Why It’s Worse Than You Think

Recently reader Bob Kraus wrote another comment to my blog which you can read here.

In essence, Bob is arguing that our policies regarding monetary inflation are to our benefit because we are trading the worthless commodity of paper for the very worthwhile commodity of (among other things) oil. Bob acknowledges that he we have “hosed” the rest of the world by perpetrating this sham but, as he puts it, “what else is new?” Bob also acknowledges that the American economy going forward “is going to be a very painful 3 or 4 years for most Americans.” Despite these acknowledgements, Bob remains a stalwart bull for the US economy because he feels that no other country is as innovative or works as hard as the United States. He feels certain that it will be the United States that innovates the next technology that will replace oil and that our manufacturing will return because the dollar has fallen so essentially the American consumer can not afford to buy imports anymore. 

Bob’s thoughts are not uncommon, so I wanted to address them here. Here’s the problem with Bob’s analysis. Currently the US government’s official debt is roughly $9.6 Trillion, but that doesn’t include the liabilities the government just took on with Fannie Mae and Freddie Mac (roughly another $5 Trillion) or the “unfunded” portions of Medicare (roughly $85.6 Trillion). If the US is to make good on its debt then the US is going to have to start seeing savings both on the government level as well as the consumer level, which would be a massive credit contraction over the next couple of decades. Basically we’d be seeing the opposite of what’s been happening over the last two decades where the US has gone deeper into debt. Now given that bull market projections for US stocks earning more going forward are assuming a continuation of the last twenty years, we’d be seeing a much lower level of earnings as the US consumer and government had to drastically rein in their spending. Furthermore, the holder’s of our foreign debt would actually have turn out to not be “hosed” because the dollars the debt would be paid for in a deflationary scenario would actually be worth more than they worth during the inflationary times. That’s assuming that the US actually choses to make good on its debt. 

Now what if it doesn’t? What if instead the US choses the easier path of just defaulting on its debt. Well in that case, I don’t see how gold would not be a far superior investment than the stock market. It’s tough to predict what would really happen were the US Dollar to be rendered worthless, but you could expect a great deal of societal chaos and upheaval as well as a flight of foreign capital from our shores. None of these things are particularly bullish for stocks. 

Regarding Bob’s longer term view of the US as being the best at innovation or working harder that most other nations, well I’d certainly like to hope so. I’m not nearly as confident as Bob is that the US is going to continue to be the source of all things economically good, but even if this is true, the fundamentals of the United States level of indebtedness are simply against any kind of scenario where stocks become strong investments over the next decade or so.

6 thoughts on “Why It’s Worse Than You Think”

  1. Hey Preston,

    I just read an article that suggested that due to the U.S. making a deal with OPEC to only accept the dollar back in the day that technically, the U.S. dollar is backed by oil…i.e. the OIL STANDARD. What’s your take on that theory?

  2. Yes, we hosed the world, but not by perpetrating a scam – it wasn’t our policy to manipulate currencies in an attempt to create unfair trade policy. We weren’t the ones who put price caps on foreign goods (think pharmaceuticals, for example – and the weak dollar has fixed that problem, hasn’t it). Europe and Japan (and now China) have a long history of manipulating the markets so that they could “get the best of us” in trade. As I said, they ended up with paper and we got the goods. Now that they’ve created this mess, they are stuck with it. If they try to cash in all those bonds at once, they will bleed badly. If you owned a large % of a public company and you tried to sell it all at once, what do you think would happen? By owning such a large piece of the US, they have a big stake and they don’t want us to lose. If we lose, they lose even more. That is the point you are missing.

    All your numbers sound very impressive (the $85 trillion is irrelevant, because the recipients of it are also the payers – if our economy is that strong in the future, then it won’t be a problem, but if it isn’t, the very people who will benefit from it will also have to foot the bill, and they might not be so eager to do so in that case). I remember when the national debt was only $1 trillion but at the time it sounded equally impressive, since the GDP was much lower and taxes collected were also much lower than now. How long ago was that, 20 years? And yet we still haven’t imploded.
    We are in a recession, and there is nothing novel about that. The “end of the world permabears” gloated during the last recession as well and I remember reading all kinds of comparisons to what was happening then and the great depression. But it didn’t materialize into the second great depression and the permabears were wrong again. That is the funny thing about permabears. My office mate is one, and I remember last year he said “the Dow is going below 12,000” and I agreed with him. Once it got there, he said “the Dow is going below 11,000”, and again, I said that is a distinct possibility. Once it got there, he said, “the Dow will go below 10,000” to which I said, “maybe, but I doubt it”. He has no bottom – the farther it goes, the farther he thinks it will go. That is the permabear mentality – there is never a bottom that satisfies a permabear except zero itself. Yet, you look at the max chart of the Dow, and it goes up, then rests, then up, then rests, then up, etc. Zero is a big reversal of the 80 year trend.
    Gold might be a good investment over the next few years, but it doesn’t have much intrinsic value. It isn’t going to solve the energy crisis or make us any more productive. It is a good defensive play, and nothing more.

