The terminal phase of the game that we are all currently participating in, thanks to your local central social engineering firm (er, uh, I meant central bank), happens to be sovereign debt defaults.
The only open question is whether that default happens suddenly in the form of an actual default (like Argentina in 2001) or occurs a bit more slowly via the back-door default mechanism known as inflation.
You see, the worst-kept secret out there is that it is now mathematically impossible for real debt to be repaid in current dollars, at least not through any hopeful combination of growth and tax increases that a sober person could possibly concoct.
I really thought Jim Rickards of Omnis Research did a very nice job of expressing these ideas in this recent piece (and to whom the title of this report is credited):
April 9, 2010
The sovereign debt crisis has crossed a threshold. It’s no longer about economics. It’s about math and a complex system whose dynamics tell us there is little time to avoid catastrophe and almost no exit. Going forward, elections and policies will matter less as the debt plague takes hold and dictates hard outcomes.
It is the case that real debt cannot be repaid through any feasible combination of growth and taxes. We will soon arrive at the point where it cannot be rolled over. Debt includes contingent liabilities as well as bonds. In the U.S., this means social security, healthcare and housing obligations estimated at over $60 trillion. That does not include unfunded pension obligations of the states whose plans use fanciful 8% growth assumptions to limit contributions. Pension debt grows exponentially; a toxic brew of increased benefits, contribution shortfalls and anemic performance.
Even what we call money is debt. Paper money is a contract between citizen and government. As with any contract, it pays to read the fine print. Embossed on each U.S. bill is the phrase “Federal Reserve Note.” Give the Fed credit for full disclosure; these notes are liabilities. If the Fed’s mortgage assets were marked-to-market the Fed itself would be insolvent. In short, it’s all debt. Wealth is illusory if it involves a claim payable in dollars which are but a claim on an insolvent central bank backed only by its ability to print more debt. The situation is worse in the UK, Europe and Japan. The global financial system is a rope of sand.
The idea that our entire system of money and promises is bankrupt is at once both simple to prove and nearly impossible to internalize and accept. But there it sits, unmoving, and it is our job to come to grips with it as best we can.
For me, it is difficult, because it triggers all sorts of feelings of loss over opportunities wasted and for opportunities yet to be denied. I feel like I'm watching a gifted student slowly throw everything away for a life of drugs.
We theoretically have the time, the resources, and the intelligence to navigate towards a brilliant future of our own design. But the reality is that the defenders of the status quo hold most of the power, and they are hell-bent on ignoring anything and everything that represents a threat to their entitlements and influence. Unfortunately, most of the threats are classified under the category called "reality," which leaves the rest of us in the uncomfortable position of knowing that our 'leaders' are making things steadily worse, not better.
But I digress.
If sovereign default is the closing act, then what would trigger it? I think about it this way:
In 2009, CIT, a very large company that made billions in loans given primarily to small and medium sized businesses, was on the ropes. Desperate for operating cash, they arranged an emergency $3 billion loan package for themselves on July 19th, 2009. On November 1st, CIT filed for bankruptcy protection. I knew this was inevitable at the time, and so did anybody else who understood basic math.
The problem was that the emergency debt that CIT took on in July was at a rate of 10.5%. But their average loan rate to businesses was several percent less than that. Well, borrowing high and lending low puts you on the fast track to failure.
That's just simple math. You can't operate in reverse for very long, and CIT proved it, to the surprise of no one who was paying attention.
I bring up this story because the same sort of math applies to entire countries. One rule of thumb that you will hear repeated a lot in the media, especially surrounding the debt crisis in Greek and the EU, is that the "acceptable" deficit-to-GDP ratio is around 3%. In fact, that number is enshrined in the Maastricht treaty governing the Euro and the EU - member countries are forbidden to operate with annual budget deficits exceeding 3%.
Why 3%? Why not 5%? Or 12%? Have you ever wondered about that? For the past five decades, real GDP growth across the developed world has averaged 3%. If your base economy is growing at 3% and your deficit is also growing at 3%, then you have a situation where the debts remain in proportion to the economy.
Debt growth is exactly matched by economic growth, and so the debt service payments more or less remain constant. In essence, the "3% rule" is nothing more than a "maximum safe borrowing rule," which, if violated consistently, leads to an eventual exponential run-away of debt service payments. If a country had a 10% long-term growth rate, you can bet your bottom dollar that there would be a "10% rule" in effect.
How does this tie in to our CIT story? Imagine now, if you will, that a country finds itself in either of two very uncomfortable situations. The first is that their GDP growth rate is less than their deficit borrowing rate. This is the situation in which the US, UK, Japan, and the EU find themselves. The second situation is that their borrowing rate is higher than their GDP growth rate.
Worse yet, imagine that some poor, unfortunate country finds itself in both situations - its GDP growth rate is less than its deficit (on a percentage basis), and its borrowing rate is higher than its GDP growth rate.
This is exactly analogous to the situation in which CIT found itself. It is a mathematical vice, guaranteed to crush the operating finances of the unfortunate victim.
Now, let's talk about Greece.
