Weekend Edition

End Times for Empire?

Dear Reader,

I am like a little bee in spring today. Here, there, and everywhere are blossoms of information cropping up that catch the eye and seem worthy of our attention.

For instance, using the orange color of a particularly handsome variety of tulips, our own Bud Conrad has painted the history of U.S. government deficits, adroitly dabbing in the fact that the month just ended saw the largest such deficit ever. It was the weather, some said, that crimped the revenue. It was the consequences of bills coming due from past bailouts, say others.

It was the largest monthly deficit in history, we repeat. Quickly adding that when the expenses of anyone, or any entity, exceed their income by historic amounts, this is not a good thing. Especially when, as you can see from Bud’s chart, the shortfalls are beginning to pile up in what is clearly a trend in motion.

Of course, this is all part and parcel of the government’s stated plan to bury the nation in another $1.6 trillion of debt, caused by the gap between incoming and outgoing by the end of this fiscal year. The trick is going to be able to finance the gap through a series of energetic auctions, including one scheduled for today of $13 billion.

With fingers crossed, the government continues to hope the rubes will keep buying long-term debt, and do so despite yields bouncing near 50-year lows.

But something is going on. The rubes appear to be waking up to the fiscal shell game: the spread between 2-year Treasuries and those that mature in 30 years is now the widest it has been since 1980.

Even so, in exchange for taking the very serious risk that rates will rise and thus sink the value of your paper – or that inflation will turn your yields negative in the not-so-distant future – the government is still only offering buyers of its 30-year paper a yield of 4.7%.

Why would anyone accept the risk of a 30-year bond for a 4.7% yield? Especially given the historic (there’s that word again) level of monetary inflation now heading toward the surface like a Great White going after a big, fat seal?

For insights on that, I wave in Terry Coxon, co-editor of The Casey Report, who has a way with words about these things that I can only aspire to…

The world isn’t divided between people who think interest rates will rise and people who think interest rates won’t rise. It is divided among four groups:

1. People who think interest rates will rise.
   
   
2. People who think interest rates won’t rise.
   
   
3. People who don’t care. Most bond buying comes from this group. It is institutions that are covering dollar liabilities, especially insurance companies and banks. It is also fund managers who will keep their jobs if they can report some yield and fiduciaries who can avoid lawsuits by doing something conventional, however dumb it might be.
   
   
4. People who don’t know. Despite being highly intelligent in other ways, 80% of the human population have no mathematical intuition beyond the number 3, so they can have no confidence in any explanation as to what to expect the economy to do. They will buy bonds because, compared to the non-cash alternatives, bonds seem safe, and unlike cash, bonds provide yield.

David again. While Terry’s explanation of the bond market participants is, in my view, spot on, the number of buyers in each category are not set in stone, and neither are the yields for future auctions.

As a result, the moment that enough bond buyers get wise to the fact that the U.S. government may actually be playing them as fools – by deliberately trying to inflate away future obligations or by deficit spending to the point where there is zero chance of repayment – the game can change. And it can change quickly.

On that topic, Bud Conrad sent over a copy of an excellent article by Niall Ferguson from the current edition of Foreign Affairs, titled “Complexity and Collapse – Empires on the Edge of Chaos.”

In his article, Ferguson lays out the thesis that, contrary to the academic version of the life cycles of empires – that they rise, mature, rot, and ultimately self-destruct over a long period of time – the seeds of destruction for empires are planted, germinate, and are reaped over a shockingly short period of time. As quickly as one generation for Rome and just 10 years for the Brits, to mention just two.

(One blogger has posted the article in its entirety – after obtaining all the necessary permissions, I am sure – and so I can link you to it here.

In the modern context, the U.S. Empire, along with essentially all of the world’s sovereign states, has planted the seeds of monetary destruction by refusing to link its currency to, well, anything… and then spending like the government is impervious to the most fundamental laws of economics.

