The End of Money

[Note: I begin today with a short bit from where we left off last week. Also today’s title is the same as the economic seminar series I give to ever growing audiences]

The greatest shortcoming of the human race is our inability to understand the exponential function. ~Dr. Albert Bartlett

I have a question for you.  Let’s say you’re driving down the road, at night, along a busy highway, 10 miles from the next exit, and the oil warning light suddenly blinks on.   What do you do?  Are you the sort that pulls over or keeps on driving?  If you’re the sort that keeps on driving, upset mainly because you don’t have any black tape to put over that pesky red light, then you might as well stop reading right now because we’re about to pull over.

First a set of definitions; when liabilities exceed assets by an amount that cannot be serviced by any conceivable future revenue stream, then one is said to be ‘insolvent’.  When current cash flow cannot service current debt payments, then we say an entity is technically bankrupt.  And finally, when a debt payment is missed, then a default has occurred, the entity is actually bankrupt and all sorts of legal machinery kicks into high gear.

In my last article I wrote about the fact that United States budgetary and fiscal officials revealed to us that in order for the United States government books to net out to zero there would need to be $53 trillion in the bank, today, earning interest.  Of course there isn’t any public money of that sort, or any sort, in the bank.

SCREEEECH!  <-- That’s the sound of this article pulling over to the side of the road

Stop.  Why is this not our #1 topic of debate in Washington DC?  If we suspect that we are insolvent as the Comptroller and Treasury Secretary have indicated, then it’s questionable as to whether it does us any good to debate, say, the finer points of federal education reform or a new flag burning amendment.  As noted above, insolvency precedes bankruptcy and bankrupt nations cannot afford to do anything so why talk about anything else?  We have a bright red oil light lit up on our national dashboard yet the Democratic and Republican leadership continue to drive on bickering about who should have brought the black tape to put over the warning light.

What would it mean if our nation went bankrupt?  A good analogy would be New Orleans.  The city is bankrupt; it’s a mess, and can only rebuild with federal (outside) assistance.  New Orleans completely lacks the ability to rebuild on its own because it doesn’t have the funds and its economy is pretty much destroyed.  But if the US goes bankrupt, who will help us rebuild?  If the answer is ‘nobody’, then you might want to take a trip down to The Big Easy to see for yourself what this country is going to look like in a few years.

The good news is that because the problem only grows more intractable with every passing day, our dithering politicians will have fewer options to chose from when the crisis hits thereby making their jobs that much easier.  The bad news is that the more time we spend in denial, the less time remains for us to get busy and do something about it.   There is even the danger that if we wait too long, we will face a potentially unfixable problem on the scale of what the Soviet Union experienced - catastrophic economic failure.

During my time as a consultant, I had ample opportunity to witness a very clear phenomenon.  If the person at the top of an organization was ethical, for the most part so were all the rungs and layers beneath them.  Conversely, an unethical leader usually presided over an unethical organization.  As a social animal, we tend to take our cues from above.

Our federal government is now several decades into a reckless love affair with unrestrained profligacy.  Because we’ve lacked any clear, moral leadership for so long, it is easy to find reflections of this behavior peering back from every corner of society.

Consider the evidence:

1)     State pension shortfalls running towards a trillion dollars

2)     Municipal pension shortfalls in the hundreds of billions of dollars

3)     Corporate pension and healthcare deficits of one-and-a-half trillion dollars

4)     401K savings of only $53k per 55 year old worker

5) A national savings rate that has steadily eroded since the early 1990’s falling from 10% to negative 1.5%, a condition last seen at the depths of the great depression in 1933

In summary, the list above indicates that at the federal, state, municipal, corporate, and personal levels nobody is saving for the future.  I could probably tick off a few more but since I’m out of fingers on my non-typing hand let’s agree that pretty much covers it.  We are not saving for our future, we are all in this together, but it will take leadership to get us out. 

It is imperative that we return to our heritage of saving and investing for the future.   Somehow we’ve forgotten that a period of living beyond your means must always be balanced by an equal amount of living below your means.   The belief that debts can be compounded forever is dangerously naive as it merely shuffles the bills off to the future as though they could be forever hidden by time.

Leaving aside the obvious moral parallel between this behavior and the fable about The Ant and the Grasshopper, this insolvency issue, large though it appears, is merely a symptom; an effect rather than a cause.  At the root of it all is our monetary system, which we need to understand before we can begin to posit solutions.

Let me be clear - I think that while it was operating well, our monetary system was a great system, one that fostered incredible technological innovation and advances in standards of living.   But every system has its pros and its cons and our monetary system has a doozy of a flaw.

It is run by humans.

Oh, wait, that’s a valid complaint but not the one I was looking for. 

Here it is:  Our monetary system must continually expand, forever.

Which means it has a math problem in the same way that a beached whale has a breathing problem.  In each case we have a massive organism that was optimized for a very different set of conditions than those in which it currently finds itself.

This will be the topic of our next article.

In the meantime, be on the lookout for DC politicians seeking to buy black tape.

All the best,

Copyright, C. Martenson, 2006©

I’d like to wish everyone the happiest of holidays.

Also, I’d like to let you know that the normal weekly update has been deferred to next week as I attend to my family and especially my three young children for whom Christmas is pure magic.

The next posting will expand upon the math problem that lies at the  base of the banking system.

All the best,
Chris

Prepare to be shocked.

The US is insolvent. There is simply no way for our national bills to be paid under current levels of taxation and promised benefits. Our combined federal deficits now total more than 400% of GDP.

That is the conclusion of a recent Treasury/OMB report entitled Financial Report of the United States Government that was quietly slipped out on a Friday (12/15/06), deep in the holiday season, with little fanfare. Sometimes I wonder why the Treasury Department doesn’t just pay somebody to come in at 4:30 am Christmas morning to release the report. Additionally, I’ve yet to read a single account of this report in any of the major news media outlets but that is another matter.

But, hey, I understand. A report is this bad requires all the muffling it can get.

In his accompanying statement to the report, David Walker, Comptroller of the US, warmed up his audience by stating that the GAO had found so many significant material deficiencies in the government’s accounting systems that the GAO was “unable to express an opinion” on the financial statements. Ha ha! He really knows how to play an audience!

In accounting parlance, that’s the same as telling your spouse “Our checkbook is such an out of control mess I can’t tell if we’re broke or rich!” The next time you have an unexplained rash of checking withdrawals from that fishing trip with your buddies, just tell her that you are “unable to express an opinion” and see how that flies. Let us know how it goes!

Then Walker went on to deliver the really bad news:

Despite improvement in both the fiscal year 2006 reported net operating cost and the cash-based budget deficit, the U.S. government’s total reported liabilities, net social insurance commitments, and other fiscal exposures continue to grow and now total approximately $50 trillion, representing approximately four times the Nation’s total output (GDP) in fiscal year 2006, up from about $20 trillion, or two times GDP in fiscal year 2000.

As this long-term fiscal imbalance continues to grow, the retirement of the “baby boom” generation is closer to becoming a reality with the first wave of boomers eligible for early retirement under Social Security in 2008.

Given these and other factors, it seems clear that the nation’s current fiscal path is unsustainable and that tough choices by the President and the Congress are necessary in order to address the nation’s large and growing long-term fiscal imbalance.

Wow! I know David Walker’s been vocal lately about his concern over our economic future but it seems almost impossible to ignore the implications of his statements above. From $20 trillion in fiscal exposures in 2000 to over $50 trillion in only six years? What shall we do for an encore…shoot for $100 trillion?

And how about the fact that boomers begin retiring in 2008…that always seemed to be waaaay out in the future. However, beginning January 1st we can start referring to 2008 as ‘next year’ instead of ‘some point in the future too distant to get concerned about now’. Our economic problems need to be classified as growing, imminent, and unsustainable.

And let me clarify something. The $53 trillion shortfall is expressed as a ‘net present value’. That means that in order to make the shortfall disappear we’d have to have that amount of cash in the bank – today - earning interest (the GAO uses 5.7% & 5.8% as the assumed long-term rate of return). I’ll say it again - $53 trillion, in the bank, today. Heck, I don’t even know how much a trillion is let alone fifty-three of ‘em.

And next year we’d have to put even more into this mythical interest bearing account simply because we didn’t collect any interest on money we didn’t put in the bank account this year. For the record, 5.7% on $53 trillion is a bit more than $3 trillion dollars so you can see how the math is working against us here. This means the deficit will swell by at least another $3 trillion plus whatever other shortfalls the government can rack up in the meantime. So call it another $4 trillion as an early guess for next year.

Given how studiously our nation is avoiding this topic both in the major media outlets and during our last election cycle, I sometimes feel as if I live in a small mountain town that has decided to ignore an avalanche that has already let loose above in favor of holding the annual kindergarten ski sale.

The Treasury department soft-pedaled the whole unsustainable gigantic deficit thingy in last year’s report but they have taken a quite different approach this year. From page 10 of the report:

The net social insurance responsibilities scheduled benefits in excess of estimated revenues) indicate that those programs are on an unsustainable fiscal path and difficult choices will be necessary in order to address their large and growing long-term fiscal imbalance.

Delay is costly and choices will be more difficult as the retirement of the ‘baby boom’ gets closer to becoming a reality with the first wave of boomers eligible for retirement under Social Security in 2008.

I don’t know how that could be any clearer. The US Treasury department has issued a public report warning that we are on an unsustainable path and that we face difficult choices that will only become more costly the longer we delay.

Perhaps the reason US bonds and the dollar have held up so well is that we are far from alone in our predicament. In a recent article detailing why the UK Pound Sterling may fall, we read this dreadful evidence:

Officially, [UK] public sector net debt stands at £486.7bn. That’s equal to US$953.9bn and represents a little under 38% of annual GDP. Add the state’s “off balance sheet” debt, however – including its pension promises to state-paid employees – and the total shoots nearly three times higher. Research by the Centre for Policy Studies in London says it would put UK government deficits at a staggering 103% of GDP.

If we perform the same calculations for the US, however, we find that the official debt stands at $8.507 trillion or 65% of (nominal) GDP but when we add in our “off balance sheet” items the national debt stands at $53 trillion or 403% of GDP.

Now that’s horrifying. Staggering. Whatever you wish to call it. More than four hundred percent of GDP(!). And that’s just at the federal level. We could easily make this story a bit more ominous by including state, municipal and corporate shortfalls. But let’s not do that.

Here’s what the federal shortfall means in the simplest terms.