If this information [about Greek debt] is correct, it is all over. Bloomberg calculates the yield on the Greek 3 Month as determined by the bid, or where investors are willing to buy it, based on BVAL sources at 21.3%. In all honesty the bid/offer market in the 3 Month are all over the place. The HDAT bid implies a yield of 14.049%, which is still game over for Greece.
Greece is out of operating cash and needs to borrow more to remain a 'going concern.' Unfortunately, the rate at which it must borrow those new funds is significantly higher than its GDP growth rate. Worse, it needs to borrow even more, at a budget deficit of over 8%.
Unless its GDP experiences a miraculous recovery, Greece is now mathematically cooked.
Even with all the talk of austerity and renewed growth aside, there is really only one option, and that's for the EU to bail out Greece by printing up a bunch of money and giving it to them. Of course, I don't mean actual, hard money that comes off a fancy printing press, but electronic money that is fashioned with the stroke of a key and shuffled across fiber optic cables from one hard disc to another. Sounds kind of intangible when I put it that way, doesn't it?
The alternative to this miracle of thin-air money is a failed state within the EU, a situation which I assume is intolerable for a wide variety of reasons, including the impact this would have on the Euro as a monetary unit.
All of this leads me to the assessment that we already have our first sovereign default on our hands and that the official response is precisely the very thing I have been warning about ever since I first started writing about such things: money printing.
To me, this explains the curious strength of gold last week. I assume a few other people are starting to draw the same conclusions that I have drawn. Fiat currencies are ever prone to human weakness, and when a bit of electronic money printing in the morning can prevent a riot in the evening, then you can be as nearly certain as one can be that money printing is what will happen.
And this brings us to the larger set of issues out there. Sure, Greece is in bad shape, but no worse than California, and, over the long haul, no worse off than any other western country.
The next pair of charts tell the story as cleanly and unavoidably as any you could ever hope to run across. The first shows the official net debt of a variety of countries (meaning only government debt, exclusive of private, state, municipal, and corporate debt) while the second shows the condition of the US when all forms of debt, no matter where they exist, are included.
1142% of GDP (!).
Just let that sink in. It's the most poorly kept secret, hidden in plain sight, of our times.
As I mentioned, there is no fanciful combination of growth, spending cuts and tax increases that can close this gap. The conclusion is simple: A decline in living standards is what we face. Government services will have to be cut, as will entitlement spending, and taxes are sure to go up.
Conclusion
I also think that the outrageous amounts of money printing that we've seen over the past two years is only the beginning. More is nearly certain to come, unless we find some politicians who are willing to be martyrs.
All of this forms the core of my investing and wealth management position.
Because I know that we, as a nation, have debts that cannot be repaid, at least in current dollars, I am counting on future dollars to be debased by inflation fueled by more reckless money printing. So I invest in gold. I am also counting on a steep rise in taxes in the future, so I have taken all my long-term capital gains from stocks (some passed down to me from relatives from long, long ago) at the very acceptable capital gains tax rate of 15% and reinvested those monies in things that I think are near-certain to be part of our future landscape, such as higher energy costs (both due to depletion issues as well as inflation) and food costs.
Further, because I am uncomfortable with the distinct prospect of a future banking crisis, I keep much of my money out of the banking system entirely (in the form of gold, silver, and physical cash stored in vaults and safety deposit boxes). What I do leave in the system is spread across a variety of mid-sized, highly rated banks who are less likely to get immediately rocked by an international interest-rate derivative crisis.
So that's the hard part - getting your mind around the fact that the major economies are insolvent. The implications of accepting that statement are enormous and take time to adapt to. Even if you happen to live in a place with slightly better economic prospects than most, such as New Zealand or many South American countries (what a reversal of fortunes!), the ripple effects of these major insolvencies will extend to every corner of the world.
So my central theme remains unchanged. Because the keepers-of-the-status-quo will rather predictably continue down the very same path that led to our current condition of insolvency, it is up to each of us working within our own communities to do what we can to build a better future.
If we wish to have a resilient nation, then we need resilient states, which means we need resilient communities/cities/towns, which means we need resilient households. It's a fractal thing. What we wish to see at the largest level must be visible and present at the smallest level. Said another way, I cannot imagine how we could possibly have resilient communities made up of needy and weak individuals or families. It begins with you.
We must become the change we wish to see.
Here's one fractal example: Because I am concerned about oil availability and pricing in the future, and my house was entirely heated by oil, we've taken steps to reduce our need for oil. We've installed a woodstove, insulated our house, and are in the process of getting solar thermal to heat our water. We will cut our heating oil use by 50% or more. If our entire town did this, then we'd have even more oil savings. If our state did it, massive savings would result. If our entire country took similar steps, then we'd go a long ways towards increasing our energy resilience and cutting our need for imports. I cannot imagine how this could happen without my individual change. That's what I mean by becoming the change we wish to see.
Unfortunately, as evidenced by the triumphant blaring of the recent news that the consumer is back to his/her old spending ways, our official recognition of and support for what needs doing is still a long way from our views of things over here in reality-ville.