The Empire Has No Clothes

The Daily Reckoning PRESENTS: Despite all of the evidence to the contrary, the average American still believes that the United States will continue to be the world’s economic superpower – indefinitely. A closer look at the facts, however, tells a very different story. Puru Saxena explores…

THE EMPIRE HAS NO CLOTHES

The United States is widely adored as the world’s greatest empire; few realize that the empire has no clothes. As the masses look up to the nation in admiration, they are fooled into believing that it is swimming in wealth; the reality being that it is up to its eyeballs in debt. The U.S. economy is living on borrowed time and judgment day is inevitable. No nation in history has ever managed to escape such economic imbalances, and I suspect the United States won’t get away with it either. Let’s take a look at how this imaginary cloak has been woven:

The economic recovery since the 2001 recession has been manufactured by excessive credit-growth and consumption. For the first time ever, a central bank has purposely engineered a credit bubble with the intention of bringing artificial prosperity via rising asset-prices. The Federal Reserve dropped interest-rates and the majority of Americans became the proverbial kids in the candy store, unable to resist the temptation of cheap credit. This is evident from the fact that over the past six years, U.S. household debt soared from $6.99 trillion to almost $12 trillion – a staggering increase of 70%!

However, some of today’s economists discard this record debt-explosion as irrelevant because the net-worth of U.S. households over the same period has surged from $42 trillion, to roughly $54 trillion (largely due to the housing boom). In other words, due to rampant credit and leverage in the economy, asset-prices have risen much more rapidly than debt levels. But the key question is whether this is sustainable – and at what cost?

In my opinion, asset-prices can continue to rise for a long time if there are willing borrowers – and a central bank armed with an endless supply of credit. However, you have to understand that rising asset-prices only give the illusion of prosperity. The truth is, rapid monetary inflation and credit growth always impoverish a society as money becomes abundant – and therefore less valuable. So, everyone may feel richer as their homes and stock portfolios appreciate in value, but it’d be a mistake to confuse rising asset-prices in an economy with real wealth creation. After all, wealth is a relative concept and if everyone else’s homes have also risen in value, how wealthy have you really become?

Given the levels of debt in the United States, I have no doubt that the Federal Reserve wants to keep the game going for as long as possible. It will achieve this by continuing to inflate the supply of money and credit. Under this scenario, the U.S. dollar will surely depreciate against other major world currencies, and especially against precious metals whose supply can’t be increased at the same pace.

In order to assess the U.S. economy’s prospects, the most important issue to understand is that the recent economic expansion hasn’t been typical. The U.S. wage growth has been extremely poor and the capital spending by American companies has also been dismal. In fact, real disposable income growth is now almost zero, and over the past five years, capital spending has increased by a paltry 12%. So far, the U.S. consumer alone has carried the baton through record-high indebtedness and consumer spending; with home prices no longer appreciating, you have to wonder where the future borrowing-power will come from.

In my view, the United States looks more and more like a bubble economy, a banana republic of some sorts, which is desperate for ever-rising asset-prices for its very survival. Should American home and stock prices stall, let alone decline, the fate of this great bubble will be sealed. Depreciating asset-prices will act like a dagger in the heart of this artificial recovery, so the Federal Reserve must continue to inflate at all costs.

In the United States, the total debt as a percentage of GDP is currently above 300% and at an all-time high. It is worth noting that the last time the United States faced a meaningful contraction in debt relative to the size of its economy, it coincided with the depression years of the 1930’s. So, you can bet your farm that Mr. Bernanke & Co. will try their best to avoid a repeat of such a disaster by continuing to aid deficit spending through their ultra-loose monetary policies.

With the U.S. consumer leveraged to the hilt, the fate of the U.S. economy now lies with its corporations and its government. For sure, American companies have recently registered great profits and are flush with cash, however; so far they haven’t shown any willingness to spend their money – capital spending is non-existent and wages haven’t increased in line with the inflation-rate. At least the American government has been more “responsible” by contributing to the economy through the deficit spending program surrounding the various wars being fought – albeit under false pretences!

The world is littered with statistics which, more often than not, are misleading and distort the truth. In this regard, the “official” statistics released by the U.S. establishment are no different. Take the U.S. budget for example. The budget reported in the media claims that the deficit was reduced to $319 billion in 2005. However, the Financial Report issued by the Department of Treasury says it was $760 billion, or over twice as large.

“But how come?” you may wonder. It is fascinating to note that the U.S. budget process meant for general reporting uses accounting procedures that ignore long-term, future obligations such as Social Security and Medicare. The United States keeps two sets of books, only wanting the world to see one of them. The “President’s Budget,” issued by the Office of Management and Budget and used to develop the annual budget, is based on cash accounting. The other set of accounts, the “Financial Report of the United States,” issued by the Department of the Treasury, uses a more realistic accrual-basis accounting. It is interesting to note that the U.S. federal law requires ALL businesses with revenues in excess of $5 million to use accrual accounting, yet the budget figures released to the public don’t follow this rule. According to the financial report issued by the U.S. Treasury which takes into account the future obligations of the federal government, the U.S. budget deficit is now at a record-high!

