Within one week, the now former leader of the International Monetary Fund and the former governor of the biggest state in the United States were caught up in separate sex scandals and a big lie. Then there was the conviction for insider trading of one of the largest hedge fund managers. Wall Street it seems is all about insider trading. Sex and lies just seem to be part of our daily lives.
As for today's ills, caused by the sins of the past, the answer has often been to just play for time. But after ignoring his own Deficit Commission and escaping a government shutdown, President Obama wrapped himself in the deficit fighting flag, promised a new period of cooperation then quickly accused Republican Ryan's budget as a "bailout for the rich". Yet, this president will spend more than $6 trillion over the next two years, pushing federal spending to 24 percent of GDP, the highest since World War II which will set him on a collision course with the Republicans who are calling for "trillions, not just billions of spending cuts". This year, the United States will spend $1.65 trillion more than it takes in. And despite reaching the debt statutory limit at $14.3 trillion, it's business as usual with America dipping into federal pension funds to pay its bills.
It's All About The Debt
Yet, this game of chicken over the handling of the US government's ballooning debt has drained investor confidence in the dollar, which hit a 40 year low against a basket of other currencies. The consequences of a default would include the much feared S&P downgrade, the dumping of US government obligations by foreign holders, a sharp rise in interest rates and a run on the dollar.
However, rather than focus on the debt ceiling, lawmakers should be more concerned about the spending increases and the staggering debt as share of GDP. With federal spending projected to exceed $3.8 trillion this year, the proposed $39 billion of spending cuts is less than one percent of the total overall federal budget. Miniscule, a rounding error. Policymakers believe, erroneously that their solvency problem is a liquidity problem. Wrong. Another big lie. It's about the debt stupid.
And as the deficit clock keeps ticking, Treasury Secretary Geithner insists that the US has made a "fundamental shift" towards fiscal discipline. Another big lie. Both sides appear more concerned about scoring debating points and political sound bites, rather than tackle the common sense and pragmatism needed to dig themselves out of their financial hole. Bit by bit the United States undermines its credibility. Somehow America believes it can solve its problems without paying and in fact, there is a free lunch.
US Policy - Postpone, Postpone
Threats of a financial apocalypse are just not credible. Today many instinctively distrust government pronouncements confirmed by the steady stash of Wikileaks. Politics has become a series of lies. Two centuries ago, James Madison said, "that all men having power ought to be distrusted to a certain degree". Denial, conspiracy theories and eventually credibility has an enormous input on US policy when Osama Bin Laden's death requires proof. President Obama was forced to prove he is actually a citizen of the nation he was elected to govern. Of course many believe the Americans never really landed on the moon. And some still believe Elvis is alive. It is this same scepticism prompted by a series of lies that sees investors doubt America's will to lift the debt ceiling and many actually expect a default in August. Credibility like virginity, once gone, gone forever.
Meanwhile contentious decisions about unfunded Medicare, Medicaid and Social Security programs will likely be deferred until after the 2012 election but this approach assumes the markets will be patient. How wrong. Playing for time is the norm but debt reduction is paramount. Canada once had a debt problem but reduced spending and austerity put Canada on a prudent fiscal path. The United States owes its creditors $14 trillion plus which is more than 70 percent of gross domestic product. Deep in debt, the US is about to remind investors of the precarious nature of its creditworthiness. In principle, there are three ways to deal with solvency issues. One way is for all creditors to take some loss and the debt starts anew. A second way is to grow out of its debt -unlikely so far. The third way and most expedient with an election in the offing, is to devalue one's currency and inflate away your obligations. That appears the path America is following since its political system is too dysfunctional to make the painful decisions to make things work. Mr. Obama might be able to spend more, but Capital Hill's brinkmanship will ensure that sometime soon, he will be forced to spend less.
And worse, states from Wisconsin to New Hampshire to California are on the brink of bankruptcy with the need to refinance a whopping $29 billion of expiring bank guarantees in this quarter to avoid downgrades or for some, default. Nearly half of the $2.2 trillion cost of state and local governments is the $1 trillion cost for their employees. So few taxpayers are paying for so many government employees.
International Picture Worsens
Faith is also waning in America's credibility as the Middle East's Arab spring threatens to involve Saudi Arabia, the world's largest oil producer. The Arab spring appears to be turning into an Arab winter as the democratization of the Arab world seems to be grinding to a halt or at least a stalemate. While regime change in Egypt and Tunisia was relatively quick, the aftermath and political transition was not so easy. Both regimes remain in a state of flux. Their economies are not yet working and investment has dried up. Populism has a price, yet their economies still suffer. Oil has been volatile and higher prices have softened the blow but there does not appear to be the infrastructure in place to complete regime change. Regime change does not translate into system change. And worse, it appears that tribal and sectarian differences are coalescing around those leaders temporarily filling the vacuum. To be sure an unintended consequence of the Arab spring is that the supply of oil is precarious indeed. Gold will be a good thing to have.
