Thoughts from the Frontline

By: John Mauldin | Sat, Jun 7, 2003
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Today we have a guest writer for Thoughts From the Frontline, as I am in Puerto Vallarta sipping margaritas by the beach. I asked my friend, Porter Stansberry, to give us his take on the recent (and very important) study which shows the US government is $44 trillion dollars in debt. I think you will like his easy reading style, even if the analysis is sobering. Then, to end on an upbeat note, I asked him to give you a free link to a recent study by David Lashmet, one of his analysts from the Pirate Investor, on new cancer treatment breakthroughs just announced last week at an industry meeting. We have all lost friends to cancer. There is real hope we may lose fewer in the near future. Now let's read Porter's thoughts:


The Bankruptcy of America
by Porter Stansberry

"There's nothing unprecedented about interest rates beginning with the numbers 1,2 or 3. They were the rule rather than the exception in the days of the gold standard. But, as far as I know, no rates such as those quoted today ever appeared in a monetary system unballasted by gold or silver."
-- James Grant, Forbes 6/9/2003

America is bankrupt.

This from Jagadeesh Gokhale and Kent Smetters.

No, these men are not a Saudi terrorist or Southern right wing extremist respectively. Instead the former is the Senior Economic Advisor to the Federal Reserve Bank of Cleveland, and the latter is a full professor at the Wharton School of the University of Pennsylvania.

Credentials notwithstanding, the men's conclusion would seem preposterous. America has never seemed more prosperous. Even this recession has been minor.

On the other hand, their source seems reliable: Gokhale and Smetters got their data from the U.S. Department of Treasury. And they performed their present value calculations on the order of then Secretary of the Treasury Paul O'Neill. Smetters was, until recently, on staff there, as the Deputy Assistant Secretary for Economic Policy. The Treasury needed new numbers because the Office of Management and Budget's numbers have almost no connection to reality. (For example, OMB projects a constant 75-year average lifespan in its Social Security and Medicare cost estimates even though the average lifespan in America is already 78...and increasing at the rate of three months every year.)

When you look honestly at our government's future obligations, the numbers in the red quickly become so large they require entirely new measures to describe them. Gokhale and Smetters invent the term "financial imbalance," to measure Uncle Sam's impending bankruptcy. Financial imbalance means: "current federal debt held by the public plus the present value of all future federal non-interest spending minus the present value of all future federal receipts."

Or, in other words, Gokhale and Smetters use FI (financial imbalance) to estimate how broke Uncle Sam is when measured in constant dollars, today. FI is how much Uncle Sam owes now and will garner in the future versus how much he is on the hook for now and later.

And the number?
" Taking present values as of fiscal-year-end 2002 and interpreting the policies in the federal budget for fiscal year 2004 as current policies, the federal government's total fiscal imbalance is equal to $44.2 trillion."

Huge numbers like $44.2 trillion don't mean much to anyone without a comparison. So, consider: Uncle Sam's "financial imbalance" is 10 times the size of our current national debt.

In order to achieve current solvency, the government would have to raise payroll taxes by 68.5%, beginning today. Alternatively the government could cut Social Security and non-Medicare outlays by 54.8% immediately and forever. (How do you think either policy would go over at the polls?)

It's unlikely that either huge tax hikes or huge Social Security cuts will occur. Most likely nothing will happen. And so, the government's insolvency will grow much larger. By 2008 FI will reach $54 trillion. To reach solvency at that point, taxes would have to increase by 73.7%.

Looking at the government's finances in a serious way is like expecting a Ponzi scheme operator's numbers to add up. They don't. And they never will; that's the game. Making political promises is easier than paying for them. Theoretically these debts could be inflated away by printing more dollars. But legally this would require the repeal of the 1972 Social Security Act, which pegs benefits to inflation.

And that will not be a simple matter.

