Last week, US Treasury secretary Henry Paulson and Federal Reserve chairman Ben
Bernanke faced congressional leaders with a reported forecast that we are
"literally days away from a complete meltdown of our financial system".
Apparently, the politicians were stunned into a long silence.
If citizens across the country could glimpse the horror seen by the congressmen
(of which we have long warned), then widespread panic would truly be the order
of the day. In particular, people will be shocked to see how Paulson’s
seemingly vast request to congress for some $1 trillion is utterly dwarfed by
the likely problem.
Of course, Paulson does not want to scare congress. So he has offered them his
own version of a teaser mortgage rate of just $1 trillion. The true figure will
only kick in later, like one of the
adjustable rate mortgages that tempted millions of optimistic home buyers. Once
congress is locked in to a "blank check", the funds will keep rolling until the
presses run dry!
To put the problem into perspective, let’s just consider some base statistics.
The publicly issued debt of the Unites States was, until very recently, a
massive $5.3 trillion. The total debt, including non-public IOU’s and unfunded
obligations including social security and Medicare, is now a staggering $50
trillion! The total annual wealth generation, or GDP of America, is some $14
trillion.
Contrast those figures with the current debt problem ascribed to the reckless
pursuit of predatory lending. Incidentally, predatory lending was made illegal
in most states until overridden by President George W Bush to protect Wall
Street profit opportunities.
The US mortgage holdings are some $14.8 trillion, including some $3 trillion of
commercial mortgages. Local government debt is about $3 trillion. But, even
these gigantic figures pale in comparison beside the $20.4 trillion of consumer
and corporate debt. Therefore, the total of non-federal government debt is in
the region of $38 trillion!
Of course, not all of it will default. All things being equal, possibly only a
small proportion will fail, at least initially. But today, all things are not
equal. We know that we are heading into a recession. This means that increasing
amounts of debts will default.
The main problem is that predatory lending incurs a high default rate. So if
only 10% of outstanding loans default, the government will have to raise some
$4 trillion, or more than five times what Congress is being asked. It will
increase the US government public debt by some 80%.
This will threaten the triple-A credit rating of US government debt. It will
also crowd out corporations and entrepreneurs from crucial debt funding.
Finally, it will put upward pressure on interest rates at precisely the time
when lower rates are called for to avoid recession slipping into depression.
If the economy moves into a severe recession and then depression, default rates
will explode. These, in turn, will cause stock markets to implode, as they did
in 1929. In addition, the US dollar is likely to plummet, driving up the trade
deficit in the longer term. Considering these factors, many of which the
government prefers to hide, things look bad - very bad.
It does not take a rocket scientist to see that we face a very serious
situation and that the $1 trillion Paulson rescue plan, although well
intentioned, is far too small and too late to avoid disaster. So what should
investors do?
An old maxim is that, gold makes sense when nothing else makes sense. Today,
not much does make sense. Gold is likely to explode, at least in the initial
stages of panic. In a recession, cash becomes a king. In a depression, gold is
an emperor.
In the current panic, many investors are jumping on US Treasury bonds as a
perceived life raft. But teetering on the shaky foundation of US dollars,
T-bonds are a trap to be avoided. As the US dollar is likely to erode fast, the
sovereign debt of countries with strong currencies, such as Swiss francs, are
attractive, even with a negative yield.
In these precarious times, think return of capital, not return on capital.
John Browne
is senior market strategist, Euro Pacific
Capital. Euro Pacific Capital commentary
and market news is available at
http://www.europac.net/">. It has a free on-line investment
newsletter.
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