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Fundamentals of Growing Public Debt a Big Negative for US Equities

Economics / US Debt Jan 05, 2008 - 02:38 AM GMT

By: Brian_Bloom

Economics Best Financial Markets Analysis ArticleSummary
For those who are only interested in the bottom line, it doesn't matter what the charts are saying. Neither US equities nor US Treasuries represent sensible investments from a fundamental perspective. Investments should be in assets which offer protection against the demise of the US Dollar.


For some time now, the equity charts have been showing significant oscillations from bearishness to bullishness and back again. Earlier this week I cast my eye over the past few articles which I wrote. This is what I saw:

  • On December 29th a case could be made for an upside breakout (which has not yet been negated).
  • On December 4th , the charts were signaling the potential for “cascading Bear Market”,
  • On October 17th I published an article entitled “I don't know”.

By way of explanation to some readers who may be confused, I approach each chart analysis session with a clear mind and no preconceptions. What I attempt to do is, via technical analysis, interpret any messages the charts may be signaling at that particular point in time – as if I was looking at them afresh. Quite simply, the reason there has been such a wide range in my interpretations, is that the markets themselves have been showing confusion. All I am doing is acting as a conduit for what I am seeing – which, in hindsight, has been a picture of ongoing confusion.

With this in mind, it is probably important to remember that charts are/should be a means of “timing” one's investment decisions. The decision as to whether to buy, sell or hold should be made based on fundamentals. So, to clarify my view for those who may be wondering what is really going on in the spaghetti which passes for my brain, it seemed like a constructive idea to take a look at some key fundamentals.

One corner piece in the fundamental jigsaw puzzle is this:

For roughly 200 years, since Sir Isaac Newton put Great Britain on a de facto Gold Standard in 1717, and right up until 1913, when the US Federal Reserve System was formed, the gold price remained fairly constant at roughly $18 - $20 an ounce. The only exception was during the period of the Napoleonic Wars. The reason that the gold price remained constant was that under a Gold Standard, the amount of money that could be printed or minted was a function of gold backing. Money in circulation had to be backed 100% by gold.

Let's see where we stand now – in the year 2008.

The latest published figure ( August 7 th 2007 according to http://en.wikipedia.org/wiki /Color ) shows that the number of ounces of gold sitting in Fort Knox was 147.3 million. The value of that gold as at the time of writing this article was:

147.3 million X $865 = $127,414,500,000  ($127 billion)

The amount of M1 money in circulation as at November 2007 was:

$     1,363,800,000,000 ($1,363 billion)

Note:  “M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of  nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and     foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits   (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union  share draft accounts, and demand deposits at thrift institutions.  Seasonally adjusted M1 is constructed by summing currency, traveler's checks,  demand deposits, and OCDs, each seasonally adjusted separately.”

(Source: http://www.federalreserve.gov /releases/h6/current/ )

$127,414,500,000 divided by $ 1,363,800,000,000 = 9.34%

i.e. Currency in circulation within the USA as at November 2007 was backed 9.34% by gold in Fort Knox . This is down from the 100% backing that presumably prevailed on December 23rd,  1913 – the day before President Woodrow Wilson signed the Federal Reserve Act into law.

By this measure, the price of gold would have to rise to $865/9.3% =  $9,258.66 an ounce if the US were ever to go back onto a Gold Standard.

Will this happen? I have my doubts, and the reason is that the M1 number is highly misleading. The M1 number excludes all the dollars sloshing around in the Foreign Exchange Reserves of the Central Banks of the US's trading partners. I don't have that particular number readily to hand, but it is my understanding that 70% (seventy percent) of all the foreign exchange reserves of all the Central Banks in the world added together consisted of US Dollars.

There are two measures of solvency in a normally functioning corporate world:

  1. Can the legal entity meet its debt obligations as and when they fall due?
  2. Do the assets of the legal entity exceed its liabilities?

So long as an organization is able to meet its obligations as and when they fall due it can be deemed to be solvent. If not, provided assets exceed liabilities, it can enter into an arrangement with its creditors/lenders to buy time by selling off assets or reorganising its affairs. The laws are slightly different in various countries, but the above are the basic principles. For some reason, in the USA, even if a company's liabilities exceed its assets it can still buy time.