Worse, these financial imbalances stem from direct wealth redistribution, from one generation to the next. They're a disincentive for saving and investment. They hinder current growth today while bankrupting America tomorrow. But politically they're sacred cows.

Ironically, the people most threatened by this hydra-headed financial and political monster are the very same people these programs were designed to benefit: the middle class.

Your typical 50-year old, middle class American isn't prepared to retire without a lot of help. In fact, most baby boomers will never even pay off their mortgages. Lawrence Capital Management notes in the last 19 quarters total mortgage debt increased by $3 trillion (+58%). To put this in perspective, prior to 1997, it took 13 years to add $3 trillion in mortgage debt. Or, said another way, before 1997, around $50 billion a quarter was being borrowed against homes. Today the run rate is near $200 billion per quarter, or four times more. Household borrowings now total $8.2 trillion in America and they continue to grow at near double-digit rates.

And it's not just mortgage debt that's problematic...

According to the Federal Reserve Bank of St. Louis, US household consumer debt is up more than 12% from last year. Debt service, as a percentage of disposable income, is above 14%. Only twice in the last 25 years has debt service taken as large a chunk of America's income -- and that's despite the lowest interest rates in fifty years.

When you look at these numbers you quickly see the problems our favorite weekly scribe, John Mauldin, hopes we can "muddle" through: The government is making promises it can't keep without bankrupting the nation; the individual American has made promises to his bank he can't keep without bankrupting his family. And we haven't even looked at the biggest borrowers yet - corporations.

Corporate America has been on a borrowing binge for most of the last 25 years. Even the very best companies are now loaded up with debt. GE, for example, has been a net borrower since 1992.

And IBM borrowed $20 billion during the 1990s, while at the same time buying back $9 billion worth of its stock on the open market. Why would you take on expensive debt while buying back even more expensive stock? It made the income statement look good, converting debt to earnings per share. And that made Lou Gerstner's bank account look good, because he got paid in options whose value was influenced by earnings growth. Meanwhile the balance sheet was covered in the concrete of debt.

Then there's Ford - one of America's greatest companies. Debt on the balance sheet is now 24 times equity.

Lower interests rates aren't necessarily helping, either.

Yes, firms can restructure debts and improve earnings thanks to lower interest expenses. But these lower interest rates are also keeping companies that should be bankrupt, alive. Consider Juniper Networks, which shows a cumulative net loss of $37 million after ten years in business. Despite having over $1 billion in debt, Juniper was able to close a $350 million convertible bond deal that pays no interest coupon two weeks ago. The company is borrowing $350 million dollars until 2008 for free. Bankers say similar deals are closing at the rate of two a day.

Why? Because investors once burned by stocks are now plowing into bonds. Through April of this year, investors sank $53.7 billion into bond funds, compared to only $4.5 billion into stock funds.

The money isn't going into new capital investment. Instead, this "free" money is paying off more expensive, older loans. Corporate America is repairing its balance sheet. The ratio of long-term debt to total liabilities now stands at 68.2%, the highest level since 1959, according to economist Richard Berner of Morgan Stanley. And cash is staying put: corporate liquidity (current assets minus current liabilities) is at its highest level since the mid-1960s. The combination of cash and extended debts is easing the credit crunch. Bond yield spreads have narrowed between investment grade bonds and government treasuries, from 260 basis points in October 2002 to only 108 basis points currently.

You can also see this new debt isn't creating new demand by looking at capacity utilization. If businesses were spending again, capacity utilization would be up. It's not. Across the board in our economy, capacity utilization has fallen from around 85-90% in 1985 to below 75% today, according to the Board of Governors of the Federal Reserve System. The data makes sense: areas of our economy that had the biggest investment boom show the biggest decline in capacity utilization today. Capacity utilization in electronics, for example, has declined from 90% in 1999 to under 65% today.

In the long term, debt restructuring does absolutely nothing to improve America's economic fundamentals. Lower interest rates aren't spurring new investment or new demand. More debt only postpones the day of reckoning. Thus, the current bond market mania is just the corporate version of the consumer's home equity loans: We're buying today what we couldn't afford yesterday...

