Deep in Debt, Caught in a Net

Your average debt-strapped American burger-mashers, in over their heads…

"Deep in Debt, Caught in a Net"…This old English proverb concisely describes the financial condition of many Americans. Household debt is rising at an 8.8 percent annual rate, home mortgage debt at 14.2 percent. Total debt in the United States doubled from 1998 to 2002, from $16 trillion to $32 trillion, and may double again in the next five years.

The Federal government, which sets the pace, reported a $555 deficit for the 2003 fiscal year; its total debt is given at $6.783 trillion. For the next two years the budget deficits are estimated at $566 billion to $644 billion each, which should increase its total debt to more than $8 trillion, or some $27,000 for every man, woman, and child.

Economists make an important distinction between "productive" and "consumptive" debt. Although the difference may not always be clear and exact and, therefore, may give rise to much controversy, it is significant as to motive and effect. A debt incurred for productive purposes, e.g. a commercial or industrial investment designed to earn future incomes, may cover its interest costs and even yield entrepreneurial profits. In contrast, new debt in the form of a second mortgage on a home may finance the purchase of a vacation home, new furniture or another automobile, or even a luxury cruise around the world. The debtor may call it "productive," but it surely does not create capital, i.e. build shops or factories or manufacture tools and dies that enhance the productivity of human labor.

Similarly, a debt incurred for the purpose of expanding Medicare may improve the health and looks of many elderly and, therefore, be deemed "productive," but it does not create capital that makes workers more productive and raises the levels of living of all. It actually may consume capital and thereby depress standards of living.

Currency Depreciation: The cost of Debt Doubles

Private debtors may find it difficult to pay for bread that has been eaten. It is likely to become ever more difficult in the future as the cost of debt is likely to double and triple. At the present, interest rates are far below market rates due to massive monetary and fiscal stimulation by both the U.S. Treasury and the Federal Reserve System. The basic Fed rate stands at one percent, three-month money market instruments at 1.11 percent, one-year paper of 1.78 percent, and two-year government notes at 1.77 percent.

For a while, government may ignore and even outlaw market prices, market wages, and market rates of interest and mandate its own, but price and rate edicts invariably disrupt the smooth functioning of the market order. They cause business misdirection and maladjustment that lead to ever more business losses and failures. In economic disarray, the Fed may have no choice but to raise its rate to market heights that enable businessmen to readjust to the judgments and wishes of the people.

Public debtors may view their debts in a different light. They may call them "a national bond" which, in Franklin D. Roosevelt’s words, is "owed by the nation to the nation." In reality, it is unlikely that future generations of taxpayers will willingly bear the bond of debt. Like so many before them, they may choose currency depreciation, which offers the most advantageous escape from a burden of debt. It depreciates all debt and, in terms of purchasing power, may even reduce debt faster than new deficits are added. In the end, no matter how large the budget deficits may be, debt depreciation may outpace the deficits, which benefits all debtors, public and private, and defrauds all creditors.

Many creditors are exposed to yet another danger. The currency depreciation may accelerate if foreign creditors should begin to question the quality of the American dollar and liquidate their dollar claims, seeking refuge in other countries and other currencies. While many domestic credit institutions are legally barred from investing in foreign currency claims, foreign creditors usually have no such limitation; they are free to shed dollar investments at any time and search for profitable opportunities elsewhere.

Currency Depreciation: The Special Position of the American Dollar

Every such liquidation would reduce the demand for dollars and aggravate its depreciation. Moreover, it would cast doubt on the special position of the American dollar as the world’s primary trade and reserve currency. For many years this special position has allowed the Federal Reserve System to provide the world with ever more of its notes in exchange for ever more goods and services. If the world should ever lose its trust in the U.S. dollar and convert some of its holdings, more than $7 trillion of American assets and claims, the consequences would be too calamitous to contemplate.

Our debt generation is a sad generation misguided by false notions and doctrines, and preoccupied with its own needs and wants. When economic conditions begin to deteriorate it may grow ever more egocentric and wretched, which tends to aggravate the social tension and strife. Clinging tenaciously to its transfer claims and rights, the unhappy society thus may deteriorate into a militant assembly of diverse pressure groups feuding and fighting each other.

