Chapter 5: The Reckoning Will Come
The more extensive a man’s knowledge of what has been done, the greater will be his power of knowing what to do.
- Benjamin Disraeli
It would be helpful at this point to summarize the existing economic problems and examine possible solutions that are being discussed. By doing this, we can sum up the extent of the imminent danger. And from that point, we can move toward building strategies for defending against looming economic problems and building real wealth for you and your family.
Problem 1: The government is trying to be the private economy
This era of Keynesian economics will be characterized by large government spending to boost overall demand and keep the economy growing during a recessionary phase. The folly of this approach shall be written that the government, using fiat paper money, cannot create demand without creating corresponding debt that the people are required to pay back with interest. In addition, the government approach is less efficient than private markets because there is no corresponding balancing mechanism to ensure supply meets market demand, so the return on investment is not optimal for the price to be paid.
The government lacks the ability to service the market because their methods of measuring the market accumulate after the need has been at least partially satisfied by free market forces that act in real time. Government planners are always too late. Lastly, the cash and credit expansion that benefits the financial elite and is paid for by the unsuspecting public further reduces the tangible benefits of the additional spending and thereby shackles the public to the yoke of business and financial elites.
Problem 2: Talent is leaving the US
For several decades, the United States was able to import top talent from other countries. We had the best university system for some time, which served to attract some of the best minds. The opportunity provided by our robust economy kept much of that talent in the country, providing the US with a healthy return on its investment in the form of innovations in science, mathematics, and production techniques. Now, however, the talent is taking their education obtained from the top US universities back to their home countries as emerging markets offer more lucrative long term prospects.
A study conducted by researchers from Duke, Harvard, and Berkeley of 1200 foreign students who are currently studying in the US or graduated in 2008 showed that 58% of Indians, 54% of Chinese, and 40% of Europeans intended to stay in the US after graduation. National Science Foundation Studies have shown that 92% of Chinese and 85% of Indians with PhDs have traditionally stayed five years in the US.1 Therefore, there is reason for grave concern over the current rates of attrition of some of our top talent back to their homes.
Without top talent, the United States will find it harder to develop products and services to compete in world markets. For example, more than half of tech startups during the tech boom were started by foreign-born entrepreneurs. Twenty-five percent of our global patents are contributed by foreign students, and almost a quarter of the science and engineering workforce are foreign born.1
The NSF study also found that these top students felt that long term prospects were better in their home countries than in the US. In many cases, advanced degrees sharply increased the rate at which these graduates ascended to management positions in their home countries versus in the US. The majority of these students feel that the best days of the US are in the past and the best days for their home countries in emerging markets lay ahead.
How long will the US continue to subsidize the global workforce talent before we can no longer offer the best universities because the talent is emigrating overseas? The defection of talent, if it continues, will eventually bring other countries’ educational systems in line with ours.
Problem 3: Debt to GDP ratio is becoming unsustainable
According to an analysis by the IMF, when the cost to finance the debt outpaces the growth rate in GDP, a country is upside-down on its payments; it is consistently earning less and required to pay more. This is an unsustainable path.2
The cost to finance the debt depends on both Treasury ratings and also on perceptions of the purchasers in the market. When more perceived risk exists, as is currently the case with Greece, then the rates that must be given to purchasers on new debt dramatically rise. The relationship of risk and interest is not linear, meaning that as risk rises, purchasers require much higher interest return on their money to finance each additional dollar of debt.
In addition, the debt issuance must not be viewed as a ponzi scheme, where additional debt issuances are made by a country just for the purposes of paying the old ones off. Once the market determines that the country issuing the debt has no intention of paying it down with production (GDP), then the market will stop purchasing the debt issuances. There is too much risk of default on each subsequent issuance of debt that at any interest rate there will be fewer and fewer buyers of the debt. At that point, the debt issuance pyramid collapses.
Problem 4: Our creditor nations use our debt against us
China and Japan have been buying large amounts of our debt for quite some time. Because they hold so much debt, we have given them leverage to use against us politically and economically.
