When velocity is low the nation essentially winds up in a “liquidity trap” which is a situation where monetary policy is unable to stimulate the economy either through lowering interest rates or increasing the money supply. This was the condition that Japan found itself enveloped in from 1989 to present. We expect the same problem in this country and hope (really hope) to be wrong. Words: 672

So says Comstock Partners (http://comstockfunds.com) in an article which Lorimer Wilson, editor of www.munKNEE.com, has reformatted below for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article reposting to avoid copyright infringement.)  Comstock Partners go on to say:

Government Debt Replacing Private Debt As the Major Problem
We have been predicting for over 4 years that the government debt (including public, gross, and state and local governments) will increase substantially, while the private debt (all forms) will roll over and decline substantially [and that is what has, is and will continue to happen well into the future].

No Inflation Foreseen in Near Term
Most bears on the stock market are fearful that, [with] the Fed printing so much money, this will result in potential runaway inflation. We, on the other hand, do not think the results of the Fed’s balance sheet increasing through quantitative easing (QE) will result in inflation in the next few years, although it could very well be a serious problem further down the road. We believe the private sector debt will continue to decline (deleverage) regardless of what the Fed and Administration do to attempt to jolt the economy.

The reason that the attempt at money printing to juice the economy will not work, in our opinion, is that the whole private sector is frozen due to the fear of losing more money. Corporations are continuing to build up cash positions and individuals are afraid of taking risk in this environment…

Quantitative Easing Has Failed
The Fed believed that Quantitative Easing (QE) would stimulate the economy but in the current credit crisis QE is not working as well as the Fed and Administration expected. While it has succeeded in jump-starting the monetary base it has failed to increase the money supply or velocity (the ratio of economic transactions to the money supply). Thus, while the banks now have the ability to make new loans, not enough qualified borrowers are interested in borrowing money, and banks are not willing to loan money to anyone that is not a prime borrower.

Velocity of Money is Needed
What we need to stimulate the economy is “velocity” which measures the rate at which money in circulation is used for purchasing goods and services. The velocity of money is computed by dividing the nation’s output of goods and services by the total money supply (circulating currency plus checking account deposits). Velocity of money is also influenced by interest rates. When rates are low, people hold more money in cash, when rates are rising, they put more money in interest paying investments.

A “Liquidity Trap” is Developing
When velocity is low the nation essentially winds up in a “liquidity trap” which is a situation where monetary policy is unable to stimulate the economy either through lowering interest rates or increasing the money supply. This was the condition that Japan found itself enveloped in from 1989 to present. We expect the same problem in this country and hope (really hope) to be wrong.

If we are lucky we will be able to go through the slowdown we expect (or double dip) and repair the household balance sheets enough to grow out of this mess in less time than it is taking Japan.

*http://comstockfunds.com/default.aspx?act=newsletter.aspx&category=SpecialReport&AspxAutoDetectCookieSupport=1

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.

 

The current economic crisis through which the United States is passing has given a heightened awareness to the country’s national debt:

The government’s deficit spending that cumulatively has been increasing the national debt has made the United States that much poorer than it otherwise could have and would have been had the dollar value of these real resources not been siphoned off and out of use in the productive private sectors of the American economy. What has made this less visible and less obvious to the American citizenry is precisely because it has been financed through government borrowing rather than government taxation.

Deficit spending easily creates the illusion that something can be had for nothing. The government borrows “today” and can provide “benefits” to various groups in the society in the present with the appearance of no immediate “cost” or “burden” upon the citizenry. Yet, whether acquired by taxing or borrowing, the resulting total government expenditures represent the real resources and the private sector consumption or investment spending those resources could have financed that must be foregone. There are no “free lunches,” as it has often been pointed out, and that applies to both what government borrows as much as what it more directly taxes to cover its outlays.

What makes deficit spending an attractive “path of least resistance” in the political process is precisely the fact that it enables deferring the decision of telling voter constituents by how much taxes would otherwise have to be increased, and upon whom they would fall, in the “here and now” to generate the additional revenue to pay for the spending that is financed through borrowing. As the recent fiscal problems in a number of member nations of the European Union have highlighted, [however,] eventually there are limits to how far a government can try to hide or defer the real costs of all that it is providing or promising through its total expenditures to various voter constituent groups. Standard & Poor’s recent decision to downgrade the U.S. government’s prospective credit rating to “negative” shows clearly that what is happening in parts of Europe can happen here.

Given current projections by the Congressional Budget Office, the deficits are projected to continue indefinitely into future years and decade, with the cumulative national debt nearly doubling from its present level. In addition, whether covered by taxes or deficit financing, these debt estimates do not include the federal government’s unfunded liabilities for Social Security and Medicare through most of the 21st century. In 2009, the Social Security and Medicare trust funds were estimated to have legal commitments under existing law for expenditures equal to at least $43 trillion over the next seventy-five years. Others have projected this unfunded liability of the United States government to be much higher – possibly over $100 trillion.

The Federal Reserve and the Economic Crisis

The responsibility for a good part of the current economic crisis must be put at the doorstep of America’s central bank, the Federal Reserve. By some measures of the money supply, the monetary aggregates (MZM or M-2) grew by fifty percent or more between 2003 and 2007. This massive flooding of the financial markets with huge amounts of liquidity provided the funds that fed the mortgage, investment, and consumer debt bubbles in the first decade of this century. Interest rates were pushed far below any historical levels.

For a good part of those five years, according to the St. Louis Federal Reserve Bank, the federal funds rate (the rate of interest at which banks lend to each other), when adjusted for inflation – the “real rate” – was either negative or well below two percent. In other words, the Federal Reserve supplied so much money to the banking sector that banks were lending money to each other for free for a good part of this time. It is no wonder that related market interest rates were also pushed way down during this period.

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Market interest rates are supposed to tell the truth. Like any other price on the market, interest rates are suppose to balance the decision of income earners to save a portion of their income with the desire of others to borrow that savings for various investment and other purposes. In addition, the rates of interest, through the present value factor, are meant to limit investment time horizons undertaken within the available savings to successfully bring the investments to completion and sustainability in the longer-term.

