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The Daily Reckoning | Tuesday, July 6, 2010 Global markets begin coming to grips with the post-stimulus mess, Here comes the "D" word again...and it ain't "double-dip," Plus, Bill Bonner on gold as insurance AND speculation and plenty more... Why Debt Does Matter Two reasons why the US will not “grow” its way out of recession Bill Bonner Reporting from Baltimore, Maryland... On Sunday, we celebrated America's independence from Britain. Having just come from London, it's hard to see what the fuss was all about. The English seem like decent people. The queen still has her dignity. The British government seems no worse than its American counterpart. And David Cameron appears to have a much better idea of what he is doing than the Obama team. Cameron is calling for 'austerity.' He wants the British public to make sacrifices so that British public finances can be brought back under control. We have some doubt that he will succeed. As far as we know, no democratically elected government has ever been able to reduce its debt burden DURING A CREDIT CONTRACTION. A number of governments - including the US and Britain - managed to reduce their debt in the '80s and '90s. But that was when their economies were booming. As long as the economy is growing faster than the debt, the burden of debt will decline as a percentage of GDP. The '80s and '90s were boom years. Credit was expanding. People were buying more and more things they didn't need with more and more money they didn't have. Obviously, that kind of boom can't go on forever. And when it came to an end in 2007 it changed the financial picture for governments as well as households and businesses. Tax revenues went down. Expenses went up. And so did the bailouts and boondoggles that they call 'stimulus' spending. As deficits rise, so does debt. And so do the voices who tell us that debt is nothing to worry about. Those voices - led by Paul Krugman at The New York Times - mention the debt decline of the '80s and '90s. They say we can "grow our way" out of debt this time, just like we did the last time. Here at The Daily Reckoning we don't rule out anything. The day is long past when we said anything with absolute, unshakeable conviction. Today, even when someone asks us our name, we check the initials on our undershirt just to be sure. Might the US and Britain 'grow' their way out? Well, anything is possible. But two things make it unlikely. As we said above, we're in a credit contraction. It's part of what we call the Great Correction. Growth rates are going to be low...and occasionally negative. US government deficits, on the other hand, are scheduled to be over 5% of GDP from here to kingdom come. And if David Stockman is right, they could stay over 10% of GDP for the foreseeable future. Stockman is the former head of OMB during the Reagan Administration. He predicts deficits as high as $2 trillion per year, thanks to a weak economy and strong spending by the feds. The second thing that makes it unlikely that we will be able to grow our way out of debt is the composition of the economy. More and more of it is under the control of government. 'Growth' in this economy is largely phony. It reflects activity. But not prosperity. The activity, therefore, is not the sort that you can tap to pay down your debt. Instead, it adds to the debt. You can see how this works just by imagining what would happen if the feds hired a million census takers. The economy would appear to 'grow' - maybe even faster than the debt. But the economy itself would be hollow and less able to sustain the debt burden. The other example used by Krugman et al is WWII. At the end of the war, US debt was equivalent to what it is today, as a percentage of GDP. "Hey, what's the big deal? It didn't do us any harm then," they say. But the federal government was actually in a much stronger financial position back then. While it had about the same official national debt, it faced almost no off-the-books unfunded liabilities, financial guarantees, and open-ended commitments. The last time we looked, these off-balance sheet debt items - such as for health care programs - totaled more than $50 trillion. And then, there's the private sector debt too. That's about $50 trillion too. How much net private debt was there in 1950? Almost none. In the post-war period we were in a different stage of the credit cycle. People were just beginning to spend. They didn't have a mountain of debt. They had a mountain of savings! Yes, dear reader, people made sacrifices during the war years. They had put off consuming. Then, soldiers came back from Europe and the South Pacific with pent-up demand, and real savings that they could put to work. So, the economy was ready for a credit expansion, not a contraction. People had lived through the lean years. Now they were ready for some fat ones. The economy too was ready to rock and roll. It had been converted to a war footing. Now it was ready to meet consumer demand. This is the opposite of the picture today. Few sacrifices were made over the last 50 years. Instead, the last 5 decades were a time of increasing extravagance. That's why sacrifices are necessary today. Households are only now beginning to cut back. Governments in Europe are cutting back too - or so they say. And under the sway of Krugman and other neo-Keynesians, the US government continues to run huge deficits...hoping that the debt will be refinanced and repaid, as it was after WWII. But probably the nicest thing about after WWII was that there was an AFTER WWII. The war had a beginning and an end. When it was over people were finally able to get on with their lives. The economy was ready to switch to a new phase too - from making tanks to making hot water heaters. And, finally, governments could stop borrowing and begin repaying their debt. The major trouble with today's struggle is that there is no end in sight. The Daily Reckoning Presents V-Shaped