Debt, Denial, and Default…

Why every investor needs to protect their wealth with precious metals

[Taken from our presentation on April 7^th, at the “World Money Show” investors’ conference in Vancouver]

While most Western economies have serious debt problems, none of these nations has a fiscal crisis as bad as that of the United States. The U.S. corporate-controlled media have been obsessively shining the spotlight on the so-called “PIGS” of Europe: Portugal, Italy, Greece and Spain.

However, if we look at the economy of the state of Michigan, we see an economy which is larger and in far worse shape than even Greece’s economy. Similarly, the economy of California is larger – and in worse shape than the economy of Spain. In other words, for every Euro economy which is supposedly in some sort of “crisis”, there is a U.S. state with a larger economy, and bigger debt problems.

For this presentation, I plan on focusing on the federal debt problems of the the U.S., with the understanding that U.S. state and local governments are in much worse shape: like the Euro nations, there is no “printing press” to temporarily postpone dealing with their problems.

I will also point out that out that it has become impossible to trust U.S. economic statistics, whether we are talking about jobs-reports, estimates of GDP, or the numbers the government uses for its “official” national debt and “official” deficits. As an example, during the eight years of the Bush regime, “official” deficits totaled $2.3 trillion, while the actual increase in debt was $4.5 trillion – nearly double the “official” totals.

In the first year of the Obama presidency, the “official” deficit was reported as ‘only’ $1.4 trillion. However, the actual increase in debt was close to $2 trillion. Put another way, the gap between the “official” deficit of the the U.S. last year and the real deficit was roughly equal to the entire national debt of Canada – and in absolute terms, it was an even bigger lie than those of the eight years of the Bush government.

These are numbers which are a matter of public record, available at the web-site of the U.S. Treasury Department, and they beg the question: why aren’t U.S. politicians (of both parties) alerting their constituents to the continued reporting by the government (and the media) of totally fictional numbers for the debt-problems of the U.S.?

Think about if this happened in Canada. If the Conservatives’ deficits were twice as big as reported, would the Liberals “not notice”, or would they cover up the truth to protect the Conservatives?

And what about the U.S. media? Are we supposed to believe that they “did not notice” for the eight years of the Bush government, and now the same with the Obama regime? At a time when the U.S. government is generating the most-massive deficits in the history of humanity, how can the mainstream media (in the U.S. and Canada) “not notice” a $500 billion discrepancy (from one year’s budget)?

The fact is that you will never see any U.S. politician, or member of the mainstream media questioning the legitimacy of the “official” U.S. deficit. Some may argue that the deficits are “too large” – but no one ever questions the legitimacy of the calculation, itself. However, the “official” U.S. deficit is only the tip of the iceberg. When it comes to the insolvency of the U.S., the real story occurs with respect to its “unfunded liabilities” and its total debt – the real total.

Unfunded Liabilities:

As of today, U.S. unfunded liabilities are greater than global GDP. Put another way, in order for the U.S. to ever meet those obligations, the entire world would have to devote their economies to paying U.S. “bills”, as it implies a debt-to-GDP ratio of greater than 100% for every nation on Earth. Obviously the U.S. government can never meet those commitments.

While both U.S. political parties talk about the need to deal with this massive problem – now – the actions of both parties totally contradict those words. The reality is that over just the last twenty years, Republicans and Democrats have ‘borrowed’ over $4 trillion from government “trust funds”; money which was supposed to pay for social programs – the same social programs from where all these “unfunded liabilities” originate.

These “borrowed” funds are still listed as an “asset” in the government’s books (as an “IOU”). However, not one penny of this money has been repaid, and there are no funds set aside in any future government projections to repay these “IOU’s”, despite the fact that those future liabilities are turning into current expenses.

The truth is that this money is gone forever. Thus, it was not “borrowed”, it was stolen – from current and future generations of Americans. Obviously, this missing $4.2 trillion must be added to the “official” national debt, in order to indicate the real national debt.

Has anyone every heard any member of either U.S. political party acknowledge this missing $4.2 trillion? Has anyone ever read or heard any mention of this missing $4.2 trillion by the U.S. mainstream media, or any questioning of the “official” national debt?

So, where do I get my information on the U.S. economy? There is a growing “army” of individual bloggers and smaller web-sites (such as BullionBullsCanada.com) who are committed to presenting an uncensored examination of the global economy (especially the U.S. economy), and who discuss facts and issues which you will never see in the coverage of the large, mainstream (corporate) media.