Due to the Fed’s policy, interest rates were not allowed to do their “job” in the market place. Indeed, Fed policy made interest rates tell “lies.” The Federal Reserve’s “easy money” policy made it appear, in terms of the cost of borrowing, that there was more than enough real resources in the economy for spending and borrowing to meet everyone’s consumer, investment and government deficit needs far in excess of the economy’s actual productive capacity.

The housing bubble was indicative of this. To attract people to take out loans, banks not only lowered interest rates (and therefore the cost of borrowing), they also lowered their standards for credit worthiness. To get the money, somehow, out the door, financial institutions found “creative” ways to bundle together mortgage loans into tradable packages that they could then pass on to other investors. It seemed to minimize the risk from issuing all those sub-prime home loans, which we now see were really the housing market’s version of high-risk junk bonds. The fears were soothed by the fact that housing prices kept climbing as home buyers pushed them higher and higher with all of that newly created Federal Reserve money.

At the same time, government-created home-insurance agencies like Fannie Mae and Freddie Mac were guaranteeing a growing number of these wobbly mortgages, with the assurance that the “full faith and credit” of Uncle Same stood behind them. By the time the Federal government formally had to take over complete control of Fannie and Freddie in 2008, they were holding the guarantees for half of the $10 trillion American housing market.

Low interest rates and reduced credit standards were also feeding a huge consumer-spending boom that resulted in a 25 percent increase in consumer debt between 2003 and 2008, from $2 trillion to over $2.5 trillion. With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow and consume today. But, according to the U.S. Census Bureau, during this five-year period average real income only increased by at the most 2 percent. Peoples’ debt burdens, therefore, rose dramatically.

The easy money and government-guaranteed house of cards all started to come tumbling down in the second half of 2008. The Federal Reserve’s response was to open wide the monetary spigots even more than before the bubbles burst.

The Federal Reserve has dramatically increased its balance sheet by expanding its holding of U.S. government securities and private-sector mortgage-back securities to the tune of around $2.3 trillion. Traditional Open Market Operations plus its aggressive “quantitative easing” policy have increased bank reserves from $94.1 billion in 2007 to $1.3 trillion by April 2011, for a near fourteen-fold increase, and the monetary basis in general has expanded from $850.5 billion in 2007 to $2,242.9 trillion in April of 2011, for a 260 percent increase. The monetary aggregates, MZM and M-2, respectively, have grown by 28 percent and 21.6 percent over this same period.

In the name of supposedly preventing a possible price deflation in the aftermath of the economic boom, Fed policy has delayed and retarded the economy from effectively re-adjusting and re-coordinating the sectoral imbalances and distortions that had been generated during the bubble years. Once again interest rates have been kept artificially low. In real terms, the federal funds rate and the 1-year Treasury yield have been in the negative range since the last quarter of 2009 and, at the current time, is estimated to be below minus two percent [which] has prevented interest rates from informing market transactors what the real savings conditions are in the economy. So, once again, the availability of savings and the real cost of borrowing is difficult to discern so as to make reasonable and rational investment decisions, and not to foster a new wave of misdirected and unsustainable private sector investment and financial decisions.

The housing market has not been allowed to fully adjust, either. With so much of the mortgage-backed securities being held off the market in the portfolio of the Federal Reserve, there is little way to determine any real market-based pricing to determine their worth or their total availability so the housing market can finally bottom out with clearer information of supply and demand conditions for a sustainable recovery. This misguided Fed policy has been, in my view, a primary factor behind the slow and sluggish recovery of the United States economy out of the current recession.

Federal Reserve Policy and Monetizing the Debt

Many times in history, governments have used their power over the monetary printing press to create the funds needed to cover their expenses in excess of taxes collected,… that is, they have monetized the debt].

Monetizing the debt refers to the creation of new money to finance all or a portion of the government’s borrowing. Since the early 2008 to the present, Federal Reserve holdings of U.S. Treasuries have increased by about 240 percent, from $591 billion in March 2008 to $1.4 trillion in early May 2011, or a nearly $1 trillion increase. In the face of an additional $3.6 trillion in accumulated debt during the last three fiscal years, it might seem that Fed policy has “monetized” less than one-third of government borrowing during this period.

The Fed’s purchase of mortgage-backed securities, however – no less than its purchase of U.S. Treasuries – increases the amount of reserves in the banking system available for lending and since 2008 the Federal Reserve had bought an amount of mortgaged-backed securities that it prices on its balance sheet as being equal about $928 billion.

The $1.4 trillion increase in the monetary base since the end of 2007, from $850.5 billion to $2.2 trillion, has increased MZM measurement of the money supply by $2,161.1, or an additional $769 billion dollars in the economy above the increase in the monetary base. This is an amount that is 83 percent of the dollar value of the $927 billions in mortgage-backed securities.

Due to the “money multiplier” effect – that under fractional reserves, total new bank loans are potentially a multiple of the additional reserves injected into the banking system – it is not necessary for the Fed to purchase, dollar-for-dollar, every additional dollar of government borrowing to generate a total increase in the money supply that may be equal to the government’s deficit. Thus, it can be argued that Fed monetary policy has succeeded, in fact, in generating an increase in the amount of money in the banking system that is equal to two-thirds of the government’s $3.6 trillion of new accumulated debt.

That the money multiplier effect has not been as great as it might have been, so far, is because the Federal Reserve has been paying interest to member banks to not lend their excess reserves. This sluggishness in potential lending has also been affected by the general “regime uncertainty” that continues to pervade the economy. This uncertainty concerns the future direction of government monetary and fiscal policy. In an economic climate in which it [is] difficult to anticipate the future tax structure, the likely magnitude of future government borrowing, and the impact of new government programs, hesitancy exists on the part of both borrowers and lenders to take on new commitments. [Nevertheless,] the monetary expansion has most certainly has been the factor behind the worsening problem of rising prices in the U.S. economy and the significant fall in the value of the dollar on the foreign exchange markets.