When the political conflict finally explodes into violence, the transfer society urgently needs a peacemaker who is prepared to suppress violence with superior violence. In the end, a society that can no longer work together in peace must submit to the dictates of a strong president armed with an array of emergency powers. In other places, at other times, he would be called Caesar.


Hans Sennholz
For the Daily Reckoning

Novemeber 04, 2003

Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy.

The Indian Summer continues. It is so warm in Baltimore we had to turn the air conditioning on.

And in the financial markets, the warm after-glow of the great bull market continues to brighten hearts and account statements. The Dow rose 57 points yesterday. The dollar went up against the euro…to $1.14.

Gold fell to $377.

"Construction surges to record in September," says a Reuters headline.

"Manufacturing index at 3-year high," adds Bloomberg.

All over the country, people are convinced that this recovery is real. Savings rates are falling; people are borrowing and spending as never before.

And so, dear reader, is it time to ask:

What if we’re wrong?

What if the recovery is genuine? What if this really is a new bull market, rather than a bear market rally? What if the trade deficit and the federal deficit don’t really matter? What if the dollar doesn’t fall – no matter how many of them we produce? What if you really can get rich by spending, after all?

Will winter never come?

Of course, to this query, we know the answer. The answer we lack is to the question: when. "In the fullness of time," we reply, for lack of a better response.

"Give me a trillion dollars and I’ll show you a good time, too," was Buffett’s answer. He was replying to a different question, addressing the beginning of today’s boom, rather than its end. The source of the present excitement on Wall Street, Buffett implied, was neither a real economic recovery nor a genuine bull market. Instead, it was a response to more than a trillion dollars’ worth of stimulus. The federal budget went from surplus to deficit – a swing of more than $700 billion – in an 18-month period. Cutting interest rates rapidly, the feds also managed to light up the housing market – adding hundreds of billions to the economy through mortgage refinancings and new construction.

Will winter never come? Can you now get rich by spending more than you can afford on things you don’t really need?

We don’t know. But it is unlikely, in our humble view, that the planet earth has shifted on its axis. Winter will show up, as it always does – sooner or later. Nor is it likely that the laws that have ruled the world of money for so many years have suddenly been repealed.

So, we turn the ‘what if’ question in a different direction. What if the economy doesn’t get another trillion-dollar jolt of stimulus? What if the government decides not to shell out another $700 billion…taking the federal deficit to, say, $1.2 trillion in the hole? What if China and Japan don’t lend more money next year? What if interest rates can’t be cut further; what if the refinancing boom has already run its course?

We don’t know that answer to these questions. But we can take a guess. One of the curiosities of the bear market of 2000-2002 was that U.S. investors never panicked. Stocks sold off. Trillions were lost. But never was there a mad flight for the exits.

This time may be a bit different; we may finally see a pell-mell panic in international currency markets, debt markets, and in the U.S. stock market. Foreign holdings of U.S. dollar securities have bubbled up from less than 10% of long-term public debt in 1997 to more than 50% in August of 2003. Some future headline is likely to tell us that the foreigners have grown a little panicky: "Foreigners Rush to Dump U.S. Dollars," USA Today may report.

In America, investors still believe in stocks for the long run…but few will be willing to hold them through another short-run collapse.

Look out.

In the meantime, here’s Eric, back in NY with more news:


Eric Fry from Wall Street…

– The stock market is soaring…and woe to anyone who tries to stand in its way.

– Yesterday, the Dow gained 57 points to 9,858, while the Nasdaq jumped nearly 2% to 1,967. Stocks are expensive. But millions of investors buy them anyway. They fear only the expense of NOT buying stocks that are going up…The stomach-turning regret over buying too many shares of Cisco Systems in late 1999 has yielded to the regret over buying too few Cisco shares in late 2002. The semiconductor giant’s stock jumped another 3% yesterday on word that global chip sales swelled by 6.5% in September to $14.4 billion, the largest monthly increase since 1990.

– The economy is recovering. Everyone knows that. So stocks will keep rising…Everyone knows that, too. Each new tidbit of favorable economic news is, a priori, a new reason to buy stocks.

– Fresh on the heels of last week’s booming 7.2% GDP report came the news yesterday that the beleaguered U.S. manufacturing sector is rebounding. The Institute for Supply Management said factory activity in the United States grew in October for the fourth consecutive month.