A couple of examples of such sites are Michael Hodges’ “Grandfather Debt Report”, and John Williams’ Shadowstats.com – which provide many of the numbers included in this presentation. The content of these sites is implied by their titles.

Mr. Hodges’ site has compiled a large collection of statistics on U.S. debt. “Shadowstats” mission is to calculate current government statistics using the same methodology for calculations which was used thirty years ago (and in the decades prior to that). Thus, John Williams’ site produces real, accurate comparisons between current and previous economic conditions.

If we were to compare Shadowstats’ “numbers” with official, U.S. government statistics, we find there is no comparison. Virtually every, major U.S. economic “statistic” has undergone numerous revisions in how they are calculated. Thus, even if you subscribe to the belief that the U.S. government is trying to honestly present data on its economy, the numbers is uses are not comparable to previous calculations – and thus none of the comparisons by the U.S. government of the economic conditions now versus prior periods are valid. Quite simply, “official” U.S. economic statistics bear no resemblance to Mr. Williams’ calculations, or to the official stats of previous generations.

The three components of U.S. debt:

1)      Annual (incremental) deficits

2)      Total, national debt

3)      Unfunded liabilities

Another expression of the annual U.S. deficit is its “current account deficit”, which is essentially the deficit (or surplus) which each nation has in all of its business with other nations. If we look (below) at the table of “current accounts” for all nations, we see China up at the top, with a massive annual surplus of almost $300 billion per year.

[insert table]

At the opposite end, sitting last in 190^th position is the United States, with its estimated deficit of over $350 billion (for just one year). Thus, even if the U.S. is a “wealthy” nation, it won’t be for long, with numbers like that.

The problem is that the U.S. numbers have been like this – for many years – which is why the U.S. is no longer “wealthy” in any rational definition of that term. Even using the “official” number for the U.S. national debt, the United States (with only 5% of the world’s population) owes nearly as much as the rest of the world, combined.

I have produced a chart showing two sets of numbers for the national debt of most of the world’s largest economies. The first set of numbers compares the U.S. to other economies using the official, national debt, while the second row shows how different things look if we add in the $4.2 trillion missing from government “trust funds”. However, this is only a tiny portion of total U.S. debt.

[insert chart]

The debt problems of the U.S. look far, far worse when we look at the total debts for the entire U.S. economy. The United States is currently carrying more than $60 trillion in total public and private debt. However, even that horrifying number does not include one penny of the U.S.’s $70 trillion in “unfunded liabilities”.

Because these are such huge numbers, let me put them into context: both numbers are equal or greater in size than global GDP. The U.S.’s current debts exceed global GDP and its future liabilities exceed global GDP, meaning it would take two Planet Earths just to service current U.S. debts – along with covering those future obligations.

The U.S. “balance sheet”:

We’ve seen the debts and liabilities of the United States, but what about its assets?

In 2004, the total value of all U.S. “household wealth” was just under $50 trillion. Since that number also includes the (U.S.-owned) shares of all corporations (i.e. their market capitalization), this is a good proxy for “total U.S. assets”.

In 2004, the U.S. “housing bubble” was already underway, which was the largest asset-bubble in history (at that time). Since all that added “wealth” was illusory, this likely overstates total U.S. assets. This leads to the following equation:

U.S. total assets                     U.S. total debts          U.S. unfunded liabilities        Balance

$50 trillion      minus              $60 trillion      minus              $70 trillion      =          -$80 trillion

Net U.S. debts and liabilities exceed the total debts and liabilities of all other nations, throughout all of history, combined.

Admittedly this is a simplification of the “balance sheet” of the United States. However, when we factor-in the compounding of debt; and the “unfunded liabilities” of state and local governments, and other public and private entities (which were not included in the previous total) the bottom-line is (if anything) an understatement of current U.S. debts and liabilities.

This leads to only one possible conclusion. The United States is hopelessly insolvent.

Debt-to-GDP:

Another way of characterizing the debt (and debt-problem) of any nation is through looking at the “debt to GDP” ratio. So let’s look at the U.S. debt problem using this alternate “measuring stick”.

Again, I have produced a chart with two rows of numbers. The first row compares the U.S. economy to other important economies without including the missing-and-gone-forever $4.2 trillion missing from federal “trust funds”, while the 2^nd row provides a comparison including that additonal debt.

