Gold and Energy Advisor

Newsletter #120  02/20/2013

“Coming Your Way: Debt Defaults and a Bond Meltdown!”

“While Congress bickers about spending cuts and prepares to fight over the debt ceiling—again!—there are not one but two far more serious financial crises approaching.

“As investors, we can and must prepare for the fallout. Thankfully, there’s one single investment that’s positioned to profit from both of these crises. That’s our topic this month!”

Two major financial crises are facing America. They will cause wrenching disruptions to our nation as a whole, and to our lives as individuals.

On a national level, they can’t be avoided. But on an individual level, they can. In fact, you can take huge profits as they unfold—if you play them right.

Let’s start our discussion by asking…

Is the US National Debt Really $16.48 Trillion?

As this issue of GEA is published, the US Treasury website lists our government’s “total public debt” as $16.48 trillion. Most people would understand this to mean that $16.48 trillion is “all” the government owes.

But that’s a falsehood.

The US government has many other liabilities that are ‘off the books’. They aren’t included in the government’s accounting. Nor are they included in the $16.48 trillion.

Chris Cox and Bill Archer recently wrote about this in the Wall Street Journal. If those two names sound familiar, it’s because both men had distinguished careers in Congress.

Both men also served on President Clinton’s Bipartisan Commission on Entitlement and Tax Reform in the mid-1990s. They predicted back then that unless something was done to reform entitlement spending, it would bankrupt America.

Eighteen years later, nothing has been done. In fact, the problem has grown far worse since then.

Why? Because “the full extent of the problem has remained hidden from policy makers and the public because of less than transparent government financial statements. How else could responsible officials claim that Medicare and Social Security have the resources they need to fulfill their commitments for years to come?...

“For years, the government has gotten by without having to produce the kind of financial statements that are required of most significant for-profit and nonprofit enterprises. The US Treasury ‘balance sheet’ does list liabilities such as Treasury debt issued to the public, federal employee pensions, and post-retirement health benefits. But it does not include the unfunded liabilities of Medicare, Social Security and other outsized and very real obligations...

“We most often hear about the alarming [$16.48 trillion] national debt (more than 100% of GDP), and the 2012 budget deficit of $1.1 trillion (6.97% of GDP). As dangerous as those numbers are, they do not begin to tell the story of the federal government’s true liabilities.

“The actual liabilities of the federal government—including Social Security, Medicare, and federal employees’ future retirement benefits—already exceed $86.8 trillion, or 550% of GDP.”

Note that this is the unfunded liability—the liability left over after subtracting projected tax revenue.

During last year’s Presidential campaign, Mitt Romney often pointed out that these liabilities worked out to $520,000 per household in the United States.

This is an outrageous figure. But is it really true? Many analysts say no.

They raise three primary objections to it:

  1. It’s only a projection. It extends today’s numbers (for example, the rate of inflation) into the future, but these numbers can change. Therefore, the projection could be incorrect.
  2. It doesn’t actually work out to $520,000 per household, because it’s applying a future liability to today’s population size. In the future, the US population will presumably be larger, and therefore the per-household liability will be lower.
  3. It isn’t a debt (a real past promise to pay something), it’s a projected future promise. And future promises are much more flexible than debts.

As Derek Thompson wrote in The Atlantic, “Real past promises are, well, very real. We have to pay back our debt. Failing to do it would be an illegal and disastrous default. Unfunded liabilities are future promises, and, since they’re not as real, we can change them whenever we want without destroying ourselves.”

Why These Objections Are Wrong

All these objections sound quite reasonable. Indeed, they’re all true—but only partially true. The full story reveals something quite different than what optimistic analysts claim.

First, it’s true that these unfunded liabilities are only a projection of today’s numbers into the future, and that the future numbers could be different. But that doesn’t mean that the future numbers will be better than today’s. In fact, there’s good reason to believe they’ll be worse. For example, as medical care improves, lifespans are being lengthened. This increases the average cost of medical care expended per person over his or her lifetime, and thus the amount the government must pay for Medicare/Medicaid. It also increases the average length of time that each person will collect Social Security and Medicare/Medicaid payments from the government.

