One important thing to note is that one of the Canadian Trusts (Harvest Energy) no longer does business by that name. It was purchased by Korean National Oil Corporation (KNOC) at the end of last year. It was perhaps the first casualty of Canada’s ill-fated decision to change the taxing structure for Trusts and it was a big one. Harvest was one of very few vertically integrated Oil & Gas operations, meaning that it owned refinery operations in addition to its exploration and production program. It was viciously attacked by short-sellers during the months leading up to the acquisition and when shareholders were offered a roughly 40% premium over the then $6 and change trading price, they jumped and Harvest was lost.

Trimming your Hedges

The hedging tool used in this particular Portfolio Model was the UltraShort Oil & Gas ETF since it correlated fairly well with the mix of assets represented. However, one of the drawbacks of these ETFs is their propensity to leave gains on the table based on the objectives they pursue. This reality has become somewhat better understood by investors, but let’s go over it again if for no other purpose than to reinforce the point.

From the ProShares website:

“This ETF seeks a return of -200% of the return of an index (target) for a single day. (Emphasis theirs) Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.“

What they’re saying is if you purchase this type of fund and it moves 2X the inverse of the correlated index or security, that if the underlying issue moves down 20%, you would expect the price of the 2X inverse fund to go up 40%. It doesn’t always work that way. Depending on the price action, you could actually end up with a much lower gain, especially if the price action is volatile and choppy.

Again, this is not meant to be an indictment of these types of funds, but rather to point out that no hedge is going to be perfect and you’d better keep your eye on the ball if you want to be successful.

The Sample Portfolio Model

Let’s see how our components have faired over the past 18 months:

For the 18 months ended June 2010, the portfolio model is up substantially not counting dividends. Assuming the purchase of the same 100 shares each and 250 shares of DUG as in the original article, our portfolio on 11/20/2008 would have cost us $31,969. As of 7/8/2010, it would be worth $47,964 for an increase of 50%. During the same time, the portfolio threw off $2,634 in dividends making the effective yield of the portfolio 8.24% and bringing in $146.33/month in dividend/distribution income. $146 doesn’t sound like a lot of money, but when you consider deploying a $100,000 or $200,000 portfolio in this fashion, suddenly you’re talking about some very nice cash flow – certainly in excess of what can be found at the local bank. The performance metrics stated above assumed that the positions were all started on 11/20/2008; a significant market bottom. Waiting until 3/6/2009 to begin them would have resulted in slightly higher gains. We put a few of these positions to work in our newsletter portfolio on 3/13/09 and they have performed in spectacular fashion.

During the same period of time, the Dow Jones Industrials are up just 34%, with well under one-half the yield of this model. The S&P500 is up only 33% with just over one quarter the yield of the model.

Conclusions

One thing that has worked extremely well for me in practice is the strategic placement and removal of hedging devices. I am not talking about trading hedges; that is a completely different animal. What I am talking about is searching for multi-month trends and then placing or removing hedges based on the results of that research. For the average investor who has neither the time nor the inclination to get involved at this level, selecting a solid hedge, putting it in place, and monitoring once a week should suffice.

Still other investors who don’t mind potential wild fluctuations in their core holdings, but are interested merely in yield, will construct a similar portfolio and put 100% of their capital to work earning dividends. We could have pumped the yield of our sample model up considerably by doing that, but decided on a more conservative approach and were willing to leave a point or two of yield on the table in favor of more stable performance.

One thing to note is that many of these components have had their dividends cut since 11/20/2008. Several have been cut significantly. A few were cut, and are now beginning to increase again. One of the lesser-known ramifications of the ongoing credit crisis is that many small and midsize companies have had a difficult time raising capital at reasonable rates. This resulted in a more protective position taken on by management as they’ve sought to preserve cash for operations. This has led to dividend cuts in many cases. Falling share prices in 2008 and 2009 made it easy to do so since they could cut the dividend and still maintain a similar yield for new investors. The argument could certainly made that this is irrelevant since 8% is 8% no matter what the price/distribution levels, but I think it needs to be mentioned to maintain a spirit of objectivity.

Disclosures: Long PWE, PGH, KMP

Most people have quickly forgotten that the biggest reason there were so many sales to begin with was due to the fact that Congress had waded into yet another market and propped it up with cash on the barrelhead for anyone willing to take the leap. When they lured all the first time buyers they could, they took the next logical step and offered the cash to pretty much everyone else. Couple those actions with the Fed’s active (and now passive) buying of mortgage backed securities and it was bubble mania all over again. Until it wasn’t. That point came at the end of April, when the tax cuts were mercifully allowed to expire, saving our children and grandchildren untold billions.

At that point, I began to have serious doubts as to whether this beaten market could even avoid another crash. I studied the Mortgage Bankers Association reports each Wednesday and watched applications for new purchases fall off a cliff. My contacts in that particular industry said their phones have never been so quiet regarding new purchases. The refinance business kept them busy, but nobody seemed interested in buying a house after April 30. At that point, I wondered how bad May’s numbers would be. It was pretty obvious that the end of the tax credit had pulled at least most of May’s agreements back into April; and quite likely some of June’s as well. Where demand would settle after that was anyone’s guess.