[insert chart]

As we can see with the first row of charts, the U.S. economy looks bad, but several other economies look even worse. However, when we add the missing $4.2 trillion, suddenly the U.S. debt-to-GDP ratio becomes worse than that of any other major economy, except Japan. Yet even this comparison is an over-simplification.

When economists measure the solvency of economies, they tend to focus myopically on only these debt-to-GDP ratios. There are two reasons why this is extremely simplistic.

It takes no account of (for example) the $70 trillion of “unfunded liabilities” of the United States, which account for over 80% of total U.S. debts and liabilities (a rather large omission). And, in a related criticism, this is a “static measurement” – meaning it takes no account of the rate at which debt is increasing (i.e. the size of the annual deficit).

To illustrate this point (as you can see in the pie-chart below), while Japan has a larger debt-to-GDP ratio, in 2009 (for example) the U.S. attempted to borrow six times as much as Japan. Indeed, the U.S. (which comprises only about 1/5^th of global GDP) borrowed more than all the rest of the world combined.

[insert chart]

Arguably, a nation with a very large debt (i.e. a high debt-to-GDP ratio) but small deficits is in a better position than a nation with a smaller debt – but huge deficits: the nation with the small deficit can easily move to a surplus, and start repaying (and reducing) its debt, while the nation with the huge deficit is going to see its own debt explode exponentially – unless radical measures are taken to reduce spending and/or increase taxation.

The reason the U.S. situation is hopeless is that it has existing debts which are far larger than any other nation, annual deficits which are much worse than any other nation, and its future obligations actually dwarf its terrible debt/deficit problems. It owes the most; it is borrowing the most; and its borrowing needs in the future will increase exponentially.

The U.S. “debt trap”:

Any accountants reading this may question my choice to focus on U.S. debt problems by including “unfunded liabilities” in my analysis, since government apologists will argue that some or all of those liabilities could be eliminated tomorrow, simply by re-writing the provisions of government entitlement programs.

In fact (as I will soon demonstrate), there are numerous practical reasons why there is no likelihood of the U.S. government reducing those entitlements, and if the government did somehow manage to reduce those programs that it would cause severe economic disruptions for the U.S.

The U.S. pension crisis:

It is estimated that (at the end of 2008) U.S. pension plans were underfunded by about $3 trillion. Even after the recent and extremely improbable “rally” in U.S. equity markets, that pension deficit still amounts to roughly $2 trillion. Thus even if the U.S. government could somehow make full pay-outs on the entitlement programs which U.S. seniors will be relying upon, they would still have to raise an additional $2 trillion just to maintain their standard of living (and the consumption-level which this consumer economy relies upon for its survival).

Over 40% of Americans have less than $10,000 of savings, meaning Americans today are more dependent on these entitlement programs than any other generation of Americans in history. With 75% of the “assets” held by retired, and soon-to-be retired Americans consisting of real estate, they would need to dump roughly $2 trillion of real estate onto the U.S. market – the most over-supplied real estate market in history – in order to maintain their standard of living.

The U.S. housing bubbles:

We are all familiar with the first U.S. housing bubble. It began after the Federal Reserve took U.S. interest rates down to what was (at the time) the most reckless, inflationary rate in history: 1%. That asset-bubble imploded in 2006, followed by what was (at the time) the worst “crash” in the U.S. real estate market in history, with prices falling three times as fast (in “real” dollars) as during the worst year of the “Great Depression”.

At that time, the entire U.S. financial sector was leveraged at an insane level of 30:1. This means that even a 3% loss on the underlying assets which were leveraged would be sufficient to take the entire U.S. financial sector to “zero”.  In fact, prices in the U.S. housing market (which was the source for the vast majority of that leverage) plummeted by roughly 30%, ten times as far as what was necessary to take the entire U.S. financial sector to zero.

This forced the U.S. financial sector (primarily the Wall Street oligarchies) to immediately panhandle a bail-out of $10 trillion in loans/hand-outs/guarantees – in order to avoid being instantly vaporized by the collapse of the U.S. housing market. This is far more capital than would have been required to create a “brand new” U.S. financial sector, from scratch: one which would not have been burdened by countless trillions in bad “bets”.

Instead, the U.S. government chose the much more expensive route of bailing-out the Wall Street banks, and “guaranteeing” endless trillions in assets – meaning trillions in losses, since these “assets” are being carried on the books of U.S. banks at totally fictitious valuations.