The National Debt and Monetary Policy

It is hard for Americans to think of their own country experiencing the same type of fiscal crisis that has periodically occurred in “third world” countries. That type of government financial mismanagement is supposed to only happen in what used to be called “banana republics” but the fact is, the U.S. is following a course of fiscal irresponsibility that may lead to highly undesirable consequences. The bottom line truth is that over the decades the government – under both Republican and Democratic leadership – has promised the American people, through a wide range of redistributive and transfer programs and other on-going budgetary commitments, more than the U.S. economy can successfully deliver without seriously damaging the country’s capacity to produce and grow through the rest of this century.

 To try to continue to borrow our way out of this dilemma would be just more of the same on the road to ruin. The real resources to pay for all the governmental largess that has been promised would have to come out of either significantly higher taxes or crowding out more and more private sector access to investment funds to cover continuing budget deficits. Whether from domestic or foreign lenders, the cost of borrowing will eventually and inescapably rise. There is only so much savings in the world to fund private investment and government borrowing, particularly in a world in which developing countries are intensely trying to catch up with the industrialized nations.

Interest rates on government borrowing will rise, both because of the scarcity of the savings to go around and lenders’ concerns about America’s ability to tax enough in the future to pay back what has been borrowed. Default risk premiums need not only apply to countries like Greece.

Reliance on the Federal Reserve to “print our way” out of the dilemma through more monetary expansion is not and cannot be an answer, either. Printing paper money or creating it on computer screens at the Federal Reserve does not produce real resources. It does not increase the supply of labor or capital – the machines, tools, and equipment – out of which desired goods and services can be manufactured and provided. That only comes from work, savings and investment. Not from more green pieces of paper with presidents’ faces on them.

However, what inflation can do is:

1. Accelerate the devaluation of the dollar  on the foreign exchange markets, and thereby disrupting trading patterns and investment flows between the U.S. and the rest of the world;
2. Reduce the value, or purchasing power, of every dollar in people’s pockets throughout the economy as prices start to rise higher and higher;
3. Undermine the effectiveness of the price system to assist consumers/producers make rational market decisions, due to the uneven manner in which inflation impacts of some prices first and effects others only later;
4. Potentially slow down capital formation or even generate capital consumption, as inflation’s uneven effects on prices makes it difficult to calculate profit from loss;
5. Distort interest rates in financial markets, creating an imbalance between savings and investment that sets in motion the boom and bust of the business cycle;
6. Create incentives for people to waste their time and resources trying to find ways to hedge against inflation, rather than devote their efforts in more productive ways that improve standards of living over time;
7. Bring about social tensions as people look for scapegoats to blame for the disruptive and damaging effects of inflation, rather than see its source in Federal Reserve monetary policy;
8. Risk political pressures to introduce distorting price and wage controls or foreign exchange regulations to fight the symptom of rising prices, rather than the source of the problem – monetary expansion.

What is To Be Done?

The bottom line is [that] government is too big. It spends too much, taxes too heavily, and borrows too much. For a long time, the country has been trending more and more in the direction of increasing political paternalism. Some people argue, when it is proposed to reduce the size and scope of government in our society, that this is breaking some supposed “social contract” between government and “the people” but the only workable “social contract” for a free society is the one outlined by the American Founding Fathers in the Declaration of Independence and formalized in the Constitution of the United States.

The reform agenda for deficit and debt reduction must start from the premise that all men are created equal, with governmental privileges and favors for none, and which expects government to respect and secure each individual’s right to his life, liberty, and honestly acquired property and have as its target a radical “downsizing” of government. That policy should plan to reduce government spending across the board in every line item of the federal budget by 10 to 15 percent each year until government has been reduced in size and scope to a level and a degree that resembles, once again, the Founding Father’s conception of a free and limited government.

A first step in this fiscal reform is to not increase the national debt limit. The government should begin, now, living within its means – that is, the taxes currently collected by the Treasury. In spite of some of the rhetoric in the media, the U.S. need not run the risk of defaulting or losing its international financial credit rating. Any and all interest payments or maturing debt can be paid for out of tax receipts. What will have to be reduced are other expenditures of the government but the required reductions and cuts in various existing programs should be considered as the necessary “wake-up call” for everyone in America that we have been living far beyond our means. As we begin living within those means, priorities will have to be made and trade-offs will have to be accepted as part of the transition to a smaller and more constitutionally limited government.

In addition, the power of monetary discretion must be taken out of the hands of the Federal Reserve. The fact is, central banking is a form of monetary central planning under which it is left in the hands of the members of the Board of Governors of the Federal Reserve to “plan” the quantity of money in the economy, influence the value or purchasing power of the monetary unit, and manipulate interest rates in the loan markets. The monetary central planners who run the Federal Reserve have no more or greater knowledge, wisdom or ability that those central planners in the old Soviet Union. The periodic recurrence of the boom and bust of the business cycle demonstrates that there is no way for them to get it right – in spite of them saying, again and again, that “next time” they will get it right…

The goal should be to move towards a market-based monetary system, the first step in such an institutional change being a commodity-backed monetary order such as a gold standard and in the longer-run serious consideration must be given the possibilities of a monetary system completely privatized and competitive, without government control, management, or supervision.

The budgetary and fiscal crisis right now has made many political issues far clearer in people’s minds. The debt dilemma is a challenge and an opportunity to set America on a freer and potentially more prosperous track, if the reality of the situation is looked at foursquare in the eye. Otherwise, dangerous, destabilizing, and damaging monetary and fiscal times may be ahead.

*http://www.thedailybell.com/2306/Richard-Ebeling-Monetary-Policy-the-Federal-Reserve-and-the-National-Debt-Problem.html

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
• Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.

If you thought Wall Street’s debt crisis was traumatic, wait till you the see the consequences of Washington’s debt crisis! Words: 1085

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com, provides below further reformatted and edited [..] excerpts from Martin Weiss’ (http://www.moneyandmarkets.com) original article* for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article reposting to avoid copyright infringement.) Weiss goes on to say:

Never before in history has a world power like the U.S. been so utterly buried in debt and never before has that debt been financed so massively by foreign investors! The consequences will be dire if history is any guide:
a) 19th century Mexico, Spain, and Argentina accumulated so much debt, they were forced to default.
b) In the 20th century, a similar fate befell Germany (1932) … China (1939) … Turkey (1978) … Mexico again in 1982 … Brazil and the Philippines (1983) … South Africa in 1985 … plus Russia and Pakistan in 1998.
c) Argentina kicked off the 21st century with a default in 2001.
d) Barring a euro zone rescue, Greece, Spain, and Portugal are prime candidates for debt defaults this year.