One of the problems with the report on existing homes released today is that the report is based on actual closings. So any one who was hurrying to get locked in during March and perhaps even the early part of April would have had their closing count in May’s number provided it happened before the end of the month. May’s actual purchases for existing homes (or lack thereof) will not hit the statistics until at least June and perhaps July. So the 2.2% drop, while not a surprise, does not reflect base demand for existing housing ex-stimulus. Unfortunately, this was the spin being applied by at least some folks in the MSM. They posited that housing can indeed survive and even thrive without further stimulus and declared the tax credits a smashing success and a fine example of the benefits of government intervention.

However, stimulus in the housing arena has taken on three forms; one fairly transparent; the other two much less so. The transparent stimulus was the tax credits. Many are in fact clamoring for a reinstatement of the credits. Unfortunately, this is an election year, and right now it just isn’t cool to be a big spender – at least not openly. Congress will actually forego having a budget for FY2011. If there is no budget, I guess there can be no budget deficit. Are we really that far along in this charade? We could go a long way down that road without ever finishing this point, however. The second type of stimulus with regard to housing is the ultra-low interest rates that have been created by the Federal Reserve and it’s illicit (and often illegal) actions. These actions have kept 30-year mortgage rates under 5% and that alone has been enticing many people into taking the plunge. In truth, the total amount repaid on a $200,000 mortgage will be over $20,000 less if you can get a 4.8% rate as opposed to 5.25%. The bottom line is that low rates trump tax credits any day of the week. The third type of stimulus – and one that is setting an alarming trend is the number of mortgages being essentially underwritten by the US Government. This number has been hovering somewhere around 50% on average depending on the week.

What must be asked, however, is how much lower mortgage rates can reasonably be expected to go? At the same time rates have been near historic lows, it is more difficult than any time during the last 20 years to actually obtain financing. Many lenders, still ringing from 2007 and 2008’s losses are demanding better financial situations lending in many areas. It is not odd to hear lenders requesting 20% down, which was virtually unheard of just a few years ago. The rest have pretty much been following suit despite the fact that they were made whole by the US Taxpayer.

With so many economists and policymakers hanging their hats on the return of the housing bull to fuel the next economic binge, it would seem that today’s number was maybe a small jolt. If today was a jolt, tomorrow’s new home purchases report is likely to act as a thunderbolt. Contrary to the manner in which existing sales are reported, new home numbers are tabulated based on when a contract is actually signed. In other words, tomorrow morning’s report will give us the first glimpse at the post stimulus housing market. Economists are expecting quite a drop – roughly 20%.

One point that is often overlooked is the fact that there are now so many publicly traded homebuilders. They even have their own index. Inventories have been a problem since the middle of 2006, but never once has anyone seriously mentioned a cessation to building. Sure, permits fluctuate, but most experts will readily agree that the quickest resolution to this crisis would have been to put a moratorium on homebuilding for a few months and let them inventory get worked down. However, how many public company CEO’s would be able to hold their job if they took a quarter off? How would a homebuilder’s stock fare if they hung up the shovels for 3 or 6 months? Answer: it wouldn’t. This is why the housing problem won’t get better, and in fact will probably get worse. Prices will adjust until it simply ceases to be profitable to build a house. Once that happens, the building will stop and the market can start to address its inventory problem.

Contributing to that inventory problem are foreclosures, which are still running at all-time highs, tax sales, which are close to all-time highs in many locales, and the continued loss of quality jobs, which are driving people out of certain areas while not bringing anyone back in to replace them.

With so much of our economic prospects tied into housing, it will be very important to see how well this market stands on its own – if it can do so at all. Should the numbers start to falter, will the Congress race back in with more incentives? Are potential buyers expecting more tax credits? Will the Fed continue to keep rates in the cellar? My guess at this point is that, like so many other areas, it’ll go until it doesn’t. And then once again we’ll have to be reactive as opposed to proactive.

The Housing Market’s Freefall

While the actual damage to the housing market in the near term cannot be totally assessed until later this month, there are some hints in the rate at which purchase applications for mortgages have plunged. The following data is compiled weekly and presented by the Mortgage Bankers Association:

During the past 4 weeks, purchase applications are down a whopping 35%. It is easy to see the spike at the end of April as the end of the tax credit lured May’s (and perhaps June’s too) sales back a month. The downward trend of new purchase applications has continued into June despite very low relative interest rates for home loans. These low rates boosted the Refinance portion of the index during May and remain low, the national average currently at 4.88% according to bankrate.com.

With an upcoming election, we will now likely get the first glimpse at the true state of the housing market. Granted there are still many programs in place at the Fannie/Freddie/FHA level that are encouraging purchases to varying degrees, but it is not likely that direct stimulus through tax credits will be used for at least the next few months. What is very disconcerting is that more than half of the purchasing blitz during March and April was done on the back of government mortgages. Much in the way the government nationalized the student loan business it is now similarly giving the heave ho to private lenders in the mortgage market. These actions virtually guarantee the perpetuation of the distortions currently seen in this critical area.