Next, it’s true that the unfunded liabilities aren’t actually $520,000 per household. So let’s calculate a more accurate figure. We start by noting that the US population isn’t growing very quickly: its current pace is about 7.3 percent per decade. Extending this out 75 years (the standard time for actuarial projections like unfunded liabilities), we arrive at a population of about 524 million, or about 201 million households (using today’s figure of 2.6 people per household).

This means that unfunded liabilities are actually $432,000 per household: not as bad as $520,000, but still an unmitigated disaster.

Finally, it’s true that these are future promises to pay, not current debts. But this hardly matters. Congress can’t even address the unfunded-liabilities disaster now, before the promises come due. How will they address it later, when there will be millions of outraged voters expecting to receive the payoff from those promises?

Expecting Congress to have the courage for this is comically shortsighted.

Despite all of this, the media often dismiss the unfunded-liability crisis, because the money has been set aside to solve it… or has it? In other words…

What About the Trust Funds?

The majority of these unfunded liabilities are supposedly covered by the Medicare and Social Security trust funds. In theory, these funds have been accumulating and saving enough money to pay for future expenditures.

In reality, this is a lie.

The funds are empty. Congress raids them each year, taking out all the cash and replacing it with nonmarketable Treasury securities—IOUs that the US government has written to itself. (Which is just as illegitimate as it sounds.)

And what’s the only thing worse than an empty trust fund that can’t supply your future needs? An empty trust fund that can’t supply your current needs.

Unfunded liabilities aren’t only a problem for the future—they’re starting to bite us right now.

As Boomers retire, Social Security and Medicare are plunging further into the red. Social Security’s expenditures first exceeded non-interest income in 2010. As for the Medicare HI Fund, it’s been paying out more than it receives since 2008.

In the delicate words of the Social Security and Medicare Boards of Trustees, both funds will pay out more than they receive in income “in all future years.” Both funds also ‘fail the test of short-range financial adequacy’.

In other words, both funds are broke.

With each passing year, the entitlement-program deficits increase. Since Congress has already spent the money that was set aside for the future of these programs, the government will have to fund them from ongoing revenues—which are already $1 trillion short of annual expenditures.

It’s a no-brainer to predict that radical changes are coming to federal benefit programs. Retirement ages are going to be raised. Tax rates are going to be jacked up. Cost-of-living adjustments will be suppressed. And there will probably be some sort of “means testing,” to deny benefits to the “rich.”

But it will still be...

Grossly Inadequate

As Cox and Archer pointed out in the WSJ:

“When the accrued expenses of the government’s entitlement programs are counted, it becomes clear that to collect enough tax revenue just to avoid going deeper into debt would require over $8 trillion in tax collections annually. That is the total of the average annual accrued liabilities of just the two largest entitlement programs, plus the annual cash deficit.

“Nothing like that $8 trillion amount is available for the IRS to target. According to the most recent tax data, all individuals filing tax returns in America and earning more than $66,193 per year have a total adjusted gross income of $5.1 trillion. In 2006, when corporate taxable income peaked before the recession, all corporations in the U.S. had total income for tax purposes of $1.6 trillion. That comes to $6.7 trillion available to tax from these individuals and corporations under existing tax laws.

“In short, if the government confiscated the entire adjusted gross income of these American taxpayers, plus all of the corporate taxable income in the year before the recession, it wouldn’t be nearly enough to fund the over $8 trillion per year in the growth of US liabilities. Some public officials and pundits claim we can dig our way out through tax increases on upper-income earners, or even all taxpayers. In reality, that would amount to bailing out the Pacific Ocean with a teaspoon.”

