What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece? Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets.

Market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.

All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. The system cannot cope with higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”

They still bought bonds in 2011

2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defense asset.

Amazingly, Treasuries did almost as well as gold (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefited from the disaster in other euro bond markets. They pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). This is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going up.

This cannot go on for long. Bonds are fixed rate investments with finite maturities. The price gains of 2011 have lowered the yields to maturity, in some cases markedly so, and thus diminished the chance of additional gain. Does that mean reversal is imminent? No. Maybe the notion, or better the myth, that the bonds of the United States, the United Kingdom and Germany are risk-free assets can somehow be maintained. Maybe yields can decline even further. Who knows? Personally, I doubt it.

In the case of the US, the fiscal situation seems beyond repair. The Congressional Budget Office publishes its own projections on the long-term fiscal outlook. These are based on some overly rosy economic assumptions and still make for rather grim reading – hundreds of billions of dollars in deficits every year forever. The true path for the U.S.’s public accounts will certainly be much worse. The U.S. has now acquired a habit of running budget deficits to the tune of 10 percent of GDP year after year (more than $1.5 trillion in 2011) and there seems to be no end in sight. There is presently no deflation in the U.S. Neither does the TIPS market expect any. Yet, investors seem happy to hold U.S. government paper at what are certainly negative real yields. Investors are practically paying the U.S. government for the privilege of funding its out-of-control spending.

I have long maintained that government bonds are a bad investment because the endgame for them will either be outright default or inflation. In both cases, as a bondholder, you lose. The outcomes are either default or default. The idea that these debt loads could be elegantly inflated away is nonsense. They are already too big for that. So either you face outright default or, if authorities try to inflate, hyperinflation and currency disaster, and then default. In either case, you will not be repaid with anything of real value.

“Let them eat bonds!”

But are default or inflation and then default really inevitable? What if the present scenario continues forever? This seems to be the new “hope”. It is not a pretty scenario in that it involves the ongoing confiscation of wealth from bondholders but it seems to be less drastic than default or hyperinflation. Could we not work off the excessive stock of debt by suppressing bond yields below (moderate) inflation rates for an extended period of time? Of course, we cannot rely on the self-sacrifice of the bondholder, although he appears rather willing of sacrifice at present. So the government will have to use all its might to force bond-investors into accepting zero or negative returns for an extended period of time. After all, the state is the territorial monopolist of coercion and compulsion. It makes the laws. And controls the banks.

In a state fiat money systems banks must ultimately cease to be private, capitalist enterprises. Many banks have already been fully or partially nationalized. The remaining private ones are under tight, and ever tighter, regulation by the state. Should it not be easy for the state to force banks to invest more in government bonds, even at low or negative real returns? Should it not be possible to redirect whatever saving and credit there is from the private to the public sector?

Such a strategy has been outlined – not advocated- by Russell Napier of CLSA. He calls it ‘repression’. It ultimately involves rather draconian market intervention in order to continuously force the diversion of capital from private use to public use at artificially low levels of compensation. At some stage it will require capital controls.

But let’s face it: most of what we have experienced over the past three years in terms of government intervention would have been simply unimaginable only five years ago. We should therefore not be surprised if market intervention becomes ever more heavy-handed and is used increasingly to favour the funding of the public sector.

That such a policy will be implemented, and ever more boldly, I have no doubt. In fact, I predicted it in my book. See chapter 10 of Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, in particular pages 226 -228. I called it ‘the nationalization of money and credit’. It is a phase in the crisis but it is not an endgame. Where I disagree with the above mentioned writers is the following: Repression, to the extent that it works, will not reduce government debt, and besides, it won’t work.

Consider the recent environment: Certain governments have been able to borrow directly from their central banks via quantitative easing and in the bond market at low or even negative real interest rates. Does that mean they have reduced the amount of outstanding debt? Are such hugely advantageous conditions used to cut back the debt load?

No. The opposite is the case. Access to cheap credit, whether that credit was provided by the printing press, obedient bond investors or hyper-regulated banks, has allowed states to run larger budget deficits and accumulate more debt. Remember, we are not talking here about the workout of a debt-situation resulting from a war, a natural disaster, or some other one-off event. We are talking about the modern welfare state with its ever-growing commitments and increasingly out-of-control spending. Only cutting off the state from cheap funding will ever constrain it, not giving it access to more resources more cheaply.