I had commented, perhaps cynically, to some friends back in 2005 that the housing bubble seemed to be little more than a giant property grab. With government now owning or guaranteeing the majority of mortgages (69 percent), it seems that very well could be the case. Unemployment is still high, decent paying jobs are difficult to come by, and people are still being laid off. Consumer debt burdens are causing the financial hardships endured by many to continue. Repossessions of houses just hit another all-time record high last month. When the government owns the mortgage and someone defaults, who gets the house? Some food for thought on a Friday afternoon.

Retail’s May Swoon

This morning’s retail sales report gave much more cause for concern than any of the recent month’s reports in this area. I’ve dissected these reports on several occasions for our paid subscribers to reveal the biases. Put simply the numbers are not what they seem and haven’t been for quite some time now. The biases, statistical and/or hedonic, tend to overstate retail sales.

Even those biases could not conceal last month’s drop. It is quite likely that the 1.2% decrease in sales was caused in no small part by the ‘Here we go again’ mindset when global stock markets began another round of liquidation. The media had been blaming a late Memorial Day for the potential downdraft in sales well in advance of the release of this morning’s report, which really makes no sense. The drop in sales speaks volumes about the delicate nature of consumer confidence. It is easily shaken these days, and it doesn’t take much. Granted the European (and spreading) debt crisis is a huge problem and will affect us eventually, however, that is not the impression the average person has thanks to the largely absentee media in this country. The crash of 2008, however, is still on people’s minds, and there is a general fear of a recurrence of those conditions. So when the markets act up, people slow spending and increase savings. It is one of the few things we’ve seen in recent memory that actually makes sense. Ironically, the University of Michigan’s consumer sentiment index is telling us that confidence is at the highest level since 2008. So much for our brief trip back to sanity.

The retail sector has not been without its share in the government stimulus binge of the past three years either. Most of the stimulus other than the checks sent out in early 2008 has been indirect, however, the benefits from foreclosure prevention tactics, strategic defaults, and hyper-extended unemployment benefits have perpetuated the spending bubble much in the same way the housing bubble has been prodded along. However, with more and more states such as Colorado and California having to borrow money to pay unemployment benefits and record repos of homes, it would seems likely as though the fuel for this leg of the spending bubble might be petering out somewhat.

Another weight on the consumer is the comparatively higher interest rates on credit cards. According to creditcards.com, the national average for credit cards in May 2010 was 14.31%, up from 12.75% just 6 months ago. So even as banks have been able to borrow from the Fed for essentially nothing, they’ve repaid the consumer for the hefty bailouts by jacking interest rates. Of course the selling line here is that so many consumer loans are in default. Small wonder. Maybe if the underwriting department hadn’t taken 5 years off this wouldn’t have happened.

In summary, the pressures on these two critical markets are increasing as the government’s ability to intervene is hampered by a broadening awareness of its own insolvent state. Granted, one or two months does not a trend make, but we need to be aware of the possible paradigm shift that is occurring – the end of the age of perpetual stimulus.

True to form, even the mainstream press is starting to take notice, long after the trend has been well established. Ambrose Evans Pritchard dedicated a piece yesterday to the collapse in M3 growth, something that hasn’t been seen in the US since the Great Depression. Monetarists the world around are frightened about this trend, and with good reason. US interest rates are already essentially zero. The massive monetary and fiscal stimulus has been epic in nature. And all this has still not prevented the actual textbook deflationary trend we now find ourselves in.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

The major reason for this is that the banking system has severely curtailed its lending activities, which are largely (but not entirely) responsible for the growth in the money supply thanks to the money multiplier. One must ask how this is possible since essentially the banks have the Taxpayer Put in place where the US taxpayer is immediately hooked for any significant failure. For decades we have had an economy that relied on credit for its survival and now, like a drug addict in rehab, that credit is being limited. The result was fairly predictable.

Given the massive debts in our system, there are two obvious choices. First, hyperinflate away the debt. However, that ultimately ends in the destruction of the currency and the end of the current fiat age. Secondly, we could default through deflation/devaluation, and try to, in effect, reset the system much like what happened in the 1930’s. The major difference between then and now is the relative financial position of both the nation and individuals. Both are considerably weakened as we approach this next phase in America’s existence.

I’ve argued for the coordinated default/devaluation outcome for some time now. The collapse of M3 growth is one of the biggest factors on this side of the argument. The second is history. The US already has a rich experience in fiat money, dating back to before Lexington and Concord. We also have a rich history of defaults thanks to the over-issuance of fiat money. Granted, the defaults consisted of ceasing to redeem paper money for specie (Gold/Silver), but a default is a default.

We are clearly out of control in terms of our debts, both internal and external, and don’t seem the least bit concerned about real generational or fiscal reform beyond traditional Washington lip service. The Fed has been largely ineffective at doing anything but fattening bank cash flows by squeezing savers and allowing banks to collect generous margins on the performing consumer loans they do have. The bailout money sits in bank coffers, withheld from an economy that now depends on loans for its very survival.