In none of the examples above did the debts represent[ed] little more than a small fraction of the total debts outstanding worldwide but that is not so in our case today! The United States government and its agencies have the largest pile-up of interest-bearing debts ($15.6 trillion), the largest accumulation of unsecured obligations (over $60 trillion), the largest yearly deficit ($1.6 trillion), and the greatest indebtedness to the rest of the world ($4.8 trillion).

In proportion to the size of its economy, one important country, Japan, does have more debt than the U.S. but unlike Washington’s debts, nearly all of Japan’s debts are financed by its own citizens — loyal, long-term savers who are far less likely to pull out in a storm.

Washington’s debt crisis represents a unique, unparalleled, and unimaginable convergence of circumstances because no one can answer this simple question being asked by former GAO chief David Walker: Who will bail out America? Not you, not me, and not 300 million Americans! Not China, not Japan, nor all the powers on Earth put together! They’re simply not big enough. They don’t have the money.

Despite the utter gravity of our plight, however, nothing is being done to change our course. Congress can not even agree to study the issue. Congress could not vote on a deficit commission so the President appointed a separate commission but it will have no authority to bring its recommendations to a vote in Congress — let alone get them passed. The consequences of this complacency will be catastrophic. To whit:

Consequence #1: Interest Rates will Rise
Due to the avalanche of government borrowing to finance the deficit, there is no power on Earth that can avert sharply higher interest rates. Just a few weeks ago, the yield on 30-year Treasury bonds busted through a declining trend that had not been penetrated in more than 20 years and just last week, it came within a hair of its highest level in over two years. With just one more, ever-so-slight nudge to the upside, all heck could break loose in the Treasury-bond market. You could see a surge in long-term interest rates that will make your hair curl.

What’s so damning about this action in the bond market right now is the fact that it’s coming at the worst possible time and that is why Washington and Wall Street fear it so much. That’s why they’re so anxious NOT to tell you about it.

Consequence #2: Bond Yields will Soar
All long-term bonds — whether issued by other government agencies, corporations, states, or municipalities — will also collapse, driving their yields through the roof because, when Uncle Sam has to pay more to borrow, they inevitably have to pay more as well.

Consequence #3: Rates on Mortgages and Car Loans will Surge
Why? For the simple reason that they’re also tied at the hip of long-term Treasury rates.

If you want to take out a 30-year fixed mortgage (now close to 5 percent) on a median-priced home ($178,300), and you can afford a 10 percent down payment just a 1 percent rise in rates will drive your monthly payment from $861 to $962 and a 2 percent increase will drive it to $1,068 per month. That’s $1200 to $2500 more per year! Worse, if you go for variable-rate mortgages, balloon mortgages, or other now hard-to-get alternatives, the impact of surging interest rates will be even more traumatic.

Consequence #4: Fledgling Recovery will Stall
The fledging recovery in housing and auto sales — the pride and joy of Washington’s bailout brigades — will be toast.

Consequence #5: Long-term Bonds will Plummet
Institutions and individual investors holding piles of lower yielding long-term bonds will get killed. Not all of these holdings are of the long-term variety but most are and investors and institutions who own them on behalf of millions of retirees will suffer shocking declines in the market value of their portfolios gutting their income stream as a result.

Worst of all, we now have some reason to fear the de facto default of the biggest debtor of all — the government of the United States of America – although I doubt very much we will see THAT happen.

Nevertheless, it is quite possible, even likely, that America will lose its triple-A rating and if the Wall Street rating agencies don’t have the moral fiber to announce downgrades, the marketplace will do it for them.

Ultimately, there is NO choice. We must bite the bullet. We must make the sacrifices. Like California and Greece … like every household and any company … our government MUST cut back and accept the rest of the consequences:

Consequence #6: Declining Home Values

Consequence #7: Falling Stocks

Consequence #8: The End of the Recovery

… and many, many more.

Our leaders will eventually face an Armageddon unlike any since the Civil War unless they must either muster the courage — and the support of the people — to accept the pain and make the sacrifices of a lifetime … or face the downfall of America. They will, no doubt, seek every other alternative and try every other trick but, alas, no printing press can run faster than our foreign creditors can sell their U.S. bonds. No one will bail out America.

*http://www.moneyandmarkets.com/armageddon-3-37911 (Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil.)

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With all the attention being focused on whether or not there will be a sustainable recovery in 2010, the potential for a wave of sovereign-debt crises following the wake of the global recession has just recently started to appear on people’s radar screens – and such a wave should not be surprising. Words: 2541

In further edited excerpts the original article* Marius Gustavson (www.mises.org) probes the issue in depth as follows:

Government Debt Crises Follow Financial Crises
As historical research conducted by University of Maryland economist Carmen Reinhart and Harvard University economist Kenneth Rogoff and presented in their book, “This Time is Different: Eight Centuries of Financial Folly”, shows, financial crises are usually followed by government-debt crises. This starts as private debt is shifted onto the balance sheet of the government, through bailouts and purchases of toxic debt. The government-debt problem is then made worse as the economic downturn leads to an increase in expenditures in the form of unemployment benefits and stimulus spending, coupled with a decrease in tax revenues.

Not only does this historical trend align with the American experience in the aftermath of the financial crisis, but it is being replicated in Europe and Asia too. It makes us painfully aware of some of the costs of Keynesian fiscal stimulus, and it clearly displays how a short-run fix turns out to be a long-term problem. The Keynesian long run will dawn upon us much sooner than mainstream economists believe.