Recovery, Where Art Thou? by Bill Bonner This week was largely spent watching the recovery fall apart. Not a dramatic collapse. No market crash yet, for example. But the important indicators are giving way. On top of the bad news from housing and employment over the past few weeks, Richard Russell's famous PTI indicator finally dipped into negative territory - signaling a bear market. And the Baltic Dry Index - a measure of world trade - continued to fall. No new buyers are coming into the housing market. No new jobs are being created. Consumers are still de-leveraging. Banks are still reluctant to lend. And businesses are still loathe to expand in the face of an economy-wide de-leveraging. Automakers say they see no sign of recovery. Investors are spooked by the thought of a double-dip recession. And 10-year US Treasury notes are selling at the lowest yields in 14 months. To make matters even more unsettling, the world's governments have pledged to reduce their countercyclical spending. They won't get an argument from us on that score. They are doing the right thing. But if they follow through, it will result in the private sector and the public sector de-leveraging at the same time. This is highly deflationary. Countercyclical spending cannot stop a correction. But pro-cyclical tightening may be able to trigger a depression (as Treasury secretary Andrew Mellon's drive to balance the budget did from 1921-1930). Let me put that another way. Governments can't make bad debt go away. So they can't prevent a correction and a de-leveraging; they can only delay it. One way or another excess debt needs to be reckoned with. But when the authorities begin to tighten at the same time that the private sector is tightening, the effect will push the world into a sharper, deeper correction...even into a depression. This is a dangerous situation. This period of price deflation and debt destruction could be more dramatic than we expected. Seen through this lens, cash and gold seem preferable to stocks. The goal is not to lose money while waiting for the next great opportunity. Gold is the ultimate money. It is only useful as a store of value - and then only when other forms of money are defective. In a healthy monetary system, investors scarcely need gold. It functions best as a reserve currency and a reserve monetary asset. Your bank should have gold. You shouldn't need it. But the special conditions of our time make gold: (1) a necessity and (2) a good speculation. It is a necessity because the banking system lacks real reserves. One bank holds IOUs from other banks in place of reserves. The others do the same thing. If one fails, they all may fail. Central banks are no better. They hold the IOUs of their governments. But the governments are nearly all close to insolvency. Depending on how you look at their balance sheets, most governments in the developed world are already broke. And they are all adding more debt. At the recent G20 meeting in Canada, the world's richest nations pledged to gradually reduce their deficits. If all goes well, deficits will decline. And sovereign debt will plateau at about 100% to 150% of GDP. Governments that are reducing their deficits are headed in the right direction. There are two big questions: How far will they go? And what will happen along the way? The private sector is de-leveraging. Even $12 trillion worth of bailouts and boondoggles has not been enough to stop it. Imagine what will happen when government begins de-leveraging too! Much more could be said about this. A research report written by our friend Dylan Grice at Societe Generale revealed that it is unlikely governments can actually stay the austerity course. The only successful examples, he points out, occurred under much different circumstances - that is, when the private sector credit cycle was still in full expansion. We doubt that governments will have the stomach for deep spending cuts. It is easy to talk about austerity; it is difficult to implement it. And it is especially difficult when the economy is de-leveraging. In fact, the move towards tighter government budgets could produce a terrible outcome. It may not be enough to reduce sovereign debt levels...but still be enough to tip several national economies into depression (thus reducing GDP growth and keep debt-to-GDP ratios dangerously high). We could see greater losses to equities, bigger write-downs at banks and more bankruptcies than expected. This would clear away debt fast. And allow a speedier recovery. Gold is an insurance policy against monetary mistakes. We think we see an error coming. The Fed has nearly tripled its balance sheet since 2007. The Bank of England expanded its balance sheet fivefold. If the private sector were still expanding its use of credit, these moves would be horribly inflationary. Instead, credit is shrinking in the private sector. The inflationary policies of central banks are not being transmitted to the economy. There is no sign of consumer price inflation so far. Does that mean we're going to see much give in the gold price? We don't know. No one does. Gold went up 13% so far this year. Stocks worldwide are down 10%. Gold is clearly not responding to inflationary pressures. It is responding to uncertainty, and the increasing risk that the monetary system will fall apart. During the 1930s the price of gold doubled in sterling terms. Of course, we could be facing something more dramatic this time. In the 1930s the developed nations did not face such huge debts and deficits. They had no institutional or structural bent towards currency debasement. They were merely in a de-leveraging period and trying to get out of it. This from John Hussman: One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and de-leveraging risks we currently observe are, from that context, wildly "out of sample." To form valid expectations of how the economic and financial situation is likely to resolve, it's necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don't seem to be contemplating. Hussman makes an important point: it is very difficult to forecast what will happen in the markets except through the lens of our own experience. Most investors have only seen bull market/credit expansion conditions. Those conditions (although punctuated by setbacks) have dominated housing, stocks and bond markets since the early 1980s. It is therefore very difficult now to imagine how bad things could get. In 1932 for example, the S&P 500 sold for just 2.8 times the peak earnings of the pre-depression period. And this was a time when the US was still overwhelmingly the world's most dynamic, richest, fastest-growing economy - one with relatively little regulation, low taxes and great prospects for future growth. By contrast, today we seem to be approaching endgame. The neo-Keynesian plan for stimulating the economy, for example, has pretty much played itself out - except in America. So has the dollar-based monetary system. Meanwhile, the system of open-ended, debt-based financing of social welfare spending is also running out of room to maneuver. Even in the best of circumstances, it would be difficult to make the adjustments that even one of these challenges calls for. Trying to do them all at once - against the backdrop of a huge private sector debt destruction - could be disastrous. From Hussman again: Having squandered trillions in an empty confidence-building exercise, it will be nearly impossible for those same policies to build confidence again in the increasingly likely event that the economy turns lower and defaults pick up again. The best approach will still be to allow bad debt to go bad, let the bondholders lose, and defend the customers by taking whole-bank receivership (as the FDIC does seamlessly nearly every week with failing institutions). Almost undoubtedly, however, our policy makers will choose to defend bondholders again, pushing our government debt to a level that is so untenably high that little recourse will remain but to suppress the real obligation through long-term inflation (though...the near-term effects of credit crises are almost invariably deflationary at first). This is our view, too: deflation now, inflation later. Which is why we favor gold as insurance AND as a speculation. As insurance, it is the oldest, simplest and surest place for your money. It may or may not be overpriced at any moment. But it will never be 100% overpriced. It represents real wealth. Always will. As a speculation, it is a bet that the financial authorities really are as maladroit as they appear to be. So far, they've given no indication that they grasp what is really going on. If they did, they would immediately give up their project of trying to stop the market from correcting. They would look to their own precarious situation, immediately cut spending and immediately try to beef up their own balance sheets. (In any event, no one asked our advice...) Most likely, as Hussman argues, the feds will not abandon their neo- Keynesian stimulus. And when they realize this stimulus doesn't work they will turn to debt monetization - they will create money to buy their own bonds. This will work. It will cause inflation - possibly hyperinflation - which will wipe out much of the debt (along with much of America's counterfeit economy). Gold has been going up ever since I first recommended it to readers more than 10 years ago. The cracks in the world's monetary system are widening. But they remain just cracks. My guess is that the bull market in gold will pause during the coming deflation and then resume, probably turning into a speculative frenzy when the deflation turns into consumer price inflation. At that point - which could be 5 or 10 years ahead - we hope to trade our gold for stocks, buying the best companies at the best prices in a quarter century. Patience... Bill Bonner, for The Daily Reckoning Joel's Note: "Long suffering readers," as Bill jokingly refers to them, might like to know exactly what the author of this column is doing with his OWN money. Well, now you can get the specifics...the investments...the inside contacts Bill has built up over the past three decades in the financial publishing business. For details on how to become part of the Bonner & Partners Family Office, check out this invitation. Great Correction Expectations And now back to Bill Bonner, for the rest of today's reckoning... Americans may have fretted a bit over the holiday weekend. The news has been bad. At least, if you regard a correction as bad. California is cutting its payroll and putting others on minimum wage salaries. Illinois has run out of money and stopped paying its bills. The stock market is going down. Bond yields are at record lows. The housing credit has expired. The clunkers have all been crushed. Census workers are being awarded medals for counting above and beyond the call of duty...and sent home. The feds' stimulus didn't stimulate...their recovery didn't recover...their counter-cyclical fiscal policy didn't counter much of anything. And now it's all running out...and we're beginning to see the word 'depression' used to describe America's malaise: "Dow repeats Depression pattern," says an item on CNBC. US "trapped in Depression," says a headline at The Telegraph in London. Consumer bankruptcies are at their highest level in 5 years. Houses aren't selling. Retail sales are down. Factory orders are falling. And the cruel Senate told those whose unemployment benefits have run out to 'go fish.' "Recession Jolted Most Americans into Cheaper Living," said a recent Bloomberg headline. That's what you'd expect in a Great Correction. But who expected a Great Correction? Not many people. Instead, most expected a recovery. Whatever is going on, a recovery is not it. There were fewer jobs at the end of June than there were at the beginning of the month - 625,000 fewer. The Labor Department reported that the unemployment rate went down to 