The problem is that the bills are now coming due. And the creditors are getting a bit testy. Sure, the problem is acute in Greece today, where pretty much everyone has gone on strike including, gasp, the journalists! But it is close to becoming acute here in these United States, as attested to by February’s historic deficit and the additional layer of debt that adds to our pile of IOUs, the largest pile ever accumulated by any nation in history.

The day may come, and sooner than people expect, that the following conversation occurs…

RING-RING

Hello

Is this Uncle Sam?

Uh, maybe. Who’s calling?

The Chinese, Japanese, oil exporters, and a few others – we’re on a conference line.

Oh, okay. What’s up? I’m a little busy, you know. Iraq, Afghanistan, healthcare, that sort of thing.

Yes, even so, there’s this matter of $4 trillion in outstanding loans you owe. We’re getting a little nervous about your ability to repay and think it’s time we talked.

CLICK

Uncle Sam? Uncle Sam?

Of course, given that Uncle Sam’s debts are not actually secured by anything, our creditors can’t foreclose on, say, the Pentagon. But they can demand higher interest rates for any future borrowing. And that spells big problems – Greece-like problems – because all of the government’s forecasts, without exception, are based on rosy predictions that interest rates will remain near 50-year lows for as far as the eye can see.

Should reality prove different, as we very much expect it will, then things will get very ugly, very fast.

(Tip of the day: Note the size of the crowd in the photo out of Greece today. When at the gym, you may want to start focusing more on your arm muscles. That’s because the bigger the crowd, the harder it is to deliver your stone all the way to the target. And it is the height of poor protest manners to have your rock fall short, into the backsides of your fellow protesters.)

How did things get to this point? As is evident in the following quote from an essay published in 1930 by my favorite political commentator of all time, H.L. Mencken, while the end of an empire can come about in the blink of an eye, the conditions that ripen the potential for such a fall can be a long time in building.

“The legislature, like the executive, has ceased, save indirectly, to be even the creature of the people: it is the creature, in the main, of pressure groups, and most of them, it must be manifest, are of dubious wisdom and even more dubious honesty. Laws are no longer made by a rational process of public discussion; they are made by a process of blackmail and intimidation, and they are executed in the same manner. The typical lawmaker of today is a man wholly devoid of principle – a mere counter in a grotesque and knavish game. If the right pressure could be applied to him he would be cheerfully in favor of polygamy, astrology or cannibalism."

H.L. Mencken writing in the American Mercury, May 1930

Real Estate – Whatever It Takes

Real estate insider Andy Miller and I regularly exchange emails. Were you a fly in my email box (the way the NIT WITs no doubt are), you might be bemused by the constant expressions of amazement at just how fast and furious the various government agencies are rolling out new programs and bailouts.

Here’s a taste of just some of the announcements from the past week…

Program Will Pay Homeowners to Sell at a Loss

In an effort to end the foreclosure crisis, the Obama administration has been trying to keep defaulting owners in their homes. Now it will take a new approach: paying some of them to leave.

This latest program, which will allow owners to sell for less than they owe and will give them a little cash to speed them on their way, is one of the administration’s most aggressive attempts to grapple with a problem that has defied solutions.

More than five million households are behind on their mortgages and risk foreclosure. The government’s $75 billion mortgage modification plan has helped only a small slice of them. Consumer advocates, economists and even some banking industry representatives say much more needs to be done.

For the administration, there is also the concern that millions of foreclosures could delay or even reverse the economy’s tentative recovery — the last thing it wants in an election year.

Taking effect on April 5, the program could encourage hundreds of thousands of delinquent borrowers who have not been rescued by the loan modification program to shed their houses through a process known as a short sale, in which property is sold for less than the balance of the mortgage. Lenders will be compelled to accept that arrangement, forgiving the difference between the market price of the property and what they are owed.

(Read the full NY Times article here.)

Then there was this, from Bloomberg,

Sen. Dodd urges action on commercial real estate

‘On the Edge’ Banks Facing Writedowns After FDIC Loan Auctions

March 8 (Bloomberg) -- A Federal Deposit Insurance Corp. plan to auction more than $1 billion in assets seized from failed banks next month, including a loan to build a W Hotel in Atlanta, may trigger writedowns that weaken lenders nationwide.