Larry Summers, President Barack Obama’s top economic adviser, has asked Congress to “grit its teeth” and approve a fresh fiscal boost of $200bn to keep growth on track. “We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on,” he said.

I wrote many moons ago that once the parade of stimulus started that it would never end. Summers’ statement is tantamount to admission of the failure of his own Keynesian thinking. He is now acknowledging that in order to ‘grow’, we need stimulus (debt). Every once in a while the truth does come out.

Given these undisputable facts, it is really hard to conjure up a scenario where we can have any type of broad, well-grounded economic recovery. The various economic reports I dissect on a weekly basis bear this out. However, the bottom line as we solemnly observe Memorial Day weekend is M3. Where it goes, so goes America. Such is the way of things in a fiat money system.

]]> http://www.sutton-associates.net/blog/2010/05/27/the-consequences-of-m3/feed/ 1 http://www.sutton-associates.net/blog/2010/05/22/liberty-talk-radio-interview/ http://www.sutton-associates.net/blog/2010/05/22/liberty-talk-radio-interview/#comments Sat, 22 May 2010 13:14:17 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=380

Andy spent an hour with Joe Cristiano on Liberty Talk Radio discussing the global financial crisis, the problems in the Eurozone, and some of the different scenarios for our financial markets moving forward. To listen, Click Here

In yet another example of the failure of globalization, or regionalization as it were, the Euro is poised on the precipice of disintegration. Ironically, it will not be the overprinting and resultant hyperinflationary spiral that kills the Euro, but dead weight in the form of various Eurozone welfare states. Germany and some of the other quasi-responsible members simply cannot carry their own burdens and those of Greece, Spain et al. The $1 Trillion rescue fund created in haste this past weekend was intended to inspire confidence in the dying behemoth. Instead, the sheer magnitude of the bailout has done the exact opposite. The Euro-Dollar pair has now sunk below pre-bailout levels and there is a good deal of doubt as to whether rescue recipients will be willing or able to hold up their end of the bargain. I pointed this out in last week’s piece. The temporary euphoria created by a trillion dollars of palliative paper is already gone. This is something that was alluded to in these pages years ago; the law of diminishing returns applies to stimulus and bailouts. As the periods of crisis occur in a more frequent fashion, the effectiveness of Keynesian monetary policy falls commensurately.

That aside, there are several other points that must be addressed as we examine the latest Tower of Babel in the global macroeconomic arena.

National Sovereignty Ceded

While anyone looking at the debt picture could tell that Greece (like so many others) was in trouble almost since its acceptance into the Eurozone, its problems burst into the international media in early 2010. One of the first things that many people noted was the major difference between the Greek government and that of America. Greece was hamstrung in that it did not have its own national bank; it relied on the ECB. While I am not a fan of national or central banks absent a strict Gold standard, this total absence of flexibility accelerated the Greek crisis in months, rather than years. Greece had given up its national identity to join the Club. And for a time it worked. The people of Greece enjoyed lavish social benefits and a carefree lifestyle. As an IMF official recently said, however, and I am paraphrasing: “The party is over”.
Other dominoes are set to fall as well since every other country in the Club has essentially the same problem: they cannot pay their bills, and have no way to wiggle out of it. While in the strictest of terms, this is not a bad thing; it outlines the categorical failure of international trading and currency blocs in the long run. There are always members of any cohort who will try to ride the coattails of someone else. It is human nature and it will not change. From that standpoint, the breakup of the Club was ordained from the day of its inception.

The mere existence of these multinational blocs also fosters a temporary sense of false security, as member nations don’t mind their own fiscal indiscretions because they have the perception that they’ll be picked up by the rest. And they usually are initially, so why change? This is precisely why the Greek people (and now the Spaniards too) are resorting to riots and national strikes. Old habits die hard.

At the bottom of the mess, however, is the loss of national identity. While we look at them as Greeks and Germans, they have in a way come to view themselves as Europeans – citizens of Europe. As Ben Franklin so eloquently put it, new nations come into the world like illegitimate children; half compromised, half improvised. In the case of the EU, we’ve already seen the compromise. Now the improvisation has begun in earnest.

Destruction from Within

Much in the same way the EU is being destroyed by the profligate spending and lackadaisical approach to fiscal matters of a few members, the United States is in a similar position of being devoured from within. This is where it gets very dicey, and I am bound to step on a lot of toes here, but it needs to be said. We know that roughly half of Americans pay nothing in the way of Federal income tax. While I don’t have exact numbers for the 50 states, I cannot imagine that the situation is much different there. This means that, like the EU, America has roughly half of its population riding the coattails of the other half. I am sure that in many cases there are good and noble reasons why this is the case, but I’m trying to address this from a structural macroeconomic standpoint rather than drilling down to specific reasons why people aren’t paying. Frankly, for the purposes of this discussion, it doesn’t even matter. In this way, America is a microcosm of the Eurozone. And we’re not alone. Great Britain is in the same boat. The bills cannot be paid. There is no way to squeeze enough money from the paying 50% to take care of their benefits let alone those of the other 50%.

