Paying off the Piper

Given the size of the U.S. debt bubble and the fact that the Federal Reserve has "a printing press," why would the U.S. even consider repaying its loans with today’s expensive dollars…when it can simply inflate and repay with tomorrow’s cheap ones?

"I place economy among the first and most important of republican virtues, and public debt as the greatest of dangers to be feared."

– Thomas Jefferson

The majority of stock and bond investors are facing a dire future. The only thing higher than tensions in the Middle East is the price of crude oil. Meanwhile, the popular press openly questions whether the president has the leadership skills to warrant re-election.

Sound like today’s situation? Actually, I am referring to 1979…but the parallels to 2004 are undeniable. President George W. Bush is certainly cut from a different cloth than President Jimmy Carter, but the problems America faced in the late 1970s – rising debt, slow growth and an explosive Middle East – have returned in droves.

Those of us with a few gray hairs remember the ’70s, not just for the outlandish clothes and mindless music, but also for the long lines of cars snaking from gas stations during the Arab oil embargo. And who could forget the decade-long bear market in stocks and bonds?

Divestment of Treasury Debt: Perpetual Government Debt

In the 1970s, the concept of perpetual government debt was still a relatively new idea in the United States. In fact, at the dawn of that decade, the United States was the world’s largest creditor. Since then, however, successive presidents and Congresses have refused to let a large deflationary period occur on their watch. Big companies like Chrysler near bankruptcy? No problem – taxpayer money will bail them out. The same solution was used for reviving both the banking and thrift industries during the S&L crisis of the 1980s.

It seems as if there is no problem that Washington cannot wash away with taxpayer money. But just as there are limits to how much oil we can draw from the Earth, there are limits to how much money Uncle Sam can borrow without triggering an economic crisis. After all, our government does not earn money. It can only fill its coffers in two ways: taxation and borrowing. But borrowing has become an albatross around the government’s neck.

Currently, the federal government is spending half a trillion dollars more than it collects. Even in the face of this troubling fact, the president and Congress continue to contract new obligations. There is the $100 billion – and growing – tab for our involvement in Iraq and the $14 billion conscripted for the war on terrorism. That is even before we spend a nickel on traditional social and defense spending. In the midst of this, our president is determined to cut taxes to revive a mature economy. And then there are the interest costs on all this debt.

The U.S.’s financial obligation is so big that it is hard to fathom. One way to look at it is to consider the fact that America’s annual deficit almost matches the total value of goods and services that Canada produces in a single year.

U.S. federal debt was relatively flat until the mid-’70s. But from then on, it has been on an almost uninterrupted upward trajectory. We have reached a point where federal debt stands at a level equivalent to each American owing roughly $25,000. A bit of arithmetic shows that a family of four is on the hook for $100,000 in federal IOUs.

Divestment of Treasury Debt: $3.5 Trillion in Debt Since 1990

Most shocking is that half of this debt – some $3.5 trillion – has been borrowed since 1990! That is amazing when you consider that since the creation of our nation until the mid-1970s – a span of 200 years that included two world wars – our federal government accumulated a debt of less than $1 trillion.

Fast forward to 2004. Washington’s guns-and-butter course of action will result in a debt of $1 trillion a year by the end of this decade.

Not that long ago economists argued that federal debt was of little consequence, since it was money we owed to ourselves. That is no longer the case today. Of the $3 trillion in Treasury debt outstanding, foreigners hold more than half of it. In other words, the rest of the world – much of it envious of the American way of life – is financing America’s social spending, the government’s interest payments and even our defense spending.

Today, the United States no longer faces the threat of Soviet aggression, but the country now faces a much more subtle menace – mass selling of Treasury bonds by foreigners. The results of any rush for the exits by our foreign creditors would make the stock market crash of October 1929 look like an inconvenience. The fact is that the greenback is vulnerable to a sudden and devastating vote of no confidence.

The divestment of Treasury debt by foreigners would send the dollar reeling and wreak havoc in the bond markets. America has made itself so dependent on the lending of foreign interests – most notably foreign central banks – that it wouldn’t know how to survive without it.

In military terms, the United States’ power is unparalleled…but it is nevertheless vulnerable to the economic whims of foreigners, who own $8 trillion of U.S. financial assets – including 13% of all stocks and 24% of corporate bonds. And foreigners have the ability to slowly but surely divest themselves out of dollars. In fact, I believe this is exactly what has been happening over the past year.

But keeping foreign nations committed to U.S. dollars and Treasurys is becoming tougher by the day as the value of the dollar slides and America keeps spending money it doesn’t have. The United States must try to manage a delicate balancing act between borrowing heavily from foreigners and keeping rates low for the folks at home.

To keep the economy out of the ditch, the Fed must not only keep rates low to make government borrowing affordable, but also they must create an atmosphere where the vast majority of Americans can afford to spend now and pay later. Just how long this loop can continue remains to be seen, but if the government has its way, the payments promised in the future will exact a lot less pain than most anticipate.

One thing seems certain – with a total debt load now measuring four times America’s GDP, the nation’s ability to pay back what it has borrowed is next to impossible. It is probably safe to say that no empire has faced such a startling predicament since Rome.

Divestment of Treasury Debt: Only One Way Out

America’s debt bubble has grown so big that there is only one way out – inflating the dollar and reducing the real cost of its payments. In order to do this, the Fed will not be able to raise interest rates.

It wouldn’t take much in the way of interest rate hikes to collapse this debt-laden economy. The last time the Fed raised rates (1999 to 2000), it brought about a collapse in the stock market and a subsequent recession. Today the economy is far more dependent on asset inflation in real estate, stocks, bonds and mortgages. Therefore, a sharp rise in rates would bring about severe deflation in paper assets.