1) There is no way to ‘grow out of this problem’. What really jumps out is that the US financial position has deteriorated by over $22 trillion in only 4 years and $4.5 trillion in the last 12 months (see table below, from page 10 of the report). The problem did not ‘get better’ as a result of the excellent economic growth over the past 3 years but rather got worse and is apparently accelerating to the downside.

Any economic weakness will only exacerbate the problem. You should be aware that the budgetary assumptions of the US government are for greater than 5% nominal GDP growth through at least 2011. In other words, because no economic weakness is included in any of the deficit projections presented, $53 trillion could be on the low side. Further, none of the long-term costs associated with the Iraq and Afghanistan wars are factored in any of the numbers presented (thought to be upwards of $2 trillion more).

2) The future will be defined by lowered standards of living. As Lawrence Kotlikoff pointed out in his paper titled “Is the US Bankrupt?” posted to the St. Louis Federal Reserve website, the insolvency of the US will minimally require some combination of lowered entitlement payouts and higher taxes. Both of those represent less money in the taxpayer’s pockets and, last time I checked, less money meant a lower standard of living.

3) Every government facing this position has opted to “print its way out of trouble”. That’s an historical fact and our country shows no indications, unfortunately, of possessing the unique brand of political courage required to take a different route. In the simplest terms this means you & I will face a future of uncomfortably high inflation, possibly hyperinflation if the US dollar loses its reserve currency status somewhere along the way.

Of course, it is impossible to print our way out of this particular pickle because printing money is inflationary and therefore a ‘hidden tax’ on everyone. Consider, what’s the difference between having half of your money directly taken (taxed) by the government and having half of its value disappear due to inflation? Nothing. Except that the former is political suicide while the latter is conveniently never discussed by the US financial mainstream press (for some reason) and therefore goes undetected by a majority of people as the thoroughly predictable outcome of deficit spending. All printing can realistically accomplish is the preservation of some DC jobs and the decimation of the middle and lower classes.

In summary, I am wondering how long we can pretend this problem does not exist. How long can we continue to buy stocks and flip houses, forget to save, pile up debt, import Chinese made goods, and export debt? Are these useful activities to perform while there’s an economic avalanche bearing down upon us?

Unfortunately, I am not smart enough to know the answer. I only know that hoping a significant and mounting problem will go away is not a winning strategy.

I know that we, as a nation, owe it to ourselves to have the hard conversation about our financial future sooner rather than later. And I suspect that conversation will have to begin right here, between you and me because I cannot detect even the faintest glimmer that our current crop of leaders can distinguish between urgent and expedient.

What we need is a good, old-fashioned grassroots campaign.

In the meantime, I simply do not know of any way to fully protect oneself against the economic ravages resulting from poorly managed monetary and fiscal institutions. For what it’s worth, I am heavily invested in gold and silver and will remain that way until the aforementioned institutions choose to confront “what is” rather than “what’s expedient”. This could be a very long-term investment.

Are you shocked?

All the best.

Chris

All rights reserved, Copyright, 2006 Dr. Chris Martenson

While the US stock market blithely ambled about last week, unable to decide if it should blast higher or maybe give up some of its outlandish recent gains, ominous clouds of data darkened the sky. Here’s a sampling:

• US manufacturing shrank for the first time in 3 ½ years
• Consumer confidence slipped
• A sharp increase in initial claims for unemployment benefits was registered
• Weak holiday sales, and the first yr/yr decline in monthly sales for Wal-Mart in a decade, spoke to a flagging consumer mentality
• Durable goods orders and corporate investment fell sharply
• New home sales tanked
• A very sharp pullback in construction spending (both residential and non-residential), the most since September 2001, was recorded
• Mortgage applications declined
• Slumping auto sales signaled an auto recession (at the least)

How the stock market is able to remain elevated at, or above, all time highs (depending on which index is being considered) is simply beyond me. Massive flows of liquidity are blasting into the stock market from somewhere, somehow.

Meanwhile, back at the ranch, the US press was, as usual, furiously trying to soft-pedal the now worrisome weakness in the US dollar. Here’s the spin Business Week applied to the ugliness:

Europe calmly looks at sliding dollar

With the European economy on the upswing, companies and governments are shrugging off the dollar’s renewed slide against the euro this week — a phenomenon once dreaded as potential poison for the continent’s many exporters.

Companies appear to have made their peace with a stronger currency for the time being, especially in export champion Germany, helped by stronger growth at home, currency hedging and increasingly globalized production practices.

Don’t worry! Europe isn’t! That seems to be the opinion of this particular Business Week writer and his editors. Meanwhile, this is how it was being played over in the UK press:

Plunging dollar will set world markets reeling

The slowdown in the US economy, which has sent the dollar into freefall over the past fortnight, will have devastating knock-on effects in markets around the world, analysts warn.

It could just be me but I think I can detect a slight difference between the two articles.

So let’s take another look at that USD chart we viewed last week and decide for ourselves how Old Uncle Buckie is doing. When viewing the chart below keep in mind that ‘everybody’ was expecting the dollar to rebound after that horrible 2-day slide from Thanksgiving week. It did not. Things got worse.

[note: This is a daily chart so each bar, or candle, is a day.  Last week is represented by the last five bars, two white and three red]

Ugly. That’s some bad action right there. No recovery at all.  We’re still a couple of points away from the ‘danger zone’ at 80.50 but this past week did nothing but confirm that the dollar is under severe strain.

What we don’t know, out here in the cheap seats, is what’s really driving this decline. The US news does its best to ‘explain’ such movements by linking the dollar movements to recent happenings like weak US manufacturing data or weak holiday sales but in my experience such news has nearly zero predictive power for actual movements in the US dollar.

For example, it is not uncommon for the US press to report that the dollar went down because of weakness in some reported data set one month, only to state the opposite the next month. The point is that the US press feels an obligation to provide ‘an explanation’ but usually never does.

I believe that for the past several years the US dollar has gone up or down for one primary reason and one reason only; foreign central bank activity. Which foreign central bank is number one on that list? That’s right, China. And have there been any recent news reports that might help us understand why the dollar has been stumbling?

I’m glad you asked:

Paulson reaching out to China

Hank Paulson, US treasury secretary, will on Monday begin a series of discussions with industry leaders to hammer out the Bush administration’s policy towards China ahead of a high-level delegation to Beijing next week.

Monday you say? You mean this Monday after two weeks of dollar hell? Geez, it’s not like the US is planning to approach its largest creditor with a huge list of demands that might cause that creditor to ‘send a little message’ in advance of that meeting, right?

What? That is the case? That doesn’t seem too smart:

WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke will accompany Treasury Secretary Henry Paulson and other cabinet officials to Beijing next month to try to persuade China to alter its economic policies, senior U.S. government officials said on Thursday.

The 1-1/2-day visit in mid-December has an ambitious agenda to push, from urging China to let its Yuan currency to appreciate further to persuading it to reduce barriers to foreign investment and crack down on piracy and theft of intellectual property.

When I read the above, I think about the US hemorrhaging in every possible way in a dreadful Middle East conflict, a debtor nation without parallel that has squandered massive amounts of international prestige but now sees fit to ‘pre-sell’ a trip to it’s largest creditor trading partner with an exhaustive, if not petulant, list of demands. Search though you might, you will not find a corresponding list from the Chinese side. Why? Because that would be bad diplomacy and the Chinese are careful diplomats. I can only imagine how steamed they are over there right now. Oh to be a fly on the wall at those negotiations.

In the face of all of this, the stock markets continue to trundle along as if there wasn’t a care in the world. One area the stock market has allegedly drawn some comfort from is the government inflation data, which shows inflation backing off pretty sharply. The twisted logic of the stock market today is this; lower inflation will lead the Fed to reduce interest rates, which will translate into cheaper borrowing costs, which will lead to even more consumer borrowing which is ultimately good for the stock market.

It’s a logic train that only Rube Goldberg could love, but that’s what we’ve become as a nation…everything hinges on our ability to borrow ever more at ever cheaper rates.

However, as you know I am a huge critic of the way that our government collects and reports inflation numbers and I think the stock market is making a huge mistake in believing the ‘official inflation numbers’. For example, in the most recent GDP announcement it was reported that food costs are up 2.4% over the past year.

Hmmmm. Could they have forgotten to include the cost of orange juice which is up not 2.8%, not 3.9% not even a horrendous 9.2% but rather 66.0%(!!) over the past year?

In fact, this is not an isolated example. The following links to charts of all the major grain types reveals similar patterns. I wonder how food costs can be said to be up 2.4% when the actual price increases are up over 15 to 30 times that amount? A fair question, to be sure.

Corn (up 87% over the last year)

Wheat (up 58%)

Oats (up 44%)

Continuing into other basic materials I cannot find any that even remotely correspond to the government’s numbers

Oil (Unchanged)

Copper (up 60%)

Silver (up 75%)

Aluminum (up 39%)

These charts show, in frightening and graphic detail, that inflation is running at anything but the ~3.3% that the government recently reported.

The bottom line to these charts is that inflation is actually raging along quite nicely, thank you very much, and I sincerely doubt that the Fed is going to be able to reduce interest rates because of low inflation.

Instead the Fed may be forced to combat a severe economic slump initiated by a housing crash by slashing interest rates but that would then cause the dollar to decline even more sharply (since high interest rates support a stronger dollar and vice versa).

Hence the Fed is stuck between the proverbial rock and a hard place. Lower interest rates risk a severe dollar decline, but higher interest rates assure a recession with American citizens as poorly positioned for a recession as they can possibly be. What to do…what to do?

I predict the Fed will display their stupendous bureaucratic sclerosis and employ the vaunted ‘deer in the headlights’ strategy, which will manifest as a non-decision at their next meeting. Interest rates will remain unchanged.

As for stocks…look out below!

Best,
Chris

To subscribe for the free delivery of this weekly missive by email, please register over at DRMSS.COM
All rights reserved, Copyright, 2006  Dr. Chris Martenson 

I will have to make this very short this week. I blame turkey induced napping.

The US markets were shortened this week with Thursday being entirely closed and Friday a half-day.

However, the rest of the world was open and boy (!) did they have something to say about the US dollar.

In the chart below the red ‘candles’ (as they are called in financial chart-speak) indicate times when the US dollar is falling against a basket of foreign currencies, and the white candles indicate times when it is strengthening.