We do not live in Paul Krugman’s parallel universe of Keynesian fiscal stimulus, where every dollar spent by the government magically translates into 2 dollars of real GDP growth. Here, on planet Earth, the constant shift of resources from private markets to the state bureaucracy weakens the economy. Shrinking the private sector and growing the public sector kills economic growth. In the perverse logic of the modern welfare state. This then requires even more state spending in the next period. As the economy continues to struggle, public sector outlays will grow while tax receipts will shrink.

‘Repression’, to the extent that it succeeds in shifting resources from the private market to the state, makes the crisis worse. It must lead to more debt, more capital misallocation and a weaker economy. We will not save our economy by trampling on the remaining bits of functioning capitalism and by confiscating more resources from the private sector. ‘Repression’ is self-defeating.

Additionally, it won’t work. Private wealth-holders will not sit on their hands forever while their hard-earned savings are being confiscated by the state. If banks become mere tools to fund the state and thus provide zero or negative real returns to shareholders and depositors, shareholders and depositors will pull their money from the banks.

But there is no alternatives for the depositors, is there? Of course, there is: Gold.

As the enemies of gold in the establishment financial press never tire of reminding us, gold pays no interest and no dividend. Because of storage and insurance costs, it is a ‘negative carry asset’. But in an environment of ‘repression’, so are government bonds and bank deposits.

With zero or negative returns guaranteed on supposedly ‘safe’ government bonds and bank deposits, ever more investors, including small savers, will turn toward gold which has the additional advantage that its upside is practically unlimited – its price can double, triple or quadruple (all of which I expect) as long as paper money debasement continues (which I consider a near certainty).

Of course, a determined state will counter any evasion of controls with more controls. Maybe we will see taxes on gold investment or even restrictions on trading and owning gold. Via capital controls the country could be locked down. All of this is, of course, hugely destructive for the economy and ultimately self-defeating. I expect that we will see quite a bit of this stuff in coming years. Try and be prepared!

But this will not be part of the solution. It will make matters worse. And it means that the endgame is still either voluntary default or hyperinflation and default. ‘Repression’ or ‘nationalization of money and credit’ is a policy of desperation. It is not a solution. It won’t be the endgame.

Regards,

Detlev Schlicter

Paper Money Collapse

When the Bond Buying Stops, the Game Is Over was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

While I am pleasantly surprised that many so-called “conservatives” can now spot an obvious bankruptcy when they see it, I am less than impressed with their understanding of what bankruptcy entails for a government. Almost invariably, they naively assume that government bankruptcy is analogous to the bankruptcy of a private company. Just as a bankrupted company like Enron shrivels up and disappears from the economic stage, they assume, bankrupted governments will shrivel up and, if not disappear from the world stage, at least take on severely limited roles.

The bankruptcy of governments is, thus, assumed to be a positive development for individual liberty, according to many so-called “conservatives,” because governments will be forced to live within their means and abandon most of their unsustainable and meddling schemes. A golden age of liberty and respect for the Constitution is assumed to be right around the corner.

This idea that government bankruptcy is a positive development for individual liberty is just plain wrong, however. More than that, it is just plain delusional. Governments are not, in any way, analogous to private companies, and it cannot be sanely assumed that they will shrivel up or disappear like private companies, just because they are bankrupt.

Governments obtain their wealth by “taxing” people, and bankruptcy in no way impedes their ability to seize wealth (unless they, like the Romans, stupidly neglect to pay police and military salaries). On the contrary, their desperate need for money during bankruptcy should be expected to induce them to try to suck even more money out of their subjects than they did before.

And why shouldn’t they? A politician’s job always entails spending other people’s money. Some of this money is seized in the form of taxes from the hapless taxpayers of the country, some is printed out of thin air and some is borrowed from people or politicians in other countries that are too stupid or economically ignorant to know better. When a government goes bankrupt, as Greece and Italy are currently in the process of doing, and the flow of funds from the suckers abroad dries up, the government loses only one of these three sources of other people’s money. It can still tax the daylights out of its own subjects, and it can still print money. What’s to stop it?

The example of interwar Germany is instructive in this regard. As a result of the disgusting Treaty of Versailles following World War I, the German government was made insolvent in exactly the same way that today’s Western governments are insolvent. The gigantic war “debt” foisted on the German government’s books was, literally, impossible to pay off, just as most Western governments today have debts and future liabilities on their books that cannot possibly be honored.

What was the result of this de facto bankruptcy of the German government in the 1920s? Did it automatically usher in a golden age of individual liberty and limited government in Germany in the 1930s? Did the German government stop taxing its subjects or printing money? Did the German government learn its lesson about wasting its people’s money on pointless and extravagantly wasteful wars? (N.B.: If you don’t know the answer to these questions, you are about as bright a “conservative” as Newt Gingrich or Mitt Romney.)