Almost half of the loans were originated by Silverton Bank N.A., whose collapse last May was the biggest in Georgia history. Community banks that joined Silverton in providing $80 million for the 237-room hotel and condominium complex, as well as backing for 39 other projects, could be forced to write down their stakes to reflect sale prices. The auctions may have wider repercussions. Of the $50.4 billion in loans seized from failed banks currently held by the FDIC, 63 percent involve participations by other lenders, according to data provided by agency spokesman Greg Hernandez.

(Read the article here.)

And the following, which has the NIT WITs trying to slip the bad paper that brought down the banks into the portfolios of pension plans. Were this program suggested by an evil hedge fund operator instead of an officially sanctioned NIT WIT, can you imagine how quickly the regulators would grab for the lead pipes?

FDIC Said to Encourage Pension Funds to Invest in Failed Banks

March 8 (Bloomberg) -- U.S. regulators are encouraging public pension funds that control more than $2 trillion to inject capital directly into the banking system by buying failed lenders, said people briefed on the matter.

The Federal Deposit Insurance Corp. is trying to attract pension funds that want to buy stakes or assets of distressed bank-holding companies, according to two of the people. Direct investments may allow public retirement funds to reduce fees for private-equity managers, and the agency to get better prices for distressed assets, the people said. They declined to be identified because talks with regulators are confidential.

Oregon’s retirement fund may contribute $100 million as regulators seek “the support of state pension funds to solve the crisis surrounding ongoing bank failures,” Jay Fewel, a senior investment officer at the Oregon State Treasury, said in a presentation made at the fund’s Feb. 24 meeting. New Jersey’s pension fund may also participate, said Orin Kramer, chairman of New Jersey’s State Investment Council.

(Read the NY Times article here.)

And finally this from Andy Miller, who will be at our upcoming Crisis & Opportunity Summit in Las Vegas to pull this all together and to answer your questions on the outlook and opportunities in real estate... (Details here.)

David, when it rains, it pours. This is not securitization. It is much worse and much more visible. In addition, this uses real dollars and not future guaranties. This is part of the massive effort underway to move overleveraged assets onto the public balance sheet and out of the banking system or the bond market. Andy

Freddie Mac Poised to Roll out Multifamily Mezz Program

WASHINGTON, DC-Freddie Mac is finalizing the details of a mezzanine lending program that would boost its multifamily originations as well as provide a solution for apartment owners that need to refinance and have found their properties have become overleveraged in the current market.

… The news was first reported in Nasdaq.com, which also said that the program could be used by the lenders to acquire B pieces from new Freddie Mac CMBS. According to Nasdaq, Freddie Mac will originate lower-leverage senior debt and then work with one of the mezz lenders in the program to provide additional leverage, up to 85%.

(Full story here, from GlobeSt.com.)

Now, some might be tempted to assume that all of these efforts are carefully structured, tightly coordinated, and competently executed. But that would be thinking about things in entirely the wrong way. Imperfections are to us humans as trunks are to elephants. And those imperfections are made only more acute by the granting of unrestricted power and by joining the ranks of bureaucrats whose pay is in no way related to success or failure in the free market.

What are the implications of all of this latest round of meddling? It is too early to say. But we can say that, at this point, the actions of the NIT WITs have been dedicated almost exclusively to the task of denying and delaying the inevitable consequences of the historic real estate bubble we have just come through.

Simply, the odds of this latest batch of ingredients producing a satisfying economic result, versus a smelly glob that deepens the ruin of the economy, are long indeed.

Unfortunately, real estate is just one of many pots now being stirred by the NIT WITs. The projection of U.S. power across the globe, as Vedran Vuk explains here, is another. And with predicable results…

Battle for the Budget

Bud Conrad, March 7, 2010

After the close of markets on Friday, March 5, the Congressional Budget Office (CBO) published its scoring of President Obama's budget for the next 10 years. It shows a budget deficit of $9.8 trillion. That is just shy of $4 trillion worse than the CBO’s baseline budget, a budget that includes only the laws as currently enacted, with no estimates of any new programs lawmakers may add that worsen future projections.