Famed investor and analyst Doug Casey agrees. In a recent interview with The Daily Ticker he said this:

“The problem is so big at this point, I think it’s very questionable whether it can be solved at all. The $16 trillion that the US government owes is only the official debt. You have to look at their other liabilities: future obligations that they promised to pay, debts that they’ve guaranteed that are off the books. And there we’re talking about a number upwards of $100 trillion...

“This is FAR more than can conceivably be repaid, so the debt is going to be defaulted on at some point.”

He continued: “There’s no question about that. It’s simply a question of HOW it will be defaulted on.

“Will it be by destroying the dollar, so that the people that get the debt get it in worthless dollars? Or will they actually say (as Argentina has done), ‘We’re not going to give it to you, because we can’t pay it’?…

“Let me say something that’s going to sound outrageous and way too radical… I think the US government should default on the national debt, and I say that for several reasons. The most important of them is: if they don’t default on it, it’s going to make the next several generations of Americans into (in effect) indentured servants—serfs to pay off that debt that their parents and grandparents have incurred, to live high off the hog. I don’t believe in indenturing future generations, so it should be defaulted on, for that reason… Another reason is to punish the people that have been lending that money to the US government to finance all kinds of ridiculous and counterproductive schemes.”

As you can tell from that quote, Casey is controversial sometimes. And I disagree with his last statement—whether or not the US government should default, I doubt it ever will. Not openly, anyway.

Instead, the US will default on the purchasing power that the debt represents.

What is a dollar, after all? It’s merely a unit of accounting.

The dollar’s value can be driven down on a whim—and it will be. Once it’s driven down far enough, repaying trillions of dollars in debt then becomes possible.

And as for those investors whose financial plans were based on the dollar actually retaining some value... they’ll merely be collateral damage. Tough luck for them.

(Fortunately, you don’t need to be among this group. More on this later.)

So that’s the first major crisis facing our nation—a gargantuan debt that can’t be repaid, at least not with the dollar at its current valuation.

Now let’s talk about the second crisis. This one is creating some bizarre symptoms, such as...

The Federal Reserve Becoming Bipolar

In December, Fed officials were hinting that they would be bolstering the American economy for a long time.

We were told to expect bond purchases at least until the end of 2013. Possibly even until the end of 2014.

Even though the third Quantitative Easing program (QE3) was still fairly new, there was already talk of QE4.

Then in January, the Fed reversed itself. Turns out that in the FOMC’s December meeting, several Fed officials wanted to slam on the brakes.

Forget about a Fed bond-buying program lasting through 2014. It might not even last until the end of 2013.

In fact, we found out that at least one FOMC member wants to stop bond purchases immediately.

Then a couple of weeks ago, the Fed abruptly reversed itself again.

Now we’re told that the Fed will continue its $85 billion per month bond program for the foreseeable future. And its “highly accommodative stance of monetary policy” will continue until unemployment comes down below 6.5 percent.

This is unnerving.

The Fed is supposed to be an ultra-conservative institution: a bunch of bowtie-wearing academics and economists who get excited poring over flow-of-funds data and industrial production statistics.

That’s why it’s all the more ominous that...

Fed Officials Appear to be Panicking

If “panicking” is too strong a word, here some alternatives: Faltering. Floundering. Overwhelmed.

A flip-flopping Fed can wreak havoc throughout our economy. The Fed is probably the single most powerful influence on both the economy and the markets. When the Fed suddenly has multiple-personality disorder, we’re in serious trouble.

Not only does it become impossible to prepare for whatever the Fed does next, it also has grim implications for the United States overall.

Remember, Federal Reserve officials know everything that there is to know about the American economy. They have all the numbers. They sit in the driver’s seat.

If they don’t know what to do... what does that tell us about how bad the economy really is?

And what does this also say about...

The Worst Threat to the Bond Market

Last month, I discussed several growing threats to the bond market.

Ironically, one of the worst is the Federal Reserve itself—the institution that is supposed to be propping the market up.

