I made a New Year’s resolution to try writing more, both on my blog and in my newsletter. To be honest, sometimes I wondered why I should write. I used to get in the most ridiculous arguments with people who didn’t know what the hell they were talking about, and it used to piss me off. I also know that things are going to get so volatile that I am likely to get a lot of flack for no reason. But I’m a little older now and have a little more capital to play with. Now I just put my capital into investments, take my profits, and shrug my shoulders if people tell me my investment thesis is wrong. The one good thing about talking to my readers is that I know there are people out there with a genuine thirst for learning who see things through a child’s eyes, which is the beginning of knowledge. I am willing to help these people navigate through the disastrous debt crisis that is unfolding in slow motion.
Anyway, the hardest aspect of investing is seeing ALL possible scenarios and finding the probable solution to a problem. This is a form of divergent thinking, and an exercise to see if you have this skill is to write down as many novel uses for something like a blanket or knife as you can in 10 minutes. There are people with sky-high “genius” IQ’s that literally can only come up with “something to keep warm with” and “a tent”, so don’t expect our “genius” leaders (aka economists and politicians), to figure this crisis out. This is the problem we generally face today. Our leaders only see the economy through the traditional view and don’t realize so much has changed over the years and that this is a dynamic system. And sadly, most people (from psychological studies), only think an idea is valid if it comes from an expert source; in other words, most people can’t see the validity of an “out of the box” idea if it doesn’t come from an expert.
If you take humanity as a whole, you will always find extreme elements on both sides that can not see any other alternative. This is called being a stubborn bastard in colloquial terms. If everyone were unbiased and could (gasp) see things for what they are, we wouldn’t see these great wipeouts of capital. We would not see booms and busts. It would be impossible because stubbornness on both sides creates extreme trends. Anyway, because there always has been an element that has faith in government, there always has been massive destruction of capital when government bonds implode. And governments default on their debt without fail historically. The chart below is courtesy of Economist John Taylor and is based on CBO assumptions. The timeline should be pushed forward because the interest rate assumptions of the CBO are flawed, especially in an environment where interest rate spikes will result in asymmetric increases in debt servicing based on total debt. Also keep in mind that revenue as a percentage of GDP hovers around 18%.
Revenue as % of GDP
It is just crazy to me because Treasury bonds, and by extension the Fed’s balance sheet, CAN’T WITHSTAND even a minor uptick in interest rates. Both Republicans and Democrats are misreading this crisis so bad that you wonder what they are doing with their free time. Republicans, if you eliminated every single social program, we still would pay interest on our debt. Democrats, if we taxed everyone at 100%, we still would pay interest on our debt. So even if either faction got 100% of what they wanted, we would still reach a point where our entire tax revenue is consumed by interest payments. Time for Plan B, anyone?
This is the best chart I could find, although it’s a little misleading. The effective interest rate is actually lower and shouldn’t be based on the 30-year; in other words, the uptick in effective interest rates need not be all that dramatic in absolute terms for huge dislocations to occur. The current effective interest rate is more in the 1% range because the Fed is purchasing shorter maturity debt, so an increase to the 4% or 5% range is actually pretty disastrous. And for some historical perspective, the 3-month T-bill was 5% in 2007; now it is 0.08%.
But anyway, the chart adequately demonstrates how this historically anomalous interest rate environment is affecting debt servicing costs. In 2009, our interest expenditures expressed as a percentage of revenue would have roughly tripled simply by assuming historically normal interest rates. Considering that we have added about $4 trillion in debt since then, at historically average interest rates, we are now talking about almost $1 trillion in debt servicing costs annually. So basically you are adding 2 deficits per year that compound, simply from normal interest rates. This is the dynamic nature of debt. Unfortunately, interest rates climb dramatically in a debt crisis, so the day of reckoning is a lot closer than people suspect. Debt servicing costs can and will rise from $300 billion to $1 trillion in the blink of an eye.
The Nuanced Difference Between Crises
I don’t know what it is about human nature, but people see the future in broad terms, and they will defend that point of view in the face of all evidence. So you have the “Great Depression” crowd that has been predicting a stock market collapse for years now. People always assume I think stocks are going to crash because I’m a bear, but regular readers know I’ve said stocks are going to explode, as they have. These stock market bears fail to account for the change in our monetary system from a gold standard to the floating exchange rate system. They fail to account for our good friend Helicopter Ben who has been balancing out the natural deflation that occurred in real estate with new money. From a social perspective, people in general don’t account for the fact that all these entitlements are a product of the Great Depression- they did not precede it. So in terms of civil unrest, it will be a lot worse than the Great Depression because if people are promised something and don’t get it, they get pissed off.
The “we will grow our way out of this crowd” is arguably worse. Debt at this point is interconnected, and since banks are getting nationalized, the situation will ironically get worse. Basically all the failed investments that went on in the private sector ends up on the government balance sheet. The whole point of getting interest on a bond is to hedge against the risk that the bond will default. If the government makes everyone whole, bankers are the only ones celebrating. The average person is the one who suffers under the weight of higher taxes and austerity. So trust me, if you talk to anyone in the investment community, they will have blinders on, especially if they are a low-level employee (people my age). The people who actually invest successfully in all environments understand a lot better how things are interconnected, and they will just ride whatever wave the government creates.
Debt is also growing globally at a much faster rate than revenue, implying the end is near, so this is just a matter of timing at this point. Our leaders decided to raise taxes on everyone more or less (payroll taxes anyone?), and this is going to stall real growth rates. When revenues fall, our leaders will believe it’s because they didn’t tax enough, so they will raise taxes on everyone again. As usual, they are bringing on their own demise and don’t even know it. It would actually be amusing if their actions didn’t literally affect billions of people.
Real Estate or Gold?
I know people are going to misunderstand what I’m saying about real estate because it is nuanced. After all, I made the move to Las Vegas, so I’m supposed to be an eternal optimist on the real estate market, right? Wrong! And part of the reason is that I see homes I bought for $29,000 going for $45,000-$50,000 in less than a year. I see about 10 all-cash offers above list within a day of a home coming on the market. I talk to real estate agents (who admit to me they got crushed by the crash) who only see perpetually rising prices in Vegas, even though the investment environment just got a lot worse because of our idiot leaders. And most of all, I see publication after publication calling the bottom in real estate. So what does this add up to? Real estate being a hold, unless you purchase with a 30-year fixed mortgage and unless you buy in the right areas. The bigger cities most susceptible to a muni crisis do not apply.
Luckily I don’t get engulfed by any one investment and I am open-minded. And amidst all this, gold has been setting up beautifully for a rocket launch of the ages.
We are talking about the ultimate hedge against government stupidity, and the year-long correction is exactly what gold needed. The perpetual gold bears are going to point at gold and say “see, you doom and gloomers were wrong!” At their maximum point of self-satisfaction, gold is going to shoot right past $1800, then $2000 and never look back. Then when gold hits $3,000, they will say “I always knew gold would rise, duh!”, but of course, they didn’t have a position. Let these people live in their self-imposed dreamland. As for the true investors out there, put your capital in play with gold in the early part of 2013. You will thank me later.