Debt Illusion!

By: David Chapman | Fri, Sep 26, 2003
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We live in a world of illusion. With all due respect to magicians, illusionists and Hollywood techno wizardry our biggest illusion seems to be debt and its eventual impact. Here are some interesting numbers. To the end of the second quarter 2003 US GDP rose $417 billion from $10,376.8 billion to $10,793.8 billion or 4% from the second quarter 2002 (all numbers from the most recent Federal Reserve Flow of Funds Accounts of the United States). Debt, however, grew in the same period from $19,941.3 billion to $21,597 billion for a rise of $1,655.7 billion (8.3%). A ratio of 4:1 of Debt: GDP.

But even the GDP numbers were an illusion as are many other numbers that are reported on a regular basis. In a fascinating article by Jim Puplava of Financial Sense ( (The OK' (but fictional) Economy - September 12, 2003) he outlined numerous other areas of illusion.

With GDP he pointed out how defence spending made up over 55% of GDP growth in the 2nd quarter 2003 an item driven by the Gulf War II and not likely to be sustained; how business spending was overstated by $32.1 billion in the same quarter; how the debt numbers that are reported on the Federal Reserve Flow of Funds above are understated as they do not include unfunded liabilities such as Medicare, Social Security, Medicaid and Pensions; and, how unemployment is consistently underreported as it ignores those that have given up looking, not on unemployment insurance, those that don't apply for benefits or whose UI has expired. The real unemployment rate in the US is probably closer to 10% or higher which would actually make it higher than here in Canada that does count many of those categories not reported in the US.

And the illusion extends beyond the numbers reported by the Government. Corporations continue to report earnings based on pro forma rather than the GAAP earnings that would be at least 40% lower. There is also a large gap between what is reported on annual reports and to the public versus what is reported for tax purposes. This illusion feeds into the stock market where the story of increasing earnings is being bought.

The US now has triple deficits of budget, trade and current account (for us Canadians we currently have surpluses in the big three). The budget deficit is estimated to be $525 billion in the upcoming year. That requires $1.4 billion a day to finance. Similarly the trade and which is also nearing $500 billion requires similar flows daily to finance. And these flows are dependent on foreigners supplying the funds. As well there is a growing and worrisome current account deficit telling us that US savings are now substantially lower than investment in the US including investments by foreigners.

The US has managed to maintain flows as many countries especially in Asia are concerned about the value of their currency and as a result they have recycled the US dollars obtained through exports back into purchasing US debt Securities. It is estimated that foreigners have over $0% of the US debt and of that Asians countries hold an estimated $1.3 trillion of debt. At one time the US was a significant world creditor but now they have become the world's largest debtor. The total debt to GDP ratio based on the Flow of Funds is now over 2:1 and when the unfunded liabilities are taken into consideration it is over 3:1. Federal Government debt similarly is 36% of GDP based on reported numbers in the Flow of Funds but with the unfunded liabilities is 63% of GDP.

But if the government debt is considered a problem then all should be alarmed about consumer debt and the lack of consumer savings. The consumer makes up roughly 75% of the economy. But consumer debt has been rising at an alarming rate. Over the past year the biggest debt growth was in mortgage loans borrowed on the basis of rising house equity. Mortgage loans grew by 13.6% or $774 billion from the 2nd quarter 2002 to the 2nd quarter 2003. Consumer debt by comparison grew only 3.4 % or $65 billion in the same period.

Mortgage debt now represents over 45% of household real estate. This is up from 43% at the end of the 2nd quarter 2002. While this does not seem too bad it of course under represents many that job erosion and rising long term interest rates that will dampen the housing market. Recent numbers would seem to indicate that the housing market is cooling. Couple this with a low to non existent savings rate and any rise in the jobless coupled with a fall in the real estate market is courting a potential disaster.

Numerous pundits have declared that the debt is not a problem. That as long as the economy grows and the Federal Reserve remains prepared to supply endless liquidity the debt can be serviced. But we have noted that the Kondratieff winter cycle is all about cleansing the debt. That was certainly the case in the 1930's. But the 1930's was also a lot about trade wars that helped exacerbate the debt situation contributing to the collapse.

Today the trade wars are taking the form of currency wars. The long overvalued US Dollar has been falling since a final top in February 2002. Recent rallies only brought it back to key resistance levels. The attack is being led by the US who have been losing manufacturing jobs at a rapid pace throughout the 1990's. The jobs have largely migrated to the Asian economies particularly China. While the US would like to see a lower dollar to help their beleaguered trade and current account deficits the Asian economies want to maintain their competitive export advantage. As we noted above in order to help keep some restraint on their currencies from rising they have been buying US securities.

In the US it is estimated that upwards of 2.7 million manufacturing jobs have been lost in the last three years. This is causing great consternation in the halls of the senate and congress where wails of searching for a scapegoat get louder. Japan served as one in the past and today it is China. The recent Cancun Accord or, how some have dubbed it, the Dubai accord as it had its beginnings in earlier meetings in Dubai is designed to get try and get the Chinese to float their currency and the Japanese to strengthen theirs.

But wishful thinking is not sufficient to change what is a good thing for China but bad for the US. Nor is necessarily good as the huge imbalances of huge deficits in the US coupled with huge holdings of US securities in the hands of Asians particularly China and Japan and others has the potential to cause even more global currency instability. There have also been threats of tariffs and other measures if they do not cooperate. The recent Cancun trade talks collapsed because of the failure to come to agreements over tariffs. Even the esteemed Economist in their recent issue September 20th - 26th 2003 expressed alarm at the potential growing instability.

In a world where the world's largest economy lives in denial as their wealth sits not on a solid rock base but instead is supported by the shifting sands (quicksand?) of a mountain of debt illusion and their currency is backed by nothing but empty platitudes and is in a clear downtrend, foreigners who hold a substantial asset base can only become increasingly alarmed at the attempts to devalue their holdings. For years this scenario has been playing itself out usually unnoticed by most although occasionally as we saw in the 1998 Asian currency crisis it rears its ugly head with the potential for a financial earthquake.

The fact that it hasn't happened yet is no reason for complacency or even to suggest that it won't happen. It is for these reasons why we remain convinced, amongst others, that ultimately as the world has been forced to in the past when fiat currencies failed that a real asset, gold, will return to some prominence in the world's financial system to once again provide stability.


David Chapman

Author: David Chapman
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