Where are the Profits?
What we need are genuine profits. But there aren't many real profits in the leading companies of the baby boom generation, the generation that's approaching retirement with a bankrupt social net and no net savings.

Consider Adobe Systems, a leading software firm, headed by a baby boomer (Bruce Chizen, CEO, was born in 1956). Sales are rebounding. Earnings are up. But profits genuinely available to shareholders have all but disappeared.

In the last five years, Adobe's net income has grown from $105.1 million to over $191 million. But stock based compensation in the same period grew from $50 million a year to over $184 million a year. Taking into account options expenses, net income shrunk from $54 million to only $6 million. Adobe, a firm valued by Wall Street for $7 billion can only produce $6 million in genuine net income.

Without profits, an entire generation of Americans will see their retirement savings wiped out. Moving into bonds instead of stocks will not save anyone - interest payments must come from corporate profits. Even with zero coupon loans, principle must be repaid.

And there are still bigger threats to corporate profitability.

As was reported this week in the Wall Street Journal, New Jersey State Senator Shirley Turner, upset that a firm hired by New Jersey would use cheap Indian call-center workers, introduced a bill requiring state contractors to use U.S.-based employees. As a result, New Jersey wound up paying 22% more for the $4.1 million contract -- $100,000 per job it saved. Politicians in five states - New Jersey, Connecticut, Maryland, Missouri and Washington - are now partnering with the AFL-CIO to craft new laws against using cheaper offshore workers for service sector jobs like accounting, programming and customer service.

The goal, of course, is to prevent service sector jobs from leaving the country, like we lost manufacturing jobs. And as with Social Security financing, the politicians believe they can simply legislate economic reality. They won't save jobs, but they will force more investment capital away from America and make American professional service firms less competitive.

Meanwhile, new FASB guidelines regarding stock options -- rules meant to encourage genuine profitability -- are in danger of being stymied by Congress. Congressman David Dreier (R, California) and Congresswoman Anna Eshoo (D, California) have written new legislation that would impose a three-year ban on the new rules. The FASB wants to force companies to count options grants against earnings, where excessive executive compensation would impact the bottomline (as it should). Unfortunately, super-rich technology executives, who have fed at the stock option trough for ten years are the main factor in California political fund raising.

Legislation like these two recent items and the never-ending stream of consumer protection laws, environmental laws, SEC regulations etc., will all combine to dampen any lasting economic growth and to discourage entrepreneurial risk taking.

It's more to muddle through. All of which is reason to doubt corporate profitability will rebound substantially before corporate debts, home loans and America's retirement crunch begins in 2010.

And I haven't even mentioned the problems lower interest rates are causing for insurance companies (annuities) and life insurance companies...

So...what will happen? What's the financial endgame? What are the consequences of America's bankruptcy...?

Inflation and the Fall of the Dollar
Like John, I'm sure we'll find a way to muddle through. In the end - even if there's more deflation in the short term - our government will end up monetizing its debts. Greenspan and others at the Fed have already mentioned they're prepared to buy large amounts of long-dated Treasury bonds. Retiring Treasury obligations with dollars the Fed prints will cause a weaker dollar. That means, sooner or later, inflation will be back -- and in a big way.

This is the real endgame, as I see it. Let me explain.

One of the smartest and best investors I've ever met, Chris Weber, says we're entering the third dollar bear market. And if there's anyone worth listening to when it comes to the currency, it's Chris Weber. Starting with the money he made on a Phoenix, Arizona paper route in the early 1970s, Chris built a $10 million fortune, primarily through currency investing. He has never had any other job. When I met him seven years ago he was living on Palm Beach. Now he resides in Monaco. I saw him two weeks ago in Amelia Island, Florida.