These trillions in hidden losses have turned Wall Street banks into “zombie banks”, just like in Japan, after it suffered its own bursting asset-bubbles. While the U.S. government has continually claimed that it would never “repeat the mistakes of Japan”, in fact, not only is the U.S. government duplicating those (failed) policies, but it is engaging in much bigger subsidies for its own “zombie banks”.

It is hardly a “coincidence” that Wall Street banks are the largest contributors of campaign funds to both U.S. political parties, and that Barack Obama has been the single, largest recipient of Wall Street campaign-bribes since he first became a Senator. Thus, to help Wall Street, the U.S. government has been desperate to ‘re-inflate’ the U.S. housing bubble – at any cost – and in so doing, the Obama regime has created a second U.S. housing bubble (along with the help of the Wall Street banks).

What evidence do I have of a second housing-bubble?

Instead of taking interest rates down to 1%, the U.S. Federal Reserve has taken the interest rate all the way down to zero (and left it there). Millions of U.S. properties have either been held off the market by U.S. banks, or are tied-up in U.S. foreclosure proceedings. This has artificially reduced “inventories” of unsold homes by at least 50% - in order to put a (very) temporary “bottom” in prices.

An example of this “shadow inventory” is in Florida, where there is an estimated 500,000 pending foreclosures currently in its court system – and this is just one state.

There is also a new “sub-prime” sector in the U.S. real estate market. Remember my suggestion that the U.S. government could have simply created a brand-new banking system – instead of bailing out the Wall Street banks? Many of you may have thought that such a suggestion was absurd. However, today, over 90% of all new U.S. mortgages are either originated or directly guaranteed by the U.S. government (i.e. U.S. taxpayers), effectively “nationalzing” the entire U.S. mortgage market.

The U.S. government agencies which are responsible for all these mortgages have (once again) lowered their lending standards, and (when the government buyers’ “credit” is factored-in) more than half of all U.S. homes purchased in 2009 had zero down-payments.

Simultaneously, the Federal Reserve has been buying-up every U.S. mortgage-bond in sight, since no one else in the world will touch this “toxic” crap, given the record default-rates which currently exist in the U.S. (15% of all U.S. mortgages are currently in default and/or foreclosure: an all-time record).

‘Buying’ all these “bonds” (with newly-printed dollars) has temporarily kept U.S. mortgage rates several percent lower than they would have been without this hidden (and very expensive) taxpayer subsidy. This has resulted in the Federal Reserve absorbing more than $2 trillion of “bonds” and securities which (to be polite) are of extremely dubious value. And the moment the Fed stops buying-up all these debt-instruments, U.S. mortgage-rates will shoot higher.

On the other hand, if it continues recklessly printing endless trillions of new dollars, it will inevitably ignite “hyperinflation”. Indeed, both I and many other economic commentators are already certain that the U.S. is heading for hyperinflation (but I will get into that issue in greater detail, a little later).

The second bubble “bursts”:

At a time when millions of foreclosed homes are being hidden from the market, with more than 25% of all U.S. mortgage-holders having “underwater” mortgages, with millions more new homeowners having zero equity; recent U.S. sales numbers show U.S. home sales once again collapsing . And as all this happens, millions of “option-ARM” mortgages are about to reset.

What is an “option-ARM” mortgage? For those who have never heard of these “exotic” mortgages, option-ARM’s not only allowed the borrower to avoid repaying any “principal”, it even gave borrowers the choice of not even paying the full amount of interest. The unpaid interest would then be added to the “principal” – dramatically increasing the size of the mortgage (and future payments).

Typically, the initial interest rate was a “teaser rate”, and when the mortgage “resets”, the new interest rate could be up to triple the teaser rate. More than 40% of the millions of Americans holding these mortgages have been making minimum payments. This means that when these mortgages reset, borrowers could see their monthly payments not merely increasing by 40% or 50% per month, but by up to several times their current payments.

These millions of mortgage-resets are occurring at the same time that long-term unemployment in the U.S. is at its highest level in at least 70 years, and U.S. housing inventories (the real inventories) are at their highest levels ever. And once this second collapse begins, there is no means of stabilizing this market.

Why is this?