The basket has a number of different currencies within it but the ‘big three’ are the Euro, the Pound Sterling, and the Yen.

What this chart tells us is that the dollar had a really bad two-day losing streak on Thursday and Friday (Nov. 23rd & 24th). One of the worst in recent years.

I am keeping my eye glued to the dollar this week for several reasons:

1. If the dollar breaks ~80 on the scale above, there is suddenly a very real possibility that it will lose up to half of its international value. And pretty quickly too.
2. Gold, oil, and a significant proportion of our imported items will double in price (including oil).
3. The worldwide derivative tower, or colossus (or nightmare) rests on a stable dollar value. Upset one, and you upset both.

In fact, the dollar has gained and lost a lot of ‘value’ compared to other currencies in the past and this has largely gone unnoticed by the average American.

What could make it different this time?

1. America owes more to the rest of the world than ever before. In fact, the total amount has roughly doubled over the past six years.
2. Derivatives grew over 30% in size over the first six months of this year from $285 trillion to $370 trillion. Yikes! In six months! Let’s not trivialize this number. Let’s draw it out. That’s $370,000,000,000,000 … or more than 5 times the total yearly world economic output.
3. America now imports a much larger proportion of its basic needs. Stuff we either cannot produce (oil) or no longer produce (clothes, shoes, electronics, etc). If the dollar falls a lot, and quickly, we will simply have to adjust to higher prices.
4. Interest rates are very low but debt levels are very high. If the dollar starts to fall and our fiscal & monetary authorities want to stem those losses, the only tool in their tool kit (besides the gunboats I mean) is raising interest rates. What would happen to our economy if interest rates doubled? Nothing good.

If the dollar reaches and then breaches the key technical level of 80.50 I will be sending out my first ever email alert. What you do with that information is up to you, but I will be converting more of my dollars into foreign currencies, gold, and oil.

And now, for some random articles of import.

First, the USA imports a bunch of oil from Mexico. Mexico has a single ‘super-field’, the second largest in the world, as well as a number of less notable oil fields. The largest is called Cantarell and, as mentioned in this missive nearly a year ago, Mexican officials are now admitting that it is declining far faster than originally stated. There are some pretty serious implications behind this data.

PEMEX CEO Sees Cantarell Field Declining 14% Per Year

26 November 2006

In testimony before the Energy Committee of the Mexican Senate, PEMEX CEO Luis Ramirez Corzo said that production at the giant Cantarell offshore field will decline by an average of 14% per year between 2007 and 2015. The Cantarell complex currently produces about 1.8 million barrels of oil per day (bpd)—about 55% of the total 3.3 mbpd PEMEX estimates it will produce this year.

Next, why is the housing bubble going to be so painful? Because some people are going to be asked to pay over $1 million in interest and more than $450,000 in principle on a house they originally bought for $97,500. Confused? Read on:

Ana Martinez has repeatedly remortgaged her three-storey home since buying it in 1994 for $97,500, moving down the chain from bank lenders to sub-prime mortgage companies. In all, she has taken more than $300,000 that she says went for major house repairs and trips to Honduras to visit her ailing mother.

Most recently, she refinanced through a California sub-prime lender in October 2005. She ended up with two loans, one for $427,500 and another for $28,500.

The interest rate on the larger loan was fixed for two years at 7.35 per cent. After that, the rate is to ratchet up every six months until it hits a maximum of 13.35 per cent, said Virginia Pratt, a counselor at an community group called ESAC that is working to save Martinez’s house.

Documents show her monthly payment is to rise from $2,766 to $3,612 beginning June 1, 2008. After paying that amount for 27 years she will still owe a lump-sum “balloon payment” of $276,938. In all, she is scheduled to pay $1.14 million in interest over 30 years.

Can you imagine? This woman, who is not unique in the American experience, somehow convinced herself that lying about her income in order to obtain a mortgage the she could not afford, so that she could extract $300,000 in spending power from a house that she originally bought for $97,500 but is now going to pay $1.14 million in interest cost for…somehow she convinced herself that this made good fiscal sense. If Santa cares about this country, this year he will distribute a few million pocket calculators, plus instruction booklets.

And finally, Wall Street is starting to seriously fret about the outsourcing of jobs. It has finally dawned upon the financial masters of the universe that America losing it’s most important job categories is a terrible thing.

How and when did they come to this conclusion? After the data showed that their own “irreplaceable positions” as creative paper pushers, er, I meant ‘the center of financial innovation’, is rapidly slipping away:

Whatever the causes, the numbers bear out America’s slippage. It is still well ahead of Europe in hedge-fund and mutual-fund assets, securitisation, syndicated loans, and turnover in equities and exchange-traded derivatives. In all but one of these, however, the gap narrowed in 2005. Europe’s corporate-debt market overtook America’s last year (see chart 1), although America still leads in high-yield “junk” bonds, a distinction less dubious than it once was.

The loudest sucking sound has been in the market for initial public offerings, a crucial barometer of financial wellbeing. America’s share (measured by proceeds) has collapsed since the late 1990s (see chart 2). Five years ago the New York Stock Exchange dwarfed London and Hong Kong. This year it is being beaten by both.

This is shocking data because it means that we flubbed our most basic assumption about the future. We (and by “we” I mean congress and their lobbyists) gave up our manufacturing base under the assumption that our financial economy would then service the needs of the rest of the world. You know, along the lines of we’re the brains and they’re the muscle. That sort of thinking.

Ha ha ha America! It turns out, shockingly, that the rest of the world can creatively push paper around just as well as we can. Who knew?

At any rate, it sort of begs the question – if we no longer manufacturing things and we are no longer the financial center of the universe, what exactly are we? And how will we earn a living at it?

I need to go take a nap.

All the best,
Chris

All rights reserved, Copyright, 2006 Dr. Chris Martenson

Since there’s nothing really new to report on the markets this week – stocks remained mysteriously levitated despite a bevy of harsh news on the housing front; bonds, gold, the dollar and oil seem to be in holding patterns – I will use our time this week to round out a topic that we covered in some detail in the lecture series. And, no, that topic is not my waistline.

What I’m talking about is debt.

Here’s what we know about debt. Debt comes in two forms. The first is called, in banker parlance, ‘self-liquidating debt’ and represents borrowing that will boost economic activity and therefore stands an excellent chance of ‘paying itself back’. The simplest example would be a case where you could borrow money at 5% but loan it out, risk free, at 7%. If I had the opportunity to conduct such a trade I would go into as much debt as possible, sit back, and watch the money roll in. More broadly, self-liquidating debt typically has a productive asset tied to it, such as a utility company, an apartment building or a factory which generates the income to pay off the debt.

The other type is ‘non self-liquidating’ debt which, as you have already guessed, does not ‘pay for itself’ and is used for consumption, not investment. An example would be borrowing $40,000 to buy a car which does not get you to work any faster than your old beater. Or the construction of a shiny new town hall. Or a war of choice in the Middle East. All of these represent debt taken on today in order to purchase and consume something today but the purchases do not then lead to new economic earnings. The money is spent, but the debt remains.

Since 2001, our national level of debt has very nearly doubled. Almost all of this mountain of new debt has been of the non self-liquidating variety.

And here’s the one thing we need to remember about this kind of debt; it represents future consumption taken today. Sometimes people find this statement confusing so let me flesh this out. In the case of the auto purchase given above, $40k was borrowed and the car purchased. But later, the loan has to be paid back, with interest. And every one of those future payments are made with real cash that is not available to spend on something else (or even save). Cash that you can’t spend in the future represents consumption that you must forgo. In other words, a preference for a car today acquired via debt is really just another way of saying that having the car NOW has a higher ‘value’ than having a car’s worth of purchasing power in the FUTURE.

And finally, remember that there are only 2 ways to make a debt go away:

1) Pay it back

2) Default on it

Unless you are the federal government in which case you can always go for the third option:

3) Print money to pay the debt.

The federal government always favors this last option because so very few people correctly perceive the (inevitable) resulting inflation for what it really is, a hidden tax that erodes the value of all existing money, whereas everybody understands that raising taxes directly takes their money away. But, having sat through the seminar series, and having the buttocks calluses to prove it, you understand this mechanism and know that inflation is everywhere and always a monetary phenomenon. Excess printing by government always, always, always leads to inflation. End of story.

So what does any of this have to do with the title? What does any of this have to do with morality?

Well, we can rotate the topic slightly and see that there are two other ways to view debt. On the one hand there’s debt taken on with the intent of paying it back, and on the other hand there’s debt taken on with the intent that it will not be paid back.

To pass judgment on these two approaches, the former is moral, the latter is immoral (and usually illegal). To really understand this judgment we’ll need to take look at this in greater detail.

Certainly we can all agree that taking out a loan with the intent of never paying it back runs afoul of a variety of civil and criminal laws. But what about a situation where one generation borrows with the intent that a future generation will be the one paying off the loan? Further, what if the loans were of the non self-liquidating (consumptive) variety and zero benefit would accrue to the future generation? Would we call that immoral as well?

Well, the 6,000-pound elephant in the room is that is exactly how the US has been operating for the past 20 years or so. This is not to point a finger of blame, or to create victims and victimizers. We have all been equal, eager and willing participants in this game. We have been robbing Peter to pay Paul. Unfortunately, Peter has not yet even been born, which means what we’ve done is even easier than taking candy from a baby. Babies cry a lot when you take their candy, which I find troubling. Earmuffs help, but even then…

At any rate, we can observe the phenomenon of generational theft in the negative $65 trillion net worth of the US at the federal level, the $8.6 trillion in direct federal debt, and the negative $1 trillion in unfunded pension obligations at the state level. Each of these represents borrowed promises that the current generation has opted to lay upon future generations. In every case it has also meant that current and past generations have been able to enjoy both high consumption and low taxes.

Need more proof? Observe the record-breaking 97% pass rate of state bond issuances in the November 2006 elections. This Bloomberg article explains, and is worth your time to read:

Welcome to the Golden Age of Public Finance — Nov. 8 (Bloomberg)

That’s the message voters sent to the municipal market yesterday, as they approved the majority of the record $78.6 billion in bonds placed on the ballot this year.

Of the $56.5 billion in bond issues totaling $200 million or more being considered nationwide, Bloomberg News this morning calculated that 97 percent had passed. The majority appear to be for education, the remainder, money to be used for infrastructure construction and maintenance.

The election of 2006 marks a watershed for the municipal market. Never before have voters had to consider so many bond issues. Never before had they approved so many.