Meanwhile, the band-aids that papered over the European Union are coming unstuck. A European default is in the offing. Portugal has followed Greece and Ireland in yet the need for another EU bailout. Interest rates are still increasing. Europe's debt problems have returned full-circle from a year ago as it appears the Eurozone is more a monetary union than a political union with some members balking at another bailout. Greece which received a €110 billion bailout last year, has seen its deficit grow over 10 percent of GDP, pushing up Greek bond yields and is in need of another restructuring. Despite five austerity packages, Greece's rising debt is just too big to be repaid. Equally disturbing is that the UK has the third biggest budget deficit in Europe at 10.4 percent of GDP. The contagion has spread. The global banking community is also digging a deeper hole, with the IMF concluding that the world's banks will require $3.6 trillion over the next couple of years just to pay for debt redemptions and new debt. Another major banking crisis is in the offing. And like before, governments will be asking their taxpayers to recapitalize the banks. More than two years passed since the financial crisis began, and politicians have dug a deeper hole, causing yet another man-made crisis.
Sinking Feeling
Standard and Poors' threat to downgrade America's rating surprised the markets. At the very least, it brings to the fore, the folly what we and others have been warning about America's fiscal recklessness and now political partisanship. Where did America go wrong in such a short period of time? America dug itself a deeper hole by bailing out Wall Street, papering over the Eurozone sovereign debt problems, fighting wars and spending unfunded commitments. The end result: the US economy became a government supported economy. And worse, the country went deeper into debt, with the share of indebtedness to GDP going up. The mighty greenback has fallen to all time lows against the franc and yen and is set to fall again as trade and investment balances with the rest of the world remain negative. Investors led by Pimco, the largest bond holders in the world are not as patient and have dumped US obligations for fear of America reneging on its debt. Oh yes. Anne Gudefin, manager of PIMCO's global equities portfolio disclosed that her largest position is gold.
Inflation Is Here, Washington Doesn't See It
While Chairman Bernanke sees little risk of inflation, he simply isn't looking at the right places. When he announced that the United States would keep interest rates low, gold, silver and oil spiked upward as he threw more oil on the fire. Already the United States is faced with inflation thanks to its lax monetary and fiscal policies together with negative real interest rates which are directly inflationary. Even with the recent pullback, commodity prices are near parabolic highs fuelled ironically by the weaker greenback which is feeding through to the consumer. The government continues to use "core inflation", which omits food and energy prices, and is heavily weighted towards housing which is some 40 percent of the index. Mother Nature continues to influence everything from sugar to coffee.
Yet the biggest inflationary factor is the Federal Reserve. America is the sole country to own the printing press of its reserve currency. Despite extraordinary times, the debt crisis has not become a crisis because the United States and others were able to fall back on Quantitative easing ("QE") to ease their financing burdens and postpone a resolution. Quantitative easing "aka" printing money has also been great for Wall Street adding liquidity to financial markets but little has trickled down to the overall economy. For investors, quantitative easing provided cheap money so that investors could swap dollars into higher-yielding currencies, commodities and even gold. This "carry trade" resulted in a 15 percent drop in the dollar and a 27 percent increase in gold.
Few have studied the consequences and of course what happened to all this money. We believe the consequence of continued double digit growth in money together with a falling US dollar is more inflation , whether the Fed uses "core inflation" or not. Economics 101 teaches us that too much money chasing too few goods is inflationary. To date, the world's most powerful bank has pumped nearly $600 billion newly minted greenbacks into the US financial system. During this period, global markets have soared, gold hit new highs and commodities reached ever higher levels. Cheap money is crack cocaine to the US financial system and there appears to be no rehab program in the offing.
Fiscal Ponzi Scheme
We believe the threat of a default or plunge in the dollar could end America's great fiscal Ponzi scheme. The dollar is a fiat based currency and the very foundation upon which the mountain of US debt is built. In financing an ever growing national debt, foreign creditors were repaid by the issuance of new debt. Like Madoff's investors, as long as there was an infusion of new investors, the scheme kept going. However, when offshore investors like China balked the taxpayer was asked to fill in. The Fed's balance sheet has tripled in size and is stuffed with more than $3 trillion of government paper such as $1 trillion of mortgage backed securities which allowed it to finance further inflationary increases in the money supply and huge budget deficits as far as high as the eye can see. The Fed's massive purchase of Treasury debt replaced foreign buyers. For some time, the banking community was the Fed's surrogate, using bailout money to finance those out of control deficits in a quid pro quo transaction.
However, once confidence or the illusion of solvency disappears, the music stops. That is what happened to Greece, Portugal and AIG. In Madoff's case, when the market collapsed, his investors wanted their money back and his scam ended. The same thing is happening today. That a default on August 2 is unlikely, but the possibility is enough for one of America's creditor to ask for a return of funds. China and other creditors like PIMCO won't be as easily duped as Madoff's investors.