  3. Dear Bob,

    Your comments are from the perspective of the last 30 years or so. Over that time frame, world governments have engaged in various forms of currency control. But before Nixon closed the gold window in 1971 that was not the case. Before then, all currencies were indirectly pegged to gold by way of the Bretton Woods agreement or the gold standard before that. This made for very stable exchange rates between countries. The United States did renege on it’s commitment to exchange dollars for gold in 1971, which was the very basis of how the dollar became the world’s reserve currency. That is what I mean when I say that the US has taken part in perpetrating a sham. It is cashing in on the dollars image of stability it gained back when it was backed by gold.

    In regards to your comment that we “still have not imploded” I would have to remind you that debtors do not spontaneously implode. As long as a debtor has lenders at the ready, he can carry on his merry way. It is only when the lenders stop lending and instead ask to be paid back that problems emerge. If the international community goes on lending to us as they have in the past, then we will continue to be fine and the permabull may once again ride high. But, this situation is novel in terms of world history. Never before has every world currency not had linking to precious metals. Yes, we bears are amazed it worked at all. “Why would anyone continue to take on our fiat dollars in exchange for real goods?” we ask. It just doesn’t make sense to us.

    From the perspective of world history, this situation can not continue indefinitely. A day of reckoning will come by which nations will, at the very minimum, demand an even exchange in terms of goods and services. I believe that that time is now and that that spells the end of the permabull.

    In regards to your comment about the Dow, I believe the Dow will continue to fall until it reaches a small multiple of the price of one ounce of gold. Say three or so. That would mean that if gold were trading at $900 an ounce, then the Dow would fall to 2700 or so. On the other hand, the Dow may remain at 10,000 and perhaps we will see gold rise to 3000 or so. Over the course of American history, these kinds of contractions are very common.

  4. Backing the global currencies with gold would be nothing more than symbolic. I think all the gold in the world is worth less than $5 trillion (the last time I figured it out it was only $2 trillion, but gold has gone up since then). The net “value” of the global economy is probably something like $200 trillion (I know some people say $60 trillion, but I think they are simply calculating the yearly gross global product – I know my economic value is a lot more than my yearly salary). Basically, if you were making $60 thousand a year and had an economic value of $200 thousand, backing our economy with gold would be equivalent to buying a $5 thousand dollar life insurance policy. That is what I was trying to explain. Gold has no real intrinsic value, and it is falling in price relative to all the things that DO have enormous intrinsic value (like oil). It used to make sense to back economies with gold because gold was the panacea of wealth. It is no longer much different than paper when compared to the value of everything else. That is why it makes more sense to back the dollar with the economy which is representative of those things that have great intrinsic value instead of something so disconnected like gold. That way, when you have countries like Japan or China that are trying to cheat us by manipulating the value of their or our currency, they end up getting pay back in the end. If our currency was somehow propped up artificially, we wouldn’t have the weak dollar forcing an equilibrium in trade.

  5. By the way, I’ve LONGED for the day that they would want American goods instead of our currency, but they just don’t. I hope you are right, because then we can force them to lift their unfair trade policies and allow us unfettered access to their markets. That is the only way they are getting American goods, but they don’t want that. They know that can’t compete with us on a level playing field, so they’d rather accept worthless paper for the competitive advantage it gives them. If you REALLY think about it, it is all the same thing. The more paper they take, the less it is worth and therefore the trades are leveled anyway.
    But, if they ever do allow us full access to their markets, I can tell you that the US stock market will be the place to have your money, because US industries will be making hand over fist money.

  6. Dear Bob,

    Gold does have intrinsic value. People want it. It’s pretty. Etc. The argument that you are now making is that there’s not enough gold in the world given the number of dollars in circulation. That is true, however that just goes to show how many dollars have been allowed to enter circulation after the gold standard was lifted. There is more than enough gold for it to serve as a medium of exchange, and that would limit how much currency was in circulation. It would also greatly limit a central banks ability to create money out of thin air as well as a government from consistently spending far more than it took in. You see, back in the days of the gold standard, our national debt was measured in millions of dollars. It did manage to work it’s way up to $16 billion after the introduction of the Federal Reserve, but those numbers are still nothing in comparison to what they are today.

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