What’s going on here? The easiest answer would be to blame California, where voters were asked to approve that outlandish package of $43 billion for transportation, water, and school construction, and did.

That’s the easy answer. It would be harder to prove, but it wouldn’t be overstating the case to attribute the big election to generational change.

Stay with me here. The people who approved these bond issues, most of them, I’d bet, grew up in the 1970s.

What does that have to do with it? These are people who are used to having nice things. By comparison, those who grew up in the Great Depression and the 1940s were used to making do. They were suspicious of government, and of debt.

When they entered their 30s and 40s, it was the 1970s. The approval ratio for the 1970s, the entire decade, was 49 percent. There were years when this frugal generation approved 9.5 percent (1975), 18 percent (1971) and 33 percent (1973) of the bonds put before them for consideration.

Those who grew up in the 1950s and 1960s, certainly a happier group, approved marginally more borrowing 30 years later, when they started raising their families. The average approval ratio during the 1990s was 69 percent.

Now we’re talking about people who were born in the 1970s. These are the people who enjoyed air-conditioned schools and comfortable college dorms and coffee that tastes good, and they want the same things for their children, as well as things like smooth roads that aren’t too crowded, and new sidewalks, and nice parks, and roomy stadiums. They grew up cosseted, and squeamish about things that are less than just so.

These are the people who have moved to the suburbs and the exurbs and they see no reason why they shouldn’t borrow millions and billions of dollars for things that are going to have a useful life of, oh, when it comes to bridges and highways and sewers and the like, of 50 years to forever. The approval ratio for bonds put up for the vote in the 2000s is 80 percent, according to the Bond Buyer.

So welcome to the Golden Age of Public Finance. Now that this bunch has seen how easy it is to get a whole barge load of bonds passed, look for election ballots to swell to even more unseemly sizes in the years ahead.

I think the author, above, has made a very good set of observations. Namely that the current generation has lost all compunction about borrowing long-term to finance near-term consumption.

And this has come about because Greenspan’s “easy money 4-ever policy” of 1995 through 2005 has lulled us all into thinking that easy, cheap borrowing is a permanent condition. It is not. The piper always must be paid.

But more importantly, I have serious moral reservations about one generation saddling the next with its debts. How can this be right? At the federal level we’ve decided, as a nation, to make all sorts of promises that cannot possibly ever be kept at current levels of taxation. So either future senior citizens are going to be sorely disappointed by meager entitlement payments or future taxpayers (my kids) are going to have to shoulder crushing employment tax burdens.

For the senior citizens this is patently unfair since they paid more than their fair share into these retirement programs all their working lives. Should it be their fault that our leaders decided to use those ‘excess funds’ for current spending on hapless wars, bridges to nowhere, and other exotic examples of pork barrel spending of every conceivable stripe?

On the other hand, should it be the responsibility of subsequent generations to shoulder the burden of paying for all that past consumption and our collective decision to ‘fund’ past societal excess with future promises to pay?

In this skirmish, I must side with the future generations. I think it is incumbent on each generation to figure out how to pay for whatever levels of consumptive spending it deems fit.

I think that racking up huge debts with the intent of pushing their repayments off to future generations is morally equivalent to loan fraud. It would not surprise me in the least if future generations decide that they have no legal or moral obligations to make good on that debt.

In the meantime, we each must ask of ourselves where we stand on this issue, how we’ve benefited, and whether we have any sort of an obligation to correct the situation.

I hope you have found my logic to be even more expansive than my waistline.

All the best,

Chris

Copyright 2006, all rights reserved.

I’m leaving later today for a long weekend adventure, which means I’m going to have to put this out in record time. Which is an oblique way of saying my normally shoddy quality control is headed right out the window. So brace yourself for a rough ride as I arrange the typos and grammatical blunders in a tight washboard pattern on a horribly constructed metaphorical road.

Market action: This week saw the stock market start to yield some of its recent outsized gains as the reality of an impending recession started to force its way into an irrationally exuberant market. Retail sales were softer than expected, auto sales rebounded compared to last year but were hardly spectacular and the steady trickle of bad news on the housing situation continued unabated. Worse, productivity dropped while labor costs rose which was a double whammy for the stock market bulls who were hoping for another round of interest rate easing by the Fed.

Isn’t it odd that our stock market would care more about interest rates than actual economic activity? Wouldn’t this imply that the stock market cares more about people’s ability to go deeper into debt (low interest rates = cheap money = more debt at a faster rate) than it does about the actual growth of our productive enterprises?

Yes it does, and that is sad. It means that somewhere along the line US citizens slipped from a position of adding value via productive enterprise(s) to the shallow occupation of being consumptive borrowers. As always, if anyone out there can find any country, any persons, any businesses that managed to borrow and consume their way to wealth, please call me at any hour of the day or night.

Robert Rubin, former Treasury Secretary under Clinton, recently put it this way:

“I think there’s been a curious phenomenon in the equity markets, at least in the last few months: When there is news that the U.S. economy is slowing, the market often gets stronger because investors figure the Fed will stop raising rates, or maybe lower rates — or maybe they think bond yields will decline. For some reason, they don’t seem to say to themselves that earnings may be lower. I think it’s very strange.”

He’s right, it is very strange. Unless you’ve been through The Straight Story seminar series, then you understand that for a late-stage, debt based, fiat money system (such as ours) nothing is more important than additional, new credit (debt) creation. If the credit machine ever fails to create enough new debt (money) to pay off the old interest (uh oh!) the US economy will resemble a failed Saturn-V rocket launch, tipping slowly to the side as it’s forward momentum fails. The stock market understands this very well.

What the stock market doesn’t understand very well, anymore, is risk. With all the indexes perched near their five-year highs one would be hard-pressed to find any indication that a recession is even a remote possibility. Here’s Rubin again on risk:

“Sandy Weill (the former Citigroup chairman) made a good comment to me. Nobody’s going to ring a bell to tell you, but someday you may wake up and find out that these risks have materialized.”

Rubin observed that many people seem to think the risks that do exist won’t matter in the short run. Therefore, they’re fully invested — “because that’s not their time horizon in calculating an expected value. … Also, some assume that they can get off before the music stops. You know, not everybody is going to get off before the music stops.”

Which raises a set of important points. First, all the market participants seem to be assuming that the Fed, or the government, or whomever is going to ‘save’ the market should it start to decline. Second, if this turns out not be the case, everyone assumes that they’ll be able to get out “before the music stops”. These are both very, very dangerous assumptions. In the first case because the market is waaaaaay bigger than the Fed and the government combined and second because more than 60% of the market is now traded by computers with sub-millisecond execution times.

By the time you or I, or most market participants, find out that something is amiss in the markets most of the important trading will have been over a long, long time ago. Many hundreds of thousands of milliseconds ago.

Lastly, Rubin said this on the dollar:

“You have to figure out some way — which I have not done, I might add — to protect yourself should we have a real currency problem here. I’m not saying what the odds are. I have no idea. Maybe the odds are very low. But that is one concern.”

I have managed to figure out a way to protect from a falling dollar and that is to buy gold, silver, or any other commodity priced in dollars. What Rubin meant was he couldn’t find a way to protect the gigantic bank he works for from a fall in the dollar. That, truly, is a very significant problem because they have tens of billions under management. But for you or I, gold would work very well.

Moving on…if you like hypocritical, self-serving statements by powerful people you’re going to love this recent comment by Ben Bernanke, the Fed Chairman regarding ARMs:

“Some evidence, including recent Federal Reserve research on consumers holding adjustable-rate mortgages, suggests that awareness could be improved, particularly among borrowers with lower incomes and education levels,” Bernanke said in prepared remarks to a conference here on community development.”

Uh, earth to Ben? You do recall that it was your predecessor Greenspan who advised consumers to use ARMs back when interest rates were low in 2004? And you are also aware that it is at least in part up to the Fed to set lending standards? I could go on and on deconstructing Bernanke’s dismissive attitude towards “low income and education” borrowers, but I’m sure you get the idea.
Next up, USA Today continues to shine a bright light on the economy and actually points out how distorted the official inflation measures actually are in this remarkably revealing article:

Low inflation rate? Some consumers beg to differ 11/1/2006 11:05 AM ET by John Waggoner

Ask most economists about inflation, and they’ll tell you it’s low. Ask the average consumer, and you might get a very different answer.

Sean Taylor, 34, an information technology consultant in Trenton, N.J., ticks off the changes in his bills in the past nine years: property taxes, now $9,000 a year, up 105%; heating oil, $238, up 109%. His wife, Carrie, a state employee, pays $87 a month for health care; nine years ago, it was free. His income varies from year to year. Her salary is $75,000, up from $45,000, or 67%.

The consumer price index, including food and energy, has risen 2.1% in the past 12 months, according to the Bureau of Labor Statistics (BLS). By most measures, that’s low inflation. At that rate, it would take about 35 years for prices to double.

Somehow, though, it doesn’t sound quite right to Stacy Harris, editor of Stacy’s Music Row Report, a country music news website based in Nashville. “I feel the bite every time I go to a grocery store,” Harris says. Food prices have gained 2.6% the past 12 months, according to the BLS.

“The CPI is somewhat of a plutocratic measurement,” says Mark Zandi, chief economist for Moody’s economy.com. “Spending is dominated by wealthier households.”

The index also adjusts for the increased value of goods, which critics argue understates inflation. For example, if you buy a laptop computer today, you’ll pay roughly the same amount you would have three years ago. But your computer will be faster, have more storage and probably a Wi-Fi card, too.

Using the BLS methodology means that personal computer prices have fallen about 61% in five years and about 85% since September 1998 — a discount most consumers haven’t actually experienced.

I love that the practice of hedonic adjusting is finally being exposed in print. However, the article missed a golden opportunity to point out that property taxes, which were flagged as problematic by the persons they interviewed, are not actually included as a component of the CPI measure. All in all though, a great article.

And finally, I got a bit of a kick out of this report in Fortune on recent auto purchases by US consumers which showed a big spike in SUV sales:

NEW YORK (Fortune) — Who can remember all the way back to last summer, when we had daylight-saving-time, baseball and $3 a gallon gasoline prices?

Not American car buyers, apparently, and you can see the evidence in the results of October auto sales.

Sales of big pickup trucks and SUVs went through the roof - doubling from the year before in some cases. Sales of small, fuel-efficient cars, meanwhile, remained stagnant. It is as if all that moaning and groaning about price gouging by oil companies never happened.