That our budget is out of control is no surprise, but the charts I present here should provide some perspective of just how dangerous this set of budget estimates could turn out to be. The first chart below shows the amount of red ink in each year for the two CBO estimates.

To get a visual interpretation of just how big these budget deficits have become, I plotted the long-term history, then tacked on the CBO evaluation of the president's proposal. Knowing the propensity of governments to spend more than they promise makes one question if the large improvement shown in the dotted line will actually occur. Even if nothing changes, however, the results look like they could be very damaging for other aspects of our economy.

One aspect of the CBO projections that is difficult to defend is the expectation that inflation will stay incredibly low. In the next chart, I present the same sort of long-term history, coupled with the projection, for the Consumer Price Index (CPI).

In the next chart, I put together two of the most important measures: the three-month T-bill interest rate and the deficit expressed as a percentage of the gross domestic product (GDP). Both history and projection are shown.

The most important observation is just how disastrous the current deficit is in the historical context, even after rationalizing it by dividing it by the GDP. I overlaid the two series to show that higher deficits in the past tended to occur along with higher interest rates.

As you can see, we now have a significant anomaly, with the budget deficit at its worst in half a century, while interest rates remain near their lows for the period. A closer look at history shows many divergences, to the point that in the short term these two series tend to bounce in opposite directions. That is probably because when the economy shows weakness, the government expands its spending and collects lower taxes, so the deficit becomes worse. Thus, in the short-term cycle of a few years, these two measures often move in opposite directions.

But the situation we face now is much bigger than anything we've seen since the 1950s. The government bailouts and stimulus are at record levels, and the special actions of the Federal Reserve have driven interest rates close to 0%. It is my expectation that both inflation and interest rates will rise dramatically because of these large deficits.

I also think the projected interest rates are much lower than what I expect the deficit would require. As foreigners and others recognize how seriously indebted the U.S. government is becoming, they will expect higher interest rates to compensate for the debasement of the currency.

The budget analysis goes further in calculating the expected growth of the economy, which ranges from 2 to 4% over the years. Those are not large numbers for real GDP, but there is no expectation of another recession during the decade. If the economy didn't grow, tax revenue would be less, and the budget deficit would be worse.

While interest rates are expected to rise as shown in the chart above, the projections expect that they roll over and stop rising at around 5%. That is contrary to my expectations that they will be much higher, and even perhaps closer to 10%, by the end of the decade. If they are, the cost of funding the outstanding government borrowing escalates rapidly because the increased interest has to be added to the debt so that the debt grows even more.

The problem from the onset of this crisis has been the debt, and that continues to be the case.

Leaving aside the above two adjustments that could make the budget deficit worse, it’s helpful to look at the outcome with the given assumptions and see where it leads. Perhaps the most problematic result is that the debt of the federal government held by the public grows from $7.5 trillion in 2009 to $20 trillion by 2020. Such big numbers are hard to understand, though you can get some sense of things by considering that the government is intending on almost tripling the debt in just 11 years. The ratio of this outstanding debt to the GDP gives a flavor of how dangerous the situation has become. As Ken Rogoff and Carmen Reinhart have indicated in their new book, when we approach 90% government debt of GDP, we have serious potential for a currency crisis. As you can see, we are well on our way to those levels, even without assuming the two adjustments above.

How will the deficit be funded?

The question arises who will service the rising levels of debt. Clearly the taxpayers are on the hook for all these projections, with more to come. So the question becomes whether the tax base can grow fast enough to provide support for servicing the debt. The CBO gave us two series for the tax base. One is Domestic Economic Profits, and the other is Wages and Salaries. The basic assumption is that these are the main revenue streams that can be taxed by the government to fund its expenses. I added these two series together and divided by the GDP to determine if the tax base is growing more rapidly than the economy. Unfortunately, but as expected, the blue line in the above graph shows that the tax base only grows about as fast as the economy itself. That's not surprising, but the contrast to the rapid growth in debt will be a serious source of problems, as the only way the debt can be sustained will be through increasing the tax rates, and probably quite dramatically.

