Debt Deal is a Blank Check

By Peter Schiff

By supposedly compromising to raise the debt ceiling, Congress and the President have now paved the way for ever higher levels of federal spending. Although, the nation was spared the trauma of borrowing restrictions, the actual risk of default existed solely in the minds of Washington politicians. But the real crisis is not, nor has it ever been, the debt ceiling. The crisis is the debt itself. Economic Armageddon would not have resulted from failure to raise the ceiling, but it will come because we succeeded in raising it. This outcome falls along the lines that I had forecast (See my commentary, “Don’t Be Fooled by Political Posturing” from July 9th).

Both parties are now pretending that the promised cuts in spending outweigh the increase in the debt limit. But the $900 billion in identified cuts are spread over a decade and are skewed toward the end of that period. There are an additional $1.4 trillion in cuts that the plan assumes will be identified by a bi-partisan budget committee. But similarly empowered panels in the past have almost never delivered on their mandates.

Debt Ceiling Myths

Michael Pento’s Market Commentary

The debt ceiling debate that has dominated the headlines over the past month has been thoroughly infused with a string of unfortunate misconceptions and a number of blatant deceptions. As a result, the entire process has been mostly hot air. While a recitation of all the errors would be better attempted by a novelist rather than a weekly columnist, I’ll offer my short list.

After having failed utterly to warn investors of the dangers associated with the toxic debt of entities like Enron, Fannie Mae, Freddie Mac, and AIG, as well as the perils of investing in mortgage-backed securities and sovereign debt of various bankrupt countries, the credit ratings agencies (CRAs) have now apparently decided to be more vigilant. Hence, many have offered conspicuous warnings that they may lower U.S. debt ratings if Washington fails to make progress on its fiscal imbalances. But then, just in case anyone was getting the impression that these rating agencies actually cared about fiscal prudence, Moody’s suggested this week that its concerns would be lessened if Washington were to make a deal on the debt. The agency has even suggested that America’s credit could be further improved if Washington would simply eliminate the statutory debt limit altogether. In other words, Moody’s believes that our nation’s problems are more a function of squabbling politicians rather than a chronic, unresolved problem of borrowing more than we can ever hope to repay.

With or without a deal, the CRAs should have already lowered their debt ratings on the $14.3 trillion of U.S. debt. In fact the rating should be lowered again if the debt ceiling IS raised. And it should be lowered still further if we eliminated the debt ceiling altogether. To lower the rating because the limit is NOT raised is like cutting the FICO score of a homeless person because he is denied a home equity loan.

Republicans are making a different misconception about the debt ceiling debate in their belief that they can dramatically cut government spending without pushing down GDP growth in the short term. In a recent poll from Pew Research Center for the People and the Press showed 53% of G.O.P. and 65% of Tea Party members said there would be no economic crisis resulting from not raising the debt ceiling.

They argue that leaving money in the private sector is better for an economy than sending the money to Washington to be spent by government. That much is undoubtedly true. But a very large portion of current government spending does not come from taxing or borrowing, but from printed money courtesy of the Fed. If the Fed stops printing, inflation and consumption are sure to fall. While this is certainly necessary in the long run, it will be nevertheless devastating for the economic data in the near term.

Over the last decade and a half our economy has floated up on a succession of asset bubbles, all made possible by the Fed. Our central bank lowers borrowing costs far below market levels. Commercial banks then expand the money supply by making goofy loans to the government or to the private sector. As a consequence, debt levels and asset values soar and soon become unsustainable. Ultimately, the Fed and commercial banks cut off the monetary spigot, either by their own volition or because the demand for money plummets. The economy is forced to deleverage and consumers are forced to sell assets and pay down debt. Recession ensues. That’s exactly what could happen if $1.5 trillion worth of austerity suddenly crashes into the economy come August 2nd. Although they don’t seem to realize it, this will create huge political problems for Republicans.

And then there is the deception coming from Democrats who argue that we need to raise taxes in order to balance our budget. This is simply not possible. The American economy currently produces nearly $15 trillion in GDP per annum but has $115 trillion in unfunded liabilities. With a hole like that, no amount of taxes could balance the budget. Raising revenue from the 14% of GDP, as it is today, to the 20% it was in 2000 would barely make a dent toward funding our Social Security and Medicare liabilities. Therefore, we need to cut entitlement spending dramatically. But the Democrats refuse to face the obvious facts.

