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Thursday, May 10, 2012

Bites Of Elephant

Oy.  This is going to be a connect-the-dots article.  I'm going to try and feed you an elephant - one bite at a time.  The first couple of bites:

The US federal government spent $3.8 trillion in 2011.

They took in $2.2 trillion in tax receipts.

They borrowed the other $1.6 trillion.  This is equal to 40% of every dollar spent.  It's called the Federal Deficit.

Of the $1.6 trillion we borrowed, the Federal Reserve Bank (FRB) provided 62% of that, or $1 trillion.  This is called Monetizing Debt.

As Wikipedia explains:
Monetizing debt is thus a two-step process where the government issues debt to finance its spending and the central bank purchases the debt, leaving the system with an increased supply of base money.
The FRB literally created that $1 trillion out of thin air.  They simply pushed keys on a computer.

Again, Wikipedia -
In this latter case where bonds are placed with the central bank, the central bank will create the needed money by conducting an open market purchase, i.e. by increasing the monetary base through the money creation process.

When the FRB engages in this practice of creating money, it's called Quantitative Easing (or QE).

Sounds so civilized and proper.

Just like with any other item, if more of that item is introduced into the market, identical items that currently exist lose value.  With money, this process is called Inflation.  Each dollar has less value, thus it takes more of them to buy whatever you need.

OK, let's digest some of that elephant.  Think of our federal government as a household.  It's in over its head - living beyond its means.  Like an enabling parent, it just can't say "No".  Whichever dead-beat kid asks for a couple of bucks, they get it.

There is no concept of, "Tough Love".  "Sorry, honey, you've got to make your own way in the world now.  You're going to have to get your own housing, your own food, your own condoms, you're own healthcare, your own education, your own clothing."

It sounds so harsh and heartless.  These are not emotions that politicians want associated with their re-election campaigns, so they buy the votes - with your money.  They provide MORE government housing, MORE government food, MORE government healthcare.

Instead of expenditures decreasing to meet revenue, they go in the opposite direction.

Each year that we have a Federal Deficit, that amount is added to the Federal Debt.  Our accumulated Federal Debt now stands at over $15.7 trillion.  That equals more than $138,000 per taxpayer.

But wait!  There's more!  We also have a much less discussed, but massively greater set of social service promises that are going to be damned near impossible to meet.  When you combine the unfunded liabilities (promises) made for Social Security, Prescription Drugs and Medicare, we have another debt of  $118.7 trillion.  Seriously.  That equals more than $1 million per taxpayer.

I believe they will accept personal checks for your portion....

If you looked at the markets over the last couple of days, you'd see stocks and precious metals taking a beating.  Precious metals, in particular, move in the opposite direction of the dollar.  When the dollar gets weak, PMs get strong, and vice versa.  Something is causing the dollar to get stronger.  How can this be?  If the FRB is printing up all of this money, the dollar should be dropping, not rising.

Welcome to the world economy.

The European Union (EU) is crashing.  A number of countries over there are hurting.  Badly.  Collectively, they're called the PIIGS nations - Portugal, Italy, Ireland, Greece and Spain.

Many of you have heard of the riots, etc., going on in Greece.  The government tries to cut back on it's social services promises, and the people are pissed off.  Stuff gets broken and burned.

Over the past few days, we've seen changes in the governments in Greece and France.  Both countries voted in Socialist leaders.  The people have elected politicians that are saying they will not institute the harsh austerity programs needed to balance their budgets.  They'll balance them by taxing the rich (all this sound familiar?).

You may be saying to yourself, "BFD - let those idiots crash and burn.  I don't have anything to do with those European commie bastards!"

Ahh, but you do.

Time to loosen your belt.  Some more bites of that elephant -

Like the US, the countries in the EU borrow to pay their bills.  This is called Sovereign Debt.

Many buyers/investors of this debt want to be assured that they will get all of their investment funds returned to them in case one of these countries defaults on their promise to repay.  To do this, certain companies - usually private banks - issue a sort of insurance policy called a Credit Default Swap (CDS).  If the sovereign debt is not paid as promised, the CDS policies make up the difference.

Worldwide, there are approximately $700 trillion in CDSs.  The 9 largest US banks hold about 1/3 of that balance - $228 trillion [link with awesome graphic].

None of these US banks has any reserves available to pay CDS claims should that become necessary (as it was when Greece defaulted on their debt earlier this year).


Soooooooo, if EU countries default, US banks will go teats up.

Well, they would if the FRB wasn't there to bail them out. Ever heard the term, Too Big To Fail?

The US government simply will not allow these banks to fail.  Ain't gonna happen.

We'll create more money, and pass it along to Europe.

As I noted back in November ("Why You Need To Care About The EU"), here's what I think will happen -
The third option would be to use a third-party bag man to deliver the cash. Oh, like maybe the International Monetary Fund (IMF). We'll dump buckets-o-fiat-currency into the IMF, and they'll pass it off to the EU countries that are gasping for breath.
Along the same lines, the Federal Reserve may open up a big-assed line of credit for the European Central Bank (ECB) to keep things afloat. Same thing as the IMF route, just using a different bag man.
Since we're not currently flush with excess cash to pay for all of this, Uncle Ben Bernanke will flip on his laptop, and just create the needed funds. Expect lots of commas and zeroes in the number.

This will exacerbate the inflationary effects of QE. It's a vicious, vicious circle.  Bad debt begets more debt.  We're trying to borrow our way out of an economy which can't fix itself because the government won't let the rotten parts die.

