I’m From the Government and I’m Here to Help You

Below, find an excerpt from my December “Moving Markets” newsletter, for a full copy free, click here:  www.usawealthmanagement.com:

To give credit where it’s due, much of the inspiration for this section of the newsletter came from a special report authored by economist John Williams who published one of the many newsletters, magazines and periodicals we read monthly.

There have been many bright folks who have made many compelling arguments that the current state of the economy was brought about by government policies and the reaction of the Federal Reserve to the consequences of these policies. Specifically, as the US economy moved away from a manufacturing economy toward a more consumer spending dependent economy, the Federal Reserve promulgated policies that artificially created economic growth at the expense of future production. In short, much of the reported economic growth of the last decade was fueled through debt expansion. Ironically, our current politicians continue to use this same strategy in an attempt to solve the current economic problems as they continue to spend and borrow against future production.

To fully understand this concept, it’s important to embrace the concept that the US Dollar is nothing more than debt. Our currency used to be backed by a hard asset – gold. Not anymore. Now the dollar is backed by the belief the US Government will have the ability to collect future tax revenues. Using this definition, a US Dollar is nothing more than a loan against future US production.

The greater the US deficit and ultimately the US debt becomes, the larger the loan against future production becomes. At a certain point other countries around the world may look at the financial condition of the United States and come to the conclusion we’ve borrowed too much against future production, doubting our ability to produce enough to pay back the money we’ve already spent. While that day is probably a little ways off, due to the high amount of government spending and money printing, we believe that day is much closer than many may think.

In a recent report, economist John Williams argues that the US Government and the Federal Reserve have made the decision to sacrifice the US Dollar. Federal deficits are running at record levels. Last year, the official US deficit was $455 billion. Yet, when GAAP accounting standards are applied to the government’s books, one gets a much different number. GAAP accounting procedures are the accounting standard that major US corporations use. These accounting rules require that liabilities for retired employees’ pensions and health insurance be reported on the financial statements of the corporation. Yet, the government doesn’t use the same standard.

During the Bush Administration (and probably during the Obama Administration too), the Administration argued that unfunded liabilities of Medicare and Social Security should be left off the nation’s balance sheet because those programs could be changed should the government elect to change them. Given the hesitancy to reduce government spending for anything, especially these programs, the notion government will reduce spending in these areas seems about as likely as “The View” going prime time.

Using GAAP accounting standards, the government’s 2008 deficit is far more than the $455 billion reported. Using GAAP standards, it becomes obvious we’re in deep financially, so deep it may be extremely difficult for the US to recover. The GAAP based 2008 deficit was $5.1 trillion according to Williams in a report published on December 2, 2009. The 2009 shortfall likely was around $8.8 trillion rather than the cash based, reported $1.4 trillion.

And now, with Washington considering another stimulus package and a healthcare bill, both of which will likely be costly, the Treasury department has elected to delay publishing the GAAP based 2009 financial statements for 2 months, until February of 2010. That timing is purely coincidental right?

According to Williams’ report, using GAAP based accounting standards, even if the IRS confiscated 100% of all wages, salaries and corporate profits the government would still be operating at a deficit. Or, to look at this really grim situation another way, considering only current revenues, if the government stopped spending every penny other than for Social Security and Medicare, it would still be operating at a deficit.

The following chart shows total federal obligations as a percentage of Gross Domestic Product.  Gross Domestic Product is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. When you look at the chart, simply stated, it ain’t pretty. While total federal obligations have been out of control for a long time, obligations to production have recently spiraled out of control also.

 This year total federal obligations are now over 5 times Gross Domestic Product.  We’ve dug ourselves a hole that will be difficult, if not near impossible to dig out of. Before you dismiss what I’m saying as ‘out there’, take a look at the following graph.  It shows who is buying US Debt, in other words, who is helping us finance what I consider reckless spending.

Note that in 2004, all debt sold by the US Treasury was purchased by foreign investors.  Through 2007, 70% of all debt issued by the US Government was purchased by foreign investors. However, given the massive growth in the reported deficit and the GAAP standard deficit, foreign investment is waning.  In 2009, only 20% of US Government debt was purchased by foreign investors.  Who bought the rest?

A good portion was purchased by the Federal Reserve. Succinctly speaking, the Federal Reserve decided back in March to guarantee a market for US Treasuries when they made a decision to buy US Government debt in an effort to stimulate the economy, virtually guaranteeing a weak dollar.  Refer to the US Dollar chart on page 2 again to review the dollar’s performance since the fed’s decision.

Why aren’t foreign investors buying US debt like they used to?  Think they can do the math too?  Think they’re pretty sure we’re in too deep too?

Our view has been and continues to be that we’re in a deflationary environment.  Excessive debt in the system is typically deflationary and causes prices to fall.  However, given the current set of facts and circumstances, we are of the opinion there is a high likelihood this deflationary environment could quickly transform into a highly inflationary environment.

Here’s one potential scenario.  Since the Federal Reserve is the buyer of last resort for US Treasuries should significant or even panicked selling of US Dollar denominated assets occur, the Fed would likely be forced to buy the assets.  This would result in the Federal Reserve monetizing the debt – simply printing money to buy back debt.  The dollars used to repurchase this debt, however, will be worth far less than the dollars were worth when the debt was sold.  These new dollars would buy far less than the old dollars resulting in inflation, most likely significant inflation.

In such an environment, precious metals like gold and silver and investment in foreign currencies may potentially help investment returns and perhaps even more importantly, help us maintain buying power. While a weakening dollar might help market performance nominally speaking, in terms of real performance (adjusted for the value of the dollar), performance will likely lag.  Look at the chart below (Source: John Williams, Shadow Government Statistics)

The red line on the chart illustrates the actual performance of the Dow Jones Industrial Average while the blue bar chart represents the performance in constant dollars.  Reviewing the chart, one comes to the conclusion that with constant dollars, this rally may not be a rally at all.

While the US Dollar may be ready for a bit of a rebound albeit temporary, we also believe the long term fate of the US Dollar may be sealed. It is this anticipated rebound of the dollar that may act as the catalyst for the market correction we believe still may come. A rapidly weakening dollar may prevent it, but that brings with it its own set of problems.

Securities offered through USA Advanced Planners (Member FINRA/SIPC).  Advisory services offered through USA Wealth Management. USA Advanced Planners and USA Wealth Management are affiliated companies.  The opinions expressed herein are those of the writer and not necessarily that of the above noted affiliated companies. This update may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. The information obtained from third party resources is believed to be reliable but the accuracy cannot be guaranteed.

This information is education in nature and, therefore, is not intended to constitute investment advice and should not be interpreted as a recommendation to purchase, sell or hold a particular security. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal situation of each individual investor.  Investing in market related securities involves a risk of principal loss