1)      With interest rates already at 0%, interest rates can literally only go higher

2)      U.S. homeowners have less equity in their homes than at any time in history

3)      Retiring baby-boomers will have to dump $1 to $2 trillion of real estate onto this market – just to partially fund their under-funded retirements (and much more than that, if entitlement programs should have their benefits slashed). This will not only undermine the U.S. housing market for many years to come, but any reductions in U.S. entitlement programs will directly make the next collapse of the U.S. housing sector that much more severe – because it would force the sale of much more real estate

Back to “unfunded liabilities”:

With U.S. baby-boomers starting to retire, U.S. “unfunded liabilities” are already starting to become current obligations. At the same time, the Obama government has already admitted that over the course of this decade that more than 50% of every new dollar of debt will be consumed in interest payments on old debt. Those interest payments (alone) will exceed $1 trillion/per year before the end of this decade.

Added to this will be roughly $2 trillion per year of “unfunded liabilities”, which will now have to be funded. This means that over the course of this decade, the U.S. government will have to come up with an additional $3 trillion/year – above and beyond all current spending programs. This will roughly double U.S. government spending, and roughly quadruple current deficits.

Even the largest tax increases in history could only fund (at most) about 10% of this spending-gap. This means either cutting trillions per year in government spending (totally impossible) or simply printing-up trillions and trillions of new dollars to pretend to “pay” those bills. This, in turn, guarantees hyperinflation.

Political factors:

The previous budgetary constraints which I have discussed have all been of the “economic” variety. However, arguably it is U.S. political constraints which are an even bigger obstacle in beginning to address the massive, triple-problem of U.S. insolvency: debts, deficits, and liabilities.

Decades of “gerrymandering” have transformed roughly 80% of U.S. electoral districts into the permanent holdings of one or the other of the two, U.S. political parties. The candidate of the favored party is essentially guaranteed a seat for life. Naturally, this eliminates any incentive to produce positive results for their own constituents (other than bringing home the “pork”).

As a result, partisan politics has taken precedence over any and all other considerations. And the #1 rule of partisan politics is to never allow the party in power to accomplish anything (good) of significance.

The one exception to this scenario of total indifference is with respect to the AARP (“American Association for Retired Persons”). The AARP is not only the largest, single voting bloc in the U.S., but it is comprised of the only segment of the U.S. electorate which has a constently high “turn-out” in every election.

What issues are important to the AARP? Social Security and Medicare: the two social programs which are 100% certain to bankrupt the U.S. economy. Barring a complete “metamorphosis” of the entire U.S. political system, these “unfunded liabilities” are essentially carved in stone, since they are the only issues where doing something unpopular could threaten the security of the U.S.’s elected-for-life politicians.

This leaves current and future U.S. government with nothing but terrible options. The questions they must ask themselves are:

1)      Do they fully “fund” all these entitlement programs, through simply printing-up countless trillions of new dollars (the only possible way to cover those entitlements 100%)?

2)      Do they slash entitlements (and lose their own, cushy positions), sucking trillions of dollars out of the economy, at a time when long-term unemployment is at record levels and the U.S. housing market is about to suffer a second, worse collapse? That road leads to a debt-implosion which would make the death of the former Soviet Union look like a “picnic”.

And if the U.S. does not commit to one course of action or the other, the U.S. will likely suffer the worst of both worlds: a “hyperinflationary depression”, which John Williams first predicted for the U.S. economy back in 2003.

Hyperinflation:

What is hyperinflation?

While you can all understand what I mean by a debt-implosion, many of you may not be familiar with the concept of hyperinflation. It is more than just “soaring prices”, but also reflects a crisis of confidence with respect to the currency in question, and the beginning of a death-spiral for that currency.

Because the currency starts to rapidly lose value, this forces the government in question to print-up vast quantities of new currency to subsidize the depleted wealth of its citizens – so they literally do not starve to death. Then, that excessive money-printing leads to an even more rapid rate of devaluation for the currency, and this vicious circle gets more and more severe. In virtually every example in history, such currencies effectively go to zero.

For the reasons previously mentioned, many people will argue that hyperinflation is the inevitable course on which the U.S. is headed. Not only is the Federal Reserve under extreme pressure to continue to print-up countless trillions of new dollars, but hyperinflation “solves” the twin problems of massive, current debts and completely unpayable entitlement programs.