Actually, it is worse than that. American consumers have reinforced all the stereotypes they are labeled with: short attention spans, lack of social consciousness and thinking with their wallets.

Does anyone seriously believe that having once spiked up to $3 with very little provocation, gasoline prices won’t do it again? Have they forgotten about the ongoing instability in the Middle East? And have they stopped caring about traffic density, scarce resources or global warming? And if they haven’t, why aren’t they exercising better sense in their vehicle preferences?

For SUV sales to tank when gas is $3 but come roaring back at $2.30 merely shows that the American consumer assumes that whatever is happening at the moment is a permanent condition.

Not at all unlike a 1 year-old that has not yet developed a sense of object permanence.

I mean, good gracious! An SUV purchase is a 7-10 year capital purchase but somehow the last 4 years of rising energy costs is meaningless to the average US consumer. All that matters is the last two weeks of gasoline prices at the pumps. Such intellectual rigor usually gets everything it deserves.

In closing, now more than ever would be a good time to remain alert. I would be especially leery of any government numbers regarding housing, employment, the GDP, etc. The stakes involved in this election are simply too high to ignore.

And I hope that your long, endless trip to get this far into the missive wasn’t overly bumpy.

All the best,

Chris

Copyright 2006, all rights reserved.

This was a big week for economic numbers. Those of you who have attended the Straight Talk seminar series know that most of the economic numbers come from either the government or trade associations and that both sources have conflicts of interest when it comes to presenting unbiased data.

Unfortunately, the numbers released this week were no exception.

Let’s start with the headline Gross Domestic Product, or GDP, number that was released on Thursday morning and came in at a disappointing 1.6%.

Growth rate is weakest since first quarter of 2003

By Greg Robb, MarketWatch
Last Update: 12:38 PM ET Oct 27, 2006

WASHINGTON (MarketWatch) — U.S. economic growth slowed sharply in the third quarter, increasing at a real seasonally adjusted annual rate of 1.6% after a 2.6% increase in the second quarter, the Commerce Department said Friday.

Investments in housing fell 17.4% in the third quarter, the largest decline since the first quarter of 1991. Housing subtracted 1.1 percentage points from third-quarter growth.

In nominal terms, GDP increased 3.4% to an annualized $13.3 trillion.

Inflation at the consumer level eased in the July-through-September period. The personal consumption-expenditure-price index increased at a 2.5% annual rate, down from 4% in the second quarter. The core PCE price index — which removes food and energy costs — increased at a 2.3% rate, down from 2.7% in the second quarter.

But the core PCE price index has increased 2.4% in the past year, up from 2.2% year-over-year growth in the second quarter. That’s the fastest pace since the second quarter of 1995.

Government spending increased 2%. Federal spending increased 1.7%, including a 6.9% rise in nondefense spending. State and local government spending increased at a 2.1% rate.

There was little evidence of the weak auto sector in the GDP report. Motor-vehicle output added 0.7 percentage point to growth and consumer spending on cars added 0.4 percentage point

There are a number of very odd things about this GDP release. First of all, the basic numbers do not add up. The Real GDP is what is left after nominal GDP has inflation (using the notorious ‘implicit price deflator’) subtracted. After 4 quarters of stating that inflation was 3.3%, this time around the BEA announced that inflation was only 1.8% - or that it had been cut nearly in half. Inflation is not usually so volatile but, unfortunately, no explanation was given for why/how this number suddenly plunged.

Next we might take note of the rather rapid collapse in residential real estate investment and ponder how many economists persist in claiming that collapsing real estate will have no impact on the economy (see the post from 3 weeks ago for an answer).

Lastly, we find the immensely bizarre claim in the report that the automobile industry expanded by a full 26% over last year leading, all on its own, to an incremental addition of 0.7% to the nation’s GDP. Here we have to note a few things…last year was a record year for auto sales and this year was not. So how did auto sales manage to expand? Next, the big three auto manufacturers all reported significant cutbacks in production this past quarter. So how do such cuts sum up to a hefty expansion?

Again, we are simply dealing with extremely fuzzy government numbers. I wasn’t the only one scratching my head at that one. This article points out that much of the financial world was shocked at the great pre-election auto-revival miracle:

U.S. Data Fluke Exaggerated Growth, Will Be Reversed

By Carlos Torres

Oct. 27 (Bloomberg) — An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist.

Last quarter’s annualized 26 percent increase in auto production shocked Joe Carson, now director of economic research at AllianceBernstein LP in New York. Without the gain, the economy would have grown at an annual rate of 0.9 percent, not the 1.6 percent the Commerce Department reported today.

The reported increase in output came despite cutbacks announced by General Motors Corp., Ford Motor Co. and others. A drop in the wholesale price of SUVs and light trucks as the automakers cleared leftover 2006 models made production look stronger than it actually was, said Carson. The economic fallout from the auto-industry cutbacks will instead come this quarter, he said.

“Last quarter was weak even with the benefit of this mismatch and the fourth quarter will now also be weak because it’s going the other way,'’ Carson said. “Whatever output you have this quarter, which will probably be down, will be discounted by a likely rebound in prices.'’

The mismatch can be explained by looking at how the government adjusts the figures for price changes.

Commerce Department economists use wholesale light truck prices, from the Labor Department’s producer price report, to eliminate the influence of inflation on investment and inventories for that category. A 5.5 percent drop in price of SUVs and other light trucks last quarter made output look stronger when adjusted for inflation.

Did you follow that? I’m not sure I did but basically it seems that the government interpreted lowered truck prices as the same, statistically speaking, as a gigantic increase in output. Confused? Don’t worry! That’s normal. If you’re not confused, you may want to apply down at the Commerce Department for a very satisfying career in number torturing. The job of water-boarding the auto data is clearly well staffed, but perhaps there are other opportunities.

And so, as expected (by me) the great auto-revival of 2006 has been revealed to be nothing more than garden-variety statistical fakery. Also not surprising is that the statistical ‘fluke’ had a positive bias. In fact, I cannot recall the last time a government statistic had a negative bias…

Prediction time. When the next quarterly GDP report is released watch for two things; this quarter’s amazing increase in auto production will be quietly revised down (heavily) and then next quarter’s auto data will handily beat that number allowing our DC denizens to point to yet another expansion in auto sales. Wash, rinse, repeat.

That’s how the game is played. Spin every number to the upside, quietly revise it later to the downside, then beat that new lower number on the next pass trusting that nobody will care about a huge downward revision of ‘old data’. I’ve seen this done with ever increasing frequency over the past 5 years to the point that it is now standard operating procedure. Wash, rinse, repeat.

Why do we care about such arcane minutia as fraudulent auto sales in a quarterly GDP report? Because bad data can lead to bad decisions which often leads to malinvestment. [I wonder how many stockbrokers are advising buying or holding auto shares based on the GDP ‘strength’?]

Nobody is doing us any favors by misreporting this data – nobody gains except the incumbent politicians. So consider the latest GDP report to be the national equivalent of a nice, gigantic happy face carpet laid over a field of withered crops.

Next I’d like to refer you to this article about David Walker, Comptroller of the USA (head of the GAO) detailing his efforts to make our current political establishment take notice of our nation’s precarious economic situation. Here are a few snippets from the article:

GAO Chief Takes to Road, Warns Economic Disaster Looms Even As Many Candidates Avoid Issue

AUSTIN, Texas (AP) — David M. Walker sure talks like he’s running for office. “This is about the future of our country, our kids and grandkids,” the comptroller general of the United States warns a packed hall at Austin’s historic Driskill Hotel. “We the people have to rise up to make sure things get changed.”

From the hustings and the airwaves this campaign season, America’s political class can be heard debating Capitol Hill sex scandals, the wisdom of the war in Iraq and which party is tougher on terror. Democrats and Republicans talk of cutting taxes to make life easier for the American people.

What they don’t talk about is a dirty little secret everyone in Washington knows, or at least should. The vast majority of economists and budget analysts agree: The ship of state is on a disastrous course, and will founder on the reefs of economic disaster if nothing is done to correct it.

This year Walker has spoken to the Union League Club of Chicago and the Rotary Club of Atlanta, the Sons of the American Revolution and the World Future Society. But the backbone of his campaign has been the Fiscal Wake-up Tour, a traveling roadshow of economists and budget analysts who share Walker’s concern for the nation’s budgetary future.

Wow! It turns out that David Walker and I are running about giving substantially the same lecture. Only he’s got a supporting cast of big-name economists whereas I have two good shirts, one without gravy stains on it. At any rate, I consider this article important enough that I have given it a permanent home over on our discussion forum. David Walker points out that every year we fail to deal with this issue means an additional $3 trillion of additional liabilities pile up on all of us. How much is $3 trillion? Beats me. But it’s a very, very big number.

I take this article to be further confirmation that our ‘leaders’ are not going to do anything about our fiscal situation until there’s an emergency. If you too wait for that moment to attend to your fiscal preparations you may find the situation chaotic and uncomfortable.

Housing: Finally, we need to keep our eye on the nation’s housing situation as this holds the key to our near-term economic future. Besides the usual litany of rapidly rising inventory and slumping sales, we had a real shocker on Wednesday with this news:

The Commerce Department reported yesterday that the median price of a new home plunged 9.7 percent last month, compared with September 2005, falling to $217,100, the biggest such drop since December 1970.

Holey smokes! This means that (on average) everybody who bought a new house over the past 9 months now finds that their house is worth less than what they bought it for. Is 9.7% decline a lot? Well, it’s the biggest decline ever recorded. So yes, it’s a lot.

However, even the 9.7% is known to be under reported due to some quirks in how that number is derived by the Census Department. From the same article as linked above:

The home builders’ association reported that 45 percent of builders and developers said they cut prices in September to maintain sales volume. That was up from only 19 percent a year earlier. Similarly, the association reported that 55 percent offered amenities like granite counters or upgraded kitchen cabinets for no additional cost. Only 19 percent did so a year earlier.

The cost of those incentives was not reflected in the new-home price data, which suggested that builders were making even less money from each sale than the shrinking official prices would indicate.

I could show you dozens of articles from this past week revealing the myriad of builder incentives that are now a normal part of the sales pitch ranging from free trips to warm locales, granite counter tops, pools, money towards closing costs, and even to the entire first year of mortgage payments being picked up by the builder. None of those incentives are counted against the sales price by the government which serves to (surprise!) bias the data positively.

