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The Daily Reckoning | Thursday, February 18, 2010 Poorly Defending Government Spending Selling a Moonshine Plan in a Pinot Noir Package Joel Bowman Taipei, Taiwan - Before we get into today’s reckoning, a quick public service announcement: No doubt many of you have heard the news. Here at our Daily Reckoning out-out-outpost, in Taiwan, we are already in crisis mode. The shocking details began to emerge late yesterday afternoon, at a time when the importance of an already-fragile consumer confidence simply cannot be overstated. “Pinotpocalypse,” as some commentators (writing for the DR...from Taiwan) have taken to calling it, may well be remembered as the single greatest scandal to rock the wine-drinking community this year. For anyone still unaware of the details of the situation, here’s a brief rundown on what’s known thus far: A French court yesterday found twelve industry figures guilty of exporting inferior quality wine to the United States fraudulently under the Pinot Noir label. It is believed some 18 million bottles of sub-palatable plonk found their way onto US dining tables before the ruse was uncovered. The unnamed shysters, who pocketed millions carrying out their heinous act, were handed suspended sentences and fines ranging from 3,000 to 18,000 rapidly-depreciating euros. At the time of writing, the questionable batch appears to be confined to E&G Gallo’s “Red Bicyclette” label, although it is difficult at this early juncture to fully assess the extent of the damage. Until further information becomes available, your editor has taken the precautionary measure of switching to Australian Shiraz and Argentinean Malbec only. We suggest you employ a similarly protective strategy. It’s one thing to foist a huckster government and a currency of deteriorating value upon an innocent citizenry, but to subvert their confidence in wine? That’s just plain evil. And now, back to our usual musings... The Dow rose about 40 points yesterday. Gold fell a few bucks. The dollar spent the day treading water. Nothing much to report there... But what’s this? It appears that a $787 billion stimulus package ain’t what it used to be, at least according to the Congressional Budget Office. The government’s spending watchdog (yes, such a thing exists) estimates that, all in, President Obama’s stimulus package will end up costing $862 billion, a $75 billion blowout. How did this accounting error come to pass, readers want to know? In painfully predictable fashion, the feds drastically underestimated the cost of unemployment compensation. Who could have guessed? Well, anyone and everyone, really. This is the same government, remember, whose vice president warned that unemployment might breach the 9.6% mark if the stimulus program was not implemented, pronto. That was before the bill was passed...and before “official” unemployment went to 10.2% anyway. Including those workers categorized as “discouraged” and the millions who have taken cutbacks in hours, the real figure is closer to 22%, just 3% shy of the peak rate during the first depression. Vice President Biden, who for some reason is allowed to continue squawking about the issue, defended the stimulus measures in an interview on CBS’s “Early Show” yesterday – the first anniversary of the bill. “We’ve only been halfway through the act,” Biden assured citizens. “The job-creating portions are really loaded at the second half here.” Lest Americans realize they’ve been sold a moonshine plan in a Pinot Noir package, President Obama weighed in to defend the spending. “Our work is far from over,” the president stated in his White House address, “but we have rescued this economy from the worst of this crisis.” How does the president know this? In short, he doesn’t. It’s a guess. And probably a very bad one. Nobody can know what cometh tomorrow, nor can anybody know what might have been. Of all people, President Obama ought to know this better than most. Last year, for instance, he committed more than $3.5 billion of stimulus money to projects that he now wants to cut. How’s that for foresight? According to a USA Today review of stimulus spending: “The president’s budget released this month recommends getting rid of Army Corps of Engineers’ drinking-water projects, which got $200 million in stimulus funds, and a US Department of Agriculture flood-prevention program, which received $290 million from the stimulus.” Why give billions of somebody else’s dollars to moribund projects? Well, because they are somebody else’s dollars, of course. As long as public servants’ salaries keep rising and Beltway budgets continue bloating, who cares about the somebody elses of the world? The obvious problem with spending other people’s money is that, before it’s yours, it’s theirs. Politicians can extort money from their own voters through taxation at home, but where does the rest of it come from? With falling tax receipts (thanks to high unemployment levels), the government must increasingly rely on foreign investors’ contributions to the “somebody elses’ money pie.” The government calls these fundraising fêtes “Treasury auctions.” Unfortunately, foreign somebodies, particularly those in China and Japan, are becoming less and less excited about sending money abroad to finance American drinking water and flood prevention pr ojects. Bill Bonner has more on that below, but first, guest columnist, Puru Saxena, offers some insights on the great bond market scam...including a few safe havens where concerned investors might wish to seek refuge.

The Daily Reckoning Presents Ponzi Scheme

Puru Saxena

Hong Kong, China - Let’s face it, the government-bond market in the West is a gigantic Ponzi scheme. Most governments in the ‘developed’ world are drowning in debt, they are running mind-boggling budget deficits and printing money like there is no tomorrow. Furthermore, under the guise of quantitative easing, their central banks are buying their own newly issued debt!