Much like the EU, America has a central bank, which advocates Keynesian policies such as deficit spending and unfettered monetary creation. Save for one brief stint of interest rate austerity in the early 80’s, America has never wavered. And before we sing the praises of Mr. Volcker, we must consider that his actions most likely were taken to perpetuate the broken system as a whole as opposed to representing some blanket metamorphosis of economic thinking.

The single biggest difference here is that the members of the Club still have the ability to vote others off the island, and/or leave themselves. There is a point certain where the people of Germany, for example will no longer tolerate the abrogation of their economic and financial sovereignty and will either compel Ms. Merkel to take appropriate action or will replace her with someone who will. Hence all the talk of the breakup of the Eurozone. The die was cast on January 1, 1999 when the Euro officially became an international unit of account.

Race to Gold – the Endgame of Paper

All the gloom and doom aside, there is an out for those countries and individuals who fear the breakup of the Eurozone, dollar standard default, national bankruptcy, and the types of cataclysmic financial events that our behavior causes us to flirt with. It is shining right now, making new all-time highs as I pen this commentary. It is soaring even as the dollar races higher thanks almost entirely to the fall of the Euro. The mini liquidation last week in global markets was unable to shake it, so unlike the Lehman days in 2008. People around the globe are racing to Gold as the ultimate safe haven. Where the US Dollar is a proxy on the flaws of the Euro, so is Gold the ultimate proxy on the fallacy of stable paper currencies in a Keynesian world. Where paper currencies represent control, Gold represents freedom and a standard weight and measure.

This is probably one area where many here in America fail to understand the connection between our wallets and the first round of the Eurozone bailout. Thanks to our contributions to fund the IMF, and the resumption of various Fed emergency swap programs, the American taxpayer is on the hook for more of the European rescue fund than anyone who seeks to maintain their position in politics or finance is willing to admit. The burdens of lesser paper currencies are shifting to the already compromised US Dollar and the American taxpayer. There is nowhere else to turn except honest money. Truly, the buck will stop there.

One of the biggest ways our premium newsletter has benefitted its subscribers over the past few years is comprehensive analysis of the macroeconomic, monetary, and precious metals environments. In May’s issue, which will be released on 5/15, we cover the conventional wisdom surrounding sovereign debt loads, propose some alternate metrics, and look at the latest jobs figures. For more information, click here.

The ‘Strong Dollar’ is Back?

For the past several weeks, the proclamations of a ‘strong dollar’ have been floating around the airwaves. Commentators will point at the rising USDollar Index and mistakenly assume that everyone wants our currency because our economy is recovering so nicely. What they fail to understand and/or convey is how the index is calculated. The index is nothing more than a weighting of the value of various currencies versus the Dollar. The Euro is currently 57.1% of the index and is in freefall thanks to out of control sovereign debt. Our policymakers should be taking notes on the developments in Europe. At any rate, since currencies are traded in pairs, when one half of the pair falls, the other rises. This recent surge in the US Dollar index, while good for us in terms of the cost of European imports has nothing to do with the strength of our currency. I’ve said this time and time again. We have to hope for bad things to happen to the rest of the world to keep the Dollar afloat. The true barometer of the strength of a currency is the cost of Gold in that currency. Even as the Dollar index has risen over the past several months, Gold priced in Dollars has risen right along with it. Gold is sniffing out exactly the points made above. People are fearful of paper currencies, and while they dump the Euro in favor of the Dollar in the short run, they are also loading up on Gold, the ultimate money.

The reality shown above is not a one or two day event, but a three month trend, which is intact even in a period of extreme market distress. Many people will try to draw parallels between 2008 and the present. By that logic, they argue that Gold should be falling since we’re flirting with another period of all-out liquidation. However, 2008 was largely a liquidity crisis whereas today we are facing that plus the bankruptcy of roughly 20 nations and the possible disintegration of at least one currency along with it. Yes, the sovereign debt crisis is that bad. Granted, the emerging divergence between the equity markets and Gold (shown below) is in its infancy, but it is a very important development and needs to be pointed out now.

Will Greece Pay Up?

On the front burner and driving the current hysteria is the situation in Greece. While the EU has come together to bailout the embattled nation, there are legitimate fears that:

a) The bailout isn’t big enough and is merely a band-aid. Apparently folks have been paying attention to the bailout of the US financial system.

b) The EU won’t be willing (or able) to extend the bailout

c) The people of Greece will not accept austerity measures

d) The people of Greece will dismiss their standing government in favor of one who will continue the current welfare state.

e) Greece will not pay back its neighbors for the bailout

I would contend that all of these are legitimate concerns. Several days of intense rioting and national strike by the people of Greece are making it very clear that at this point they have no intention of being under the thumb of austerity. This is what happens when you create a welfare state. Again, our policymakers should be taking notes. The country can’t pay back what it already owes, hence the ‘need’ for a bailout. How is a reasonable person to accept the notion that somehow Greece will now be able to pay back the money already owed plus another $146 billion in bailout loans?