The Top Ten Government-debt Issuers Most Likely to Default
So far the looming sovereign-debt crisis — the series of fiscal crises around the world leading to calls for restructuring of public debt and to the potential of outright defaults — has made itself felt most strongly along the periphery of the world economy, not the least along the rim of the European Union. Topping the list is, perhaps not surprisingly, Hugo Chavez’s Venezuela followed by Ukraine, Argentina (where the Kirchner government recently made a move against its own central bank, and is on a fast path toward the third debt crisis in two decades), Pakistan, Latvia, Dubai, Iceland, Lithuania, California (which, alarmingly, has a 19-percent likelihood of defaulting, according to this ranking), and, of course, Greece.

PIGS, PIIGS or PIIIGS – They All Smell Like Bacon
The Greek debt crisis has led many observers to believe a eurozone-wide contagion is in the making, including all of the PIGS — Portugal, Italy, Greece and Spain — and it could spread to the northwestern periphery as well. As Ian Bremmer and Nouriel Roubini recently commented in the Wall Street Journal:

“The current crisis in Greece is only the worst example inside the EU. The PIGS … all boast public debt above or headed for 100% of GDP. Though the PIGS acronym was apparently coined by British bankers, Britain, Ireland and Iceland also smell distinctly of bacon.

So far the two PIGS most afflicted by the European debt crisis, Greece and Spain, blame mysterious foreign conspirators, rather than home-grown macroeconomic mismanagement. Greek Prime Minister George Papandreou expressed the view that the crisis is “an attack on the euro zone by certain other interests, political or financial,” whereas the Spanish government has, reportedly, ordered an investigation into the alleged “collusion” between American investors and the media to hurt the Spanish economy — a policy response that was dubbed “Europe’s crisis of ideas” in a recent Wall Street Journal commentary.

Along the EU’s eastern borders, the Baltic countries were hit hard by the financial crisis and global downturn, as the rapid inflow of “hot money” in the boom years — caused in large part by low interest rates in the eurozone — created a huge potential for currency crises and rising debt in these previously rapidly expanding markets.

The United Kingdom and the United States are Not Immune
In the long run the United States and the United Kingdom could also see their fiscal position severely weakened as well according to a recently released Global Sovereign Credit Risk Report, both countries “have been among the worst performing sovereign CDS” in Q4 of 2009 and that “concerns are mounting about the increase of debt to GDP ratios in UK and USA, 97% and 75% respectively.”

a) The UK
The weakening of the British fiscal position has triggered a political debate on the urgent need for fiscal consolidation. A group of 20 economists, including Kenneth Rogoff, published a letter in the Sunday Times warning that in “the absence of a credible plan, there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.”

Responding to the arguments made by Rogoff and his cosignatories, another group of economists, including the famous Keynes biographer Lord Skidelsky and U.S. economists Brad DeLong and Joseph Stiglitz, published a letter in the Financial Times. They support the decision of the British finance minister, Alistair Darling (Labour) to delay spending cuts until 2011. The letter argues that the “first priority must be to restore growth.”

However, by tightening its fiscal policy too late, the government could make things much worse. Public borrowing, needed to finance the unprecedented peacetime deficit, will crowd out private investment, making an economic recovery even harder, thereby further weakening the country’s fiscal position. This will in turn put pressure on the central bank to “accommodate” public borrowing (i.e., bond issuing) by printing more money. This is one reason why the pound is weakening.

On the suspicion of further depreciation of the pound, foreign holders of British debt will demand even higher yields, pushing long-term funding costs higher, thereby making the debt burden harder to service as interest payments shoot up. This is, in other words, a recipe for fiscal disaster unless drastic measures are taken in the near future.

b) The U.S.
The outlook for America doesn’t look too promising either, as the Obama spending spree has led to a record $1.6 trillion deficit and a 2011 budget proposal that would push the US debt-to-GDP ratio to 77 percent. According to IMF estimates, the debt-to-GDP ratios of the United States and the United Kingdom could reach 100 percent by 2014.

This out-of-control debt spiral is threatening the U.S. credit rating, as reflected in the official bond ratings by agencies such as Standard and Poor’s, Fitch, and Moody’s. The latter recently released a warning that the triple-A sovereign-credit rating of the United States could be downgraded:

Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the triple A government bond rating.

Both scenarios — increased budget discipline and stronger-than-expected growth — however, seem rather unlikely. Even though Obama recently announced his desire for a three-year freeze of discretionary spending, this will only come after a further spending spree and it will ignore the unsustainable growth of entitlements and military spending.

High Levels of Public Debt are Usually Accompanied by Low Growth Rates
As for the growth projections, again Reinhart and Rogoff warn us: history shows that high levels of public debt are usually accompanied by low growth rates. The Obama growth projections are most likely too optimistic, largely because of a fake recovery based on short-run monetary and fiscal fixes, which do not address the underlying problems of the economy’s need to structurally adjust to a postcrisis reality.

A Vicious Cycle
The misalignment of deficits and a growing national debt burden on the one hand, and lower than expected growth rates on the other, could lead into a vicious cycle, whereby investors become ever more reluctant to put their money into U.S. treasuries — up till now seen as “safe havens” in the global economy. This would push bond yields up, creating even more fiscal pressure, as the cost of servicing debt would be higher. This would make bond holders even more reluctant to invest further in treasuries, and so on.

So far, the U.S. government’s ability to raise debt has been helped along by:
1. the bad news coming out of Europe
As financial historian Niall Ferguson explains: “The worse things get in the Euro-zone, the more the U.S. dollar rallies as nervous investors park their cash in the ‘safe haven’ of American government debt.” The same thing happened during the Great Panic in the fall of 2008, as investors rushed into dollars, i.e., U.S. government securities, since they are usually looked upon as a “safe haven” when things get even worse in other developed countries.

2. the “generosity” of the Chinese government
They have invested heavily in US government securities during the last decade, thereby funding large chunks of the annual deficits needed to finance soaring healthcare costs and two expensive foreign wars, not to speak of the explosion in public debt during Obama’s first year. However, the Chinese are growing more and more reluctant to put their surplus export revenues into U.S. debt. Not only are they diversifying their portfolio of foreign securities, thereby reducing the purchases of U.S. government debt, they have actually started to sell off some of their currently held securities.