However, suppose you paid $250k for a nice house and that your new neighbor bought a similar house 6 months later for $250k but their house had a pool, nicer amenities, and more square footage. You’d likely consider the sales prices to have been unequal. The government would not. If you find yourself in this particular situation, I recommend selling your house to a government official.

Why are we seeing such a rapid decline in new home prices? An excerpt from the San Francisco Chronicle explains:

If you are interested in reading more about the current state of housing I highly recommend that you visit this site: http://thehousingbubbleblog.com/

There you will find:
· Rapidly climbing inventory levels virtually everywhere in the country
· Falling house prices
· Rising foreclosures
· Tales of appraisal fraud
· Tales of woe from unwary ‘flippers’ (people buying and rapidly selling houses hoping for a gain).

As I read it, the correction in the housing market is picking up speed, and shows no signs of getting close to a bottom. Based on the behavior of 4 past housing booms, I would expect a bottom sometime between 2008 and 2010.

In the meantime, I’ll do what I can to keep you apprised of the various fuzzy numbers that you may encounter and which may cloud your vision.

Signed, your very fuzzy economist,

Chris

All rights reserved, Copyright 2006, C. Martenson 

Since I was away all last week watching groups of people interact with each other in the great outdoors, and not home watching the market’s daily gyrations, this week’s summary will focus on a macro issue that’s been stewing in my brain for a while.

Please understand that today’s missive will be more speculative and scenario based than usual. It is styled in the manner of a short strategic think-tank document. All links to the base data have been provided. As always, do your own research and come to your own conclusions. Counter arguments are always appreciated.

To begin, you may be puzzled as to why the economic data clearly reveals desperate and mounting fiscal realities that somehow never get the light of day in Washington DC. How can this be? How is it that 100% of both Democratic and Republican ‘leadership’ have completely avoided even mentioning the burgeoning issues? Are the issues not real, or is it merely that the “guy from Bernardston MA” is creating darkness out of shadows? Or is it that the economic realities are just too esoteric for DC to comprehend? Actually, this last one does not hold water because there are now lots of articles being written about these issues.

For example, here’s an Op-Ed piece from the Oct. 23rd Washington Post that captures the reality for us:

When historians analyze the decline of empires, they tend to point to economic frailties that undercut military vigor. Well, the United States has several economic frailties and can’t seem to address any of them.

Every honest politician knows that entitlement spending on retirees is going to bust the budget. But since the failure of Bush’s proposed Social Security overhaul last year, nobody is doing anything about it.

Every honest politician knows that we need to quit gobbling carbon. But higher gas taxes are seen as a political non-starter on both sides of the political spectrum.

Every honest politician knows that support for globalization is fraying because of rising inequality at home. But how many of them stand up for policies that could reduce inequality without harming growth — most obviously, tax reform? You don’t hear anybody on the left or right denouncing the absurdity that more than half the tax breaks for homeownership flow to the richest 12 percent of households.

This concise summary states the obvious; the US is on unsustainable paths with respect to entitlement programs, energy usage, and globalization – any one of which could make life miserable for us. Literally nothing is being done at the policy level to address any of these issues, let alone all three.

So we must ask ourselves again, why is nothing being done? Is it that there are no political points to gain by approaching these issues? The answer to that must be a hearty “NO!” because every single person I have talked to would welcome initiating a program equivalent to the Manhattan Project to address our current and future energy needs. I have talked to hundreds of people and I have yet to talk to a single person who does not agree that a bold US initiative centered on energy is needed. Something approaching 100% agreement exists within and among the electorate. But 0% of politicians have latched onto this issue.

Are we to believe that somehow no politician at the national level has figured out how to capitalize on 100% unanimity?

If we cannot believe that, then what are we to believe?

I think the answer lies within a quote from Dick Cheney from 1999, prior to his assuming the mantle of power:

Back in September 1999, a full year before the US elections, which made him the most powerful Vice President in history, Cheney gave a revealing speech before his oil industry peers at the London Institute of Petroleum. In a global review of the outlook for Big Oil, Cheney made the following comment:

“By some estimates there will be an average of two per cent annual growth in global oil demand over the years ahead along with conservatively a three per cent natural decline in production from existing reserves. That means by 2010 we will need on the order of an additional fifty million barrels a day. So where is the oil going to come from? Governments and the national oil companies are obviously controlling about ninety per cent of the assets. Oil remains fundamentally a government business.

While many regions of the world offer great oil opportunities, the Middle East with two thirds of the world‘s oil and the lowest cost, is still where the prize ultimately lies. Even though companies are anxious for greater access there, progress continues to be slow. It is true that technology, privatisation and the opening up of a number of countries have created many new opportunities in areas around the world for various oil companies, but looking back to the early 1990‘s, expectations were that significant amounts of the world‘s new resources would come from such areas as the former Soviet Union and from China. Of course that didn‘t turn out quite as expected. Instead it turned out to be deep water successes that yielded the bonanza of the 1990‘s.”

One does not need to be a linguistic expert to read between the lines….Cheney was laying out the power framework for the next few decades and he clearly thought (and rightly so) that it centered on access to oil, and Middle Eastern oil in particular. Further, he makes clear that in 1999 the calculus of diminishing production and rising demand had already been converted into a strategic policy framework.

And so, we might speculate that the current DC ‘leadership’ is all too painfully aware of the implications embodied within Cheney’s quote above and the reason that we are seeing zero positive activity at the national level on these issues is because nobody has a plan. Or possibly there’s a set of super secret plans that can’t be shared with the little people because we might do something irresponsible with the information such as stop buying stuff that we don’t need with money that we don’t have.

I am in the camp that believes that plans exist. Strategic plans, tactical plans, contingency plans, secret plans, diplomatic framework documents, super-double-secret-contingency plans and all the rest. Why? Because I would have them, that’s why.

This brings to mind a quote by John Adams:

Power always thinks it has a great soul and vast views beyond the comprehension of the weak; and that it is doing God’s service when it is violating all his laws.

Regardless of whether plans exist or not, what are we, the denizens of the cheap seats, to make of this peculiar situation?

I think the conclusion is both simplistic and chilling; the US economy must be engineered to fall, and fall hard.

Here’s the logic.

1. Oil is the lifeblood of every economy. Oil is a non-negotiable necessity to conduct modern war. Accordingly, governments have never actually cared about the price since all governments simply print money out of thin air. All the political hand wringing about ‘the price at the pump’ is mere show for the locals. On the international stage all that matters is access, not price.
2. Global production has not increased since the 4th quarter of 2004, nearly 2 years ago(!). Despite the powerful economic incentive offered by $50, $60, and then $70 oil, somehow all the oil producing countries never managed to exceed their 2004 total output. We must now be ready to accept that at least a temporary global peak in production has been reached. Remember, when demand outstrips supply at the global level, a phenomenon of national hoarding may develop.
3. Current fields are collapsing faster than previously estimated. The vaunted North Sea fields which supply the majority of northern Europe’s petroleum needs are declining between 10% and 11% per year. The Cantarell field in Mexico (the second largest producing field in the world) may lose 75% of its production in only 3 years, or a 15% to 20% decline rate per year. So Dick Cheney’s 1999 estimate of a 3% annual decline in existing fields has not been validated in the field. Rather, it seems that our new drilling technologies, which boosted production dramatically throughout the 1990’s, did so at the expense of future (that is, current) production. If you were a policy maker, knowing how dependent the US is on imports, and knowing that production declines were far more dramatic than you previously thought, what would you do? Would you invade a country centrally located in the Middle East?
4. If I were a power-centered politician, I would do everything in my power to prevent demand from crossing supply. Everything. Why? Partially because of my fear of the national hoarding mentioned above, but mainly because the US imports more than 65% of its petroleum energy needs and is therefore uniquely vulnerable to supply disruptions. A cut in supply would rapidly topple the US economy and, because we have more debt than ever, might do so in a fairly dramatic fashion. Also, I might worry that all of my past policies would be revealed as abject failures and that my friends and I might get permanently removed from office (*shudder*).
5. China and India are ramping up their consumption dramatically. In fact China will overtake Japan this year to become the second largest seller of automobiles in the world. At this clip, China will overtake the US in only 13 more years. Think about that for a minute. I can state with near certainty, having looked at an exhaustive list of all the new oil projects that are slated to come online over the next 5-10 years, that world production cannot possibly meet this new demand.
6. The only way to force China and India to halt or even reverse their demand for additional oil would be to engineer demand destruction. One way would be to invade the countries and wreck their infrastructure. That’s not a realistic option. The other way is to wreck their economies. How? Easy, both countries are completely dependent on US demand, so all one has to do is pull the rug out from under the US consumer and there will be massive economic hiccups ‘over there’.

Admittedly, this is a rather lengthy string of dots to connect, but it feels about right to me. If you’ve attended The Straight Story economic series you are aware of the other dots that we could weave in such as the new bankruptcy law that seems specifically designed to protect banks from a consumer melt-down and possibly conclude that there is an elite group that will not only survive an economic dislocation, but stands ready to convert lots and lots of worthless debt into hard assets such as houses and land.

Accordingly, there will not be much resistance within the halls of power to a plan that lays the burden of a global energy insufficiency upon the backs of unwary US consumers.

If anybody has another way to connect these dots, one that offers a more flattering view of our DC leadership and our economic future I invite you to send them to me to share with this group.

As always, now is the time for us to become educated, think for ourselves, and come to our own conclusions. Which brings me to my personal motto: “I’d rather be prepared and wrong, than unprepared and right”.

What I mean by this is that I am the sort that is happy to take steps to protect my family’s happiness and wealth that turn out to be unnecessary. The alternative is being caught short by circumstances that had been considered as possible outcomes.

Of the two, my personality is far better suited to the former than the latter.

All the best, Chris

All rights reserved, Copyright 2006, C. Martenson

Quick! Name something that the majority of economists have not gotten right in over 50 years. Some of you are thinking smart-alec comments like “owning a tie without gravy stains” or “having a firm handshake” but the answer pertains to the most important function of their jobs.

Give up? It turns out that forecasting a recession, arguably the single most important bit of prognostication they perform, has completely eluded the economic profession for over 50 years.

Risks of recession continuing to rise

Economy is slowing, showing warning flags

By Will Deener, Dallas Morning News, Published October 9, 2006

Most major polls of economists have said the chances of a recession and its ill-begotten progeny, a bear market, are very low.