Yanking the carpet out from under a welfare state is going to have monumentous social implications. The people of Greece are likely to dispatch their current government in favor of one who will take a disposition similar to that of Iceland and tell the lenders of the bailout money and the country’s creditors in general to take a real long walk off a short pier.

It would be bad enough if this problem stopped at the Greek borders, but unfortunately, it is nearly systemic in Europe, and in fact extends across the Atlantic as well.

Freddie Mac Continues to Bleed

In a harsh reminder of the perpetual state of bailout that the US has entered, Freddie Mac announced earlier this week that it will need another $10.6 Billion from the Treasury by the end of June to cover first quarter losses of $6.7 Billion. This wil run Freddie’s tab to well over $50 Billion with no end in sight.

Back in 2008, the USGovernment pledged to guarantee that both Freddie and Fannie Mae maintain a positive net worth. This has led to periodic infusions of cash into what is now admitted to be a black hole at both companies. What is most concerning about these actions is that there is little or nothing being done to end the reliance on bailouts. At the root of this problem lies the reality that people, for various reasons, cannot pay their mortgages. For many it is because of job losses. If we’re going to borrow and throw money down a black hole, it would have made a lot more sense to use the $50 Billion to build some factories that would employ workers who would produce goods made in the US. That would have put people to work and at the same time would have helped us ease our reliance on foreigners. Instead, we throw the money away, choosing to perpetuate a broken system.

April Jobs Report

As of this writing, the April jobs numbers are available. The economy ‘added’ 290,000 jobs in April, with generous upward revisions to both February and March. What is disconcerting about this report is the fact that we now know that roughly 600,000 new census workers are in place, yet these folks don’t appear to be attributed to the government’s portion of the non-farm payroll. BLS is claiming that of the 573,000 jobs created so far this year that 483,000 were created in the private sector. Yet looking at the Federal Government’s workforce over the past few months there hasn’t been much of an increase at all. So either government is trimming the sails in other areas or the census workers aren’t being counted as government employees, but are instead being credited to the private sector. A recent Gallup survey seems to bear out this discrepancy in that it concluded that government hiring was outpacing private sector job creation. While we don’t yet have the birth/death adjustment to April’s numbers, it is clear that something is amiss. The headline and U-6 unemployment rates rose to 9.9% and 17.1% respectively. State and Local government workforces continued to shrink in April, outlining the dire circumstances that continue to face many geographic areas.

With the cost of insurance on European bank bonds surging to a pre-Lehman high, it is apparent that at the very least, there is again a severe ripple in the credit system, this time at a sovereign level. Given debt levels around the globe it is quite likely that damage control will take precedent over containment.

Probably the most misleading of conclusions is to simply point at the national debt and declare America to be bankrupt. While there is no denying that America is in big trouble with its national debt that will not be what causes bankruptcy. Think of it on a micro scale – a family. Family X has $120,000 per year in revenues and $150,000 in expenses. Let’s say for the sake of simplicity that the family replicates these figures for 4 years. At the end of the 4 years, Family X’s debt (not counting interest payments) will be 100% of its revenues. Is Family X bankrupt? Absolutely not. Truth told, this family could continue to run these annual deficits as long as someone is willing to give them $30,000 in loans each year, dismissing debt service payments for simplicity.

For some reason when it comes to looking at Sovereign debt and debt ratios, the number always used as a benchmark is GDP. I am uncomfortable using GDP in creating a quantitative measurement of solvency since GDP is not some cash account from which public debt may be paid off. GDP is a rather convoluted measure of output, not an expense account. Since the Federal government has assumed this debt on behalf of you and I (a whole OTHER issue), they (we) are responsible for paying it back. Therefore, since the government is on the hook, we need to be looking at the government’s revenues, not GDP when making judgments on the veracity of the government’s financial position.

In fiscal year 2009, the US Government had revenues of $2.198 Trillion. This was a decrease of $463 Billion from FY 2008 according to the Treasury’s Financial Report of the US Government report. The outstanding debt as of this writing is $12.87 Trillion making the debt/revenue ration 5.85. This is a whole lot worse (and much more accurate) than saying that debt is 90% of GDP. As bad as it is having an outstanding debt that is roughly 600% of revenue, it doesn’t even begin to address the issue of bankruptcy.

Marginal Utility of Debt Turns Negative

The underlying graphic has been seen in many different places, and with good reason. One of the biggest justifications of borrowing money in any situation is to cause growth. What has become apparent, however, over the past 5 decades is that the utility at the margin has diminished. What this means is that our ‘bang for the buck’ has disappeared. For example, back in 1966, a dollar of debt resulted in nearly $.90 in GDP growth. Today, adding a dollar of debt results in an over $.40 contraction in GDP. While this doesn’t have a direct bearing on national bankruptcy per se, what it is telling us is that our borrowing addiction is now cannibalizing economic growth. Small wonder. However, since economic output has a direct bearing on government revenues vis a vis tax receipts, the broken debt function will sit like an albatross upon our backs as we try to negotiate this brave new world.