With the Tea Party gaining traction in Congress, and causing nightmares for incumbents, Republicans have little incentive to raise the debt ceiling (although they raised it 7 times under George W. Bush). Democrats aren’t going to reduce entitlements without raising taxes on “the rich” and Republicans aren’t going to raise taxes when the unemployment rate is 9.2%. There’s your stalemate and anyone expecting a significant deal to cut more than $4 trillion in spending by the August 2nd deadline will be severely disappointed. Although there has been some movement by the so-called “Gang of Six” centrist senators in recent days, a substantive deal may be more unlikely than most people think. And even if a much smaller deal can be reached in time, the credit rating agencies may follow through on their promise to downgrade our sovereign debt. The fallout could be devastating to money market and pension funds that must hold AAA paper. But an even worse outcome will occur when the real debt downgrade comes from our foreign creditors, when they no longer believe the U.S. has the ability to pay our bills.

In my opinion, the best news for the long term future of this nation is the Republican “Cut, Cap and Balance” plan that just passed the House. It now heads to a much harder hurdle in the Democrat controlled Senate, and if it passes that, to a certain veto from President Obama. At least something so promising got to the table at all. However, I think the country needs some more tastes of brutal reality before such bitter medicine has a chance of going down.

It Ain’t Money If I Can’t Print It!

By Peter Schiff

I have been forecasting with near certainty that QE2 would not be the end of the Fed’s money-printing program. My suspicions were confirmed in both the Fed minutes on Tuesday and Fed Chairman Ben Bernanke’s semi-annual testimony to Congress yesterday. The former laid out the conditions upon which a new round of inflation would be launched, and the latter re-emphasized – in case anyone still doubted – that Mr. Bernanke has no regard for the principles of a sound currency.

Don’t Be Fooled by Political Posturing

By Peter Schiff

As attention focuses intently on the negotiations to raise the debt ceiling, House Republicans have made a great show of drawing a line in the fiscal sand. They claim that they will not vote for any deal that includes tax increases to narrow the budget deficit. But we all know how the game works in Washington. With the 2012 elections looming the Republican bluster is merely a bargaining chip that they will quickly toss into the pot when they sense a political victory. In fact there are signs that such a compromise is already underway.

The Psychology of Bond Investors

Michael Pento’s Market Commentary

Those who take issue with the outlook of Austrian economists in general, and Euro Pacific Capital in particular, have pointed to the persistence of low bond yields as proof that our philosophy does not hold water. We argue that as the United States takes on ever more debt and prints greater quantities of dollars, that buyers of our debt will demand higher rates of interest to compensate for greater risk. In fact, our philosophy leads us to believe that rates would currently be spiking as Washington debates whether to raise the debt ceiling yet again or default on existing debt. Instead, rates are hitting close to multi-year lows. As a result, our critics have found a seemingly valid issue. However, we believe that there are strong market reasons that are holding rates low for now that do not invalidate our central thesis.

Looked at objectively, there are a litany of reasons why rates should be much higher than they are. Official government data from the Labor Department has year over year consumer inflation rising at 3.4%. With the Ten year note offering a paltry 3.1%, negative real interest rates now extend out over a decade! At the same time, total non-financial debt as a percentage of GDP is at the highest level on record and in our view there are no credible projections that show the trend reversing anytime soon. In addition, with the end of quantitative easing, the Federal Reserve will apparently no longer be soaking up 75% of all new Treasury issuance. Given this, does it make sense that yields on Ten Year Treasuries are trading 60% lower than their 40-year average? Forget the flowers, where have all the global bond vigilantes gone?

But, what makes these low yields on U.S. debt even more unfathomable is the current debate over raising the debt ceiling. If a deal to lower the trajectory of debt isn’t reached by August 2nd, we are being told that America could enter into default. But you wouldn’t know it from looking at the bond market. It seems that everyone is convinced the U.S. will never renege on her obligations and that the Democrats and Republicans will come to an agreement with time to spare.

Peter Schiff subscribes to this logic. He believes the bond market is pricing in an increase in the debt ceiling that temporarily lays to rest any fears of default. As a result, he believes that traders are buying bonds now so they can sell into the “positive” news that will result from a debt deal in Washington. However, Peter believes, as I do, that an increase in the debt ceiling is actually very negative for bonds. That means that after the dust settles he expects interest rates to rise dramatically. But that won’t stop the traders from booking a quick profit.

However, I believe there is little to support the belief that a deal will be made. Republicans have very little incentive to agree on a deal that includes tax hikes, which are an essential prerequisite for Democrats to assent to dramatic spending cuts. The Republicans want spending cuts without any tax increases and that’s exactly what they will get if the August 2nd deadline comes and goes. In fact, the Republicans will force a severe dose of austerity upon the American economy, which could be a double-win for the GOP. They may simultaneously balance the budget without increasing revenue and engender a recession that will force the current party out of the White House.