The latest set of budget predictions will probably be wrong, and not just because the assumptions are too optimistic but because there is a relatively high probability that something will go off track to cause a major shift before the 10 years are completed. Unfortunately we are not preparing ourselves for such problems, and so I would interpret the CBO projections as being far too rosy.

David again.

For more on this very important topic, don’t miss the current edition of The Casey Report, featuring the Point of No Return, with more on the challenges looming for the U.S. economy and how you can protect yourself and profit. If you aren’t yet a subscriber, our three-month, no-risk terms guarantee you’ll love the service or get a full refund. Details here.

When Soda Was a Nickel and Social Security Wasn’t Much More

By Vedran Vuk

Every generation scolds the next one down the line and blames society’s ills on the guy up at bat. Considering past policy decisions, this common perspective doesn’t make much sense. Just look at the Great Depression generation, both known for its great character as well as the worst policies of the century. Clearly, older generations did not always make the best decisions.

One of those bad decisions, Social Security, still haunts America today like the grim reaper waiting to take his harvest. It’s strange to think the same men who courageously stormed the beaches of Normandy didn’t have the political courage to dismantle this ticking time bomb. If it wasn’t for WWII veterans, many believe that this article would be written in German. That might be true. But due to an exploding national debt and that generation’s failure with Social Security, we’ll be speaking Chinese sooner than German.

The lack of political will isn’t surprising since most past retirees were net gainers from Social Security while new retirees are net losers. Older folks love bemoaning runaway spending, welfare queens, and handouts. But often they don’t consider their own gains from the welfare state.

As Social Security taxes increased over time, so did the benefits. Essentially, previous generations paid into the system when taxes were low and retired when the benefits were high. A retiree’s maximum tax loss from Social Security in 1940 was $923 in today’s dollars. Compare this to the current maximum of $13,243.

To find the dividing line between net gainers and losers, we created a projection assuming an individual with a salary equaling the top taxable Social Security limit for 45 years (to get an idea of this amount, consider the limit was $3,000 dollars in 1940 and $106,800 in 2010 – both nice salaries). Our test dummy paid the maximum Social Security taxes every year.

On the other hand, upon retirement, he would receive maximum benefits. According to the Social Security Administration, maximum taxation is a prerequisite to maximum payouts. Next, we added Social Security benefits received over 13 years (derived from the average U.S. life expectancy of about 78). Finally, we calculated the difference between taxes paid over 45 years and the payouts received for 13. The results were shocking.

Before 2007, our projected retirees were net gainers from Social Security. 2007 retirees were the first net losers at -$411. By 2011, retirees will be -$40,403 in the red.

In the ‘80s, a Greatest Generation survivor retiring at 66 in 1985 received a net gain over his expected lifespan of $113,350 in 2010 dollars. Just a decade down the road, a 1995 retiree still profited by $67,982.

While welfare is often equated with public housing residents, perhaps nursing home residents should be considered too. These Social Security payments outweigh many welfare handouts. For example, California’s maximum TANF (welfare) payments for a family of three were $9,373 a year in 2005, inflation-adjusted for today. It takes over 12 years of welfare to equal the 1985 retirement net gain. (To be fair, if housing subsidies, food stamps, and other benefits were included, the number of years would be lower.)

So, are pre-2007 retired generations complete bums? Well, not exactly. It depends on how the money would have been spent otherwise. Suppose that instead of paying Social Security, the same amounts had been placed into an account earning five percent a year.

After 45 years starting in 1940 and ending in 1984, this account would have been worth over $297,000 in 2010 dollars. This is $44,000 more than 13 years of Social Security benefits starting in 1985.