Luo Yuan, a researcher at the Academy of Military Sciences states that “our retaliation should not be restricted to merely military matters… For example, we could sanction using economic means, such as dumping some US government bonds.” 3
While China and the US have been locked into a mutually beneficial relationship for decades, where the US buys Chinese goods and the Chinese buy US bonds, that relationship is becoming more tense. Disagreements over the Yuan peg rate have been exacerbated due to the deteriorating economy. The US has called China a currency manipulator, claiming the Chinese have suppressed their currency, the Yuan, in order to keep exports cheap.4
This is the same policy the Chinese have used for years, but the difference now is that the US economy is floundering. The US needs the Chinese currency to appreciate so Chinese consumption will rise and make up some of the demand that has been lost due to the economic downturn. “China can increase purchases from (U.S.) states facing mass unemployment because of recession in the manufacturing sector,” said Li, a Harvard-trained economist. In addition, a stronger Yuan makes US exports more competitive. Both results of a rise in value of the Chinese currency will ease pressure on the US trade gap.
The Chinese are in a quandary. That is, the Chinese economy has been growing at double digit rates. But this growth is unsustainable and a huge asset bubble has formed. The Chinese added to this bubble by using a massive stimulus program in the wake of the global recession, which has propped up property values and led to excessive building and public works projects.
“As I see it, it is the greatest bubble in history with the most massive misallocation of wealth,” says James Rickards, former general counsel of hedge fund Long-Term Capital Management LP.5
The Chinese don’t want to raise the value of their currency too quickly. If they do and the local demand for their production has not increased enough, slumping exports resulting from a stronger Yuan will result in a slowdown in their economy. China’s middle class does not yet have the purchasing power to sustain the country’s economic production, and they need assistance from other countries like Japan, Australia, and the US to boost demand for their goods. Therefore, if China allows the Yuan to appreciate, they then are presented with a tough choice.
Once the Yuan rises and makes their goods more expensive, the Chinese will export less. To stimulate their economy, they can then increase already record stimulus level spending by the government, or they can face a steep recession when demand falls. Politically, it would be difficult to tell the Chinese public that the recent economic expansion was merely a mirage and that contraction must now happen. The Chinese, like the US politicos, are married to their current path of increasing government spending and controls, at least in the short term.
While the Chinese are putting themselves into a position in the future to let the Yuan exchange rate rise, they are not in that position today. Therefore, the US-China relationship will continue to be strained as the US continues to fight its trade balance issues with China. The question is not whether the economic relationship will degrade, but how quickly and whether there will be enough momentum to involve a military reaction.
The China Plan
In response to the current recession, China is preparing for a move away from US debt and currency holdings. While the US is threatened with downgraded ratings on their Treasuries, China is vigorously reducing their US debt and dollar holdings.
Perhaps this is why the Chinese are stockpiling commodities. While they are pumping up their own economy in the short run to avoid a massive economic collapse, the Chinese know that the chances of US default on debt and a potential mass currency printing scenario is all too real.
An article in the New York Times states that “at least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing.” 6
However, Chinese steel production has not recovered to pre-recession levels. “Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.”
China appears to be stockpiling commodities for the future as a hedge against paper currency and/or debt collapse. The Chinese are also not only stockpiling iron ore for steel. They are also stockpiling large quantities of many other metals, cooking oils, soybeans, and oil. These stockpiles go beyond the levels needed to replenish after an economic downturn.7 The purchases now would be considered bargain prices against a backdrop of shortages when global demand returns.
In addition, China is positioned with a valuable stock of real assets in the case the US dollar fails as the reserve currency and a new standard emerges. China sees this as the best way to exchange their devaluing stock of dollars for assets with a tangible value that will appreciate as the dollar weakens. In addition, if the US dollar fails, a new currency standard may emerge to take the dollar’s position. The Bancor, suggested by John Maynard Keynes during the Bretton Woods conference in 1944, is modeled after thirty popular commodities of which China will own vast quantities. This implies that China would be able to influence, with their reserves, the value of the Bancor in international markets by being able to buy or sell those commodities, should the Bancor or similar currency standard take hold.
China’s current strategy stops the Yuan from rising without direct manipulation of currency (because they are not changing the current peg), exchanges devaluing US paper assets for assets that will rise in value over time as a true investment, and mitigates the risk of exposure given a commodity supply crisis in the future when economic demand rebounds.