Effectively, in terms of these principles, the USA as a Sovereign Nation has been in “Chapter 11” for some years now because it has no hope of meeting its obligations as and when they fall due. Effectively, the USA is insolvent – or it would be except for one loophole. It has the ability to create money out of thin air.

Let's have a look at the liabilities side of the balance sheet.

One of the US's liabilities is the Public Debt which, as these words are written, is:

$ 9 , 2 1 2 , 6 1 9 , 5 7 4 , 3 0 4 . 9 9

Source: http://www.brillig.com/debt _clock/

Now there are two things that are particularly interesting about this number.

  1. If you divide it by the number of ounces of gold in Fort Knox (which is one of the USA's sovereign assets), then the price to which gold would need to rise to enable the gold to be used to pay the debt would be $62,543 per ounce
  2. The rate at which this debt is growing is accelerating. At current 30 year bond yield of 4.369%, the annual interest burden on this debt is $402,499,349,201. That's $402 Billion a year interest. The fact is that the debt is now growing at a faster rate than $402 billion p.a

Assuming that the US Government manages to balance its budget in everything else, including medical and retirement entitlements, but continues to borrow to pay the interest burden, the table below shows what this means if the interest rates stay at (say) 4.5%

US Public Debt
$ Trillions
Interest 4.50% p.a.
Opening Closing
Year Balance Interest Balance
2008  $    9.21  $    0.41  $    9.62
2009  $    9.62  $    0.43  $   10.06
2010  $   10.06  $    0.45  $   10.51
2011  $   10.51  $    0.47  $   10.98
2012  $   10.98  $    0.49  $   11.48
2013  $   11.48  $    0.52  $   11.99
2014  $   11.99  $    0.54  $   12.53
2015  $   12.53  $    0.56  $   13.10
2016  $   13.10  $    0.59  $   13.69
2017  $   13.69  $    0.62  $   14.30
2018  $   14.30  $    0.64  $   14.95
2019  $   14.95  $    0.67  $   15.62
2020  $   15.62  $    0.70  $   16.32
2021  $   16.32  $    0.73  $   17.06
2022  $   17.06  $    0.77  $   17.82
2023  $   17.82  $    0.80  $   18.63

 

In simple English: The outstanding debt will double every 15 years.

So, where does that leave us?

Well, let's look at how the banks solved the Latin American Debt crisis in the 1970s and 1980s. They created what they called debt:equity swaps. The US banks took equity in many companies which were unable to pay their debts because the Latin American countries did not have access to foreign exchange reserves.

But there's a very significant difference here. When a company owes you money and can't repay it because it doesn't have access to foreign currency, it has the option of exchanging its own equity (shares) for the debt. But what happens if a government can't repay its debts?

Logically, this is one possible scenario:

  1. The debtor nation declares default and the problem becomes that of the creditor nations
  2. The creditor nations might:
    1. Cut off all further credit, and/or
    2. Push for the nationalisation of privately owned assets which could be sold off to pay the debts
  3. The creditor nation might assume political control over the debtor nation

Another possibility is that the debtor nation does not declare default. It becomes aggressive and belligerent and increasingly attacks weaker nations so that it may shore up its power. Eventually, some larger nations begin to think in terms of retaliation.

In the long term, if we are to avoid World War III, the most likely outcome will be a merger or an acquisition – depending on the level of euphemism you want to apply. As an example, the USA's biggest creditors could land up owning large swathes of the US Government's assets. But what would happen if the US Government had insufficient assets to swap? Would the overseas creditors insist on taking ownership of private enterprise companies?

At the extreme , to avoid such an outcome, the USA could merge as a Sovereign Nation with surplus sovereign nations to create one great big “multinational” country – and, eventually, the world would become truly globalised, with one single Central Government.  Think APEC, EU, MERCOSUL, NAFTA and then think of a merger between two or more of these four entities.

And life would carry on as it did before – except that those in power would remain in power until hell froze over. The very idea of democracy would become a distant memory.

So, fundamentally, that is what has been happening at a sovereign level within the USA. Except that it's been happening quietly, and the sleight of hand has been difficult to track because Government obligations have been building in the background. Pension Funds? What Pension Funds?