Already America's trading partners have taken a different tack. China has raised interest rates for the fourth time in five months, over concerns about a pickup in inflation. Even the weakened European Central Bank hiked key rates with the beleaguered euro a stronger currency than the greenback. The era of easy money may be ending. Tightening moves by Australia, United Kingdom and New Zealand has forced their central bankers to counter rising inflation. The US dollar continues to sink further as the Fed's zero interest rate policy finds fewer converts.
Inscrutable Chinese
China itself remains particularly concerned about the Standard Poor's warning. Chinese Premier Wen Jiabao is worried that to his country, the world economy has become, "unsteady, unbalanced, uncoordinated and unsustainable". With the world's largest foreign reserves exceeding $3 trillion, some two thirds are believed to be invested in US dollar assets. China has voiced disapproval of the Fed's lax monetary policy. China for a long time absorbed nearly all of America's multi-billion debt issuances but they haven't been buying lately. China has sold treasuries, for the fifth straight month but remains the largest holder at $1.14 trillion. China has diversified by buying dollar assets like oil, even western companies and gold. It has set up commodity exchanges and stockpiled commodities in an effort to increase its self-sufficiency. China's total annual gold demand topped 700 tonnes last year, becoming the largest gold-consuming market in the world, according to the World Gold Council. In China, the Yangtze Evening Post reported, that a jewellery store sponsored the world's first "gold-plated" bus in Nanjing as a marketing ploy - what happened to inscrutable?
Monetary System Ballasted By Debt
The United States is the leading world economy, China is second, and Japan is third. The US has a serious problem with an overvalued dollar and a mountain of debt. China is still growing but Japan has much to do. Two of three have sick economies. And then there is Europe, where there are some sick economies and some strong economies. The cure in each case is painful. We believe that gold is a perfect haven while these countries sort their problems out. Left unsaid, is that America's aggressive money printing and easy money policy has created the risk of a sharp rise in inflation. That in turn creates a risk of a further drop in the dollar, making gold more attractive as an inflation hedge. To be sure, rising inflation in China together with loose money in the west will feed straight into prices and having lived through the Great Inflation of the seventies, we haven't seen anything yet.
Once upon a time, gold was money. Today gold is back in fashion. Part of gold's allure has been its traditional status as a safe haven. But today it's seen as a store of value when all currencies appear risky. In addition, the creditability of the Americans and their currency has eroded. But prices have a long way to go before they approach the inflation adjusted record in 1980 of $2200 an ounce. America has been able to issue debt in the world's reserve currency. The damage of trust in America, damages the world and its currencies. Investors are simply left wondering what they could trust. We believe gold is that alternative to paper currencies.
Gold Is The Ultimate Default Currency
For 182 years, United States was on the gold standard until 1971. Britain went off the gold standard in 1931. In the twenties, Britain's sterling was the key currency but weakened by the First World War, Britain suffered huge financial losses, incurring deep deficits and was forced to abandon the gold standard. The US dollar filled the vacuum. And of course after racking up losses in the Vietnam war, President Nixon too ended the link to gold which was followed the great inflation of the 1970s. In 1985, the Americans were forced to devalue the dollar again in the Paris Accord, which caused a massive depreciation of the dollar. Since 1971, the dollar has been in the same position as the British and others in that there is no backing for their currency. No backing means no monetary discipline. Since then, the world's industrialized countries have gone through a series of booms and bust. Today in Europe where some countries have run up huge budget deficits, the euro without a backing has not provided the discipline on some of the weakened members, thus the bailouts.
With the structural imbalances in the international monetary system, investors and sovereign nations have fled to gold. Mexico has joined other central banks in buying gold as part of their reserves. China, Russia and India have acquired huge sums. Thailand, Sri Lanka and Bolivia purchased gold from the IMF. Central banks became buyers of gold last year for the first time in two decades. The recent purchases are in stark contrast when the UK government sold most of Britain's gold holdings for a paltry $3.5 billion which they used to buy US dollars. Today that $3.5 billion stake would be worth some $19 billion and it is no coincidence UK gold sales coincided with the low of gold reached 12 years ago.
Gold is simply the haven of choice for those who are distrustful of governments self-dealing actions. By default, gold has become the world's reserve currency. What is clear, however is that the present dollar exchange system of non-convertible currencies and America's fiscal Ponzi scheme is close to an end. The present system is ballasted by the dollar which has lost much of its purchasing power. Without confidence in the dollar, the world has no valid reserve currency. Since too many dollars have been printed, there is only one direction to go and that is down. Gold will continue to rise in value so long as the United States keeps on printing dollars to pay for their deficits and spending. The rise in gold does not come through as a surprise to us. In our last report we forecasted a $2011 average price in the year 2011. We received a lot of cat calls. That this message is lost on the central banks and most players suggests to me that gold can only go higher. This bull market has just begun.