Next, let’s review the strange U.S. unemployment numbers released in the media. Since the end of the recession in November 2001, reported employment growth is up moderately, which makes it the worst performance during any post-war economic recovery. However, closer inspection reveals that even this small reported growth in employment is an absolute joke. The reported official unemployment figures don’t include those people who’ve given up looking for a job (due to non-availability of jobs), joined a university or taken a part-time job since they can’t find full-time employment. When you add all these people, the real rate of unemployment is closer to 10%.

Finally, the biggest “cover-up” award must go to the officials who determine the Consumer Price and the Producer Price Indices (CPI and PPI). These “inflation-barometers” are a total fraud! Remember, the Federal Reserve’s biggest motive is to conceal the ongoing inflation and manage the inflation expectations, or else the viability of the Federal Reserve itself may come into question. Therefore, both the consumer and producer prices are massaged, seasonally and hedonistically adjusted to keep inflationary fears under check. So, by keeping the CPI and PPI artificially suppressed via voodoo accounting and understating the inflation menace, the Federal Reserve maintains the public’s confidence in the US dollar as a great store of value. After all, as long as the masses continue to believe in the “inflation-controlling” powers of the Federal Reserve and the other central banks, the more inflation and credit they can create!

In summary, the U.S. economy isn’t in good health and eventually the monetary stimulus and injections of liquidity will fail to revive this terminally ill patient. Accordingly, I advise you to minimize your exposure to American assets. On other hand, tangible assets (especially precious metals) and mining stocks represent a great opportunity for the medium to long-term investor. Despite the recent pullback, the long-term bull-market is still intact and I anticipate a rally over the coming six to eight months. Accordingly, this is an ideal time to add to your positions in precious metals as well as mining and commodity-producing companies.

Regards,

Puru Saxena

P.S. You can safely invest in the commodities market with EverBank’s MarketSafe Resource CD – but the offer is only open until October 17.

Editor’s Note: Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise “Email Updates”, which are sent out when an important development in the capital markets warrants immediate attention.

“Lenders gone wild,” runs the headline of an article at MarketWatch:

“More than a year after Alan Greenspan warned of the ‘potential for individual disaster’ from a new breed of mortgages that were helping to fuel the housing boom, federal regulators are finally trying to do something about it.

“Bank regulators knew more than a year ago that lenders were aggressively marketing interest-only and payment-option adjustable-rate mortgages to consumers who didn’t fully understand what they were buying… Studies show that a large number of borrowers with simple ARMs don’t understand the terms and underestimate the amount their mortgage payment could rise. Nontraditional ARMs are even more complex.”

That a public spectacle begins as a fraud, progress into farce and ends in disaster is one of our daily dictums here. We have spent so much time and so many pages describing the lies behind the housing bubble that our readers must be tired of hearing about it. So, now we move on – to the farce.

That too, has been described at length, but at least it is more entertaining. For here, we move from humor in the abstract to slapstick…to real life stories of people whose brains have been turned into suet pudding by the lure of big money from house-price increases.

Nothing was too absurd or preposterous for them to believe, it seemed. Buyers bought condos before they were built with every intention to flip, and then they were sold…before the water was even turned on. Householders believed they could ‘take out’ equity from their houses…and never have to put it back. Hustlers quit their jobs at dotcom start-ups in order to become mortgage-brokers. Financial engineers devised new and innovative ways to leverage the witless homeowner into a house he couldn’t afford and could never hope to pay for.

MarketWatch continues:

“The housing credit bubble led to the growth of exotic loans, which, in a vicious spiral, drove prices even higher, said one observer. In a bubble, ‘the financing gets progressively worse. At the end, you get nuttiness,’ said Dean Baker, an economist for the Center for Economic and Policy Research, a Washington think-tank.

“Finally, prices got so high that ‘the only way people could buy houses was by bending the rules,’ said Baker, who’s been warning about the real-estate bubble for years. In the Orwellian parlance of the mortgage industry, loans that ignore the true ability of the borrower to pay for the loan are called ‘affordability’ products. Most of the exotic loans have low introductory interest rates that ultimately adjust to market rates, usually after two years. Some loans require that only the interest be paid, putting off the day when the borrower must start to pay down the principal. Some of the loans allow borrowers to make a monthly payment that doesn’t even cover the interest, resulting in a negative amortization when the unpaid interest charges are added to the principal. And most of such loans sold in the sub-prime market have large prepayment penalties that make it expensive to refinance.”

None of this will come as news to our long-suffering readers. But it is sure to come as a shock to homeowners who haven’t read us. A $200,000 ARM, for example, can rise from a $643-a-month burden in the first year to a $1,578-a-month burden in year six…by which time, the principal would have risen to $214,857, according to a MarketWatch source.