According to Chris, the first dollar bear market began in 1971. It ended when gold peaked out at $850 an ounce in 1980. This inflation helped ease the debts the U.S. incurred fighting the Vietnam War while wasting billions on the "war on poverty."

The second dollar bear market began after the Plaza Accord in 1985. This inflation helped pay for Reagan's tax cuts and the final build-up of the Cold War. (You should remember the impact the falling dollar had on stocks. They collapsed in 1987 on a Monday following comments over the weekend by Treasury Secretary Baker who said the dollar could continue to weaken.)

And Chris thinks this - the third dollar bear market - will be much worse than the last two. This time the falling dollar might lead to the end of the dollar as the world's only reserve currency. He's not the only one who thinks so. Doug Casey sees this happening too. And I believe it's not an unlikely outcome.

Why? Because the imbalances inside the U.S. economy have never been this large, nor has our current account deficit ever been this big and never before has the United States been more dependent on foreigners for oil.

This possible move away from the dollar as the primary reserve currency for the world is high-lighted by a recent comment from Dennis Gartman (The Gartman Letter):

"At what has been promoted as "The Executives' Meeting of East Asia-Pacific Central Banks" (The EMEAP), those attending took the preliminary steps toward creating an Asian bond market fund to be managed by the central bank's central banker, the Bank for International Settlements (The BIS). According to the Nihon Keizai and The Japan Daily Digest, the EMEAP is a co-operative of eleven regional central banks and it intends to create a fund with contributions from its member banks and to use the money to invest in dollar denominated government debt... initially. Then from our perspective, the fun begins. Given that the idea works in practice, the fund will proceed to increase its size and to start buying debt denominated in local currencies, moving away from the US dollar. The idea according to the Nikkei is to give the Asian central banks a place to invest the dollars their economies generate in something other than U.S. Treasuries. The intention is ultimately to keep the foreign currencies that these economies generate available in the region for investment. They are apparently weary of washing these earnings back into the US dollar, and that weariness has become all the more emphatic in light of Mr. Snow's ill-advised comments over several weeks ago. President Bush's comments over the weekend might have assuaged those concerns somewhat, but they are still looking above for other avenues of investment. Were we in their shoes, certainly we'd be doing the same. The EMEAP's member central banks include Australia, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore and Thailand. Other's may join, making the effect even more material. Snow's comments created a veritable blizzard effect."

If this happen, it will accelerate the drop of the dollar predicted by both John and myself for some time.

For investors, while we muddle through this mess, it will pay to remember: America is bankrupt. Another big inflation is coming. And that's bad for equity investors. From 1968 through 1981 the Dow lost 75% of its value, in real terms.

What should you do? Imagine the 1970s, but on an even bigger scale. Doug Casey says fair value for gold right now is $700 an ounce. And he expects it to go to $3,000. It's hard for me to imagine that he's right. But then I look at my fellow American's finances, at Uncle Sam's balance sheet and the mockery corporate America has made of accounting standards...and suddenly gold looks pretty good.

Dr. Sjuggerud compiled this list of the annual returns of various asset classes from 1968 to 1981, during the last major collapse in the dollar:

Chances are pretty good that you don't have a big position in these assets (with the exception of housing). It might be time to consider moving some of your savings out of stocks and bonds and into things more attuned to the declining value of the dollar.

We'll muddle through...the way we always do.

Your filling-in-for-my-friend analyst,

Porter Stansberry

Editor's note: Porter Stansberry is the founder of Pirate Investor, a publisher of independent financial newsletters. Pirate Investor titles include: Porter Stansberry's Investment Advisory, Steve Sjuggerud's True Wealth, Extreme Value and Diligence, a small cap research service for high net worth investors.

Here is the link I promised you on the cancer treatment e-letter:
http://www.pirateinvestor.com/BiotechBlast.html

Your can't wait to get on the plane analyst,


 

John Mauldin

Author: John Mauldin

John Mauldin
Frontlinethoughts.com

John Mauldin

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