Last month, the US treasury department announced that “foreign demand for U.S. Treasury securities fell by a record amount in December as China purged some of its holdings of government debt.” Furthermore, this “shift in demand comes as countries retreat from the ‘flight to safety’ strategy they embarked on upon during the worst of the global economic crisis and could mean the US will have to pay more to service its debt interest.”

Is the Greek Crisis Coming to America?
The grim story of fiscal crises afflicting major economies is something that should not be taken lightly. Furthermore, it could happen sooner than most people think if the governments of the U.S. and other debt-ridden countries don’t get their fiscal houses in order. Ferguson recently warned that a “Greek crisis is coming to America,” stating that the U.S. fiscal outlook is not sustainable in the long run.

A Tricky Balancing Act
The above story shows just how precarious the “rescue” programs by the United States and other industrial countries have been in achieving actual, sound economic recovery. Surging debt will create conditions that make it harder for the economy to grow. At the same time, monetary and fiscal stimulus on a level never seen before in peacetime needs to be unwound through monetary and fiscal exit strategies. So far, the proposed exits in the United States — Obama’s budget forecast and Bernanke’s announced exit measures — don’t even come close to tackling the immense troubles ahead.

Exit Strategies Fraught With Pitfalls
If enacted too soon, the exit strategies could set off another downturn, and if enacted too late, they would lead to ever more unmanageable debt burdens, fiscal crises, and low growth. This is the precarious position in which the economy will find itself when put on short-term life-support by the government; economic expectations get intimately tied to government actions. This creates a lose-lose situation in which, whatever the government does, the likelihood of another economic crisis increases by the day.

The managing director of the International Monetary Fund, Dominic Strauss-Kahn, said at the recently held World Economic Forum in Davos, Switzerland, “If we exit too late … it’s a waste of resources, it’s bad policy, it’s increasing public debt, we should avoid this … But if you exit too early, then the risks are much bigger” as this could lead to a “double dip” recession.

Strauss-Khan has been a leading advocate for massive fiscal stimulus, launching this idea at the World Economic Forum two years ago. However, recent developments have clearly demonstrated that, to quote Niall Ferguson, “there is no such thing as a Keynesian free lunch.” In his view, the effects of the stimulus have been much more moderate than expected, and “explosions of public debt incur bills that fall due much sooner than we expect.”

If, on the other side, the authorities of major economies decide to start tightening both fiscal and monetary policy, this could very well trigger a new downturn, the much-dreaded double dip. And if that happens, policymakers have exhausted most of their tools besides monetizing public debt through the central bank’s printing press. To do so would be to follow the path of countries like Argentina and Weimar Germany. This is a scenario that should be avoided at all costs.

A Fake Recovery
Most of the measures initiated in response to the crisis, such as the Fed creating a floor for housing prices through its purchase of $1.25 trillion in toxic mortgage-backed securities and agency debt (i.e., Fannie Mae and Freddie Mac bonds), have at best only delayed inevitable corrections. This program is supposed to end in March of this year, and others have already been terminated or are about to be phased out.

Michael Pomerleano, visiting scholar at the Asian Development Bank Institute, makes the case for letting markets correct themselves, when he says that the “nationalisation of private debt injects considerable inefficiency into the economic system, inhibiting Schumpeter’s process of Creative Destruction that is essential in a market economy and needed to maintain the private sector.”

Japanese Deja Vu
We have seen this all before. In the 1990s, the Japanese government socialized private losses through a massive transfer of private debt to the national balance sheet. This happened in the wake of the Japanese asset bubble — another boom fuelled by a tidal wave of easy money from the central bank — and led to a decade of slow growth and a lack of restructuring of the economy. Whether or not the US economy is “turning Japanese” is still an open question, but is becoming ever more likely as fake fixes are delaying painful economic adjustments. Christopher Wood made the following observation in the Wall Street Journal:

“With the U.S. government stepping in to keep markets from clearing, today’s U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump.”

Conclusion
Soaring debt levels (resulting from fiscal stimulus and low growth) and financial forbearance (socializing private losses) is not a recipe for economic success. In other words, the day of reckoning is already upon us, at least for the PIGS, and it is moving closer by the day for the United States and the United Kingdom.

*http://mises.org/daily/4151 (Marius Gustavson is a research fellow at the Reason Foundation also works for the Norwegian think tank Civita, where he published a book-length report on the causes of the financial collapse. Gustavson is currently writing a book on the global recession.)

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There is no shortage of debate these days regarding the future purchasing power of the dollar—and understandably so. With the recent explosion of the Federal Reserve’s balance sheet, it is easy to understand why many are terrified of the possibility of the kind of rampant inflation often found in banana republics. After all, prices are more or less a product of the money supply and its velocity and the Fed has more than doubled the monetary base since September 2008. Words: 1142

In further edited excerpts from the original article* Nathan Kawaguchi (www.IgnoreTheMarket.com) goes on to say:

Be that as it may, we have not yet seen high inflation because the velocity, or multiplier, of money has gone down by roughly half over the same period. The potential for high inflation is there, however, and this is what folks are rightfully worried about.

To make matters worse, the U.S. was already heading down a dangerous path in regards to budget deficits and an unmanageable mountain of unfunded Social Security, Medicare, and Medicaid liabilities. The stimulus response to the financial crisis only added fuel to an already blazing fiscal fire.

Arguments for Inflation
The strongest risk of inflation comes from rapidly increasing government debt that currently carries a low average interest rate and low average maturity. This is the economic equivalent of an adjustable rate loan because we don’t have the resources to repay principal. Recent data from the U.S. Treasury show an average maturity of about 4.5 years at an average interest rate of 2.5%. This equates to about $165 billion in annual debt service (interest only), which is about 7% of total estimated 2010 receipts of $2.381 trillion. There are three specific factors that could exacerbate this problem and push interest rates higher:
1) Investor fear of dollar devaluation;
2) Rising fear of technical default;
3) Simple supply and demand forces from ever-increasing debt issuance due to the $1 trillion annual budget deficit that is estimated to persist for at least the next decade and the government is notorious for making overly optimistic budget predictions.