Problem 5: US liable for Everyone Else’s Economy
As we have seen, the United States’ problems are not limited to what we find in the United States. Greece recently threatened to default on their debts. As a member of the Euro nations, their defaults would have seriously damaged the Euro currency for all member nations. Greece’s dire economic situation forced other member nations, specifically Germany, to offer support to further Greek debt issuances, which allowed Greece to pay its bills. However, Germany did not want to front the entire cost of bailing out Greece, so they turned to the IMF for assistance. The IMF is currently considering a plan to guarantee 1/3 of the new loans to Greece.8
How do loan guarantees impact US citizens? The IMF is a global bank, whereby the United States provides a substantial amount of the funding to this bank. Therefore, the US is at risk if Greece is again unable to pay down their debts. Given the current economic climate and the track record of Greece’s financial issues, a turnaround of sufficient size to raise revenues to pay for current Greek debt is very unlikely. Therefore, the United States may be asked to eventually make good on its promises to guarantee Greek debt by paying the debt holders themselves through the IMF.
Greece is not the only damaged European economy. Portugal, Spain, and Italy all face similar fiscal problems. Any of these countries is a risk to the Euro and therefore a risk to the United States through the IMF.
The United States government may have already assisted in bailing out European banks. The US Treasury overpaid for AIG preferred stock to the tune of $30 billon dollars. Taxpayers paid $43.2 billion, but only received $13.2 billion in stock in return. This overpayment was said to support AIG and the Federal Reserve who gave AIG a $60 billion line of credit, but in the process, made several of AIG’s credit default swap (CDS) counter-parties whole on their losses. These other parties include Societe Generale with exposure of $16.5 billion, Deutsche Bank with $8.5 billion, and UBS at $3.8 billion.9
Problem 6: The US Government takes ownership of industry
Our government has nationalized three major industries.
As problems mounted during the recession in 2008, the United States seized control of Fannie Mae and Freddie Mac.10 Fannie and FHA purchase most of the loans available in the market, therefore the US effectively nationalized the mortgage market. Considering the US ownership in several banking companies, the government owns a sizable portion of the financial sector. When you also consider that insurance programs like the FDIC and the Federal Reserve Bank, as lender of last resort and essentially bail out firms who take excessive risk, it becomes clear that the US Government is at risk for a large portion, if not most, of the risk found in the financial sector. Who bails out our government when they take on this excessive risk? The working people do through taxes, debt, and inflation.
In addition, the US bailout of the big three automakers – GM, Chrysler, and Ford – ensured the US people would own and be liable for the fates of the American auto industry. The initial bailouts totaled $24.3 billion in January 2009 and have led to government ownership of and intervention in the large US autos market.11
The US government, at the time of this writing, has passed a national healthcare plan as an expansion of the existing Medicare and social security plans. Retirement and healthcare are now government run enterprises.
The United States has traditionally taken a “small government” approach to the regulation of the large industries. However, recent administrations have increasingly taken on a more active role in struggling areas of the economy. This is now only a fuzzy distinction between government assistance and government takeover. Questions remain as to how this approach will define the relationship between a gorging government with vastly increasing payrolls and labor forces and the interests of private industry in our country. As these industries slowly recover, will government’s role be forever changed? Is America headed down the path of socialization of industry by economic bureaucrats who believe they can pull the levers more effectively at the state levels? It is likely that the unprecedented level of involvement of the US government in private industry will become the norm during challenging economic times.
This begs the question: Where are the demonstrations against our government’s policies now? It appears as though the American people are acquiescing to the government in exchange for “security.” What the people do not realize, however, is that the current spending patterns indicate an economic collapse, not a secure future.
Problem 7: Balance of Trade is Upside Down
The US cannot be competitive with foreign countries in exports. We simply do not have the cheap labor pools that other countries can draw from. Therefore, Americans purchase products from overseas and send our dollars to our overseas trading partners The dollars in large part come back into the US as investment in assets or debt issuances. This has forced our asset markets into inflated bubbles that will pop. This has also greatly increased the public debt that our nation will have to pay back.
We cannot get out of this situation without increasing exports and balancing the trade gap. That requires lower costs, mainly a cheaper labor pool. Because developing nations have vast worker resources and lack enough demand for all of their labor, emerging market labor costs over the long term will fall further.12 The result is that our labor rates must fall relative to other nations for an economic recovery to occur. Therefore, look for lower US wage rates in the future as the US struggles to balance the trade gap that is damaging our economy.
In addition, asset prices will come down; the value of stocks will fall, as will real estate. This must occur when fewer of our dollars move overseas and are put into the hands of other nations who in turn buy our assets and debt. Whether asset contraction results in a massive bubble pop, or a long series of smaller declines, is not yet known. But economic retractions must occur for the US economy to balance and heal. There is no other way. We have been living too long on easy credit and this era must end for the United States economy to remain solvent.