The EU cratering also makes it likely PMs will still suffer for a while.  How far and how long is anybodies guess.  Personally, I don't think it's going to be much, as I think the market has already priced in the EU crashing.

I could be totally wrong - this could be 100% wishful thinking.

At least PMs (and land) have never been worth zero.  You can't say the same thing about fiat currencies.

OK, Chief, the world is coming to an end.  Now what?  How can all of this debt get unwound?

The plan of the FRB was that by injecting all of this cash into the economy, it would stay afloat long enough for jobs to be created.  With jobs comes spending and taxes.  Sales tax and income tax.  The government would take those taxes, pay down the debt and all would be well again.

BUT, if jobs aren't created, the "plan" won't work.  It can't work.  Consumers make up 70% of our economy.  If you don't have a job, you ain't buyin' stuff.  No income or sales tax.

Our country is like a body wracked with diabetes.  We're over-weight and out of shape.  Some of our toes are losing circulation and need to be chopped off.  But we really, really like those toes.  Instead of changing our lifestyle to improve our circulation, we do something to reduce the pain.  A shot of this numbing drug, or a pill to "take the edge off".

The toes continue to rot.  You don't want to look at them.  They're getting pretty ugly, but you'll just ignore them, and things will get better.  Hey, you were actually able to move your big toe a couple of days ago - things are looking up!

The toes turn black with rot, and it moves up into the foot, calf and leg.  Soon enough radical surgery is needed to try and save what's left of the leg.  But you really like that leg, and just take more drugs.  Keep yourself numb enough, and you don't feel the pain.

The rot is starting to spread.  The other foot is looking gnarly.  Your fingers have lost all function.  More drugs to numb the pain.

And so it goes.  When do you make the decision to chop off the bad parts - and save the body?  Or do you just continue to let the rot spread to the whole?

We've got to get all of this money that coursing through the world's economy, out of circulation.  One way you do this would be to restrict the money supply.  The FRB does this by raising interest rates.  But that's a dual-edged sword.

Raising rates extends to all facets of the economy.  The few qualified borrowers that are out there now would be further reduced.  If you don't have money to grow or maintain your company, you go out of business, or cut back.  Both result in lower taxes for the government.

Additionally, the US Treasury would now need more money to pay the higher rates on T-bills.  Since tax receipts would be reduced because of the tightening of the economy, they'd have to borrow MORE money, digging a deeper hole.

A "pay down" of the debt in this economy - or even a normal economy - will never happen.  We simply can't tax the country enough to make a dent.  I guess if we had enough lame duck members of congress and the White House, we might be able to come up with a budget where expenditures were less than revenues. 

Pigs will fly the same day that budget is passed.

We could nationalize all of the assets of the rich in the country.  As soon as that happened, people would "Go Galt" en masse and the economy would implode.

To pay it off, I can think of only one realistic option. The ONLY way the US Federal Debt will ever be paid off is if our economy goes absolutely crazy.  Unprecedented levels of productivity.  Something to spur the economy that has proven successful in the past.

Like if you had a war or something.  A big 'un.  Hmm.  I can just seem them now in DC:  "Hey, it's worked before.  What have we got to lose?"

You folks know my plan is as much preps as I can store, with the rest in precious metals and productive land.  

If the government continues on its current path, this makes sense.  If we purposely start a massive world war, I've got no idea.  That's some elephant I need to digest...

[Just as I was proof-reading this rather lengthy piece, I came across a "surprise" announcement from JP Morgan (Chase Bank).  It seems that they just took a $2 billion loss.

On CDSs gone bad [link].

Surprise. Looks like someone just burped up a chunk of elephant. ]

Copyright 2012 Bison Risk Management Associates. All rights reserved. Please note that in addition to owning Bison Risk Management, Chief Instructor is also a partner in a precious metals business. You are encouraged to repost this information so long as it is credited to Bison Risk Management Associates.


Andrea said...

Ugh. Ate too much elephant, feeling all bloated.

Nice job explaining it all. I feel worse than ever seeing things explained clearly, but nice job LOL.

Chief Instructor said...

I actually wrote this with the intent of sending a copy to my mom. She's one of the 6 people on earth without an Internet connection, so I've got to go printed for her!

She's at a point in her life where she doesn't care what's going on in the world around her. Her retirement payments keep coming in, so all is good. No understandig that the (pretty sizable) chunk of cash she's got in the bank is losing value.

I tried explaining it to her a couple of weeks ago, and I saw her eyes glaze over. Hence the small, digestible bites. Kind of like a dim sum restaurant - bunches of little bites that turn into a meal...

Adam said...

Yeah, I saw the PMs going down. I'm expecting it to go down a bit more. I also expect the market to remain volatile until around the election. I'm expecting PMs to decrease some as the EU goes down in flames, but once people realize it affects the US, the stock market will go down and PMs will skyrocket.

Chief Instructor said...

Adam, (sorry for the late reply) - my gut says we're at or very near the bottom. The way Uncle Ben's been talking lately, it sounds like another QE is in the works. I think that will keep PMs afloat a bit, even with the EU crashing and burning.

Now, if one or more of the big EU dogs does down - France, Spain or Italy - and goes down hard, we could definitely have another massive dip.

I think Uncle Ben is already passing the fiat dollars to the ECB and IMF to make sure that doesn't happen.