Government Shutdown Averted, Debt Still Problematic

The tendency of our leaders is to focus on small things and lose sight of big things. Just last week, there was a panic over a potential “shutdown” of our government because of a budget impasse. Luckily, we averted a crisis because Democrats and Republicans were able to put their differences aside and come to a compromise of $38 billion in cuts. But oh wait, isn’t our projected 2011 deficit $1.65 trillion? This much-publicized cut in spending is noise in the grand scheme of things.

QE3 is another topic that gets a lot of attention. People view the end of QE2 as a positive because it implies a recovering economy. But the truth is that the proposed end of QE2 most definitely doesn’t reflect our debt situation. Economic indicators may be turning up, but they have little meaning without context. Sure GDP can be up 2%, but what if debt rose 10%? This has always been an economic crisis centered around debt. Government spending has not fallen and the basic costs of running government are going to rise dramatically with government workers retiring on generous pensions. Interest rates  have also risen with quantitative easing, so this is not the universal elixir that everyone presumes it is.

Funding our Deficit

The elephant in the room is the question of how we will continue to fund record deficits with waning demand for Treasuries from foreigners. If the Fed ceases its program of quantitative easing, will demand suddenly appear at the margin? And even worse, if interest payments consume an ever-increasing portion of our revenue, won’t foreign holders of our debt begin selling? The chart below shows that foreigners wield a lot of influence in this market.

There are obviously many ways to look at this data. Some would find this date bullish for the U.S. because we own most of the debt. Others would find this data bearish because the last time our debt was this high relative to GDP, over 80% of our debt was held domestically. Furthermore, we didn’t have the problem of owing money to the Social Security Trust Fund (aka ourself) or having the Fed own over $1 trillion in Treasuries. I tend to think these factors make our debt situation concerning.

China is significant because they are the single largest foreign holder of our debt. I find it amusing when people say that China won’t sell their Treasuries because by selling, they will lower the value of their remaining inventory. Sorry, but this is very weak argument. When investment banks were sitting on toxic waste mortgage-backed securities, did they all sit on their hands because by selling they would reduce the value of their holdings? This is a plain ignorant argument that shows a gross misunderstanding of how markets actually operate. By buying gold, China is effectively hedging against a devaluation of the dollar and Treasuries. As an advisor to the U.S., I would try to point out this obvious situation. However, as an advisor to China, I would say to continue to let  the U.S. pound their chests about how foreigners can’t sell their Treasuries.  Then I would unload my holdings.

The Chinese save and receive interest; we borrow and send interest to China. This is an economic shift of major proportions we are all witnesses to. We need to stop with the hubris and just deal with the situation at hand.

Gold and Debt

Gold will continue to track the growth in public debt since the rise in gold is a the smart money’s way of getting out of anything government. There is a serious bond crisis on the horizon and I supposed paying over $400 billion in interest on debt is not enough to wake people up. I guess having underfunded pension obligations right when there is a tsunami of retirees coming is not problematic. Let’s also not forget that new people need to be hired to replace retired government workers. The housing collapse is just now starting to crush state coffers. Interest rates can only go up, and this increases the proportion of our revenue dedicated to interest payments. Put the pieces of the puzzle together:major problems lie ahead.

Those who say there is no debt crisis ahead have truly lost their mind. I am not selling my gold until our leaders wake up.