Famed investor Jim Grant, founder of Grant’s Interest Rate Observer, recently discussed this on The Daily Ticker. Before his interview, the Fed had announced it would maintain its $85-billion-per-month bond purchase program. As Grant commented:

“The Fed means to re-energize [our economy] through the creation of credit... The Fed intends to buy $85 billion worth of securities every month.

“You might ask: Where does it get that money? It creates it. It didn’t exist before the Fed materialized it through the very humble action of a keyboard and a computer. That’s the way it does it.

“But notice that this money is coming into the system without any commensurate increase in production. This is money in search of mischief. It is likely going to find it...”

Notice what Grant is saying here. Money-creation isn’t necessarily bad for an economy. In fact, if an economy is growing at a healthy pace, most economists would say the money supply should expand too.

(This doesn’t necessarily have to be paper money, by the way. Back when the United States was still on a gold standard, its economy still grew at a healthy pace for long periods of time. Gold mining increased the supply of gold enough to support an appropriate rate of economic expansion, without risking runaway inflation.)

Anyway, that’s not what we have today. What we have today is...

A runaway train of money creation: $85 billion per month, in an economy that’s contracting instead of growing.

In the most recent quarter, the US economy shrank by a tenth of a percent.

Yes, the contraction—our economy’s negative growth rate—was probably an aberration.

We’ll probably see a positive rate of growth in the current quarter. But it won’t be positive by much. The US economy is struggling to keep its head above water.

And large-scale money-creation in a stagnant economy risks triggering a financial disaster—usually, a large-scale inflation.

This inflation isn’t happening yet. But unless these new mountains of money can be destroyed later without ever entering the economy—which is an extremely unlikely feat—then there will be a heavy price to pay.

Worse, the Fed is putting us at tremendous risk, but for little potential benefit. Money-printing has only a limited effect today.

True, the markets reacted eagerly to the first rounds of government stimulus. But that enthusiasm was used up several years ago.

To use a medical analogy, the patient has now built up a dangerous level of tolerance to the medication. He’s not responding to normal doses anymore.

Now he requires a bigger and bigger “hit” of monetary drugs to get any effect.

That’s why each new liquidity program seems to be bigger than the previous one, but has less of an effect.

Also, as I’ve pointed out many times, the Fed is running out of tools in its toolbox. Real interest rates are already below zero, and bank policies are already highly accommodative.

All that’s left to do now is to print tons of money and buy stuff with it.

That policy is not only weak and ineffective, it’s dangerous in an economy like ours. As Jim Grant said in his interview:

“If it were as easy as printing money or creating credit to levitate an economy or to reactivate business activity, the world would have been richer many generations ago...

“The Fed’s actions are counterproductive... The Fed is... suppressing interest rates. An interest rate is of course a price, a very important price—the price of money, and the promise to pay money. Ben Bernanke himself has come out against the institution of price control—he did this before the students of George Washington University a year ago. Yet he persists in controlling this one very important price.

“But price control ultimately fails. And when it fails, the failure is replete with all manner of drama and fireworks as prices find their own level.

“The bull market has been going on in bonds since 1981... It’s been going on for 31 years and counting. The counting might soon be over.”

This is a vital point to consider. We don’t normally think about the Fed in this way, but by manipulating interest rates…

The Fed is trying to control one of the biggest markets in the world.

But it has two crippling handicaps in doing so.

First, it has a limited set of policy tools. As I mentioned earlier, most of those tools have lost their effectiveness.

Second, the Fed has to act transparently. Everything it does is immediately visible to everybody else. And there are lots of big players who are watching it very closely.

Obviously, successfully manipulating a market is impossible when everybody else knows what you’re doing.

Therefore, this effort will ultimately fail. It’s common sense that nobody can control a market forever, especially an entity with only a few tools at its disposal, that has to be transparent about what it’s doing.