While stock market bulls may take comfort in that, they should remember this: Not one recession in the past 50 years was forecast in advance by a major poll of economic forecasters, said James Stack, a market historian and editor of InvesTech Research.

Recessions and bears can and often do arrive unexpectedly. Savvy investors simply cannot rely on assurances that the economy won’t lapse into recession, generally defined as two consecutive quarters of negative economic growth.

Recent polls of economists put the odds of this at less than 25 percent.

Why does this matter to us? Because the airwaves and newspapers are full of economist’s rosy guesses about the future and you need to know that their guesses turn out to be worse than random. Even a monkey throwing darts would at least predict a recession some of the time. But economists never do. In fact, we might speculate that such a poor, one-way track record reveals an institutional bias to ‘be positive’.

Either that or their profession needs to take a good, hard, long-overdue look at its methods and tools.

In any case, one would be well advised to take what economists take with a grain of salt or, more accurately, to take whatever they say with a grain of pessimism.

You need more proof?

Try this out. Economics 101 teaches us that prices are a function of supply and demand. If demand goes up, prices go up, and vice versa. Similarly if supply goes up prices go down, and vice versa. This is the most basic, unquestioned, bedrock, foundational, provable economic principle there is.

So how do we explain this article?

The unsold inventory of new homes in Orange County is at the highest level since 1996, according to an economic forecast released Friday in Irvine.

Through August, sales of existing homes in Orange County were off 29 percent compared to the same period a year ago, the largest year-over-year decline, according to the UCLA Anderson Forecast: Orange County Economic Outlook for 2007.

The rate of sales over the last five months have been “brutally low,” with Southern California home sales falling to their lowest level in nine years last month, according to the forecast.

“Sales of new and existing homes are down 30 percent or more from the peaks established in 2003 and 2004, and home price appreciation has slowed to single digits in most areas. This slowdown has taken its toll on the California economy.”

So, testing out our handy-dandy Econ-101 formula on the paragraphs above we find that supply is way up (highest in a decade) while demand is “brutally low” and down some 30% from a year ago levels. The supply numbers indicate prices should fall, as does the demand information. Both are saying the same thing. Clearly Econ 101 would predict that prices would need to fall substantially to clear up such an imbalance.

Let’s read a bit in the article to find out what the economists think about this:

The report noted that what usually happens when a real estate market bubble bursts “is that sales just dry up” because buyers won’t buy homes at the listed price and sellers are unwilling to cut their prices. It described the result as “the economic equivalent of Chinese water torture” — with the decline in prices starting slowly but lasting a long time.

The economists said they do not expect a major decline in home prices this year.

What? Huh? Then do they expect a major decline next year? Or will the declines not be major? Or do they not expect any declines at all? All of that is left unsaid but I will leave you with this advice; do not take any real estate advice from economists – if you do, you can expect a major decline in your financial net worth. That’s just Econ 101.

Another piece of news from this week that needs decoding was the President’s claim that ‘the deficit has been cut in half’.

As we discussed in the lecture series, such claims rest on the use of accounting gimmicks that would land the accounting departments of private businesses in jail. But I’ve harped on this enough that I’ll take a break and let Peter Schiff of Euro Pacific Capital tell the tale:

This week, while President Bush took credit for supposedly cutting the enormous budget deficit in half, the Commerce Department reported that the trade deficit in August was a record $69.9 billion. Annualized, the trade gap comes to well over $800 billion of foreign-made merchandise tacked onto our national charge card, a figure that dwarfs the federal budget deficit by comparison.

In the first place, the fact that President Bush maintains a straight face while claiming to be a deficit cutter is a testament to his political skills and the media’s and Wall Street’s gullibility. Who does the President think he is kidding? So far, the national debt has increased by about three trillion dollars during his presidency, or about $500 billion per year. Those are the real numbers. The non-sense budget deficit the government reports excludes off-budget items and money borrowed from government “trust funds.”

However, expenditures excluded from official budget numbers still must be financed, and the money borrowed to do so adds to the national debt. In addition, those numbers do not reflect expenses accrued during the year but not yet paid. Were such expenses properly accounted for, the official deficit would be several hundred billion dollars higher. Finally, the numbers do not include any growth in contingent liabilities, which now exceed $40 trillion, making the actual national debt over eight times the official figure, which includes only the funded portion.

The last paragraph (above) is the heart of the matter – the US government simply excludes all sorts of very real expenditures and accrued liabilities when deriving the ‘budget deficit’. By hiding the true state of our fiscal descent into third world status, and by observing the way that our media aggressively avoids performing the 10 minutes of leg-work necessary to paint the true picture, we can conclude that our nation has a huge future problem that it has no interest in hearing about. I call it the Ostrich Phenomenon. It is wanton denial by the people we have entrusted with our future, which is precisely why you and I are working to create solutions at the local level.

And how can we explain the fact that Big Media has been utterly unable to comprehend the most basic of budgetary and accounting principles to bring us the straight story? I’ll let author Upton Sinclair explain it in a single sentence:

“It is difficult to get a man to understand something when his job depends on not understanding it.”

That sums it up nicely. Under the current operating rules of DC, any reporter that told the truth would be excluded from press conferences and barred from black tie dinners. Which means they would effectively be out of a job. Hence, our persistent confusion over a very simple matter of accounting.

Now let’s turn our roving eye back upon housing; the most important determinant of our economic future.

I’m not entirely sure what the author of this Newsweek piece means by “endgame” for housing since we are surely in the very first innings of a correction in the housing market, but he correctly notes that much hinges on the outcome.

Oct. 16, 2006 issue - We are at the endgame for housing. Until recently, our national motto has been “in real estate we trust.” Just last week, the Census Bureau reported that median home prices after inflation rose 32 percent from 2000 to 2005. In some places, the gains were huge: 127 percent in San Diego, 110 percent in Los Angeles and 79 percent in New York. But real estate—which has acted as a national piggy bank, with homeowners borrowing and spending against rising house prices—no longer looks so trustworthy. On this, more than falling oil prices or a record Dow, hangs the economy’s immediate fate.

But then he goes on to lose it by quoting an … wait for it … wait for it…economist.

Economist Richard Green of George Washington University thinks much of the run-up of home prices is permanent, reflecting lower long-term interest rates. As rates dropped, buyers could afford to pay more. I largely agree with this view.

It’s an interesting argument, this “permanent” plateau of housing prices theory, but it ignores much. For example, 28% of all homes purchased last year were by speculators who mainly used adjustable rate mortgages of one flavor (e.g. interest only) or another (e.g. negative amortization). I would think that an economist would both have this sort of information and realize that ARM interest rates are set based on short-term, not long-term, interest rates.

Yet he cites the decline in long-term interest rates as the primary factor for why housing prices are likely going to remain stuck at a new permanent plateau of prosperity. Hmmmm. I guess I’ll bust the quote out again.

”It is difficult to get a man to understand something when his job depends on not understanding it.”

And to further my confusion, surely the economist above realizes that prices are set at the margin, meaning that the last sale sets the price for the whole market. And surely he also realizes that speculators are unlike homeowner/residents who typically have more choices in whether or not list their house for sale and at what price.

Speculators who bought in 2004 and 2005 are guaranteed to be bleeding red ink from their portfolio of houses since current rental rates are so far below the carrying costs of ownership and further that growth in the stock of housing has outstripped population growth meaning there simply are not enough families out there to rent all the available houses.

A speculator who is watching house prices tumble, and who is draining their life savings as they wait for the tide to turn, will at some point hit their personal point of maximum financial pain and they unload at whatever prices the market can bear. I’d love to hear an economist explain how that particular fiscal reality is going to be permanently delayed because “long-term rates are lower”.

To continue on, I have a friend in California who is weighing their own sell/hold decision and so I’ll continue with reports from CA gleaned from the media this past week in the hopes that he might find the information useful.

First, a report on foreclosure activity in San Diego County which are being linked to the use of risky mortgage loans (notable because such increases are usually only noted at the tail end of a down-turn, not the front end):

San Diego County is experiencing mortgage foreclosure rates not seen for the past eight years, two monitoring companies reported yesterday.

Locally based DataQuick Information Systems said foreclosures totaled 171 last month, more than 10 times what they were a year ago and the highest since 1998.

Similarly, the number of default notices – the first step lenders take toward foreclosure – was 872, nearly triple the 334 filed in September 2005.

Meanwhile, RealtyTrac, based in Irvine, reported area default notices totaled 1,236, up from 287 a year ago, and notices of trust-deed sales – the final notice before foreclosure – were at 247, up from 56 over the same period.

DataQuick analyst John Karevoll attributed the rise to the flattening of home prices.

“The people who get into trouble are not able to use their homes to get out of trouble the way they were able to do when there was strong appreciation,” he said.

At the peak of the buying boom, he said, as many as 35 percent of borrowers nationally were signing up for ARMs. In San Diego the figure sometimes exceeded 70 percent, DataQuick has reported.

Banks rarely hold foreclosed properties for long. Rather they are usually quickly sold with the banks happy to settle for the remaining balance of the mortgage. I think we can agree that having increasing numbers of foreclosed homes on the market is not likely to support continued house price appreciation.

Heading up the coast, the San Francisco Chronicle reports the same phenomenon up their way

The number of homeowners in foreclosure has soared in Solano and Contra Costa counties in the past year, giving the East Bay counties the dubious distinction of having the third and fourth highest foreclosure rates in the state.

Foreclosure activity in Solano County increased nearly fivefold, while in Contra Costa County they almost quadrupled, according to the RealtyTrac research firm. The two counties helped give California the No. 1 ranking among states with the most foreclosure filings in September.

And from Sacramento, we have reports of falling home sales and prices.

New-home sales tumbled 46 percent in the third quarter from a year ago, the latest evidence of a struggling housing market in the Sacramento region.

Only 1,956 new homes were sold in the just-completed quarter in the six-county area — the fewest since the fourth quarter of 2005 and 1,634 fewer than a year ago, according to The Gregory Group. It was the worst third quarter since the Folsom company started keeping track of the market in 2000.

The region’s median-home price — meaning half the homes sold for more, the other half for less — dropped 3.9 percent to $440,240, the lowest price since the second quarter of 2004.

The third quarter started slow, possibly because hot weather dissuaded home-shoppers from tours, said Greg Paquin, owner of The Gregory Group. But business picked up in late August and September, and he expects sales could rise to 2,500 homes in the current quarter. The company tracks home sales in Sacramento, Placer, El Dorado, Yolo, Sutter and Yuba counties.