The problem with assuming that governments will shrivel up just because they are bankrupt is that governments, unlike private companies, can still strong-arm people into giving them money, even when they are bankrupt. When Enron went bankrupt, it was not in a position to send armed thugs to the homes of its investors to hustle up more money. Nor was it able to simply print a pile of money in order to pay off its mounting debts. In other words, it went down, as it should have gone down, because it couldn’t force people to keep funding its idiotic and wasteful operation. Government, by contrast, does have a literal army of enthusiastic and sadistic men on the payroll, who will follow orders to kick in doors, bust heads and gas people in order to hustle up money to keep the wasteful operation rolling along. (N.B.: If you think people pay their taxes out of the kindness of their hearts, instead of out of fear that cops will haul them away to the American gulag, you, too, are about as bright a “conservative” as Newt Gingrich and Mitt Romney.)

Moreover, governments are very careful to continuously waste a very large chunk of money on the military and the police. After all, governments claim that their primary purpose is to “protect” their subjects from foreign threats, so they are mindful to spill a nice chunk of their budget on these strongmen when times are good. (Whether government does, in fact, “protect” its subjects from foreign threats can be gauged by the fact that governments often bankrupt themselves trying to fund their militaries. With a “protector” as financially irresponsible as Enron, how much protection are we really getting?)

So when a government goes bankrupt, there exists a giant horde of armed men in the military and police who expect to get paid, and who will not take kindly to budget cuts. Ever mindful that a horde of armed men is a constant threat to the civilian government when they are unpaid and unhappy, the political class should be expected to do whatever it takes to keep paying the salaries of the horde. And where, do you suppose, will this money be hustled up when the government has bankrupted itself and can no longer borrow money from foreign suckers? (N.B.: If you don’t know the answer to this question, you are definitely as bright a “conservative” as Newt Gingrich and Mitt Romney.)

Hustling enough money up to pay the salaries of the military and police (and other privileged and militant bureaucrats, as in Greece) is not always easy, however, because subjects don’t often appreciate having more and more of their money confiscated by wildly irresponsible politicians.

Fortuitously for governments, shaking people down ain’t what it used to be. They no longer need to send their armed thugs to kick down doors, crack skulls and gas their subjects in order to confiscate money. They can simply print money out of thin air and — voila! — now they can make payroll! If their subjects are stupid enough to trust paper money, then why not skin them a little in order to “solve” the government’s problems? Do you really think that an organization with a budget problem that has the ability to print money will not choose to do so for its own benefit? Do you really think Enron would have refrained from printing money to prop itself up if it had had the ability to do so?

The reason so many so-called “conservatives” cannot grasp these obvious and foreseeable consequences of a government bankruptcy is that they do not have a true understanding of what government is. Government is not a private company or a charitable organization. It does not abide by the same laws as the rest of society. It can continue to exist — nay, thrive — even when its debts vastly outweigh its assets and income. It can print its own money and continue to tax its subjects even when it has bankrupted itself. Hence, government cannot be likened to an Enron or a Lehman Bros. as a relatively benign entity when it goes bankrupt. It is an economic vampire that will not shrivel or die easily. It can continue to suck its citizen victims in order to nourish itself even when the absurdity of its balance sheet is evident to everyone.

Hence, if you are a self-identified “conservative” and you are sick and tired or scared to death of the government we have today, you should not look to our government’s impending bankruptcy as some sort of cathartic and purifying event that will usher in a new age of liberty. It will not. More than likely, if history is any guide, the slew of government defaults that are in the pipe in the Western world will usher in a golden age of government.

Government bankruptcy is not a substitute for the hard work of liberty-minded people to advance the cause of freedom. In and of themselves, a thousand government defaults would not advance the cause of liberty one iota. What is needed in the time leading up to the government’s default is a cadre of devoted, almost fanatical, freedom-fighters who are willing and able to teach the masses about the nature of government and the nature of money. Only with the persistent help of this devoted cadre will there be any chance of fighting the growth of government and the devaluation of money that government default will inevitably tow in its wake.

Regards,

Mark R. Crovelli

The Golden Age of Government Is Just Beginning was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In the NYTimes financial section former Chair to Obama’s Council of Economic Advisors, Christina Romer, opined on the lessons to be learned from the Great Depression saying, “It would be a mistake to respond by reducing the deficit more sharply in the near term. That would almost surely condemn us to a repeat of the 1937 downturn.”