Don’t be deceived by the Fed’s short-term successes. It’s true that rates are very low today, and the Fed is primarily responsible.

But can this last? No.

The Fed isn’t controlling the market. It’s just suppressing it temporarily. And once a market manipulation fails, there’s always a...

Massive Lashback

Stretch a rubber band too far, and it snaps and lashes back at you.

Similarly, every market that is stretched too far will lash back too.

Since QE first started, the Fed has ballooned its balance sheet up by $2 trillion. This is far beyond any sane level.

That position must be unwound eventually. Those bonds will have to be sold.

And just as buying bonds drove rates down, selling them will drive rates up.

(Some of the Fed’s bonds will mature, and won’t need to be sold. However, maturing Treasury bonds need to be paid off in cash... which the government doesn’t have... so more Treasuries will be sold, to raise the cash. Either way, more Treasuries come up for sale.)

Of course, this won’t happen right away. Fed officials have some discretion about how they administer their balance sheet, and no doubt they’ll maintain it as long as possible. So this is a longer-term threat to the market.

For the short term, the most immediate danger is...

The Bursting Bubble

A $2 trillion intervention is enough to create wild distortions in any market.

Here, the Fed has driven interest rates far below where they would otherwise be. Bond prices are far higher than their natural level.

Eventually, they’ll snap back to where they should be. That means bond prices will crash.

As I mentioned in last month’s issue, this would be a disaster—a haymaker landed right on the jaw of the American economy.

And the longer rates stay down, the worse that the lashback will be. As famed economist Leonard E. Burman of Syracuse University has warned, low interest rates are “creating a kind of debt bubble: our ballooning debt appears affordable to us and our lenders as long as interest rates stay low.

“At some point, investors perceive a risk of default on the debt (or inflation, which would devalue it). This pushes up interest rates, which in turn raises the risk of default, creating a vicious cycle. When the bubble bursts, the United States is an insolvent, heavily indebted superpower, with disastrous consequences for ourselves and the rest of the world. The possibility of such a ‘catastrophic budget failure’ should be avoided at all costs.”

A Clear and Present Danger

If your eyes have gotten a little glazed over by all this, here’s a simple way to look at this.

Currently, the Fed is buying almost 80 percent of all net issuance in the bond market.

Will this last forever? Can this last forever?

Obviously not.

Imagine then what will happen once the Fed stops buying—which it must eventually do.

Eighty percent of current bond demand will vanish. What will that do to the market?

The answer is clear. The market will fall like a stone.

And hundreds of billions of dollars that’s currently invested in bonds will flee the market. Let’s discuss the implications of this.

Many Crises, One Simple Solution

The $16.4 trillion national debt predicament (along with its ugly cousin, the $86.8 trillion unfunded liability catastrophe), and the massive bond bubble are overwhelming problems. Each is a national-scale crisis. What can we as investors possibly do about dangers as grave and as gargantuan as these?

On the national level, nothing. But on the individual level, everything.

Fortunately for us, we can prepare for all of these crises with the same simple technique. And by “prepare,” I mean we can not only protect our wealth as these crises mature, we can grow it handsomely.

So here’s the technique: buy gold. Not “paper” gold (mining stocks, pool certificates, or gold funds). Buy physical gold.

As a physical asset that you can own outright, the yellow metal is immune from defaults, banking meltdowns, or whatever. As a commodity with unique industrial uses, gold has inherent commercial demand. As a precious metal whose beauty and value are prized all over the world—one that’s been recognized as treasure for thousands of years—it has been and always will be a historic store of wealth, soaring in value when paper assets (like currencies) fall.

We started this issue with a discussion of America’s national finances. Bluntly put, they’re a disaster. Our debts and unfunded liabilities are unpayable, unless the dollar is steeply devalued—which will therefore happen. When it does, gold will go to the moon.

Then we talked about the bond market, and how the bubble will burst soon. This will drive gold prices up for a different reason.