We see evidence of the recognition of this reality in Washington as policymakers of varying stripes try to justify a value-added tax to close the gap and give the impression that we are, in fact, serious about austerity. No, this isn’t a joke. As usual, our government is making more colossal mistakes. Of course, real austerity would mean cutting government spending, but it should be clear to all that we will get nothing of the sort; from either bunch.

So, What Exactly is it that Constitutes Bankruptcy?

According to the Kotlikoff-Auerbach model, which is a variant of Irving Fisher’s Two Period Life Cycle Model work circa 1930, the current fiscal gap is approximately $185 Trillion. That number is a week old. Back in July of 2006, the fiscal gap stood at $65.9 Trillion. Anyone see a problem here? This gap analysis includes the full complement of social insurance programs including the new healthcare plan, military spending on wars for global empire, other domestic entitlements, and pretty much anything else you can think of that the Federal government might be involved in. The model looks at future revenues and outlays well into the future using current law and policy and uses the Net Present Value equation to bring the future amounts into present dollars.

To what extent will the Federal government be able to take the output of producers in the economy and dedicate it towards payment of these bills? We were cutting it very close when the number stood at $65.9 Trillion 4 years ago. Instead of addressing it then, we chose to do nothing. $185 Trillion is an unfathomable amount of money, especially for a government that takes in around 1/90 of that each year in tax revenue. And it is a lot for a country, whose total assets don’t even amount to 1/3 of our tab. Simply raising taxes won’t do it. The more marginal tax rates rise, the less incentive there will be to produce in following the old economic wisdom that you always get less of what you tax and more of what you subsidize. The historical landscape is littered with examples of how raising marginal tax rates actually causes tax revenues to decrease. So much for the idea of the VAT saving the day. Taking corporate profits won’t do it either. Raise taxes on corporations and they’ll lay off more employees, raise finished goods prices, and consumption will fall in proportion. So that isn’t going to work either.

An Undesirable Solution

The only real solution to this mess would be to essentially kill off Social Security, Medicare, and Medicaid benefits beyond what those programs actually take in each year on a cash basis. Going hand in hand would be the assumption that the contribution rates of these programs would remain the same. Pay 85% of benefits based on what the forecast is for the program’s revenue for a year, then give recipients a ‘catch-up’ payment at the end of year based what was actually taken in. Then start the next year with a clean slate. No unfunded liabilities. Period. At the same time, government would be turned into a flying gas can, being allowed to spend on only the barest of essentials.

Can you see the myriad of problems that lie in such a course of action? Forget the fact that it would be political suicide for anyone to propose this, which is the only reason I can get away with it – I’m not running for office. The culling of government would result in massive unemployment, with essentially no way to pay the benefits. The same would be true for private sector unemployment. The program cuts in social insurance would put most families over the edge since so many people rely on them. Ostensibly, we have no savings as a nation, with more than 4 in 10 having less than $10,000 set aside for retirement or any type of life emergency. In short, too many people rely on these programs making the social insurance Ponzi scheme too big to fail. At the same time, the sheer magnitude of these programs makes them too big to save.

Fundamentally, the question of American bankruptcy (or any for that matter) becomes the simple matter of looking at the bills that need to be paid and determining if they can in fact be paid. They certainly can’t be paid with revenues; we know that. We are already borrowing heavily and there is no indication that will change. Getting back to the earlier example of Family X, conventional analysis keeps telling us that some time uncertain, such a system arrives a point where there is simply not enough money in the system for external lenders to perpetuate it.

Points to Ponder

For all intents and purposes that has already in fact happened and the Fed is currently monetizing roughly 80% of Treasury auctions and bribing banks NOT to lend to the public by paying them interest on the reserves they keep at the Fed. This is all done to avoid what would normally turn into a hyperinflationary explosion. The bills cannot be paid. America is bankrupt. And we’re not alone. This is one of the reasons I wrote two weeks ago that we’re going to likely see a coordinated devaluation of currencies and then default as central banks slam the door on monetary creation. The monetary aggregates are already showing signs of this. It will not be pretty. At the same time expect more cuts in programs like Medicare, Medicaid, and Social Security. The money will simply not exist to pay all the promised benefits. It will be an in situ default.

There will be those who will say that the above thesis is baloney and that it will be hyperinflation forever and ever. We are so much smarter than we were back in the 1930’s and we should have never allowed that nasty deflationary collapse to occur. However, the debt bubble that exists today on a global scale is several orders of magnitude larger than what existed back then and believe me, banks and governments knew back in the 1930’s about over-issuing paper currencies.

Our national history is littered with these little experiences of wanton money creation. They never ended well. However, looking at it through that lens, the 1930’s allowed the banking elite to ‘reset’ the system and squeeze another 70+ years out of an already broken monetary model. However, the only reason we made it this far is because the first 30 or so of those years we were giving away the national treasure in the form of our Gold to foreigners for the right be the consumers of the world. History doesn’t always repeat, but it sure does rhyme. I certainly don’t have a crystal ball (or inside info for that matter), but to me, the above thesis makes a good deal of sense especially given the untenable financial position we find ourselves in.