How will the nation’s economy hold up as all these loony mortgages are reset, rescheduled, and regretted? So far, the masses are betting on more soft landings than at O’Hare or Heathrow. From Florida, comes more news that the bubble in housing is not only deflating…but that it is taking down a lot of people with it. One builder has cut his prices by 30%, says our source. And that is after throwing in new appliances for free.

Yes, a few marginal borrowers will go belly-up, the optimists admit, but everything else will be okay. But here at The Daily Reckoning, we don’t trust what people say. We’d rather place our faith in what they do. And the Wall Street Journal tells us that what consumers are doing right now is…still consuming. Meanwhile, Wall Street is still near an all-time top; apparently investors are as fearless… or as clueless… as consumers. That no one seems to register any fear is remarkable – given the catastrophic consequences of any misstep. Never before have so many people owed so much money to so many others. Never before has there been so much debt…and never before have so many complicated, contradictory debt-backed investments been stretched and spun so far out into the financial galaxy.

More below…

But first, the news, from our team at The Rude Awakening:

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Eric Fry, reporting from Southern California…

“If the free-spending – but overly indebted – American consumer begins to spend a little less freely, which industries would feel the pinch? And which would benefit?”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

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And more views:

*** Are we right to worry? We don’t know…but we spent yesterday re-reading some of our Daily Reckonings from the last seven years. We can sum them up for you as follows: Sometimes right; sometimes wrong; never without an opinion.

What we were right about was the tech bubble and the price of gold. But what we failed to see was how the feds, working hand in glove with the financial industry, would be able to keep the bubbles boiling up. We figured that the central lie of central banking – that you can create ‘wealth’ simply by putting more liquidity into the system – would have caught up to them by now.

But no, not at all. People still have faith in stocks, bonds, and the dollar.

We saw what looked to us like a great top-out of the stock market in January of 2000. Sell the Dow; buy gold, we said. Since then, stocks have gone down…but the Dow has gone right back up. Still, you would have done well to sell the Dow six and a half years ago. If you’d bought gold, instead, you’d be up about 140%. And even if you’d just put the money into 91-day T-bills, you’d be ahead of the game, because, most of the Dow stocks are still well below their highs…with GM and Intel off 60% and Microsoft down by 50%. Home Depot and Merck are both off by about 40%.

Altogether, since January 2000, if you had held the 30 Dow stocks, reinvesting the dividends, you’d be up only 12.7%. Adjust that number for inflation and you’d actually be down nearly 10%. A money market fund, by contrast, would have put you ahead by 20% in nominal terms and less than 2% in real terms.

Stocks were no place to be, post-2000. And now, the housing bubble too seems to be losing air. And we have to wonder: can they do it again? Can they create yet another bubble? One that will prop up stocks and housing a while longer?

*** A couple of small items caught our attention recently….

Like this note from Bloomberg: “Pirate Capital LLC founder Thomas Hudson, seeking to calm investors after half of his staff left, told clients of the hedge-fund company that he plans to deliver returns of more than 20 percent.

“‘I fully intend to refocus, streamline and navigate the portfolio back to the positive performance I began the firm with,’ Hudson, a 40-year-old former trader at Goldman Sachs Group Inc., wrote in a letter to customers yesterday.”

We stop dead in our tracks. How can a fund manager possibly ‘plan’ to deliver a return of more than 20%? He can plan to get 3%…or maybe even 5%. But 20% is a gift from the gods…or the fruit of a pact with the devil. The “heads I win, tails you lose” compensation system for fund managers tilts them naturally towards risk. But here, what we have is a desperate manager who is all but guaranteeing to do something desperate….and desperately stupid. Or something very, very smart. We will take a guess; this is a fund that will blow up a year from now.

*** While we are making predictions, we will make another one. In the news, two weeks ago, was the discouraging word that U.S. payments to its overseas creditors were now greater than its receipts from overseas investments. For several years, the country has been in the strange position of having a very, very negative net foreign investment position…but a positive balance in its net annual external investment account payments.

That is, for some reason never fully explained, Americans owed more to foreigners than was owed to them by foreigners…the yanks got the better of the payment flow – that is, until the 2nd quarter of this year. Two weeks ago, the whole thing went bad…after 90 years, the United States has now got on the wrong side of its capital service payments as well as its capital holdings.

And now, because Americans do not save enough money, the country has to go abroad to borrow the money…to pay the interest on the money it borrowed before. And, since Japan is the country with the most U.S. debt…and China is the country most eager to lend of late, the United States must borrow from China in order to pay Japan.

Thus do the mighty, as well as the humble, fall into the same debt trap. The marginal homeowner must borrow to pay his mortgage and credit card debt. The marginal empire of debt must borrow to pay interest on its T-bonds.