– Specifically, the ISM manufacturing index rose to 57.0 percent last month from 53.7 percent in September, the strongest pace since January 2000. Within the report, the new orders index rose to its highest level since June 1994. In other signs of economic revival, the Commerce Department said spending on construction projects rose 1.3 percent in September after a 0.7 percent rise in August.

– The resurgent economy is great news for everyone but pawnbrokers and bond traders. In the bond market, signs of economic growth are as welcome as the bride-to-be at a bachelor party. That’s because strong economic growth often coincides with rising bond yields. Yesterday, the yield on the 10-year Treasury note popped up to 4.35% vs. 4.30% Friday. Meanwhile, the gold price tumbled $7.50 to $377.10 an ounce.

– 2003 has been a kind year to most investors. Buyers of gold stocks are nearly as happy as buyers of tech stocks. But the buyers of bonds are not happy, especially foreign bond buyers. The twin declines in the bond market and the U.S. dollar have dealt a wicked blow to the capital accounts of the foreigners who are graciously supplying our capital. How long will they tolerate this sort of abuse?

– Last week, the octogenarian sages who addressed the New Orleans Investment conference cautioned the attendees to steer clear of the U.S. dollar. But the nation’s investors have no use for the seasoned wisdom of old folks, much less the wisdom of the relatively sprightly Warren Buffett. The 72-year old billionaire investor stated recently, "I am crying wolf again and this time backing it with Berkshire Hathaway’s money. Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in – and today holds – several currencies.

– "Both as an American and as an investor, I actually hope these commitments prove to be a mistake. Any profits Berkshire might make from currency trading would pale against the losses the company and our shareholders, in other aspects of their lives, would incur from a plunging dollar.

– "But as head of Berkshire Hathaway, I am in charge of investing its money in ways that make sense. And my reason for finally putting my money where my mouth has been so long is that our trade deficit has greatly worsened, to the point that our country’s ‘net worth,’ so to speak, is now being transferred abroad at an alarming rate."

– Jimmy Rogers, who is more than a decade away from 80, but who has seen more of the world than most 100-year olds, also advises unloading greenbacks. "If I could tell you all just one thing today," said Rogers to the audience, "it would be to sell the dollar."


Bill Bonner, back in Baltimore…

*** "I never met anyone who said to buy gold."

Your editor was chatting with a young woman on a flight from Atlanta to New Orleans. In North America, as in Europe, buying gold is seen as bizarre, anti-social and barbaric. That will change, we predict.

*** "It reminds me of Vietnam," said a veteran on the flight from Paris. He was referring to the war in Iraq. "I was drafted right out of college. They told me I was going to Vietnam to protect the free world from communism. It took me exactly two weeks to realize that it was a load of b.s."

This traveler was from Heston, Kansas…an engineer working for Massey-Ferguson tractors.

"What takes you to Paris," we wanted to know.

"Well, the office is in Heston, Kansas, but we make our tractors in Beauvais, France. We used to make them in Coventry, England. But we found that we can make them better in France."

Go figure.

*** A friend sends the following…

Provocative recent remarks from the host of NBC’s Tonight Show:

On the U.S. Senate: "The Senate voted 97-0 for an anti-spam bill to stop those annoying things you get on your computer. The senators made it very clear that when you start misleading the American people and start taking their money over false promises, that’s our turf, buddy!"

On the effort to write a constitution for Iraq: "As you may have heard, the U.S. is putting together a constitution for Iraq. Why don’t we just give them ours? Think about it – it was written by very smart people, it’s served us well for over two hundred years, and…we’re not using it anymore."

*** Poor little Edward. The boy has his 10th birthday this week…and he’s already got a record. He was collared at school for packing heat – a b-b gun that he had bought from another naughty boy. The two of them were waving it around to impress their friends when the law showed up – a teacher who confiscated the weapon and sent them to the principal’s office.

*** By the way, if you are free next Wednesday, November 12, you may wish to join our man in New York, Eric Fry, at the upcoming meeting of the Supper Club. The event will be held in at the Broadmoor Resort in Colorado Springs. Four new investment ventures will be presented…as well as twelve past opportunities, some of which are still open.

The Daily Reckoning