My favorite part of that last bit? Blaming falling house sales on ‘hot weather’ rather than the much more obvious reason that buyers cannot afford to buy houses that are no longer rising at these prices. Very funny.

”It is difficult to get a man to understand something when his job depends on not understanding it.”

And finally from LA, we have this report:

The number of sales in the six-county region fell 28.6% last month from a year ago to the lowest September level in nine years, and the median price of all Southern California homes rose 1.9% to $484,000, the smallest year-over-year gain since February 1997, DataQuick said.

Ventura County last month became the second Southland county to suffer a year-over-year price decline. Ventura County’s median price fell 3.3% to $584,000. San Diego County’s median price declined for the third straight month, dropping 4.4% to $476,000.

The median home price in Los Angeles County rose 3% to $509,000, as sales fell 27.9%. L.A.’s median — the point at which half of all homes sold for more and half for less — has given back all gains made since May, according to DataQuick.

So it would seem that there’s plenty of weakness all across the state of CA but it may not turn out as bad as it did in the early 1990’s because, this time, the downturn is happening for a very different set of reasons. Back then it was base closures and a job slump and this time it’s overbuilding, low affordability, and risky mortgages turning bad.

However, such stark, fundamental differences won’t prevent your average economist from drawing inappropriate comparisons to explain “this time, it will be different”.

It comes down to this. If you’d like to have your bank account cleaned out but you’d rather not see it coming, ditch your realtor and your common sense and find yourself an economist to advise you on your next real estate purchase.

All the best,
Chris

Copyright C. Martenson, 2006 

Bernanke: Baby Boomers Will Strain U.S.

Oct 04 12:54 PM US/Eastern

By JEANNINE AVERSA AP Economics Writer

Unless Social Security and Medicare are revamped, the massive burden from retiring baby boomers will place major strains on the nation’s budget and the economy, Federal Reserve Chairman Ben Bernanke said Wednesday.

“Reform of our unsustainable entitlement programs” should be a priority, he said in prepared remarks to the Economics Club of Washington. “The imperative to undertake reform earlier rather than later is great,” Bernanke added.

It marked the Fed chief’s most extensive comments to date on the challenges facing the United States with the looming retirement of 78 million baby boomers.

In his remarks, Bernanke did not offer Congress and the Bush administration recommendations on how the massive entitlement programs should be changed. Efforts by the administration to overhaul the Social Security program _ once a centerpiece of President Bush’s second-term agenda sputtered last year, meeting resistance from Republicans and Democrats alike.

As the population ages, the nation will have to choose among higher taxes, less non-entitlement spending by the government, a reduction in spending on entitlement programs, a sharply higher budget deficit or some combination thereof, Bernanke said.

Government spending on Social Security and Medicare alone will increase from about 7 percent of the total size of the U.S. economy to almost 13 percent by 2030 and to more than 15 percent by 2050, he said.

OK - let’s parse this out:

1) Bernanke admitted the obvious – that our entitlement programs are unsustainable. That is, there is no possible way for them to work at current rates of distribution and taxation.

2) He then logically concluded that our choices include higher taxes, lower non-entitlement government spending, a reduction in entitlement spending, or some combination of all three. Left obscured by this list is the fact that non-entitlement spending by the government is a tiny drop in the bucket and cannot realistically be included as a possible solution since that number would have to decline by 143%, forever, to plug the gap. Dropping your spending to zero is tricky, but dropping it all the way below zero is a trick beyond even our august DC politicians. No matter how you slice it, though, the clear policy here will be to reduce our standards of living by taking more (taxes) and returning less (entitlement payouts).

3) The reported numbers for Social Security and Medicare spending have been reported in a non-accessible, murky way and deserve to be illuminated. What does it mean that these payments will ‘increase from 7%..to13% of the total economy by 2030’? Well, 7% of the economy is roughly $900 billion and 13% is $1700 billion (or $1.7 trillion). This means that over the next 24 years entitlement payouts are going to increase by $780 billion dollars or $32 billion each and every year! Huh. That’s a lot of money. Where’s that going to come from?

Also left unspoken here is that the mess in which we find our entitlement programs today, is nearly the exact same mess in which they were back in the mid-1980’s. At that time, Greenspan delivered roughly the same lecture which was used by political parties as rationale for doubling the Social Security and Medicare tax rates to their current combined rate of 15.9%. The idea was that putting more money into the ‘trust funds’ would lend to their long-term solvency. Instead what happened was that vast gobs of excess money accumulated in these funds for a couple of years until its presence became an unbearable burden to our political leaders and they passed a new law allowing that money to be spent as though it were just another pool of available funds..

How much cash money is sitting in the entitlement trust funds today? Zero. None. Nil.

It has all been spent.

So pardon me if I am just a little bit suspicious of this new call to urgency which, although very real, does not address the root problem…any additional monies raised by higher taxes will simply be spent and not saved in reserve for future entitlement liabilities.

That is a cold, hard, political fact.

Which means we can count out raising taxes as a realistic approach towards solving this problem.

We can give ourselves a nice pat on the back for seeing this one coming from a mile and half away, or a year-and-a-half as the case may be.

At the same time that our collective bill for entitlement programs at the federal level (leaving states and municipalities out of it for the moment) will be rising by $32 billion a year, the past excesses of government over-spending have left us with another set of payments that are rising starkly.

Those would be payments of interest on the national debt as succinctly described in this NY Times editorial:

(Note: the link points to another site since the NYT quickly archives its articles, which renders them inaccessible):

There is fresh evidence, if any more were needed, that excessive borrowing during the Bush years will make the nation poorer.

For most of the past five and a half years, interest rates have been low, allowing the government to borrow more and more — to cut taxes while fighting two expensive wars — without having to shoulder higher interest payments.

That’s over now. For the first time during President Bush’s tenure, the government’s interest bill is expected to rise in 2006, from $184 billion in 2005 to $220 billion this year, up nearly 20 percent. That increase — $36 billion — makes interest the fastest-growing component of federal spending, and continued brisk growth is likely. According to projections by Congress’s budget office, the interest bill will grow to $249 billion in 2007, and $270 billion in 2008.

All of that is money the government won’t have available to spend on other needs and priorities. And much of it won’t even be recycled back into the United States economy. That’s because borrowing from foreign countries has exploded during the Bush years. In 2005, the government paid about $77 billion in interest to foreign creditors in China, Japan and elsewhere.

And that’s not the worst of it. While foreign investors were putting up most of the $1.5 trillion the federal government has borrowed since 2001, they were also snapping up hundreds of billions of dollars in private sector securities, transactions that have been a big source of the easy money that allowed Americans to borrow heavily against their homes.

Housing: there was big news this past week regarding housing as Moody’s Economy.com rendered a verdict on the potential future of house prices across all American markets.

WASHINGTON - Housing prices, slumping after a five-year boom, are projected to decline in more than 100 of the nation’s metropolitan areas, with the Northeast, Florida and California among the areas hardest hit.

The forecast by Moody’s Economy.com, a private research firm, presents one of the starkest views yet of the housing slowdown that has been gathering force in recent months.

The West Chester, Pa., forecasting firm projects that the median sales price for an existing home will decline in 2007 by 3.6 percent, which would be the first decline for an entire year in home prices since the Great Depression of the 1930s.

The forecast is included in a 195-page report, “Housing at the Tipping Point,” which The Associated Press obtained before its general release on Wednesday.

The above report calls for the first real, nationwide decline in house prices since the great depression. Combine that information with the statistics below, and you’ve really got me scratching my head as to how the Dow Jones stock index is hitting new all-time highs and how so many commentators are sure that a housing decline will not overly impact the economy.

Ø 10% of ALL homeowners have NO equity in their homes.

Ø 1 in 8 homeowners who purchased in 2005 owe MORE THAN their house is worth

Ø Nearly ALL of the growth in our economy over the past 4 years was entirely due to people taking cash out against their rising property values.

Suffice it to say that I find it a bit difficult to grasp how our economy is not going to be severely impacted by falling house prices.

And finally, I want to close with an article that perfectly encapsulates my own thinking regarding the question “are we headed for rampant inflation or a staggering deflationary event?”. As you know, I am personally positioned 50/50 and am awaiting market clues to tell me which way to break.

Harry Schultz is billed as ‘the world’s highest paid financial consultant’. While he may be that, for several years now his newsletter has been among the top five best returns (out of a universe of several thousand financial newsletters). He has consistently gotten the major market turns right over the years - the really big moves that made you wealthy or poor depending on how you were positioned.

Here’s how he sees things over the next few months:

Schultz’ list of possible October moves naturally leads with an attack on Iran by the U.S. and or Israel. Other possibilities include: Russia invading Abkhazia and South Ossetia; a Chinese invasion of Taiwan or the Spratly Islands; a North Korean “mega missile test” or attack on South Korea; a coup d’etat in Pakistan. Because of U.S. overstretch and distraction, he writes, “October is a free pass month for wild/risky moves.”

This may sound wild, but who expected the Iraq War? Unorthodox thinking is what Schultz has specialized in for (anniversary coming up) 42 years of International Harry Shultz Letters.

Schultz’ investment conclusion: “If any of the above occur, commodity-metal- oil markets will move notably higher. Oil would lead the way. If Iran is bombed (now or later) they’ll close the Strait of Hormuz in the Persian Gulf through which most regional oil must pass, increasing oil’s price by 50% in one day. Don’t be without 1-2 good oil stocks.”

He means it. Schultz’ recommended asset allocation is only 10-15% in non-gold stocks, core positions in one or two oil stocks … One suggestion: McDermott International Inc. (MDR)

And beyond an October surprise? Schultz says we’re “poised between dramatic inflation and shocking deflation (short term?), either of which can come suddenly … unprecedented debt vs. record-breaking money creation makes the situation explosive, able to go either way almost overnight.”

While I am not nearly as successful an investor as Harry Schultz, I am pleased to find myself in perfect agreement (and alignment) with his assessment of the situation.

The fiscal consequences of being wrongly positioned for dramatic inflation or shocking deflation are large, but they are avoidable.

It’s best to stay tuned to the markets and keep a sharp eye out for any and all changes.

Should I detect what I consider to be a dramatic or shocking event, I will email you immediately and let you know what actions I am taking as a result.

As always, this should not be construed as advice, merely one person’s individual decision.

All the best,

Chris

Copyright 2006, all rights reserved.