EZINE 5, August 2012
FINANCIAL WHIPLASH
By Otto Engelberth
We are now four years into trying to recover from the economic collapse that started in 2008. Today's public discourse is about unemployment, the housing real estate bubble, college student debt, credit card debt, government budget deficits, and nations such as Greece and Spain drowning in public sector debt. As if this is not enough, we have the confusing situation where the nations which use the Euro as their currency are in economic and political crisis. What's going on? How did we get into this mess and what's it going to take to get through it?
Being humans, we are big into thinking in terms of "cause and effect". We are receptive to conspiracy theories and villains. You are probably familiar with some of these: the richest 1 %, the U. S. Federal Reserve, the multi-national corporations, the Bilderbergs, President Obama, President Bush, the U. S Congress, and the big banks such as Bank of America, Goldman Sachs, and JPMorgan. I've even heard that the Chinese and the Germans are at fault.
If none of these ring your bell, you may be more comfortable blaming it on God. After all, most religions teach that bad things happen when we ignore Him. Ironically, most religions do warn about what is the cause of the mess we are in. That cause is financial debt- personal debt, corporate debt, government debt, and sovereign (national) debt, with sovereign debt being the "straw that breaks the camel's back".
Sovereign Debt
Why does sovereign debt have the capability to be the root cause of our present mess? It's because a nation's debt is different from other types of debt.
We are used to debt where there is a borrower and a lender, with the debt being secured by collateral (such as a home or automobile) or a personal signature guaranteeing payment (as in the case of credit card and student debt). In the case of corporations, as well as state and local governments, their bonds are secured by contract and are usually used to fund equipment and buildings, roads and bridges. These types of loans are either paid off by the borrowing entity or written off as a loss to the lender.
Sovereign debt is different because the borrower is the government of a country. As such, the borrowing government does not provide collateral and the lender only has the government's promise to repay the principle and interest on the loan. In other words, it is a loan that is based on the government's character and financial capacity to repay the loan.
As you may have experienced when applying for a home mortgage, automobile loan, or a credit card, your past credit history is important to the lender. The same is true for governments. For instance, Argentina has a terrible record of defaulting on their debt while the United States has never defaulted since the default on our revolutionary war debt. Both countries have similar resources, but one chooses not to make the repayment of debt a priority, in effect; they feel comfortable stealing from their lenders.
One additional difference in sovereign debt is that it is usually denominated in the borrowing government's currency. As you know from reading my previous posting titled, "Money's Value Illusion", that adds an additional risk for the lender in that the money used to pay off the loan may be of less value than that originally lent to the government. Sometimes the rate of interest the lender charges reflect the reduction in value of the currency over the life of the loan when it can be anticipated; at best it is a guess.
Another risk factor associated with sovereign debt is the type of government doing the borrowing. Ironically, representative governments are more risky to lend to then than monarchies and dictatorships because they don't have assets. This is because their citizens own most of the country's assets. This means that these representative governments are totally dependent on their citizen's willingness and capacity to pay taxes.
Additionally, since representative governments are run by people who are not personally liable to pay off their government's debt, they tend to be irresponsible in allocating how the borrowed funds are used. Typically they are biased toward using the money to buy the favor of those who voted them into office.
Understanding Today's Sovereign Debt Crisis
While sovereign debt default is not a new phenomena, never before has it been experienced by so many governments at one time. In the past most government debt defaults occurred because of the cost of war with the losers usually being the ones who defaulted. Today's sovereign debt crisis is different in that most of the nations in crisis have not been in a major war for over 65 years.
This time the common characteristic of the governments that are in debt crisis is that they all are democracies that have promised their citizens and employees more benefits than their citizens are willing or able to fund through taxes.
The governments that use the Euro as their currency have a special problem because they don't control their currency. For Greece, Spain, Portugal, and Italy, this situation has reached the crisis point now because they are not able to borrow money in the market at affordable interest rates, or print more Euros to cover their short fall in revenues. In my view, France may soon join this group.
Herb Stein once said, "If something can't go on, it probably won't." I believe that's the situation that these countries face. There are three options
Until the Euro problem is resolved, there will be ongoing instability in the world economy because of the interconnectedness of trade and banking throughout the developed world.
In case you were wondering, The U. S., Japan, and England are in the same boat as the Euro nations. The difference is that they each have their own currencies, so if push comes to shove, they can print money to pay for their revenue shortfalls. However, the fallout from this action would be inflation that would devastate the middle class and those on fixed income.
So how does this Sovereign Debt Crisis affect us individually in the United States?
First of all, each of us needs to come to grip with the fact that our federal government is presently on an economic course that can't be sustained. As I quoted earlier, if something can't go on, it probably won't.
For the past couple years, our government has borrowed 40 cents for every dollar it has spent. It is now borrowing more than one trillion dollars per year. Presently, our official total debt level is more than 15 trillion dollars. Unofficially, our estimated debt plus unfunded obligations for Medicare, Social Security, the new healthcare law, federal employee retirement benefits, etc., is in the neighborhood of 50 trillion dollars. Assuming a population of 360 million people, that works out to a future unfunded obligation of around 140,000 dollars for each man, woman and child.
In addition, if we go into a period of even moderate inflation, our annual debt service on our present 15 trillion debt will go up 150 billion dollars with each percent increase in the rate of interest on government bonds. A moderate three percent raise in our bond rate would raise our debt service cost by an additional 450 billion dollars per year.
To put it mildly, we are between the proverbial rock and a hard place with no pleasant options. Taxes will go up for everyone; not just the rich. Federal payrolls will be cut; Federal employee benefits will be cut. Defense will be cut; Medicare will be cut and Social Security will be cut. And finally, the Federal Reserve will continue to debase the dollar, i.e., we will resume our usual inflationary trend of the dollar losing 90% of its purchasing power over the next 50 years as it did the last 50 years. This means that 50 years from now a gallon of gas will cost 37 dollars.
Given the cost of the ageing population, it is probable that the younger generation will balk at supporting a tax structure that would fund Social Security and Medicare to deliver the present benefit levels. This could result in a generational tug of war in politics.
So what does this description of our present situation mean for us as individuals? If you are a senior citizen who is dependent on a government check to pay for your living expenses, you will probably get less than you expected.
If you are a young person just starting out, you will probably be less well off than your parents were because your tax burden will be higher. Your choice of career and how thoroughly you prepare for it will be important. Keep in mind that you will be compensated for the types of problems that you solve for people and organizations.
It will be critical for you to separate your "needs" from your "wants". You will need to put off getting your wants so that you can build a nest egg that will grow over the course of your lifetime. In this process, it will be critical for you to be aware of the asset classes that will protect you from the deflating value of the dollar. Examples of asset classes that you need to know about are stocks, bonds, real estate, and precious metals. You need to know about these so you can invest your nest egg so that it will grow in value. Why do you need to do build a nest egg? It is because the government will not afford to take care of you!
Wrap-up
So now you know how we got into the financial mess we are in and what it means for us going forward. The scenario that I've described is the "muddle through" scenario. It assumes that this fall's election will give us a government that will face our sovereign debt problems and have the boldness to take corrective action.
The scenario will be much more difficult for us if our new government chooses to continue the policy of denial concerning the severity of our sovereign debt problem. The end result of that course of action would be hyper-inflation with resulting political and social turmoil. If that happens, I will write a future article giving more detail about what this will mean for you.
"I did enjoy, or shall I say was refreshed by reading your booklet. I think is profitable for our grandchildren to read as it is written very well in an understandable style"
—C. Geiger