Arguments for Deflation
On the other end of the spectrum, we find another large camp of people who believe that massive deleveraging will lead to a second Great Depression. This makes sense because we have a debt-based monetary system in which money is born into existence from debt and, of course, all debt needs not only to be repaid, but repaid with interest. As debt is destroyed through repayments and defaults, the money supply is also destroyed. Lower money supply leads to more defaults and more debt destruction, and the vicious cycle continues. This was at the heart of the Great Depression. It is easy to understand why Ben Bernanke, a student of the Great Depression, made the decision to flood the market with liquidity in response to the financial crisis.

Other strong arguments for deflation are the rising unemployment rate and potentially higher tax rates to pay down ballooning debts at federal, state and local levels. Both of these would have the effect of lower total discretionary income, which would decrease demand for goods and services.

So Which Will It Be?
In a world of self-proclaimed experts, almost everyone with an opinion is firmly in one camp or the other. In fear of appearing indecisive or incompetent, many overlook the most rational answer: I don’t know. Since when did it become so shameful to admit that we don’t know what the future holds?

There are very compelling arguments for both inflation and deflation. The answer will eventually depend on decisions made in Washington and how people react to those decisions. For now, let’s stop fooling ourselves and admit that we don’t know. It is a problem that has to be dealt with and there is no easy medicine. Either path will be painful, but that’s what we get for our two and a half decade debt binge.

How Can We Protect Ourselves?
Once we admit that we don’t know what the end result will be, we can focus on how to protect ourselves based on a range of different outcomes. Investors and savers should focus on the likelihood that different outcomes will materialize and also look at the resulting consequences if they don’t and the more uncertainty there is, the more they should diversify.

Because there are such strong arguments on both sides, it may be wise to diversify your risks and build a portfolio with exposure to both outcomes. One word of caution here: even if we did know the end result, the ability to profit from it is diminished because we don’t know the timing of the end result. If we are, indeed, heading down the path of a banana republic, it may not come to fruition for another decade or longer. Conversely, the deflation scenario may be long and drawn out, much like in Japan.

If you are concerned more about inflation, you may want to favor things such as:
1. commodities and other hard assets
2. real estate
3. foreign denominated assets
4. businesses that are paid in foreign currencies
5. floating rate debt.

If you are concerned about hyperinflation, you may even consider:
1. gold and silver coins. However, the problem with these and other commodities is that they produce no cash flows and so value investors cannot estimate their intrinsic value. The return is completely dependent upon the resale price. In other words, this would be a form of speculation. It is a speculation on a bad outcome and a further speculation that these assets will protect you from the bad outcome.

If you find yourself more concerned about deflation, then the choice is easy:
1. You will want to hold a lot of cash and invest in U.S. denominated assets.

Conclusion
There is no better way to protect against both inflation and deflation than to be a value investor. Buying cheap assets and cheap cash flows can build and protect wealth in any environment – it protects on the downside and amplifies the upside.

When no opportunities exist with a sufficient margin of safety, value investors are content to hold cash—and perhaps a little hard cash (gold and silver) as speculative insurance against the unknown.

*http://seekingalpha.com/author/nathan-kawaguchi/instablog (Nathan Kawaguchi is a Research Analyst for IgnoreTheMarket.com which provides independent, value-based stock and mutual fund research, a blog, and acts as a hub for value investing information and research.)

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The inherent deficiencies in our system virtually guarantee that long-term implications of massive debt will be ignored. Unfortunately, the “long-term” may finally be upon us, and a dollar collapse of shocking proportions is increasingly likely. This Depression is just getting started. Words: 1011

In further edited excerpts from the original article* Moses Kim (www.expectedreturns.net) goes on to say:

The value of a currency is determined by a number of variables. In this article, I will focus on the dynamics of demand, supply, current account deficits, and aggregate government debt.

Demand for Dollars
The dollar has enjoyed a boost in demand and an exchange rate premium due to its privileged role as the world’s reserve currency. As a function of this status, world trade is, for the most part, transacted in dollars. However, recent developments on the periphery have slowly undermined the dollar’s dominant position in global trade.

World trade in dollars has been declining since the start of the decade. Recent currency swap agreements between countries, mostly involving China, have been used to bypass the dollar in global trade. Arrangements such as these threaten the dollar’s role as the global reserve currency, removing any support to the dollar’s value such an arrangement provided. This decreased demand is clearly reflected by a falling percentage of foreign reserves held in dollars.

Further, in a low interest rate environment, the dollar has become the carry trade currency of choice. Investors have long been waiting for a powerful countertrend rally in the dollar, but as the example in the yen shows, prolonged weakness in carry trade currencies can and do occur. Also keep in mind that alternative assets, such as gold, become much more attractive in an environment where yields are essentially 0%.

Massive Supply
It’s been well-documented that the Fed has embarked on a campaign of massive monetary stimulus. Unfortunately, it’s hard to quantify the extent of money supply growth, since the government has stopped reporting M3 money supply figures.

The real problem brewing under the surface are accumulating bank reserves, which can be thought of as a proxy for risk aversion. Once these reserves are deployed, expect inflation to increase significantly. Sooner or later, banks will have to focus on their core business, which is lending to consumers.

Current Account Deficits
Current account deficits are the quantifiable measure of a country’s profligacy and overconsumption. Current account deficits are historically a short-term solution to a nation’s underproductivity, which must eventually be settled through the balancing of capital and current accounts. As a nation continually funds consumption via debt, its currency naturally becomes less and less valuable as a medium of exchange.

Current account deficits as a percent of GDP in the U.S. have exploded to troubling levels, especially since President Nixon removed the last vestiges of our link to gold in 1971. Over the long run, the value of a currency is inversely correlated to the level of current account deficits. Persistent imbalances in current account deficits will weaken a currency without exception. The downward trend over the last decade in the dollar evidences the detrimental effect of long-term current account deficits. Gold, as an alternative to the dollar, has risen in response to rising current account deficits.

U.S. Government Debt and the Treasury Market
Moving forward, the Treasury market will inordinately dictate major moves in the dollar. Before I explain why, I want to briefly overview the relationship between treasury debt, inflation, and the value of the dollar under the Maestro, Alan Greenspan.