According to Romer and Reich, what the U.S. needs is an immediate dosage of inflation and debt. These Keynesian “cures” of endless inflation and debt to fix our economic malaise are offered because there is a profound lack of understanding of what causes a depression in the first place.

The cause of the Great Depression in the 1930s, and the Great Recession beginning in December 2007, was one and the same — an overleveraged economy. Easy money provided by banks eventually brings debt in the economy to an unsustainable level. At that point, the only real and viable solution is for the public and private sectors to undergo a protracted period of deleveraging.

The ensuing depression is, in actuality, the healing process at work, which is marked by the selling of assets and the paying down of debt. Unfortunately, our politicians today are focused on fighting the natural healing process of deleveraging by promoting the accumulation of yet more debt.

During this latest economic contraction, the Federal Reserve has taken interest rates to near 0% for the past two and three years and has just promised to keep them there for an additional two years. Meanwhile, the Obama administration is leveraging up the public sector to record levels in an effort to re-leverage the private sector. The government’s philosophy is tantamount to sticking a frostbitten man in the freezer so he won’t have to suffer the pain associated with the thawing of his extremities.

During the Great Depression, real gross domestic product plummeted 32%. The Great Recession, which we are still struggling through, began in December of 2007. But in contrast to the 1930s, GDP during this recession shrank only 3.6% from the fourth quarter of 2007 through its low point in the second quarter of 2009.

Household debt as a percentage of GDP reached nearly 100% in 1929. Between the start of the Great Depression and the end of World War II, household debt fell from 100% to just above 20% of GDP. To put that number in perspective, household debt did not go back above 50% of GDP until 1985. And it was not until the first quarter of 2009 that household debt once again approached the Great Depression level of 99% of GDP.

Debt reduction is a painful process, but such de-leveraging is the only real cure for an economy swimming in debt. Thanks to government efforts to carry on our debt-fueled consumption binge, during today’s Great Recession household debt has barely contracted at all — it has only been reduced to 90% of GDP as of the first quarter 2011.

To make matters even worse, during this current crisis our government’s response has been to dramatically increase its own borrowing. At the start of the Great Depression, gross federal debt was 16% of GDP. It peaked just below 44% when the Depression ended. While the national debt did increase significantly during that period, it was still relatively benign when viewed from a historical perspective. The U.S. entered this current Great Recession with gross national debt equal to 65% of GDP. It has since exploded to 98% of GDP! Comparing the relatively innocuous level of the 1930s with today’s pile of government debt, clearly illustrates the perilous state of the economy.

National debt did rise dramatically during World War II, topping out at 120% of GDP in 1946. But consumer debt plunged concurrently. So while the nation was adding debt to fight and win a global war, households were taking the necessary steps to ensure their balance sheets were well prepared for the aftermath of the battle.

Today, for the first time in our history, gross national debt and household debt are both at least 90% of GDP.

Unfortunately, many in government–like Mr. Reich–believe the government must spend more while consumers rein in their debts. Their strategy is based on the hope that once the economy perks up, the private sector can unwind that debt. But there are two problems with this Keynesian theory. One is that government spending doesn’t increase GDP; it only chokes off private-sector growth and creates inflation. The other is that politicians never regard the present as a good time for the government to pay down its debts.

The result is that the country is left with a massive level of both private and public sector debt, the latter always leading to an increase in taxes, interest rates and inflation — which causes GDP to eventually contract even further and thus the ratio of debt to economic output increases faster.

Since we have yet to address the real cause of this recession, we are moving inexorably closer to causing The Greater Depression. If policymakers and mainstream economists fail to understand that the progenitor of a depression is debt and inflation, they will also be unable to provide a genuine solution. And the “solutions” they do offer are tantamount to seeking the avoidance of a hangover by forcing down a few more drinks.

Regards,

Michael Pento

Michael Pento is a well-established specialist in the “Austrian School” of economics and a regular guest on CNBC, Bloomberg, Fox Business, and other national media outlets. His market analysis can also be read in most major financial publications, including the Wall Street Journal. He also acts as a Financial Columnist for Forbes and a blogger at the Huffington Post.

Why Bother Working? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“It’s getting increasingly evident that this is a once-in-a-century type of phenomenon,” he told the ever-fragrant Maria Bartiromo in an interview with CNBC this week, “not the standard type of liquidity crisis that we have seen in the past.

“It’s verging on the issue of solvency.”

