The Rising Sea of Debt, Part Two of Two
The dollar has indeed been much stronger of late, two possible reasons for which are mentioned above. This implies that dollar-denominated debt has become more rather than less expensive to service in real terms. This is in direct opposition to what the Federal Reserve is trying to achieve with QE2, which is to raise the rate of inflation. But because the Fed is now buying up Treasuries, it is not as if the US is suddenly going to face a funding crisis like Ireland. However, just as US Treasury debt has recently become more expensive to service, so has that for US states and municipalities. Here is where things are going to get much more interesting before long.
Relative to the debt crises facing a number of US states, the Irish debt crisis is but a storm in a teacup. California, for example, has an economy nearly TEN TIMES the size of Ireland. New York and Illinois, in comparably dire financial straits, have economies some FIVE TIMES and THREE TIMES the size of Ireland, respectively. All three states are struggling to service their debts amidst rising financing costs. As a result, these state governments are seeking ways to raise taxes and cut spending. But wait a minute: Not only do these states have large debt burdens; they are relatively high tax states; they are growing weakly; they have governments which appear gridlocked and generally unable to take decisive action to reduce spending. Well, what happens if state residents begin to consider the possibility that it might be better just to default than to saddle their families with huge debt burdens? What are investors going to think about that? Will they panic and dump the debt, as they already have done with Ireland and Greece and are now doing with Portugal and Spain?
What about US businesses? Wouldn’t it be better for profitable small businesses or wealthier, higher-rate taxpayers to move to lower-tax states? Indeed, there is evidence that this is already taking place, as the three states listed above have been losing population to lower-tax states in recent years. This, of course, shrinks the future tax base available to service the exponentially growing debt, something investors will no doubt fail to notice.
There is much schadenfreude in the US and to a lesser extent UK financial press regarding what is happening in the euro-area periphery, how poorly-designed the eurosystem is, how profligate member governments have been and how a big blowup is inevitable. But this schadenfreude is misplaced. Step back, take a look at the bigger picture and notice the real and growing similarities between the US and the euro-area. Consider that, when you add state and municipal debts to the federal total, the overall US government debt burden and that of the euro-area are comparable in size. (This is without taking future entitlements into account, which arguably would place the US is a somewhat worse relative position.) Also, when you add in state and local taxes–which are increasing on average–then the overall US tax burden is also comparable to the euro area. However, and this is an important distinction, the US has a huge net foreign debt position–the legacy of years of current account deficits–whereas the euro-area has no such external imbalance. The imbalances in the euro-area are internal instead, as the periphery runs a huge current account deficit with Germany and other core countries, which run surpluses.
When compared according to these important credit criteria, the US economy bears a much stronger resemblance to the euro periphery than to the euro core. Indeed, we would argue that this similarity is growing rapidly as US state and local debt and tax burdens rise; as unfunded federal mandates such as healthcare increase; as stricter regulations for all kinds of business, big and small, stifle traditional American entrepreneurialism and replace it with rent-seeking activities (and associated corruption) at all levels of government.
Although a few more dominoes in Europe are probably yet to fall, there is a huge stack waiting on the other side of the Atlantic. We have written before that we consider it highly likely that the US will face some sort of debt and dollar funding crisis before the end of 2012. The current, rapid pace of events on the euro periphery should not elicit schadenfreude from the US, but rather foreboding.
Early this year, when we published the inaugural issue of the Amphora Report, we listed the three key assumptions behind our core investment approach:
- The dollar no longer provides a safe or reliable store of value;
- There is no obvious alternative to replace it, dramatically increasing regime uncertainty;
- Diversification, the only “free-lunch” in economics, is the best protection against the unknown Subsequent events have only reinforced our conviction in these assumptions. Not only has an increasingly desperate, pathological Fed embarked on a policy of deliberate dollar devaluation–as explicitly mentioned in the recently released November meeting minutes–the euro-area now faces an acute sovereign debt crisis; Japan has intervened to weaken the yen; Brazil and South Korea, among other countries, are increasing taxes on foreign “hot-money” capital flows; and China and India face sharply rising inflation which threatens to derail their booming economies.
Everywhere you look, there are increasing risks to currencies, sovereign bonds, corporate securities and financial assets generally. The problem is, as pointed out above, there is just too much credit risk in the world and investors demand that it be reduced, by crisis if necessary. But how to avoid taking credit risk when even sovereign debt is at risk of default? When the world’s reserve currency, the dollar, is being deliberately devalued? There is only one asset class that has zero credit risk or devaluation risk: Unencumbered real assets. While in principle this includes property owned free and clear, with banks still on the hook for massive losses in residential and commercial lending, most of which are still not marked-to-market on balance sheets, we think it is too early to venture back into the property market. A much safer alternative is liquid commodities that can be traded for other goods, or services, all over the world. These cannot be defaulted on. They cannot be devalued by central banks or governments. As such, in a world of unstable currencies and financial markets generally, a well-diversified basket of liquid commodities provides the best available store of value until the reduction in credit risk has run its course, one way or the other. As global debt levels are still rising, we have a long, long way to go yet.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]