Those debts would get “paid”, and those entitlements would be “funded”, but the paper used to do this would have only a minute fraction of its former value. Because hyperinflation causes a currency to move toward zero, all debts and liabilities expressed in that currency also become effectively worthless. Thus, a very strong argument can be made that the U.S. will choose the informal “default” of a hyperinflation, rather than suffer a formal default – and the resultant debt-implosion which the Soviet Union experienced.

History is clear: the devastation of hyperinflation will destroy the wealth of average Americans to an even greater degree than through suffering the ravages of a deflationary implosion. However, such a course of action would preserve the “paper empire” of the Wall Street banks who have been dictating U.S. economic policy.

The Risk of Deflation:

Despite what was previously said, in order to delay inflation from ravaging the U.S. economy, the U.S. government has been playing a very dangerous game. It is essentially starving the entire U.S. economy of capital with bank-lending falling at the fastest rate in U.S. history – as these zombie-banks refuse to lend money to U.S. businesses, despite their promises to do the exact opposite.

I’m sure some of you are thinking “Where are the trillions of new dollars which the Federal Reserve is printing-up each year?” All the money is being given to the Wall Street banks. However, instead of lending any of that money to U.S. businesses (who are being starved of capital), the Oligarchs then “deposit” most of that money at the Federal Reserve – in what is literally nothing more than a “savings account”. That’s where the Federal Reserve has been “borrowing” the money to buy-up trillions of dollars of (worthless) U.S. mortgage bonds. The rest of the bankers’ money is then used to “play the markets” with their “proprietary trading”.

There is one last argument, used by those who insist the “mighty” U.S. economy will “bounce back”, as it always has in the past: the U.S. will “grow” its way out of its huge debt/deficit crisis. The problem is that with more than 50% of every new dollar of U.S. debt being simply interest payments on the old debt, how can the U.S. economy grow, at all, let alone at the above-average rate which is required – just to produce enough revenues to service all that debt?

Supposedly, the U.S. economy is now growing at more than a 5% rate, which is equivalent to an “economic boom” for any economy other than China’s. However, to borrow an old line: “where’s the beef?”

U.S. government revenues (for all three levels of government) are plummeting downward at an accelerating rate, so how can the economy be “booming” if no one is generating any tax receipts for the government? Is there anyone out there who can have a “booming” business with no revenues?

The fact is that it is easy to exaggerate GDP numbers, simply by understating current inflation. For example, Shadowstats calculated U.S. inflation as averaging around 8% in Q4 of 2009 (the time of the most-recent estimate of U.S. GDP), yet the U.S. government only “deflated” its raw data by less than 2% - since every estimate of GDP must be stripped of all inflation in order for it to be valid. With more than a 6% gap between real inflation and the “deflator” used by the U.S. government, suddenly 5% GDP “growth” doesn’t seem like quite the “economic boom” it’s supposed to be.

More generally, as a matter of common sense, with the U.S. carrying the heaviest debt-load in its history, and an every-larger portion of every dollar consumed just paying interest, the overall U.S. economy would have to be operating at a higher rate of activity than is normal, just to achieve average growth. Could anyone really suggest that the U.S. economy is currently stronger than normal? This is the only, possible way in which recent U.S. GDP numbers could be valid.

There is another way to make this point. As mentioned earlier, the U.S. economy is currently carrying over $60 trillion in total public/private debt. This means that raising U.S. interest rates even 1% would drain an extra $600 billion per year out of the U.S. economy – in additional interest payments, alone.

Draining that amount of money out of the U.S. economy would be equivalent to a 5% drop in U.S. GDP – even before factoring-in the “multiplier effect” of sucking that much money out of the economy. And every 1% hike would inflict a similar (but compounded) amount of damage on the U.S. economy.

This means that very likely even a 1% increase in current U.S. interest rates would be enough to send the U.S. economy into an immediate deflationary spiral. How can the U.S. government claim its economy is robust enough to produce “booming” growth, when raising interest rates to even 1% would likely destroy the U.S. economy? As a reminder, prior to this last decade of asset-bubbles, government interest rates had never been anywhere near 1% in modern history.

Derivatives:

As if this weren’t already enough for investors to wory about, even if the U.S. economy can avoid or delay its own collapse, the global derivatives bubble lurks in the shadows. Warren Buffet famously described derivatives as “financial weapons of mass destruction”, and for a very good reason. While U.S. “unfunded liabilities” are larger than the entire global economy, the derivatives bubble is twenty times as large as the entire global economy.