I believe that bond investors may be hedging their bets. If an agreement is not reached there will be a huge reduction in borrowed money that is printed by the Fed. The result will be a severe reduction in the money supply. This forced deleveraging will bring about a needed round of dramatic deflation like we experienced in the fall of 2008. From my perspective that is the best justification for the current low yields on U.S. debt. Maybe the bond market has it right after all; but reasons completely contrary to those offered by market bulls who see low yields as a sign that all is well on the economic front.

Peter and I may differ on the current psychology of bond investors, but we do believe that once the economy slows in earnest once again, the authorities will not hesitate to reignite the monetary madness thereby punishing bond investors with weaker dollars.

The Rise Of The Barter Economy

By Peter Schiff

Imagine a day when you go to buy a quart of milk, ask the price, and the cashier says, “that’ll be a tenth ounce silver.” As the US dollar’s decline accelerates, several efforts around the country are trying to make this vision a reality.

Historically, paying for items in silver or gold was actually quite common. We happen to live in an unusual time and place where generations have grown up trading exclusively in paper. While my parents still used dimes made of silver, we have now gone several decades with no precious metals in any of our official coinage. But this system of money by government fiat is unsustainable.

While the practice of bartering precious metals directly for goods and services has continued on a small-scale over the last few decades, the 2000s saw the beginning of organized efforts to revive gold and silver as money.

The Extinction of Retirement

Michael Pento’s Market Commentary

For the better part of a century the foundations for a semi-comfortable retirement for many Americans have rested on the financial pillars of rising real estate and equity prices, positive real interest rates on savings, the continued solvency of public and private pension plans, and the reliability of national entitlement programs (Social Security, Medicaid). But in the last few years, the economic sands have fundamentally shifted and these pillars are no longer sturdy, some have cracked completely. For many Americans, the traditional idea of a comfortable retirement, filled with golf carts, cruises, and fishing trips, is going the way of the dodo bird.

Over the last decade incomes and job growth have stagnated, causing savings rates to drop. According to Jim Quinn author of the Burning Platform, 60% of retirees have less than $50,000 in savings. Such sums won’t last very long, especially when consumer prices are up 3.6%, import prices are up 12.5% and commodity prices are up 35% year over year. What’s worse, any savings placed in a bank will pay next to zero interest and will likely not even pay for the fees associated with the account. With cash savings essentially non-existent, the other pillars of income take on paramount importance. But these former bastions of financial security are being washed away by a torrent of red ink.

For years the essential Ponzi-like structures of Social Security and Medicare were concealed behind positive demographics. But once taxes collected from current payers fall short of the required distribution owed to current recipients, the ruse will be laid bare. That day is now in the foreseeable future. With insolvency a real and present danger, at least a consensus is now forming that Social Security must be structurally altered if it is to survive.

According to the Social Security Administration, in 2008, Social Security provided 50% of all income for 64% of recipients and 90% of all income for 34% of all beneficiaries. With these numbers, it’s not hard to see how even small cuts will spark big protests. Now try cutting the $20 trillion prescription drug program and the $79 trillion Medicare entitlements and watch the political sparks fly! However, given the realities, it’s hard to see how the program can escape deep cuts.

In the past many retirees could count on accumulated stock market wealth to help fund retirement. Not so much anymore. As of this writing, the S&P 500 is now no higher than it was in January of 1999. For over 12 years the major averages have gone nowhere in nominal terms and have declined significantly in real (inflation adjusted) terms. The dreams of becoming rich from investments have crashed along with Pets.com and Bernie Madoff. Then there is always the supposedly safest asset of all—a retiree’s home.

Despite a misguided faith that real estate prices could never fall, they have done just that…with a vengeance. According to S&P/Case-Shiller, the National Home Price Index has declined some 30% to levels not seen since the middle of 2002. And prices are still falling, with the rate of decline accelerating. The National Index dropped 4.2% in Q1 of 2011, after dropping 3.6% during Q4 2010. This means that only those retirees who have owned their homes for at least 10 years have any hope of selling at a profit. Ownership of significantly longer periods may be needed to have built up significant equity.

That leaves public and private pension plans. But here again there are serious issues. Let’s just look at state public pension shortfalls. According to the American Enterprise Institute for Public Policy Research, “States report that their public-employee pensions are underfunded by a total of $438 billion, but a more accurate accounting demonstrates that they are actually underfunded by over $3 trillion. The accounting methods that states currently use to measure their liabilities assumes plans can earn high investment returns without risk.” Huge returns without risk? Bond yields are the lowest they have been in nearly a century! What world are these states living in? With few options, the states will undoubtedly look to the Federal government (taxpayers) for a bailout. Failing that, cuts are inevitable.