It is our contention that similar to Mr. Madoff’s hedge fund, the sovereign debt markets in the West have now become gigantic scams. Only this time around, the players have changed and the sums involved are significantly larger.

Figure 1 highlights the incredible expansion in America’s national debt. It is noteworthy that at the turn of the millennium, America’s national debt was less than half of its current value. Put simply, American policymakers have taken on more debt over the past decade than they have over the last one hundred years!

What is more astonishing is the fact that America is funding a large portion of its newly issued debt by direct purchases from the Federal Reserve. In other words, as private-sector demand for US Treasuries wanes, Mr. Bernanke is creating new money so that Mr. Obama’s government can bail out insolvent financial institutions. Strangely, the American establishment is quite content to pledge the economic fate of its future generations in order to protect the bondholders of dubious ‘too big to fail’ corporations. Hmm, talk about change...

Apart from the world’s largest economy, various other nations in the ‘developed’ world are also following such misguided policies. For instance, UK’s national debt is exploding and is forecast to reach GBP1.1 trillion by 2011. At present, its national debt is worth GBP891 billion and this equates to GBP14,304 for every man, woman and child in the United Kingdom!

Elsewhere in Europe, the situation is equally dire in nations such as Ireland, Spain, Greece and Italy. Furthermore, various countries in Eastern Europe are on the verge of economic doom.

Given the precarious state of so many economies in the West, we are amazed that the respective government bond markets have not fallen apart at the seams. Perhaps, they are all heading down Japan’s route, where national debt is now above 170% of GDP, yet the yield on Japanese government debt is pathetic. But then again, perhaps they are not...

In our view, in the not too distant future, the interest payments on the outstanding national debts in the overstretched ‘developed’ nations will become so large that their central banks will need to create money just to keep the Ponzi schemes going. When that happens, the game will be up and we will probably experience a total breakdown of the fiat-money experiment. At this stage, we do not know when the day of reckoning will arrive but we do know that all Ponzi schemes ultimately collapse under their own weight and this one will be no different.

Given the shocking debt overhang in the West and the threat of surging inflation later this decade, we cannot understand why anybody would want to lend money to bankrupt governments!? In the worst case scenario, these naïve bondholders risk losing their entire capital and the best outcome involves a significant loss of purchasing power due to inflation. Accordingly, we are not investing in sovereign debt and we suggest that you refrain from lending money to dubious governments.

Finally, although we are pessimistic about the long-term prospects of government debt, we are aware of the possibility of a near-term rally; especially if there is another round of risk aversion in the financial markets. So, if we do get another deflationary scare and bond prices rally, holders of government debt are best advised to liquidate their positions.

Furthermore, if our world-view is correct, extremely high inflation is now inevitable. As long as the monetary velocity in the US is weak, inflationary expectations will remain subdued, but once the economic activity picks up, the world will experience spiraling inflation. When that occurs, hard assets will protect the purchasing power of your savings. Accordingly, we have allocated a large portion of our clients’ capital to energy (upstream companies, oil services plays and alternative energy plays), precious metals miners and diversified base metals miners.

At the time of writing, precious metals are at a critical juncture and the price of gold is trading above an important support level.

Figure 2 shows that the price of gold peaked at US$1,075 in October 2009 and that level is now acting as important support. Now, if the bull-market’s trend consistency is intact, then the price of gold must rally immediately and challenge its December high. At the very least, the price of gold must hold above US$1,075 per ounce. So, will gold manage to stay above this critical support level?

Before we attempt to answer this question, we must confess that short-term forecasting is extremely difficult and we really do not know what will happen over the following days. However, what we do know is that the macro-economic environment has never been better for the yellow metal. After all, mined supply is in decline, investment demand is rising, the public sector has become a net buyer of gold and hatred towards paper currencies is on the rise. Under these circumstances, we expect gold to perform very well. However, you must remember that the American currency is in rally mode and this is exerting downward pressure on all metals.

Now, if we were forced to take a stand at gunpoint, we would say that the odds of a rally in gold are 65/35. Accordingly, we are holding on to our positions in precious metals mining stocks and may consider lightening up during spring (which is when precious metals usually make an intermediate-term peak).

Now, if gold does the unexpected and breaks below US$1,075 per ounce, then we envisage a deeper correction to the US$1,000 per ounce level. Even if that happens, we will continue to hold on to our positions in gold mining companies, which have already depreciated in the ongoing stock-market correction.

Short-term setbacks notwithstanding, we continue to believe that hard assets are in a secular bull-market, which will probably end in a gigantic mania. According to our guesstimate, the bull-market will end in the latter half of this decade; at a time, when inflationary expectations are spiraling out of control.

Make no mistake, the policy actions of the past 18 months are extremely inflationary and once the American economy stabilises, we will experience a significant increase in the general price level. And before this is all over, government bonds will (once again) be recognised as ‘certificates of confiscation’.

Regards,

Puru Saxena

for The Daily Reckoning