Monday, April 18, 2011

Insolvent and Going Deeper

The US budget process is entirely out of control. By extension, its fiscal future is rather bleak.
All one has to do is back up two steps, entirely ignoring the meaningless budget scuffles currently ongoing in DC, to see that the federal government's fiscal situation is in complete shambles. In fact, as things currently stand in terms of spending and revenues, the US government is insolvent - its liabilities vastly exceed its assets on a net-present-value basis.
Yes, Obama has just laid out a plan that calls for cutting some $4 trillion of new, incremental deficit additions over the next 12 years, but this merely obscures the fact that the deficit will still grow by a rather hefty amount nonetheless. Plans from both sides of the aisle call for adding more debt but at a slower pace. True, that's progress of a sort, but not the type of progress you want to bring home to meet your mother.

For anybody who is even a casual student of history or has paid the slightest bit of attention to what has transpired for Greece, Ireland, Portugal, and other countries with an unrestrained tendency to spend more than they have, it is clear what the progression of events will be for the US.
First there will be a fiscal/funding crisis that will originate in the bond market, specifically the US Treasury market. Interest rates will shoot up, and either austerity will be imposed on the US in a rather unpleasant and draconian way (the bond market is rather remorseless), or it will be self-imposed (not very likely). My estimations indicate this process will begin before the end of 2012.
Next, if the US fails to heed the edicts of the bond market and tries to maintain spending in the face of rising interest rates or print its way out of trouble, the risks increase that the US dollar will suffer a major decline. Let's say that this process will begin a year after the start of the fiscal crisis.
That's all there is to it. A fiscal crisis possibly (probably?) followed by a currency crisis - all initiated by a leadership crisis.
How long it will take the markets to wake up to this simple progression is anybody's guess. Here we must fall back on a simple maxim that has served us well: Anything that is unsustainable will someday stop.
Last year, the US was not unique in its fiscal and economic woes.
This year, the US has distinguished itself by being the only advanced economy to increase its underlying budget deficit in 2011, according to the IMF.
Quite pointedly, the IMF has been on something of a tear recently in pointing out that the US is heading in the wrong direction fiscally (and by extension monetarily) and risking a systemic crisis by pursuing an unsustainable path.
On March 20th, the IMF's John Lipsky delivered harsh words (at a forum in Beijing, it should be noted):
Lipsky Says Advanced-Nation Debt Risks Future Crisis as Yields Set to Rise

Mar 20, 2011
The mounting debt burden of the world’s most developed nations, set for a post-World War II record this year, is unsustainable and risks a future fiscal crisis, the International Monetary Fund’s John Lipsky said.
The average public debt ratio of advanced countries will exceed 100 percent of their gross domestic product this year for the first time since the war, Lipsky, the IMF’s first deputy managing director, said in a speech at a forum in Beijing today.
“The fiscal fallout of the recent crisis must be addressed before it begins to impede the recovery and create new risks,” said Lipsky. “The central challenge is to avert a potential future fiscal crisis, while at the same time creating jobs and supporting social cohesion.”
I am in full agreement with the assessment that the US is adding to, not subtracting from, the financial and fiscal risks that we face. Such are the wages of attempting to sustain the unsustainable in defense of a status quo that needs to be set on a shelf, an interesting curio of a time gone by.
We've already proven that there's a limit to how much consumptive, non-productive debt can be accumulated, yet the US is now all but isolated in its vain attempts to resurrect that model for one last fling.

The Looming Debt Crisis

The IMF has some hard data to back up its concerns and recently released a report in which it has produced a table that that captures the entire essence of the "grow or die" predicament facing not just the US, but the entire developed world.
There are a number of things to dissect in the table, so let's take them one at a time.
This first is that the total financing needs for the sovereign governments (only) of most of the so-called "advanced economies" has expanded between 2010 to 2011 from 25.8% of GDP to 27.0% of GDP (green circles). This means that even with the alleged recovery fully in place -- a statistical mirage in many respects -- the debt financing needs have grown larger, not smaller.

It is so large that it bears repeating: The gross financing needs of the US and Japan are 28.8% and 55.8% of GDP for 2011, respectively. Those are staggering amounts, and they have, as predicted by any decent framework that combines weak leadership and debt-based money with declining net energy, only grown larger over the past few years.
Zeroing in a bit, we'll note that three nations are sporting fiscal deficits in excess of 10% of GDP (Japan, the United States, and Ireland), while the UK pulls in close behind with an 8.6% deficit (see red and orange colored squares).
How does one support such magnificent borrowing needs at reasonable rates without the explicit promise that growth will soon return? It's impossible, at least for very long. Who will buy all of that debt at ridiculously low rates?
The market's autonomous participants have already arrived at a conclusion, as evidenced by PIMCO's Bill Gross, et al.,selling off their entire Treasury holdings and even beginning to short the whole mess. They are betting that the answer is "only the central banks, and their time is running out."
Following up the report that produced the above table (among many others, some equally disturbing) the IMF has gone on a PR campaign to press the issue:
US Must Cut Massive Debt: IMF
April 12 2011
The International Monetary Fund Tuesday urged the United States to outline credible measures to reduce its budget deficit, pressuring the White House to detail plans to ratchet down record debt levels.
The IMF said while most advanced economies were taking steps to rein in budget gaps, two of world's largest economies — Japan and the United States — had delayed action to nurse their recoveries.
The fact that the IMF has decided to say that the emperor lacks a credible wardrobe tells us much about where are we in the arc of this story (Hint: near the end).
Our job is to figure out what the endgame looks like.


The US is on a fiscally unsustainable path and has almost entirely wasted the opportunity this crisis represented to get its house in order.
Obama, and whoever sits in the oval office next, has an enormously difficult task of explaining to ordinary people why the belt tightening that is to come applies to them and not to the banks that created the mess (and are feverishly handing out record bonuses as a result).
Given this constraint, and the general paralysis of logic that now grips DC, we can almost certainly expect that the resolution to the multi-decade game of kick-the-can will be a crisis of sorts. The IMF has weighed in with its very measured and dry, if not boring, recitation of the risks involved.
I admit to some affinity to their assessment, at the risk of letting my guard down, because they have finally conformed to the views I have been writing about for years. Debt-based money is in a bind. It's damned if we do and damned if we don't.
The only way out is to accept the idea that living standards have to fall to match the prior excesses, an admission that 'experts' agree is politically impossible in the US at this time.
Yet the conditions and risks remain, regardless of what experts think is doable.
The job of any primary bear market -- and we are in the mother of them all -- is to destroy wealth.
Your job is to preserve wealth. But buckle up; it's going to be a rough ride.
My overall advice for what's to come remains: Convert your fiat money to useful things. True, gold doesn't earn any interest, but neither does money in the bank these days, and gold can't be devlaued away by reckless monetary policy. So holding precious metals for purchasing power preservation should be a fundamental part of your plans. And while there is real risk of a short-term deflationary downdraft in commodities as the Fed jawbones about ending quantitative easing, my general advice is anything that you expect to buy over the next year you should just buy now. What the heck, you'll use it anyways, and you just might buy it for a lot cheaper than later on.
Enjoy life, love your family, and note that the sun still rises, the birds still sing, and all of our human foibles will resolve themselves eventually. We've arrived at a peculiar point in history where attitude is a tangible element of your future wealth and paper money has become like fog on a warm morning.
Make of it what you will. My wish is that you enjoy the ride.

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