
Back To The Future
What ballasts the modern day monetary system is debt. America owes more than it owns and consumes more than it produces. This is not a deflationary environment but an inflationary one. Gold is thus a good thing to have. And rather than mint a trillion dollar platinum coin to pay the bills, we believe they should issue gold coins and revert to a gold standard which has worked for hundreds of years.
Gold was up last year for the 12th consecutive year, the longest in at least nine decades. Gold rose 7 percent last year, spurred by ETFs as well as central bank buying. Gold has rallied from $250 an ounce, moving almost eight times to a high at $1,920 in 2011, but still shy of the inflation adjusted price of $2,500 an ounce. However gold lately has not been as precious, frustrating both bulls and bears despite fears about the US economy, political gridlock and more quantitative easing. In the past these influences would act a catalyst for stronger prices.
Central banks are the largest official holder of gold with some 31,000 tonnes of gold in their vaults. In fact they have been big buyers with more than fifteen banks on the buy side in an effort to diversify their reserves in response to growing concerns about a weaker US greenback. Under Basel III, gold was rerated from a Tier 3 asset to Tier I, allowing banks to buy or hold gold instead of sovereign bonds. Central bankers will continue to be big buyers of gold. However, ETFs or the people’s central bank established in 2003 bought some 2,632 tonnes holding slightly less than IMF with 2,814 tonnes.
Although nearly 40 percent of the world’s supply is recycled, the only source of new supplies is the gold miners which lost nearly 25 percent since late 2011. Miners’ cash costs are concerns as mega-billion projects bring mega problems. But the industry has got religion. Most will emphasize profits over growth. Dividend hikes are likely and M&A actually will see the cast-offs of higher cost mines and/or emphasis on less riskier geopolitical areas. Growth has given way to profits. Moreover, we expect emerging signs of a shortage of physical gold as gold miners’ production peaked. To supply this demand the gold mines produced only 2,700 tonnes of gold annually. The only other source of gold is the estimated 22,000 tonnes in-situ reserves held by the gold miners in the ground but that must be extracted at a cost of $1,000 an ounce. We believe the in situ reserves will be more highly valued causing a reversal of the equity downtrend. Gold shares’ bull market has just begun.
Gold Stocks Have Never Been As Cheap
Chinese gold demand fell in the third quarter due in part to the lull before the leadership change. We expect resumption in demand that will see China consume more gold than any other nation beginning in the current quarter. China alone has 1,084 tonnes however that represents less than 2 percent of their reserves. If China were to increase their holdings to 10 percent, that could represent at least three years of the world’s output. Still, China is the fifth largest holder behind, the largest the United States, at 8,133 tonnes held at Fort Knox.
It doesn’t matter then, who owns gold, whether a central bank, ETF or my wife. Gold has the same value whoever owns it. Gold has been range bound. In the short term, gold needs to break through $1,700 an ounce. Gold is a hedge against the consequences that the world’s central banks will eventually ignite inflation. This fear also explains why the idea of a return to a gold standard has appeal, particularly when every major currency has fallen against gold. Gold has simply become the world’s new global currency. Gold is a hedge against debasement of currencies as well as an asset of last resort among central banks and investors. As such we have raised our new target to $10,000 an ounce. While $10,000 may seem outrageous, gold rose nearly 2,500 percent from 1971 to 1980 but is only up 550 percent from the lows of twelve years ago. There is a lot left in this bull market.
