Monday, March 22, 2010
Government Versus Private Debt
A recent Bloomberg article highlights how some highly respected corporations are paying a lower interest rate than the U.S. Government for short term debt. This is an interesting and rather unusual phenomenon for the United States. This implies that investors believe "top tier, safe" corporations like Berkshire Hathaway and Procter and Gamble are less likely to default than the U.S. Government!
Since the U.S. Government has the ability to get more cash by creating it out of thin air with the help of their central banksta friends at the non-federal, for-profit, unconstitutional federal reserve, this is saying a lot. I don't know if this trend will persist or not. A bout of fear would most likely flip this relationship back to normal with the government rate being lower than any corporation. If not, we're in bigger trouble than I thought.
But this article brings up an interesting point and gets to the heart of matter when it comes to the inflation-deflation debate. For the core issue is not issuance of money or debt. It is, plain and simple, confidence. If the U.S. Government can maintain the confidence of the world, our depression will be deflationary. If they cannot, then it will be highly inflationary.
In other words, if people turn to the public sector for "safety" with investment money, then they invest in short-term government debt. This is the usual occurrence during an economic depression and is the expected outcome in most secular credit contractions. This is what has happened in Japan over the last 2 decades. Japan has stimulated itself more than a subway frotteurist at rush hour and yet one can hardly conclude that Japan has experienced heavy inflation over the past 2 decades despite all the money/debt printing there. The Japanese people, who are savers, have retained confidence in their government and purchased government bonds hand over fist. Thus, interest rates have remained low despite the oversupply of government bonds and quantitative easing ad nauseam.
Will we in America be able to save enough money and will we retain enough confidence to help support our government's policies? If we can and do, then most interest rates will remain low and most asset prices will continue to fall (i.e. the "symptoms" of deflation). If we can't or don't, in aggregate, then most interest rates and asset prices will increase (i.e. the symptoms of inflation) in our future. Though this is, of course, a bit of an oversimplification, it is more important than any economic equation. We are simply animals engaging in herding behavior, after all.
If people lose confidence in the government in aggregate, they will turn to the private sector for safety and will avoid short-term government debt and even the currency itself. This leads to aggressive inflation or even hyperinflation. I don't see hyperinflation happening any time soon in the U.S., but aggressive inflation could. The U.S. is no more of a basket case than Europe or Japan. If the top three economic blocks of the world are all in the same dire straights, there is no reason for the U.S. to face hyperinflation - that's not how it works! Currency event - yes, hyperinflation - no. Think heavily indebted European countries in the 1930s, not Zimbabwe.
The inflation-deflation debate is really largely one of confidence during an economic depression. So where does Gold fall in this spectrum? Well, it is essentially a hedge. The reasons I think Gold is going to continue to work as this secular depression grinds on are simple.
First, Gold is not backed by debt and is real money. Debt is suspect during a secular credit contraction because most debts can't be paid back and are defaulted on. Don't be fooled by the paperbugs who say Gold can't be used to buy a loaf of bread, so it's not money. T-Bills can't be used to buy bread either, but they are a cash equivalent like Gold. However, Gold doesn't require anyone to "make good" on their debt promises.
Second, Gold cannot be debased by apparatchik decree. Sure, it can be taxed or confiscated, but that assumes someone who buys physical Gold is going to admit they still own it when the government oversteps its rights. Gold goes into hiding when governments get out of hand, all the while retaining its value until a more reasonable regime comes into power. Never forget the end game of an economic depression unresponsive to standard monetary policy/insanity: hit the reset button. What does this mean? It means change the rules of the monetary system. Just like in the 1930s (when Gold was confiscated and re-pegged at a different rate to the U.S. Dollar while all of Europe abandoned the Gold standard completely) and in the 1970s (when the U.S. Dollar broke its final link to Gold), a currency "event" can jump start the economy and get things moving again during a depression. This is by no means hyperinflationary, but it is inflationary. The timing and method are the only issues if we get another hard leg or two down.
Third, Gold has proven to rise in value relative to other asset classes during previous economic depressions. In other words, the "real" price of Gold increases irrespective of the nominal price. Now, the last economic depression in the 1930s is hard to use to demonstrate this concept because the Gold price was fixed by law. So, let's take a journey back to the 1870s, which was called the Great Depression long before the 1930s hit (chart stolen from thechartstore.com):
Gold miners often outperform the Gold price in secular credit contractions because Gold miner margins rise with the "real" Gold price and they are one of the few sectors in an economy that can experience increased margins and increased demand during a depression. It's Gold miners' reward for re-liquefying an insolvent banking system. Now I know that this hasn't happened yet (i.e. miners have lagged the Gold price), but we are still very early into this economic depression and it ain't over until it's over. For those who don't want to take the risks of owning Gold miners, Gold will continue to rise in value relative to real estate, stocks, corporate bonds and government bonds. It has so far trounced the U.S. Dollar handily and I don't think that will change any time soon.
This relative value concept is hard for newer investors to grasp. If what you own as an investment simply treads water and everything else collapses in price, you have made substantial gains because you will still have money left over to buy these other assets for pennies on the dollar! This is what the Dow to Gold ratio is all about and why even paper debt-based cash is a decent investment during most depressions. If Gold stays at $1100/oz and the Dow Jones drops to 3,000, then you roughly tripled your wealth in stock terms (assuming you are willing to sell your Gold in order to buy stocks at that point). Understanding this concept means you don't have to worry about "missing" the move to Dow 15,000 if it occurs, as it implies a much higher Gold price and the percentage gain in Gold to get to its ultimate secular highs in this scenario will be multiples of 100% while the Dow would gain less than 50% to get to 15,000 from current levels.
These are longer term themes to emphasize the safety of Gold during a protracted secular bear market and secular credit contraction. The pendulum of history ain't done swinging back towards Gold - not by a long shot. I patiently await the next breakout in Gold and Gold stocks, which I continue to believe is imminent and I continue to believe will occur regardless of what the general stock market does. Not that I'm enjoying the wait...