Bond investors are unusual: most are in that market because they require safety. When bond prices crater, they’ll be looking for an alternative asset to pour their capital into. Stocks won’t do—they’re too risky. Ditto for currencies. That leaves hard assets like gold.

Thanks to both the US national debt and the bond bubble, gold is ideally positioned for high profits today. And those aren’t the only trends waiting to drive gold up. There are several others, including...

The Chaos in the Eurozone

Will Greece exit the euro? Will Germany exit the euro?

Will plunging Spanish and/or Italian bonds destroy one or more major European banks?

Fear and uncertainty always drive investors into precious metals. And Europe is on the brink of a continent-wide meltdown.

Competitive Currency Devaluations

The conventional wisdom among the world’s politicians is that devaluing your currency creates an economic boom in your country. (A weaker currency makes your exports cheaper for other nations to buy.)

But making your currency cheaper is dangerous. Currency values are measured relative to each other. So, whenever one currency becomes more competitive, other nations’ currencies become less so. Thus, when one currency gets substantially weaker, this creates an incentive for other nations to push their currencies down too.

And when everybody starts doing this, it’s a race to the bottom. Currency devaluations can spiral out of control very quickly.

As we’ve already seen, the Fed is currently creating tens of billions of dollars from thin air every month. This is the very definition of devaluation.

And the Fed is not alone in doing this. For example, Japan’s leaders are diligently trying to destroy the value of the yen. The Bank of Japan recently announced plans to extend its QE program into “open ended” asset purchases. Once these are implemented, Japan’s debt-to-GDP ratio will balloon up to almost 240 percent (!).

What about other nations? They’re following suit. The head of the eurozone’s finance ministers’ group has warned that the euro is “dangerously high.” Translation: it’s going to be driven down. The president of the German central bank is warning of “competitive devaluations” across the world. Officials from China, Norway, Sweden, South Korea, and the UK have issued similar warnings.

The deputy chairman of the Russian central bank has even said that the world is on the brink of a “currency war”!

Again, in a world where fiat currencies are plunging, investors stampede into alternatives. Precious metals will boom.

Investing Gurus Agree

At the beginning of each year, Barron’s interviews the world’s top money managers to get their thoughts. The last couple of issues have contained this year’s interviews.

Many of these experts are excited about gold’s potential today—even gurus that normally would recommend other assets. The article in the February 2 issue started with this:

“What does it say about the markets and the times when the world’s top bond-fund manager names gold his No. 1 investment pick of 2013? We kid you not, though everyone at this year’s Barron’s Roundtable thought Bill Gross surely was joking—until he delivered an impassioned and thoroughly convincing case for owning hard assets in an age when central banks are busily manipulating financial ones.”

And technology stock guru Fred Hickey said this:

“I am recommending gold, as I have done for many years. I will continue to do so until the gold price hits the blow-off stage, which is nowhere in sight. I am excited about gold because sentiment is so negative. Gold could have a sharp rally at any time. The Hulbert Gold Newsletter Sentiment Index went deeply negative last week, indicating that gold-newsletter writers are recommending net short positions. When that happens, gold almost always rallies. The daily sentiment index for gold is at a 12-year low. Short positions by large speculators have doubled in the past few months. Sales of American Eagle coins hit a five-year low in 2012. Yet, the environment for gold couldn’t be better. We talked today about massive money-printing by all the major central banks. Real interest rates are negative. These are the best possible conditions for a gold rally.

“Felix said gold could rally to the $1,800-an-ounce level, and I agree. If it breaks that, it will go to $2,000 or more. As long as we have unlimited quantitative easing, we have the potential for unlimited gains in the gold price. Gold could go to $5,000 or even $10,000... This year I recommend physical gold. You can buy American Eagle coins, or gold bars. Everyone should have some physical gold, and almost no one in the US does.”

Truly, only a few investors in the US own physical gold. Those who do are positioned for very handsome profits in the years ahead.

Will you be among them?