The long and short of it is that credit will continue to be expanded in this country until no more borrowers can be found. Then, when borrowing dries up, the government will become the borrower-of-last-resort, with the Fed monetizing all the government’s excess borrowing or budget deficits. This monetary inflation virtually guarantees a bull market in gold, silver and commodities.

Keep printing, Mr. Greenspan, keep printing…


John Myers
for The Daily Reckoning
May 13, 2004

Editor’s note: John Myers – son of the great goldbug C.V. Myers – is the editor of Outstanding Investments, a monthly advisory on commodities and other hard assets. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits – including oil, gas, energy and gold.

Today, your globe-trotting editor is in fabulous Las Vegas for a weekend of glitz, sparkle, and pizzazz. In fact, most of the team from the Daily Reckoning will soon be in the City of Sin, leaving an eerie sense of calm in the both the Paris and Baltimore HQs.

Unfortunately, due to the rigors of foreign travel and the distractions of a conference double-header – your Paris editor will be speaking at both the Money Show this afternoon and the upcoming FreedomFest – your editor was not able to send us his musings today. Tomorrow, however, he promises a full account.

In the meantime, we turn to Eric Fry, just a few exits north on I-95…


Eric Fry, our man-on-the-scene in Manhattan…

– For a few brief moments yesterday, the lumpeninvestoriat treated bad news like bad news – by dumping stocks so fretfully that the Dow Jones Industrial Average tumbled more than 160 points to a new low for the year. But by late afternoon, the Panglossian lumps started to view the day’s bad news in a more positive – if somewhat delusional – light…(After all, without the sort of really bad news that causes share prices to fall, when would an investor ever get a buying opportunity?)

– Neither record trade deficits, nor $40 oil, nor beheadings in Iraq could dissuade the lumps from entering "Buy" orders during the afternoon for the very same stocks that seemed like toxic waste during the morning hours. The Dow soared nearly 200 points from trough to peak, to finish the day with a 26-point gain at 10,045. The Nasdaq staged an even more dramatic turnaround, plummeting nearly 3% in the morning, then recouping almost all of its losses by the closing bell. The volatile index finished the day just 6 points lower at 1,926. Some sort of relief rally was probably long overdue, but the exact timing of such a rally is as difficult to predict as a visit from your mother-in-law.

– Curiously, while the stock market embraced yesterday’s bad news, the gold market took fright. During the morning hours, gold rallied more than $6.00, but then "tanked" into the close of New York trading for a gain of only 50 cents to $377.70 an ounce. When stocks celebrate bad news and gold mourns it, something is amiss. Exactly what, we are not sure.

– Yesterday’s news included the grisly report from Iraq that a band of Al-Qaeda thugs had beheaded an American civilian. The sadistic reprisal is revolting, but hardly surprising. As we should all know by now, the war on terror is a "new" kind of war – one that draws little distinction between combatant and civilian. But just like the old kind of war, the open-ended campaign against terror promises to be extremely costly. The non-quantifiable costs will include the loss of American lives and the gain of global contempt. Meanwhile, the financial costs will likely run into the trillions of dollars, and will just as likely claim the U.S. dollar as a collateral victim.

– America’s surging trade deficit is also taking aim on the U.S. dollar. Americans continue to suck up imports like an elephant sucks up peanuts. The U.S. trade deficit ballooned 9.1% in March, as imports of goods and services rose 4.6% to a record $140.7 billion – the largest monthly rise in imports since March 1993. So much for the notion that a weak dollar would curb our collective appetite for foreign-made goodies.

– For example, the weakening dollar is not curbing demand for crude oil; it’s just making it more expensive. The U.S. petroleum deficit widened 12.2% in March to a record $12.5 billion, as our SUV-loving nation imported 331.6 million barrels in March or 10.7 million per day, up from 287.8 million or 9.9 million per day in February.

– Which brings us to yesterday’s final piece of troubling news: Energy prices soared to 20-year highs. The June gasoline contract on the Nymex jumped more than 5% to $1.37 a gallon – the highest price ever recorded since the gasoline contract first began trading in 1984 – while crude oil jumped 77 cents to $40.77 a barrel, the highest oil price ever recorded since that contract began trading in 1983.

– Could any piece of yesterday’s news be construed as bullish for stocks? Or to rephrase the question, what part of "chaos in Iraq" or "record trade deficit" or "$40 oil" is going to propel the Dow to a new record high?

– Unlike their upbeat stock-buying counterparts, bond investors recoiled from yesterday’s headlines. The 10-year Treasury note fell about half a point to push its yield up from 4.75% to 4.80% – a fresh 10-month high. The bond market has been in a freefall ever since late March, when the 10-year yielded a miserly 3.69%. In fact, the beleaguered bond market hasn’t produced as much as a three-day winning streak since the first week of March. The failure of bonds to "catch a bid" or to mount a comeback of any kind suggests that "real" investors are feeling some real pain and are REALLY worried about holding long-dated notes and bonds. We don’t blame them; we’d be worried too…if we owned bonds.

– But shouldn’t stock market investors also be a bit worried about rising rates? As we never tire of mentioning here in the Daily Reckoning, rising rates will lift stock prices like a hangman’s noose lifts a horse thief. A cycle of rising interest rates is reason enough for any stock market to struggle, let alone a stock market as richly priced as the American edition of 2004. Once Mr. Market is hanging high on the gallows of rising rates, he might then be able to see that bad news really was bad news after all.