The “great moderation” in the Greenspan years was facilitated by the recycling of dollars into our capital accounts such as stocks, treasury debt, and agency debt. This meant that inflation was temporarily stifled as dollars were sterilized in debt instruments, while asset prices received a jolt from the attendant low interest rates. Furthermore, the tremendous demand for U.S. capital products proved to be supportive of the dollar. If there ever were a period of getting “something for nothing” in America, it was during this era of massively inflated asset prices, and moderate consumer price inflation.

Now what happens when our debt grows to a level that forces the government to become a major player in the bond market? Foreign actors will start unloading their treasury debt, especially on the long end of the yield curve, to an increasingly overburdened government. As demand for Treasuries falls, yields will rise, which makes the burdens of servicing debt greater.

The monumental and ever-increasing level of debt the government has directly taken on through its program of quantitative easing is troubling. The reason is simple: in an inflationary environment, the Fed will be inhibited from containing inflation by selling bonds in the open market, and thereby, soaking liquidity from the system. Due to the sheer size of our program of monetization, any move to sell treasury instruments will likely be met with panic from foreign investors. This is something to keep in mind moving forward.

Total Debt Including Unfunded Liabilities
Now we come to the elephant in the room: aggregate government debt, including unfunded liabilities. Decades of kicking the debt-can down the road in Ponzi scheme entitlement programs, like Social Security, has created a behemoth of debt that is quite literally unpayable. Absent a growth miracle, and a bigger miracle of fiscal austerity by our government, there is no way we can fund these accruing liabilities through our dwindling tax base… If recent government actions are any indication, our government will attempt to mask insolvency through the printing press.

A weaker dollar poses tremendous complications for Americans. For one, it makes imports more expensive, which is effectively inflation. Ultimately, this means a standard of living lower than what we have come to expect. If confidence in the dollar totally erodes, then things will really get ugly.

*http://expectedreturns.blogspot.com/2009/09/case-for-depression-part-4-dollar.html

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By bailing out bankers, brokers and CEOs, Washington has created the most dangerous bubble so far: the enormous and rapidly growing explosion of federal debt — U.S. treasuries — dumped on investors worldwide. You don’t need a PhD in economics to know what’s next. Like the tech bubble and real estate bubble that preceded it, this new bubble will also burst, wiping out trillions more dollars of invested wealth. Words: 770

In further edited excerpts from the original article* Martin D. Weiss (www.uncommonwisdom.com) goes on to say:

There are 3 compelling reasons long-term bond prices MUST crash:

Reason #1: Exploding Federal Deficits
The 2009 budget deficit of $1.4 trillion was the worst in history — more than three times larger than the previous record and the Congressional Budget Office (CBO) has projected that, rather than shrinking, the 2010 deficit will be $1.4 trillion. Worse, Washington will sink a total of $7.4 TRILLION deeper in debt over the next ten years.

The White House’s Office of Management and Budget (OMB) quickly disagreed, pegging the 2010 deficit at $1.6 trillion and promising an $8.5 trillion gusher of red ink over the next decade.

The New York Times quickly chimed in, pointing out that about 80 percent of the government’s deficit forecasts over the past three decades were too optimistic. In fact, just two years ago, the CBO said the 2010 deficit would be $241 billion. Now it’s likely to be at least $1.6 TRILLION — or over SIX TIMES MORE. Imagine if the government’s current ten-year debt estimates — already over $8 trillion — turn out to be equally far off-target! Of course, that would be impossible. Bond investors would simply stop lending Washington money long before that could happen.

Reason #2: An Explosion in the Supply of U.S. Treasury Bonds
It would be bad enough if Washington only had to borrow enough to equal each year’s budget deficits but Washington also has to borrow enough to replace Treasuries that are maturing — and that means an even greater avalanche of Treasuries need to find buyers each year.

Total issuance of government debt hit a stunning $922 billion in 2008 and then surged even higher to $2.1 trillion in 2009, and it’s on track to top $2.5 trillion this year. The size of just ONE WEEK’s debt auction has ballooned to almost $120 billion — more than the total supply hitting the market in a FULL year not long ago.

The laws of supply and demand dictate that when you get a massive increase in the supply of anything, its value plunges — and Treasury bonds are no exception.

Reason #3: Global Investors Starting to Rebel
So far, given the realities above, the U.S. treasury market has proven to be remarkably resilient because, in the global competition for investor funds, U.S. Treasuries are typically viewed as the “least ugly” alternative for many investors. That is why, so far, most foreign investors — now holding about 60 percent of all marketable U.S. Treasuries — have been willing to pay a relatively higher price for them and accept lower yields but now even that is changing! China, the single largest holder of U.S. debt, recently dumped more Treasuries than in ANY month since the government started tracking the data in 2000. The 30-year auction was especially pathetic. Indirect bidders — mostly foreign governments and investors — took down just 28.5 percent of the bonds sold, compared to a ten-auction average of 43.2 percent percent. Prices slumped and yields surged as a result. In effect, the U.S. Treasury had to bribe investors with higher yields to get them to buy.

Immediately alarm bells began ringing at the Fed. [In mid-February] the U.S. Federal Reserve raised the discount rate on loans made directly to banks by 25-basis-point increase which was the FIRST hike in the discount rate since early 2006.

Secretly, the Fed is in a panic to ward off a bond market collapse! They know that, sooner or later, they MUST send the message that they’re serious about cutting back on their mad money printing. The danger of course, is that foreign investors will get an entirely different message: that Washington’s efforts to fight the most severe recession since the Great Depression are waning. If that happens, you could see turmoil — not just in the bond market, but in every asset class imaginable.

*http://www.uncommonwisdomdaily.com/on-the-brink-of-a-bond-market-apocalypse-3-8479 (Uncommon Wisdom is a free daily investment newsletter from Weiss Research analysts offering the latest investing news and financial insights for the stock market, precious metals, natural resources, Asian and South American markets.)

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
- Sign up to receive every article posted via Twitter, Facebook, RSS feed or our Weekly Newsletter.
- Submit a comment. Share your views on the subject with all our readers.
- Buy the book below from Amazon. It’s pertinent to this article and inexpensive too.