The sad facts are; Americans are broke, the real estate market is still in secular decline, stock prices are in a decade’s long morass, real incomes are falling, public pension plans are insolvent and our entitlement programs are structurally unsound. If the pillars that seniors have relied on in the past fail to miraculously regenerate (and there is certainly no reason to believe they will), all that most retirees will have will be freshly printed greenbacks that come from a never ending policy of federal deficits and an obliging Federal Reserve. Unfortunately, the inflation that will result from such a policy will sap most of the purchasing power that those notes possess. In other words, for most people retirement is now an illusion, and many Americans will find themselves working far longer, for far less real compensation, then they ever imagined. The quicker we realize this, and plan accordingly, the better off we will be.

Central Bankruptcy – Why QE3 is Inevitable

Michael Pento’s Market Commentary

As the U.S. economy seemingly limps out of the Great Recession most analysts now assume that the Federal Reserve will soon join the tide of other central banks and bring an end to the current era of unprecedented monetary expansion. Markets expect that Fed will begin withdrawing liquidity this summer, not too long after this latest round of the quantitative easing comes to an end. But this is simply a delusion.

There are many political and economic reasons why the Fed will find it extremely difficult to absorb the liquidity that it has relentlessly pumped into the economy since the beginning of the financial crisis. But its biggest problem may be that the ammunition it carries on its balance sheet is insufficient to the task.

In order to withdraw liquidity the Fed must sell most, if not all, of the assets on its balance sheet. The questions are: what types of assets will it sell, how fast will they sell them, who will buy, and what price will the market bear?

In December 2007, before the Great Recession began the Fed had an equity ratio of around 6% on a balance sheet that totaled approximately $900 billion. The assets it held at that time were almost exclusively comprised of short term Treasury debt. This had been the norm for the vast majority of Fed history. Given the size of the Treasury market and the bankability of its short term debt, the value of such a portfolio was considered virtually bulletproof.

But beginning in late 2008, as financial institutions careened towards insolvency, the alphabet soup of Fed lending facilities (TAF, TSLF, PDCF and the CPFF just to name a few) bought all kinds of assets that the Fed never before held. Through quantitative easing efforts alone, Ben Bernanke has added $1.8 trillion of longer term GSE debt and Mortgage Backed Securities (MBS). (In fact, the Fed now holds more of these mortgage instruments than their entire balance sheet before the crash.) This has drastically changed the complexion of the assets it must now sell.

But as the size of the Fed’s balance sheet ballooned, the dollar amount of capital held at the Fed has remained fairly constant. Today, the Fed has $52.5 billion of capital backing a $2.7 trillion balance sheet. While the size of the portfolio expanded three fold (and the quality of its assets diminished), the Fed’s equity ratio plunged from 6% to just 2%. Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30 to 1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51 to 1! If the value of their portfolio were to fall by just 2% the Fed itself would be wiped out.

The Fed acknowledged this insolvency risk on January 6th when it modified its accounting rules to ensure that it never technically runs out of capital. In a system that would make Enron jealous, the new gimmickry allows Fed losses to be booked directly as Treasury liabilities. In other words, just throw it on the deficit pile with the rest of the Federal red ink. But fictional solvency has nothing to do with its ability to successfully withdraw liquidity.

What will happen to the value of the Fed’s mortgage assets if rising inflation causes the Fed to sell in haste back to the primary dealers? In an environment of rising interest rates (that such a tightening pre-supposes) the value of the assets should fall. And, given the continued deterioration of the real estate market, there may be a weak market for low yielding mortgage debt.

If these financial institutions were forced to pay par for the Fed’s mortgage assets, Bernanke would destroy a great deal of their capital and a new breed of zombie banks would re-emerge. There is certainly no political will in the United States to force the financial industry further into the public sector. If the assets are sold at the fair market price (which will likely be far below what the Fed paid), Bernanke would burn through his balance sheet before all of the prior Fed liquidity injections were neutralized.

Recently some Fed officials announced that they will likely raise interest rates before they sell assets. The truth is that without the ability to fully withdraw prior liquidity the Fed is incapable of significantly raising interest rates. After all, the Fed can’t raise rates by fiat. It must sell assets to do so. Similarly, to support the dollar it must take money out of circulation, which is also accomplished by asset sales.

But the Fed’s arsenal is no longer stocked with high grade weaponry. Given what is has on hand, the Fed will be unable to raise interest rates and support the currency. In essence, they have become impotent in removing the inflation they have so diligently created.

In the end, any meaningful attempt to withdraw liquidity will not only bankrupt the institution but also zero out their remaining credibility. That’s why they’ll never even make an honest attempt.