Hence, older retirees are bums on a case-by-case basis. An investment-savvy penny-pincher would have lost from Social Security. Without the program, he could have invested privately. But spendthrift retirees benefitted enormously. The responsible saver is punished and the careless spender rewarded – the same old story of welfare retold for an older generation.

[And this note as an afterthought:

How Much Do You Really Pay for Social Security?

The government has pulled a fast one on most people. You pay half the Social Security tax and your employer pays the second half, right? No, wrong. You actually pay both.

Let’s go through this example to understand the point. Let’s say that a person earns $100,000 a year and pays $6,000 in Social Security taxes and the employer pays $6,000. In the eyes of the employer, the person’s services are worth $106,000 ($100,000 salary + $6,000 in Social Security taxes), that’s how much he costs the employer.

Now, imagine what would happen if Social Security taxes disappeared overnight. For a little while, the employer would profit by paying $100,000 for an employee worth $106,000. However, in a free market, prices move toward levels equaling the underlining value. Just like good underpriced stocks will eventually move up, so does the price for good undervalued employees – although, both may not be immediately appreciated.

Eventually, the person’s wages would be bid up in the market from $100,000 to $106,000. Because of this, the employer’s half is actually your half too. Without Social Security, your wages would be close to your value to the employer, in this case, $106,000. So, in reality, the person pays $6,000 in taxes and makes $6,000 less than he would in a completely free market, meaning that the real loss is $12,000 per year.]

(Ed. Note: This is the kind of stuff the editors of The Casey Report spend sleepless nights over. Where is the economy going? How much does politics influence the markets, and in which direction? How can we profit? Answers to these and more burning questions you’ll find in The Casey Report… this month with Bud Conrad’s musings on “The Point of No Return.” Is the U.S. economy beyond repair? Find out with our risk-free 3-month trial. More here.)

Crisis & Opportunity Summit Update

While we are still hard at work on the program for our upcoming Las Vegas Summit, April 30 – May 2, at the beautiful Four Seasons Resort, here’s the faculty so far.

Doug Casey, Chairman, Casey Research

Bill Bonner, Chairman, Agora Financial

Bud Conrad, Chief Economist, Casey Research

John Embry, Chief Strategist, Sprott Asset Management

Axel Merk, Chairman, Merk Funds

Louis James, Chief Investment Strategist, Casey Research Metals Division

Andy Miller, top real estate strategist, Partner Miller-Frishman

Marin Katusa, Chief Investment Strategist, Casey Research Energy Division

Steve Henningsen, Senior Investment Strategist, The Wealth Conservancy

David Brin, renowned science fiction writer, futurist

Dr. Marc Bustin, Senior Analyst, Casey Research Energy Division

Rick Rule, Chairman Global Resource Investments

Alex Daley, Chief Investment Strategist, Casey Research Technology Division

Chuck Butler, President, EverBank World Markets

Terry Coxon, Senior Researcher, Casey Research

Plus, these Explorers’ League Honorees – sharing their unique perspective and answering your questions on which of today’s exploration and development plays have the “right stuff” to shoot to the moon as the precious metals move into the Mania phase.

Jim O’Rourke, President & CEO, Copper Mountain

Roman Shklanka, Chairman, Kobex Resources

Duane Poliquin, CEO, Almaden Minerals

Arnold Armstrong, President & CEO, International Enexco

Ron Netolitzky, Chairman, Brett Resources

Ron Parratt, President & CEO, AuEx Ventures

Simon Ridgway, President, Radius Gold

And we’re far from done. By the time we are, we’ll have assembled the right faculty to provide you with a clear road map of where the economy and investment markets will go from here, and the best ways to profit. Most importantly, because we strictly limit the number of registrants allowed, you’ll have abundant opportunities to meet the faculty one-on-one and to get all of your most pressing questions answered. On the economy, on the big picture for investment markets, and on your most important portfolio holdings. We are approaching a critical juncture in the economy, and the timing of this event couldn’t be better. Don’t miss it. Follow this link for more information and to register today.

You’ll be glad you did.

David Galland
Managing Director
Casey Research