9.5% but everybody now understands that the numbers are fraudulent. The feds are just disappearing people from the unemployment rosters. In fact, they dropped 1 million Americans off the list in the last two months. These people are not 'actively' seeking employment, they say. But it now takes 35 weeks, on average, from losing a job to finding a new one - if you're able to find a new one. That's about half again as long as it took in the worst job market of our lifetimes, during the late '70s. With five people available for every job opening, naturally, a lot of people don't find work and give up. Bad odds. We only actively looked for a job once in our lives - in the early '70s. We had gotten out of college. It was time to start a career. So we looked in the paper for jobs in journalism, for which we were completely untrained. We saw an opening in Washington, DC, at a newsletter company. We put on a suit and went for an interview. The interview went well. But we didn't get the job. They wanted someone with a better haircut or a better resume. Either way, it did not look like job hunting was going to work out for us. Fortunately a friend needed help. He paid $100 a week. That wasn't much. But it was a start. We stuck with him until we were able to start our own newsletter company. Pity the poor people who are looking for a job now. Nearly 8 million jobs have been lost in the last 3 years. Many of those jobs will never come back. Recovery? Forget it. Who's going to build McMansions ever again? No one. They are relics of the Bubble Age...historical artifacts - like a Chrysler Imperial with huge fins from the '70s... But wait...it gets worse. Because even people who are working are earning less money. Hourly wage earnings are falling. Hey, maybe China will get out of this slump? No, China's economy is slowing down. And Ken Rogoff says its real estate market is beginning to collapse. Fortunately, (and here you see our Daily Reckoning sunny side coming through the clouds) a great correction is just what the country needs. Remember, you can't make bad decisions good or make debts disappear. You have to work through them...write them off, pay them off, default, foreclose, Chapter 11 or Chapter 7. That's what we have corrections for. Best to get on with it... And more sunny thoughts... Earnings in the private sector in Britain are falling at their fastest rate ever...down 1.1% in the first quarter of the year. Meanwhile, the economy is in a 'savage' recession; GDP growth was negative by 1.9% in the first quarter, the worst performance in 30 years. Willem Buiter, a former member of the Bank of England's Monetary Policy Committee, said: "The economy will be shrinking into next year. We'll be in recession and have sharply rising unemployment for the next year or year-and-a-half." Zombification continues. The purest and most obvious zombies are criminals. They make no pretense about it. They're out for blood. But what's interesting is how the pure zombies work hand in hand with the poseurs. You put a zombie in jail, for example, and before long the prison system - guards, suppliers, builders, administrators, unions - has become zombified, lobbying the state legislature for more laws, more criminal penalties, and more prisons. America has more prisons and prisoners than anywhere on earth. Why is that? Is it because Americans are worse people? Or is it because the correctional system has become a vast zombie gulag, leeching on the rest of the society? We saw an example of this kind of symbiotic zombification in The International Herald Tribune over the weekend. Chicago has no money. It also has a lot of young people who like to shoot at each other. So, the city hires full time counselors to work with 'at risk' youths...one on one...accompanying them to school and to the store and so forth. The counselors are supposed to help keep the hoodlums from going off the rails. Whether they succeed or not, we don't know. We just notice how the system drains blood from the real economy into an activity that may sound worthy, but is really just a conspiracy of zombies. An even more outrageous example comes from England, recounted to us by a new friend, an English lawyer: "There was a famous case a few years ago. Two boys, I think they were only 10 years old, snatched a two-year-old from his mother at a mall. They marched him into the woods. They used an iron bar to bash in his head. And they mutilated him in some way that was never described to the public. "These were very nasty boys. They planned the whole thing. After they killed the child they laid his body on the railroad tracks...where it was discovered. And then, the local people were horrified, of course. They put flowers on the railroad tracks to mark the site. The killers - who hadn't been caught yet - joined the mourners. Cold blooded. It's on videotape. "Finally, the police caught them. One of the boys cracked and confessed. "But what happened next was bizarre. The criminal justice system rose to defend the boys in the most remarkable manner. Since they were minors they couldn't be tried as adults. Instead, the legal establishment soon turned these monsters into 'victims.' They were appointed custodians, and counselors, and lawyers, of course, all paid for by the government. And the government provided full care...including schooling, of course, but also television and toys. Since they were underage, they could only be sent to a kind of reform school. But they only stayed there for a short time. Because the people of Liverpool were so incensed, the murderers got death threats. So they petitioned for something like the witness protection program, where their identities were changed, and they were to be supported by the government for the rest of their lives - even after they were no longer in government custody. You couldn't even find out what happened to them. They could be living next door to you and your children." Regards, Bill Bonner, for The Daily Reckoning