It is unregulated. It is totally lacking in “transparency”, meaning that all we know about this $1 quadrillion mountain of banker-paper is what the bankers tell us. During the 2008 U.S. financial crisis, the Wall Street banks required $10 trillion in loans/hand-outs/guarantees just to temporarily prevent their bankruptcy – more than all other bail-outs/hand-outs for all the rest of the world, for all of history, combined.

This was because of the massive instability generated by this unbelievably huge mountain of paper, and the entire crisis was based upon settling the derivatives positions of only one company: Lehman Brothers – a Wall Street investment bank.

Even that $10 trillion was not enough to prevent the collapse of the U.S. financial sector. The Wall Street banks also needed to have the U.S. accounting rules changed, so that they could assign their own “fantasy valuations” to the debts/assets on their books, instead of the actual market value of those assets. Keep in mind that without the most-radical accounting changes in history, instead of these Wall Street banks reporting (supposed) “record profits” they would be reporting their own bankruptcies.

While they brag about “billions” in supposed profits, there are still trillions of dollars of “toxic assets” being hidden off of their balance sheets. We know there has been no increase in the real value of these “assets” through the reports of failed U.S. banks. In just two years, the average amount of losses sitting on the books of these banks when they collapse are now five times as large (relative to the value of their assets) as when the first bank-failures occurred. Thus, if anything, these “toxic assets” are even more worthless than when the collapse began.

Despite this huge mountain of unstable debt, Wall Street actually increased the size of the derivatives bubble by 30% since the U.S. housing-bubble first burst. Neil Barofsky, the U.S. “watch-dog” assigned to oversee the “TARP” bail-out of U.S. banks said just one month ago that the risk of collapse of the entire U.S. financial sector has increased not decreased.

Saif Barofsky:

“Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding road, but this time in a faster car.”

Thus, the probability of hyperinflation or a debt-implosion much worse that the Soviet Union continues to increase by the day for the U.S., while for the global economy as a whole, there is an even larger ticking-bomb of highly-leveraged debt.

In the immediate term, we must protect ourselves from the collapse of the U.S. economy – which is a certainty, only the manner of that collapse is yet to be determined. Longer term, the global derivatives bubble is the vehicle which will produce the same result which has occurred to every other currency not backed by gold throughout history: those currencies, our “money”, will become worthless.

Dilemma for investors:

There is no solution for the U.S.’s economic problems. With U.S. hyperinflation likely, but a deflationary collapse still possible, this not only creates a frightening scenario for us to face as individuals, but a serious dilemma for investors. This certainly applies to Canadian investors as well, since even though we aren’t facing the same, imminent bankruptcy issues faced by the U.S. economy, as the U.S.’s closest neighbour and largest trading-partner, any deflationary or hyperinflationary “shock-waves” created in the U.S. will undoubtedly create their own economic ‘echo’ in Canada.

So, do you prepare for deflation, or hyperinflation – or, is it possible to prepare for both? This defensive investment philosophy is called “wealth preservation”. This is why investors need a precious metals component in their portfolios, because for thousands of years, precious metals have been the best investment vehicle for wealth preservation.

Why is that?

For reasons which I have already explained, and additional reasons which I will explain in a few moments, today we should think of “wealth preservation” in terms of “money preservation” – which brings us to a more elementary question.

What is “money”?:

This is what separates precious metals from all other asset-classes: they are currencies which cannot be diluted through inflation or destroyed by imploding debt.

Good money possesses four qualities:

1)      Uniform

2)      Evenly divisible

3)      Rare or “precious”

4)      A  “store of value”

Uniformity simply means that any one unit of currency is identical to all others. In the case of gold and silver, any gold or silver coin is identical to all others. Conversely, gem-stones (which have been used as “money” in previous eras) are not of identical quality/composition, and thus gem-stones have not been able to stand the test of time as a form of money.

Being evenly divisible is self-explanatory. With gold and silver being very malleable, and having a low melting-point, these two metals have always been evenly divisible. In comparison, gem-stones (for example) are not capable of being equally divided.

Gold and silver are “rare” in that they are less-common than almost all other metals. They are “precious” because their aesthetic qualities are also superor to other metals. For example, silver has the greatest “brilliance” of any metal. Thus, gold and silver are precious and rare.