From the perspective of a US Government which is unable to meet its obligations as and when they fall due, how can any forays into Afghanistan and Iraq and the like be justified? Well, if you never had any intention of repaying your debts in the first place, why wouldn't you just borrow the money to finance those wars? Oh? We've been fighting those wars in the name of democracy? Really? From where I'm sitting, those wars are serving to hasten the demise of democracy . 

It needs to be emphasised that a Sovereign Government which is insolvent may or may not be differentiated from the legal entities which conduct business within its borders. There may still be many vibrant businesses making significant profits. But one problem will be that these profits will be measured in the currency of the sovereign nation in which they operate. This begs the question: “If a company enjoys profits that are rising in US dollar terms by (say) 5% p.a., but the value of the US dollar is falling at (say) 10% p.a. relative to other currencies, will that company survive in the long term?”

In a globalised economic world, the short answer is “no”. A sovereign country which does not honour its debts is pronouncing a death sentence on the business entities which operate within it. It might be a slow, lingering death, but the end result will be death. Something structural will need to change.

The three options are:

  1. Pay your debt obligations, or
  2. Become a third world nation, or
  3. Expect that your country may be taken over by a stronger country

Ultimately, it is this particular game that this particular analyst has been focussing on since the 1980s; and I hasten to explain that I am not a conspiracy theorist. I absolutely do not believe in conspiracies. What I do believe in is the lingering Neanderthal propensity for man (or woman) to want to wield power over his domain. And I absolutely believe that those who ambitiously aspire to political power are at the extreme of those who want to wield Neanderthal power.

It is quite logical to draw the conclusion that the ultimate cause of the problems we are now facing flows from natural human arrogance which has been running amuck.

And another factor on which I have been focusing is this:

The battle for Presidential nomination is not going to be fought on a platform of meekness and humility.

So, fundamentally, given the above, should we be invested in any US assets – whether Treasury Obligations of a profligate and arrogant government, or Equity in businesses that may be facing a death sentence because of this profligacy?

Again, the short answer is “no”.

But the wild card (arguably the “good news”) is that the US is ultimately a nation which believes in the value of religion. My dollar says that that's the ultimate reason why Mike Huckabee won Iowa. He is an ordained minister. Surely he will walk the religious walk? Surely he will have the wisdom to understand the meaning of Matthew 23:12 and of Philippians 2.3-4?

Conclusion

Eventually, the charts will tell whether the financial problems of the US Government will be resolved by inflation or deflation or, possibly, in some other way. But, for the moment the jury is still out and that's why they have been sending confusing messages.

Nevertheless, whilst the chart signals are “all over the map”, the fundamentals are crystal clear. Assets which rely for their value on the solvency and/or integrity of the US as a sovereign nation should be avoided. There is no “diplomatic” way of communicating that idea. Investments should be in assets which will serve to protect against the demise of the US Dollar.

Knowing that the problems of the country have been caused by the egos and testosterone levels of its leaders, the first step in the journey to address the economic problems will be for the US Public to elect a President possessed of wisdom born of humility.

Arguably, given the results of the Iowa primaries, the US electorate understands this in their guts. Arguably, that's also why John Howard of Australia was so ignominiously dumped. Nowadays, the average voter is not as dumb as he looks, or as she is assumed to be.

Brian Bloom
www.beyondneanderthal.com

Author's comment : It appears that the authorities have not yet come to understand the subtleties and/or the nuances of the statement that "energy drives the world economy". An unholy alliance between the Banking Industry, the Fossil Fuel Industries, Big Business and the Politicians has given rise to a life-threatening accident that is now waiting to happen.

The time has come for the world to begin migrating to a new platform of industrial, consumer and transport technologies which will be driven by electromagnetic energy. There are three such energy technologies which are introduced in my novel, Beyond Neanderthal , which is targeted for publication in March 2008. The logic which underpins these technologies is compelling. If embraced, they have the capacity to usher in a new era of human evolution.

By means of its entertaining storyline, Beyond Neanderthal explains both the logic and the technologies themselves, and also articulates a clear pathway forward. If taken, this pathway will enable us to extricate ourselves from the quagmire into which we have been led by the unholy alliance of self-interested groups. There is still a window of opportunity to act - but the evidence suggests that this window will begin to close around 2012. Please register your interest to acquire a copy of the novel at www.beyondneanderthal.com

Copyright © 2008 Brian Bloom - All Rights Reserved

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