We already have what amounts to the sovereign debt equivalent of a commercial signal failure in the case of Greece, and it doesn’t take much thought to come up with the conclusion that nobody wants to step up and bail out an entire country and start the avalanche. It may well end up being that the default occurs for no other reason than it is the path that provides the least resistance.

Inflation

There are two camps and they argue bitterly. One claims that prices rise because of supply and demand factors (which is partially true) and as a function of a healthy economy, which is patently false. The other side argues correctly that prices rise because the supply of money and/or credit has increased – effectively monetizing demand, which pushes up price levels. Some analysts have argued that there is no inflation because the price of electronics always seems to drop. In the second half of 2008 they argued that there was no inflation because petroleum prices were falling. They made the tragic mistake of substituting a single good for the concept of ‘general price level’.

It is categorically impossible for general price levels to increase in the long run without a commensurate increase in the supply of money and credit. It is important here to make the distinction between short and long run. In the short run, an increase in general prices can be absorbed without a growth in the money supply because it could, in theory, be sustained by devouring savings. But in practice, generally speaking, that isn’t how things work. People tend not to expand spending unless they feel comfortable that money and (particularly) credit are readily available. The housing bubble of the early 21st century is a prime example.

Bubbles

Out of fear of destroying a very easy point, I am going to let the three charts shown below along with a very brief narrative speak for themselves. Then you decide what fueled the housing bubble, and drove up house prices along with general price levels.

As can easily be seen in the above chart, 30-year mortgage rates dropped steadily from 1981 through the present. Not surprisingly, low rates and readily available credit led to a massive price expansion by monetizing demand.

Clearly the expansion in money had to come from somewhere to fuel lower mortgage rates and the expansion in home prices. The chart below, with brackets for the 1990-2007 period shows exactly where it came from. M3 in the US nearly tripled during that 17-year period.

Deflation??

One thing that should be utterly frightening is the recent freefall of M3 growth. Most folks understand that inflation has been responsible for the vast majority of our economic ‘growth’ over the past century. Inflation fueled the dotcom and real estate bubbles. In short, our economy is set up to run in an inflationary environment. Unfortunately, there is a predictable end to this scheme. At some point, the monetary environment devolves into hyperinflation, then a deflationary collapse. We certainly haven’t experienced hyperinflation yet in the US, and we know the Fed can win a battle with deflation because it can create as much money as is necessary to overwhelm deflationary forces. The current Chairman didn’t get his nickname because he used to fly puddle jumpers. So we’re left to ask: what exactly is going on here?

I think the answer lies in the fact that there are roughly 20 countries right now that are on the verge of bankruptcy and an outright default – the US and UK among them. The US clearly isn’t the only nation in hot water with debt. Greece is a pitifully minute example of what is really a systemic problem for much of the West. In my opinion, we are likely moving towards a coordinated outright default, which will involve the devaluation of currencies followed by central banks capping money growth, which in turn will trigger a second deflationary depression. Most people realize that we now have a fiscal gap of around $100 Trillion just in the US alone. It cannot be filled via conventional means consisting of tax increases and program cuts. I and many others wrote years ago that we needed to address those issues right then or lose our chance. We didn’t do it. There are two choices now: hyperinflation or default. While the collapse in M3 growth does not yet constitute de facto proof that we’re headed for the default scenario, it is certainly something that has to be considered. The good news in that scenario is that cash money would be worth more because it would be in short supply. The bad news is that there won’t be enough of it to maintain our current standard of living – especially in a situation where there is a concurrent devaluation.

Gold

Many will be wondering how I can be an advocate of Gold and Silver in such an environment? The benefits of precious metals are well documented in the case of hyperinflation, but not so much so in the case of deflation. It is a pretty simple and logical conclusion that if there is a shortage of cash, then the presence of cash ‘substitutes’ will be very beneficial. This is especially true in local commerce as in the 1930’s when many areas saw the widespread use of ‘co-ops’ or local trading blocs. The rationale for holding precious metals will be different than if we experience hyperinflation, and their use would be different as well, but I think it is foolish to assume that they’d be a detriment in either case.

Hopefully everyone reading this understands the importance of watching the monetary aggregates for clues as to what is coming down the road. Thanks to nowandfutures.com for providing the continuation of the M3 series depicted in the chart above. Ultimately, our monetary destiny now lies in the hands of global banking interests. We will proceed down the path that best serves them, not our national interest. Congress abdicated its responsibility for our money, as outlined in Article 1, Section 8 of the US Constitution, when it passed the Federal Reserve Act back in 1913. The best thing this Congress could do with the rest of its time is craft and pass legislation to repeal that Act in its entirety.

This tax day, April 15th, we’ll be releasing the next issue of The Centsible Investor. Our focus this month will be on the President’s Working Group on Financial Markets, aka the Plunge Team. We’ll also examine the prospects for $100 oil and analyze a company that makes its money selling electrical generation, process automation, and a vast array of other products to industries ranging from petroleum exploration and pharmaceuticals to automobile manufacturers. Don’t miss it! Click Here for more information.