Conversely, while paper “money” is both uniform and evenly divisible, it is neither rare nor precious. The paper it is printed on has no intrinsic or aesthetic value, while paper money literally does “grow on trees”. This provides a very interesting perspective on the old saying that “money does not grow on trees”.

Ultimately, what is most important for any “good money” is that it must be a store of value. Indeed, it could be argued that the first, three characteristics simply explain why gold and silver are a “store of value”, while paper money is not. However, regardless of the physical characteristics of money, the true test for any “good money” is how well it retains the wealth of the holder.

Once again, there is no comparison between precious metals and paper currency. For hundreds of years, an ounce of gold has been sufficient to buy a fine, man’s suit. Meanwhile, in the less than 100 years that the Federal Reserve has existed, the U.S. dollar has lost approximately 97% of its purchasing power.

Some have also argued that good money must be “portable” and “durable”. However, living in an era where most commerce is conducted electronically, it is arguable that both of these latter considerations have become obsolete.

Why is it important to understand the properties of “good money”?

Contrary to the economic propaganda from the mainstream media, current events are unparallelled throughout all of history. More countries are carrying debts than at any time in history. The aggregate size of these debts are more than ten times greater than at any other time in history. And the whole world is off of a “gold standard” for the first time in history – meaning there is nothing “backing” all these mountains of debt.

Looking past the issue of U.S. insolvency, there is an even bigger bubble which threatens the survival of the entire, global monetary system: the $1 quadrillion derivatives-bubble.

This hopefully explains why every investor needs to protect their portfolios from the events to come. Now I’ll also endeavour to explain how precious metals provides precisely the protection which all investors need.

It is easy to explain why gold and silver are the ultimate forms of investor-protection for hyperinflation, since we have all heard about the hyperinflation in Zimbabwe (today) or historically, what occurred in Germany during the Weimar Reprublic – which led directly to both the “Great Depression” and World War II.

In hyperinflation, (paper) money rapidly becomes worthless, while precious metals retain all of their value. Indeed, the German people retain a very strong cultural attachment to silver, because even 80 years later, their society still remembers how Germans protected themselves from the worst ravages of hyperinflation by hoarding silver.

Gold and silver retain 100% of their value, while paper instruments go to zero.

It’s more complicated to explain how precious metals protect people from a deflationary collapse. Several factors must be considered.

1)      This is not like any other potential deflation in history (for the reasons previously mentioned), since we are not talking about a “recession” or even a “depression”, but entire nations effectively going bankrupt by defaulting on their massive debts.

2)      With none of the world’s currencies backed by anything, paper “money” is now essentially nothing but the unsecured “IOU’s” of the governments issuing those currencies.

3)      If/when these governments start defaulting, this implies that billions (trillions?) of dollars of government bonds would have very “questionable” value – if not becoming totally worthless

4)      If/when government bonds become worthless, then the paper currencies of those governments must also become worthless.

Think about this, as it is a very important concept.

If you are a government whose bonds have become worthless, this means you have no ability to borrow any money to fund government spending – thus you have no choice but to simply print unlimited (infinite) amounts of this un-backed paper. As mentioned earlier, these un-backed currencies are nothing but “unsecured IOU’s”.

Question: what is the value of an IOU from a debtor who has already defaulted on his debts?

Answer: zero.

Deflation vs. hyperinflation:

In both scenarios, paper currencies will go to zero. Where a deflationary implosion differs from hyperinflation is that in such an implosion, all asset-prices become severely depressed – which is why generally during deflations people move to cash. However, because that cash itself could easily become worthless, this is why you need to hold “good money” – and the only “good money” is gold and silver.

Thus in either a deflationary implosion  or a hyperinflation scenario, some (and perhaps all) paper currencies will go to zero. In contrast, during the nearly 5,000 years that gold and silver have been used as “money” by our species, they have never lost a significant portion of their value.

Summary:

1)      We live in a time of totally unprecedented economic events

2)      Much of the economic data being presented to us is (at best) misleading, and (at worst) intentionally deceitful

3)      We face the very real risk of hyperinflation and/or catastrophic debt implosions in a number of different countries, with the United States facing the greatest problems – and thus the greatest risks.

4)      In either a hyperinflation of debt-default scenario, paper assets (including paper “money”) stand the very real risk of going to zero.

5)      As the best, and only universally-accepted “money” our species has known in close to 5,000 years, gold and silver represent the ultimate “stores of value” – and thus the best protection from the events which lie ahead.

Thank you for listening.