To gauge the true scale of this crisis, Greenspan went on, just consider the fact that it took sovereign credit to stabilize first the U.K. and then U.S. financial systems. When Northern Rock went belly-up last Sept. and then Bear Stearns blew up this spring, Treasury bonds had to be lent out like adjustable-rate home loans circa 2006, covering short-term black holes with government debt.

Without these loans of government bonds, the banks simply wouldn’t lend to each other. They needed securitized tax payments to gain the credibility needed for raising new funds in the market. Short of offering government debt to put up as collateral, they found the cost of borrowing money — when they found any money to borrow — simply too high to bear.

“It’s still very evident from [inter-bank lending] spreads that we have not gotten closure yet,” Dr. Greenspan continued, pointing to the ongoing premium charged for loans backed by anything other than sovereign credit. So to fix the problem — or at least tease it out for months if not years — clearly the world needs more government bonds for the big banks to borrow and put up against cash loans in the market.

“It’s essentially, fundamentally the price of homes in the United States which are determining…the ultimate collateral of mortgage-backed bonds, pretty much around the world.”

Looking ahead, he concluded that “we’re still nowhere near the bottom of the home-price thing” — the word “thing” standing in for “crash…collapse…crisis…deflation” and all the other phenomena Greenspan must still believe can never apply to real-estate prices.

As key contractor, if not the architect, of today’s pan-global banking crisis, he chose to keep U.S. interest rates way below the rate of inflation — making debt pay and savings a suck of real value — for three years straight starting in August 2002:

That period marked the first run of sub-zero returns paid-to-cash since the inflationary ‘70s, back when loose money worldwide led to a bubble in prices that needed 20% interest rates to revive the world’s faith in the dollar.

The start of this decade also saw the gold price — dormant-to-dead ever since the U.S. took that strong medicine at the start of the ‘80s — double inside five years.

“First warning,” as Marc Faber wrote in his Gloom, Boom & Doom Report of Sept. ‘07, of trouble ahead.

“Ultra-expansionary U.S. monetary policies with artificially low interest rates led to bubbles all over the world and in every imaginable asset class. The price of gold more than doubled in nominal terms and against the Dow Jones Industrial Average.”

So why didn’t gold take a dive when Greenspan’s successor — Ben Bernanke — tip-toed his way back to 4% real rates of interest in late 2006…? Because early gold buyers never believed the Fed would succeed in keeping rates there. With housing now a political issue — and home ownership a god-given right for even the flakiest debtors — the first sign of trouble would cause a collapse in real rates, destroying the value of money in the hope of achieving “Reflation Part II.”

Hey, it worked after the Tech Stock bubble blew up. Why not again? And faced with a much greater crisis, or so Ben Bernanke believes, he’s managed to out-Greenspan the Maestro…pushing real U.S. interest rates way down to minus 3% and worse.

Take gold as a marker of stress, and the true extent of today’s crisis becomes clearer still. Bear Stearns’ firesale to J.P.Morgan in mid-March — which required an open-ended loan of $29 billion from the Federal Reserve — saw gold jump to $1,032 per ounce. We think it’s a signal that Alan Greenspan ignores it.

“Central banks, of necessity, determine what the money supply is,” as he told Congress in a 1999 hearing. “If you are on a gold standard or other mechanism in which the central banks do not have discretion, then the system works automatically.

“The reason there is [now] very little support for the gold standard is the consequences of those types of market adjustments are not considered to be appropriate in the 20th and 21st century. I am one of the rare people who have still some nostalgic view about the old gold standard, as you know, but I must tell you, I am in a very small minority among my colleagues on that issue.”

Today, almost a decade later, the Federal Reserve and its peers across the world are trying to prevent the money supply from shrinking again. That was the fear amid the “Deflation Scare” of 2002, which caused the Fed to ordain sub-zero rates, creating not only the bubble in housing but also the collapse of true money values against oil, food and pretty much all raw materials.

The world’s nostalgia for gold, in response, has seen it treble in price vs. the dollar and more than double against the Euro, Yen and British Pound. But the cheerleader for cheap money when running the Fed, Alan Greenspan points instead to government bonds when gauging the size of today’s crisis. A true policy wonk, Greenspan thinks only of political bailouts to protect the system, rather than considering how private investors might choose to protect themselves and their wealth.

Heaven knows they won’t get any help from Bernanke’s repeat of the Maestro’s “reflationary” error.

Regards,
Adrian Ash
BullionVault
August 11, 2008

The Fed and the Money Supply was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.